Demand Deposit Contracts Research Articles

Demand Deposit Contracts and Probability of Bank Runs in Nigeria

The problem of bank runs is a global phenomenon and often damaging to the banking systems both in developed and developing countries. Monetary authorities always find it very difficult to resolve such a crisis; hence, it became imperative to examine this scenario in the case of Nigeria. Therefore, we examined the effect of demand deposit contracts on the probability of bank runs in Nigeria. This is considered a major contribution to the literature on finance from the perspective of an emerging market economy (EME). In this study, a multilevel Tobit regression approach was employed. This study identified statistically significant and positive effects of liquid assets (total assets) and total loans (total deposits) on bank runs in Nigeria. Based on the results, the study concluded that bank-specific factors have an effect on bank runs, and from these variables, liquid assets/total assets and total loans/total deposits have significant effects on bank runs. As a sequel to the findings and conclusion of this study, it was recommended that to avoid such a banking crisis, there is a need for deposit money banks in Nigeria to maintain adequate liquid assets and ameliorate the high level of deterioration in the quality of risk assets as well as the cost of funds.

A SCRUTINY OF THE DEMAND DEPOSIT (CURRENT ACCOUNT) THROUGH THE LENSES OF LAW AND ISLAMIC JURISPRUDENCE

Demand deposits (current accounts) are crucial to banks activity, particularly with regards to granting loans. For commercial banks, the primary source of funds is bank deposits. This article attempts to analyze and discuss the legal nature of the demand deposit contract, with a particular focus on the widely agreed upon characterization of this contract as a loan contract in all today’s legal systems (Common law, Civil law, Islamic law and hybrid legal systems). After discussing the arguments and building blocks of the loan theory and examining the essence of both contracts through the lenses of economics, law and Islamic jurisprudence, this paper concludes that the demand deposit contract cannot be considered a loan contract, with supporting arguments from economic, legal and Islamic jurisprudential perspectives.

Demand deposit contracts and bank runs with present biased preferences

This paper extends the Diamond–Dybvig model of bank runs by incorporating hyperbolic discounting. The main question is how consumers’ myopic decisions affect the possibility of a bank run and the bank’s optimal contract. Under hyperbolic discounting, consumers’ deposit preferences differ from their withdrawal preferences. Therefore, the bank needs to consider two separate preferences when designing the optimal banking contract, making it more difficult to design a run-safe banking contract. This difference in preferences could increase the possibility of a bank run in equilibrium. Although the bank can design a run-proof contract, the ex-ante welfare through banking services will be lower under hyperbolic discounting due to its tighter incentive compatibility constraint.

The role of information disclosure in financial intermediation with investment risk

We study how information disclosure affects financial intermediation when the payoff to the long-term investment is risky. The analysis is based on a business-cycle version of the bank run model wherein a bank provides risk sharing to demand depositors who experience unobservable shocks to their liquidity preferences. The bank pre-commits to the precision of an interim signal regarding the payoff to the long-term investment. We examine the impact of bank disclosure on optimal risk sharing achieved by run-proof, signal-contingent demand-deposit contracts. We show that for utility functions that display non-increasing absolute risk aversion, more informative disclosure improves the ex ante risk sharing provided by financial intermediation.

Optimal Forbearance of Bank Resolution

We analyze optimal strategic delay of bank resolution ('grq forbearance') and deposit insurance coverage. After bad news on the bank's assets, depositors fear for the uninsured part of their deposit and withdraw while the regulator observes withdrawals and needs to decide when to intervene. Optimal policy maximizes the joint value of the demand deposit contract and the insurance fund to avoid inefficient risk-shifting towards the fund while also preventing inefficient runs. Under low insurance coverage, the optimal intervention policy is never to intervene (laissez-faire). Optimal deposit insurance coverage is always interior. The paper sheds light on the differences between the U.S. and the European Monetary Union concerning their bank resolution policies.

Optimal Forbearance of Bank Resolution

We analyze optimal strategic delay of bank resolution ('grq forbearance') and deposit insurance coverage. After bad news on the bank's assets, depositors fear for the uninsured part of their deposit and withdraw while the regulator observes withdrawals and needs to decide when to intervene. Optimal policy maximizes the joint value of the demand deposit contract and the insurance fund to avoid inefficient risk-shifting towards the fund while also preventing inefficient runs. Under low insurance coverage, the optimal intervention policy is never to intervene (laissez-faire). Optimal deposit insurance coverage is always interior. The paper sheds light on the differences between the U.S. and the European Monetary Union concerning their bank resolution policies.

The Effect of Safe Assets on Financial Fragility in a Bank-Run Model

Risk-averse investors induce competitive intermediaries to hold safe assets, thereby lowering the probability of a run and reducing financial fragility. We revisit Goldstein and Pauzner (2005), who obtain a unique equilibrium in the banking model of Diamond and Dybvig (1983) by introducing risky investment and noisy private signals. We show that, in the optimal demand-deposit contract subject to sequential service, banks hold safe assets to insure investors against investment risk. Consequently, fewer investors withdraw prematurely, which reduces the probability of a bank run. Safe asset holdings increase investor welfare and may increase the bank’s provision of liquidity.

Banking in a Matching Model of Money and Capital

We introduce banks in a model of money and capital with trading frictions. Banks offer demand deposit contracts and hold primary assets to maximize depositors’ utility. If banks’ operating costs are small, banks reallocate liquidity eliminating idle balances and improving the allocation. At moderate costs, idle balances are reduced but not eliminated. At larger costs, banks are redundant. A central bank policy of paying interest on bank reserves can reverse inflation’s distortionary effects, and increase welfare, but only when costs are small. The threshold levels of banks’ costs increase with inflation, suggesting inflation and banks’ utilization are positively associated.

Money Market Funds, Bank Runs and the First Mover Advantage

Several recent reports from regulatory bodies have recommended that money market funds should be required to move from stable to variable net asset valuation pricing, to reduce the risk of first-mover advantage and the risk of a run on the fund. Most money market fund sponsors doubt that this proposal will reduce either run risk or first-mover advantage. Thirty years of academic research on bank runs has concluded that the best protections against bank runs are retail deposit insurance or the suspension of convertibility. There are no arguments within the academic literature in favour of changing the terms of the demand deposit contract, from stable to variable value: it is quite remarkable that the preferred solution for MMFs is one without precedent in banking regulation. Money market funds are different from banks in four fundamental respects. These differences concern their legal form but also, importantly, their economic function. Money market funds do not engage in fractional reserve banking and they do not perform liquidity creation. Money market funds, like other capital markets products, are vulnerable to the unanticipated actions of investors during periods of market distress. At such moments there is a risk that money market funds might contribute to the amplification of systemic risk. In a period of heightened systemic risk, the ability of money market funds to suspend the standard terms under which shareholders are able to redeem fund units for cash, is the mechanism most likely to eradicate the possibility of a first mover advantage and thereby to reduce the risk of a run. In the absence of a credible deposit insurance policy for the money market fund industry, suspension of convertibility should be the preferred option: for regulators, for fund sponsors and for investors.

Demand Deposits, Loan Loss Provision, and Risk Sharing

We study how information disclosure affects financial intermediation when the payoff to the long-term investment is risky. The analysis is based on a business-cycle version of the bank run model wherein a bank provides risk sharing to demand depositors who experience unobservable shocks to their liquidity preferences. The bank pre-commits to the precision of an interim signal regarding the payoff to the long-term investment. We examine the impact of bank disclosure on optimal risk sharing achieved by run-proof, signal-contingent demand-deposit contracts. We show that for utility functions that display non-increasing absolute risk aversion, more informative disclosure improves the ex ante risk sharing provided by financial intermediation.

Banking in a Matching Model of Money and Capital

We introduce banks in a model of money and capital with trading frictions. Banks offer demand deposit contracts and hold primary assets to maximize depositors’ utility. If banks’ operating costs are small, banks reallocate liquidity eliminating idle balances and improving the allocation. At moderate costs, idle balances are reduced but not eliminated. At larger costs, banks are redundant. A central bank policy of paying interest on bank reserves can reverse inflation's distortionary effects, and increase welfare, but only when costs are small. The threshold levels of banks’ costs increase with inflation, suggesting inflation and banks’ utilization are positively associated.

NOISY SUNSPOTS AND BANK RUNS

In the existing literature, panic-based bank runs are triggered by a commonly acknowledged and observed sunspot signal. There are only two equilibrium realizations resulting from the commonly observed sunspot signal: Everyone runs or no one runs. I consider a more general and more realistic situation in which consumers observe noisy private sunspot signals. If the noise in the signals is sufficiently small, there exists a proper correlated equilibrium for some demand deposit contracts. A full bank run, a partial bank run (in which some consumers panic whereas others do not), or no bank run occurs, depending on the realization of the sunspot signals. If the probabilities of runs are small, the optimal demand deposit contract tolerates full and partial bank runs.

Assessing the Likelihood of Panic-Based Bank Runs

Conditional on the considered equilibrium, the probability of a bank run in the demand-deposit contract models of Bryant (1980) and of Diamond and Dybvig (1983) is either one or zero. In contrast, we establish the existence of an interval - being a strict subset of the unit-interval - of possible bank run probabilities for a two-player demand-deposit contract model where players receive independent signals about their liquidity desire from a continuous type space. As our main result we demonstrate that this interval reduces to a unique probability of a panic-based bank strictly smaller than one if and only if there exist types for which not running on the bank is a dominant action. In addition to existing models of bank runs such as, e.g., Goldstein and Pauzner (2005), our approach also provides some assessment of the likelihood of a bank run if there are no types for which not running on the bank is a dominant action. As a consequence, we can investigate the comparative statics of the likelihood of bank runs with respect to a larger range of payoff parameters than considered in previous models. Furthermore, we derive a technical result by which the findings of Morris and Shin (2005) on the dominance-solvability of binary action games with strategic complements also apply to nice games in the sense of Moulin (1984) if players' best response functions are increasing.

Bank Runs Without Self-fulfilling Prophecies

This paper proposes that bank runs are unique equilibrium outcomes instead of self-fulfilling prophecies. By assuming that depositors make their withdrawal decisions sequentially, the model provides an equilibrium-selection mechanism in the economy. A bank run would occur if and only if depositors perceive a low return on bank assets. Furthermore, a panic situation arises only when the market information is imperfect. A two-stage variant of the model shows that banks would deliberately offer a demand-deposit contract that is susceptive to bank runs.

Demand–Deposit Contracts and the Probability of Bank Runs

ABSTRACTDiamond and Dybvig (1983) show that while demand–deposit contracts let banks provide liquidity, they expose them to panic‐based bank runs. However, their model does not provide tools to derive the probability of the bank‐run equilibrium, and thus cannot determine whether banks increase welfare overall. We study a modified model in which the fundamentals determine which equilibrium occurs. This lets us compute the ex ante probability of panic‐based bank runs and relate it to the contract. We find conditions under which banks increase welfare overall and construct a demand–deposit contract that trades off the benefits from liquidity against the costs of runs.

Monnaie, banque et capital

Dans ce papier, nous développons une nouvelle interprétation du modèle de Diamond-Dybvig [1983] qui conduit à un nouveau concept de monnaie. Nous définissons la monnaie comme un portefeuille composé d’un zéro-coupon et d’une option de vente de ce zéro-coupon à la banque. Détenir un contrat de dépôt à vue est équivalent à détenir ce portefeuille. Nous montrons ensuite que pour endogénéiser la monnaie, la banque doit avoir suffisamment de capital.

Demand Deposit Contracts and The Probability of Bank Runs

We study a model of bank runs based on Diamond and Dybvig [1983]. We assume that agents do not have common knowledge regarding the fundamentals of the economy, but rather receive slightly noisy signals. The new model has a unique equilibrium in which the fundamentals determine whether a bank run will occur. This lets us compute the ex-ante probability of a bank run and relate it to the parameters of the demand deposit contract. We find that offering a higher return to agents who demand early withdrawal makes the bank more vulnerable to runs. We construct an optimal demand deposit contract that trades off the benefits from risk sharing against the costs of bank runs. Under this contract, there is a positive probability of panic-based bank runs. Nevertheless, it improves welfare relative to the autarkic regime. Finally, being able to make welfare computations, we assess the desirability of regimes that are intended to prevent bank runs: suspension of convertibility and deposit insurance.

Bank Runs, Deposit Insurance, and Liquidity

This article develops a model which shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.

The optimal capital structure of a liquidity‐insuring bank

This paper deals with the question of the optimal capital structure for a banking firm. It considers a competitive bank as an insurer of unpredictable liquidity demanded by depositors in the sense described by Diamond and Dybvig. The model developed in this paper is able to explain the stylized facts. It considers three key features of a bank: first, the demand deposit contract allows the depositor to run the bank if he believes that the bank’s solvency is insufficient. Secondly, four financial states of the shareholders’ wealth are considered explicitly. Thirdly, the maximization of the shareholders’ expected utility of pay-offs is constrained by the (weakest) condition that the expected yield on equity exceeds the risk-free rate of interest (the ‘yield-on-equity constraint’). In the frameworkof our model, the unconstrained optima as considered in the existing banking literature imply, first, a high equity-to-debt ratio in the order of magnitude of 0.88 to 1 as well as a loan-to-cash ratio of one. Secondly, the bank is not exposed to any risk at all: it stays both solvent and liquid. When the ‘yield-on-equity constraint’ is taken into account, the constrained optimum may not be contained in the set of unconstrained optima if, for instance, the interest rate differential is small or if the volatility of changes in deposits is large. Such a constrained optimum implies, first, a low equity-to-debt ratio in the order of magnitude of 0.04 as well as a loan-to-cash ratio of one. Secondly, the bank is now exposed to the risk of an insolvency or an illiquidity.

Banking, incentive constraints, and demand deposit contracts with nonlinear returns

This paper presents two results regarding banking theory: (1) demand deposit contracts are essential in providing insurance against preferences shocks, as in Diamond and Dybvig (1983), if and only if the incentive compatibility conditions bind at the social optimum; and (2) for additively separable preferences with random discount factors, demand deposit contracts have the realistic feature that the interest rate paid is an increasing function of deposit balance.