Disciplines

Finance and Financial Management

Abstract

We survey the theories on why banks promise to pay par on demand and examine evidence on the conditions under which banks have promised to pay the par value of deposits and banknotes on demand when holding only fractional reserves. The theoretical literature can be broadly divided into four strands: liquidity provision; asymmetric information; regulatory restrictions and a medium of exchange. One strand of the literature argues that banks offer to pay par on demand in order to provide liquidity insurance services to consumers who are uncertain about their future time preferences and who have investment opportunities inconsistent with some of their preferred consumption paths. A second strand of the literature argues that banks offer to pay at par because of asymmetric information about banks’ assets. The demand deposit contract can keep the bank from dissipating depositors’ wealth by exploiting information available to the banker but not to depositors. The deposit is then on demand to make its value not contingent on states that are not verifiable by the depositor. In this sense, demand deposit contracts are a discipline device in this setup because the promise to pay par on demand helps to limit the riskiness of banks’ activities. The third strand of the literature argues that banks promise to pay par on demand because of legal restrictions which prohibit other securities from playing the same role as demand deposits. Finally, the fourth strand of the literature suggests that depositors may want a constant par value because it is more convenient when using deposits in transactions. There are sharp predictions by the relevant theories. We assume that it is not zero cost to make a promise to redeem a liability at par value on demand. If so, then the antecedent conditions in the theories are possible explanations of the reasons for the banks promising to pay par on demand. If the explanation based on customers’ demand for liquidity is correct, payment of deposits at par will be promised when banks hold assets that are illiquid in the short run. If the asymmetric-information explanation based on the difficulty of valuing assets is correct, the marketability of banks’ assets determines whether banks promise to pay par. If the legal restrictions explanation of par redemption is correct, banks will not promise to pay par if they are not required to do so. If the transaction explanatiom is correct, banks will promise to pay par value only if the deposits are used in transactions. After the survey of the theoretical literature, we examine the history of banking in several countries in different eras: fourth century Athens, medieval Italy, Japan, and free banking and money market mutual funds in the United tates. We find that all of the theories can explain some of the observed banking arrangements and none explains all of them.

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