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18 Feb 2011Working Paper Summaries

A Behavioral Model of Demandable Deposits and Its Implications for Financial Regulation

by Julio J. Rotemberg
Depositors are overconfident of their chances of recovering demandable deposits in a bank run. In a recent research paper, professor Julio J. Rotemberg reviews various government regulations available to be imposed on financial institutions—minimum capital levels, asset requirements, deposit insurance, and compulsory clawbacks—to understand how much they can help protect investors. Key concepts include:
  • US households hold 11.4 percent of their financial assets in "transactions accounts" that are immediately available—about $3.5 trillion.
  • Due to cognitive bias, people are overconfident about their position in line to withdraw their deposits in a bank run.
  • Depositors who intend to spend far into the future hold demandable assets because they give investors the opportunity to change their portfolio at will on terms that are determined in advance.
  • The paper offers a justification for various policies that governments use to regulate financial institutions, helping depositors who are too optimistic about how they will fare in a run.

Author Abstract

A model is developed that rationalizes contracts that give depositors the right to obtain funds on demand even when depositors intend to use these funds for consumption in the future. This is explained by depositor overoptimism regarding their own ability to collect funds in a run. Capitalized institutions serving depositors with such beliefs emerge in equilibrium even if depositors and bank owners have the same preferences and the same investment opportunities. Various government regulations of these institutions, including minimum capital levels, requirements concerning the assets they may hold, deposit insurance, and compulsory clawbacks in bankruptcy, can raise the average ex post welfare of depositors.

Paper Information

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