Financial Intermediation – Commercial Banks: Deposits

These flashcards cover definitions of deposits, the Diamond–Dybvig liquidity-insurance model, sequential service constraint, multiple equilibria and bank-run dynamics, as well as the main preventive mechanisms—suspension of convertibility, bankruptcy, deposit insurance, and lender of last resort—plus real-world examples and relevant game-theory concepts.

What is the defining feature of a bank deposit as a debt contract?

The timing of repayment—deposits can typically be withdrawn on demand (or, for term deposits, even before maturity with possible loss of interest).

How do demand deposits differ from term deposits?

Demand deposits have no stated maturity and are repayable immediately upon request, whereas term deposits have a stated maturity but can often be withdrawn early (usually with an interest penalty).

Why is a deposit not considered a security?

Because it is a bilateral, non-transferable contract between the depositor and the bank rather than a tradable instrument.

What is the sequential service constraint faced by banks?

When many depositors withdraw at once, the bank must pay them in sequence until liquid resources are exhausted, potentially leaving later depositors unpaid.

In the lecture’s numerical example, how much cash did the bank initially hold against $90 of deposits?

$20 in cash, with the remainder invested in loans.

Define ‘liquidity insurance’ provided by deposits in the Diamond-Dybvig model.

Pooling of funds by a bank so that ‘early’ consumers can withdraw immediately while ‘late’ consumers earn a higher return, smoothing consumption across states.

What proportion of households are ‘early’ consumers in the Diamond-Dybvig set-up described?

40 % (γ = 0.4).

Without financial intermediation, why do households prefer storing cash to investing in long-term projects?

Because storing yields higher expected utility (7.6 vs 6.6) given the risk of becoming an ‘early’ consumer and having to liquidate projects at low value.

What are the promised pay-offs under Deposit Contract A?

$100 if withdrawn at t = 1 and $225 if withdrawn at t = 2.

How does Deposit Contract B improve on Contract A?

It raises the early withdrawal amount to $110 and still pays $210 later, increasing expected utility via better consumption smoothing.

What is meant by ‘strategic complementarities’ in the context of bank runs?

Your optimal action (withdraw or wait) becomes more attractive the more other depositors take the same action, leading to multiple equilibria.

Name the two Nash equilibria in the classic bank-run game.

1) No-run equilibrium: only early consumers withdraw; 2) Bank-run equilibrium: all depositors withdraw immediately.

Why does suspension of convertibility eliminate bank runs in the model?

Because once cash is exhausted, no further withdrawals are allowed, guaranteeing late consumers the full later payout and removing any incentive to run.

What practical drawback comes with allowing a bank to suspend convertibility?

Deposits lose their usefulness for true liquidity needs if early households cannot withdraw when uncertainty about withdrawal needs exists.

How does a government-backed deposit insurance scheme prevent bank runs?

By guaranteeing the promised amounts, depositors have no incentive to rush for early withdrawal, so the run equilibrium disappears.

Under EU Directive 2009/14/EC, what is the targeted harmonised deposit-insurance coverage level?

EUR 100,000 per depositor (with a payout delay reduced to 20 working days).

List two key design dimensions of deposit insurance mentioned in the lecture.

Possible answers: public vs private, funded vs unfunded, coverage limits, coinsurance, risk-adjusted vs flat premiums, types of deposits covered.

What role does a lender of last resort (typically the central bank) play in run prevention?

It provides emergency liquidity against collateral, allowing banks to meet withdrawals without liquidating long-term assets.

Why is ordinary bankruptcy law ill-suited for banks?

Because retrieving already-withdrawn cash is legally uncertain, proceedings are slow, and frozen deposits negate the bank’s liquidity-transformation role.

Give one recent real-world example of a bank run cited in the notes.

Northern Rock (2007), Silicon Valley Bank (2023), or Credit Suisse (2023).

What percentage of Silicon Valley Bank’s assets were funded by uninsured deposits at end-2022?

Approximately 78 %.

What immediate event triggered massive withdrawals from SVB on 9 March 2023?

SVB announced a $1.8 billion loss on securities sales and an equity raise, causing depositor panic.

In game-theory terms, what is a Nash equilibrium?

A set of strategies where each player’s choice is optimal given the choices of all other players.

Which classic two-player game illustrates that individually rational actions can lead to collectively worse outcomes?

The Prisoner’s Dilemma.

What feature distinguishes a coordination game from the Prisoner’s Dilemma, as illustrated by the ‘which side of the road’ example?

Multiple equilibria exist, and players prefer to coordinate on either equilibrium rather than deviate, unlike the single inefficient equilibrium in a Prisoner’s Dilemma.

How does early liquidation of bank assets harm not only depositors but also borrowers?

Borrowers may be forced into bankruptcy if their loans are called early, destroying value for owners, customers, and employees.

What is meant by ‘cross-default clauses’ in standard debt contracts and how do they relate to creditor runs?

A default on one obligation triggers default on others, allowing multiple creditors to demand immediate repayment, creating run-like incentives.

Why did the Swiss National Bank provide a CHF 54 billion lifeline to Credit Suisse in March 2023?

To reassure markets and provide liquidity as large deposit outflows (up to CHF 10 billion/day) threatened the bank’s stability.

Summarise the main reason deposit-financed banks are considered ‘fragile.’

Because the possibility of self-fulfilling bank runs exists: if depositors expect a run, rushing to withdraw becomes a rational response.

According to the lecture, what two broad policy tools are used today to mitigate bank-run risk?

Deposit insurance schemes and central-bank emergency lending facilities (lender-of-last-resort).