Dynamic Banking and the Value of Deposits

Abstract

We propose a dynamic theory of banking where the role of deposits is akin to that of productive capital in the classical Q-theory of investment for non-financial firms. As a key source of leverage, deposits create value for well-capitalized banks. However, unlike productive capital of nonfinancial firms that typically has a positive marginal q, the deposit marginal q can turn negative for undercapitalized banks. Demand deposit accounts commit banks to allow holders to withdraw or deposit funds at will, so banks cannot perfectly control leverage. Therefore, for banks with insufficient equity capital to buffer risk, deposit inflows and the associated uncertainty in future leverage can destroy value. Our model predictions on bank valuation and dynamic asset-liability management are broadly consistent with the evidence. Moreover, our model lends itself to a re-evaluation of the costs and benefits of leverage regulation and offers new perspectives on the challenges that banks face in a low interest rate environment.

Keywords: Deposits, Dynamic Banking, Liquidity, Financial Constraint, Inside Money, Outside Money, Franchise Value, Payment System

JEL Classification: E4, E5, G21, G3