Why Do Banks Promise to Pay Par on Demand?

Gerald P. Dwyer Jr. and Margarita Samartín
Working Paper 2006-26
November 2006

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We survey the theories of why banks promise to pay par on demand and examine evidence about 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, legal restrictions, and a medium of exchange. 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 conditions in the theories that result in par redemption are possible explanations of why banks promise 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 explanation 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 States. We find that all of the theories can explain some of the observed banking arrangements, and none explain all of them.

JEL classification: G21, E5

Key words: banking panics, suspension of payments, banking history

The authors thank John Boyd, Mardi Dungey, and Robert Tamura for helpful comments. The authors benefited from research assistance by Budina Naydenova and Lee Cohen and editorial assistance by Linda Mundy. Earlier versions of this paper were presented at a Society for Economic Dynamics meeting, the Tor Vergata Financial Conference, Fordham University, and the University of Carlos III. Gerald Dwyer thanks the Earhart Foundation for support of early work on this project. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Gerald P. Dwyer Jr., Vice President, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-7095, 404-498-8810 (fax), gerald.p.dwyer@atl.frb.org, or Margarita Samartín, University of Carlos III, Departamento de Economía de la Empresa, Calle Madrid, 126, 28903 – Getafe, Madrid, Spain, samartin@emp.uc3m.es.

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.