Question

Essay question: "Discuss how the deposit contract makes banks susceptible to runs, and critically evaluate potential solutions to the problematic features of deposit contracts."

Answer 1

• Deposits contract means a fixed deposit with bank where bank guarantees a fixed rate of interest for specified period of time.
• Risks related to deposits which bank turn suspectible to :
  • Managing Liquidity
  • Interest Rate Risk
• Liquidity is to be maintained by bank as with deposit also,there are chances of withdrawals which pressurises bank to maintain high liquidity.
• Intrest Rate Risk is the biggest issue with bank. As when bank rate is falling,deposits increase and bank has to honor it.When rate on deposits rises,bank deposits decrease.
• These fixed interest rate which bank shall honor in future is vulnerable to high inflation in future.
• We can notice that over a period of time ,Interest Rate decreases and decreases but bank is still supposed to pay interest as per old commitments made.
• Potential solution to interest rate market can be:
  • Hedging for interest rate
  • Dynamic Interest Rate change so that new investors get impacted by rate change.
  • Not to issue,excessive long term deposit contracts.

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