Deposit Collateral and the Role of Banks

Hirofumi Uchida

Review of Finance, 2003, vol. 7, issue 3, 409-435

Abstract: This paper explains the rationale behind deposit collateral that has not been discussed in the literature on financial contracting. In our model extending Hart and Moore\shortcite{1998} to account for liquidity shocks, deposit collateral has potentially two important effects: the enhancement of pledgeability and the provision of liquidity. We show that only if liquidity shocks are stochastic, both effects are significant and overall efficiency is improved. This improvement is the raison d'être of deposit collateral. The result also establishes a unique role for banks, since deposit collateral can only be taken by these financial institutions. Furthermore, it is shown that the collateral can be implemented in the form of compensating balance requirements with or without commitment loans and is attached with less restrictive efficiency conditions than alternative lending arrangements.

Date: 2003
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