Friday, September 14, 2007

Banks (1) - Clear Contracts

Modern banks are not very clear about the contracts they offer. Some savings accounts pay interest, but have a variable term allowing the money to be withdrawn on demand. Some cheque accounts offer interest on positive balances. The problem with these bank accounts is that it is not clear whether the money is being deposited for safe keeping or being loaned for a fixed term. The distinction between demand deposits and term deposits has become blurred. In reality they are two different things.

They are different for the bank and have different legal consequences. The bank is entitled to lend money in a term deposit to someone else for the term of the deposit. It has a duty to lend the money in away that will minimise risk of loss. The situation with a demand deposit is very different. If the bank lends money deposited in a demand deposit, or even records it as an asset in its accounts, it is stealing something that does not belong to it. To avoid being guilty of theft, an honest bank should be very clear about what type of account it is offering.

Understanding the two types of account is also important for the person making the deposit. When making the demand deposit, they are giving their money to the bank for safekeeping. Security and convenience is their priority, so they will be willing to pay a fee for that service. They also expect to be able to go to the bank and withdraw their money at any time. They want to be absolutely certain that their money will be there whenever they need it.

When a person makes a time deposit, they understand that they that their money will no be available to them for the length of the specified term. They understand that the bank will be lending the money on to someone who can use it effectively. They expect the bank to be careful and lend the money wisely. However, they know that there is some risk that the person borrowing the money may default on the loan. This risk is shared with other term depositors at the bank and with the owners of the bank, so a small default will not affect them. However, if defaults become widespread, the risk to the depositor may increase. The interest paid on the term deposit is in part compensation for this risk. Generally this risk premium will be quite small.

The full series of articles can be viewed at Bank Deposits and Loans.

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