Comparison between long term and short term deposit interest rates in a model of adverse selection: a theoretical framework

Selvaretnam, G. (2012) Comparison between long term and short term deposit interest rates in a model of adverse selection: a theoretical framework. Banks and Bank Systems, 7(4), pp. 75-83.

Abstract

This is a principal-agent model of a bank in a competitive market and depositors. Depositors are either of low or high type which indicates the probability of early withdrawal. The depositors have private information about their type. Therefore, they will consider the long-term and short-term returns in their deposit decision. Banks can offer a menu of contracts with different combinations of short and long-term interest rates to those who withdraw early and wait respectively. This paper investigates the conditions under which the contracts that the banks offer can be sustained as equilibrium – symmetric pooling equilibrium where only one contract is offered and a separating equilibrium where two contracts are offered in order to screen the two types. It is found that early return of more than one can never be sustained (i.e. no short-term interest rate is sustainable). Further, there is no symmetric pooling equilibrium when both types withdraw early with some probability. However, a symmetric pooling equilibrium can be sustained if the proportion of low type agents is high enough and they never withdraw early. There exists a separating equilibrium if the proportion of low type agents is sufficiently high. The problem of establishing equilibrium means, frequent changes in the banks’ contract can be expected. Regulators should ensure that information of such changes are communicated clearly and sufficiently in advance to the depositors.

• Item Type: Articles
• Status: Published
• Refereed: Yes
• Glasgow Author(s) Enlighten ID: Selvaretnam, Dr Geethanjali
• Authors: Selvaretnam, G.
• College/School: College of Social Sciences > Adam Smith Business School > Economics
• Journal Name: Banks and Bank Systems
• ISSN: 1816-7403
• ISSN (Online): 1991-7074