Demand Deposit
A demand deposit is a bank account from which funds can be withdrawn on demand, without prior notice, typically by cheque, card, or electronic transfer. Demand deposits are the principal means of payment in modern economies and form the largest component of the narrow measures of money. Their nature creates both the liquidity that makes them useful and the fragility that makes banking vulnerable to runs.
Characteristics
Demand deposits are highly liquid: the depositor can convert the balance into currency or make payments at short notice. Traditionally, demand deposits did not pay interest, reflecting the cost of providing liquidity and payment services and, in some jurisdictions, regulatory restrictions. Deregulation and competition have led to interest-bearing transactions accounts in many countries, blurring the distinction between demand and savings deposits.
Demand deposits are liabilities of the bank and are insured up to specified limits in systems with deposit insurance. The insurance protects small depositors and reduces the incentive to run, contributing to stability, while creating moral hazard that is addressed through supervision and capital requirements.
Creation of Deposits
A common misconception is that banks merely lend out deposits placed with them by savers. In fact, banks create demand deposits when they make loans. When a bank extends credit, it credits the borrower's account with a new deposit, expanding the money supply. The deposit is supported by the bank's assets, including the loan, and the banking system as a whole can create deposits multiple times the quantity of reserve money, subject to reserve requirements, capital constraints, and the demand for credit.
This process links demand deposits to the broader money supply and to the transmission of monetary policy. Constraints on the ability of banks to create deposits, including capital and liquidity requirements, influence the volume of credit and the level of economic activity.
Runs and Stability
Because demand deposits are payable on demand while the loans they fund are illiquid and long-term, banks are inherently susceptible to runs. If depositors lose confidence and demand repayment en masse, the bank may be forced to liquidate assets at a loss, transmitting distress to other institutions. Deposit insurance, central bank lending facilities, and prudential regulation are the principal defences against this fragility.
The stability of demand deposits is a public good, since a general loss of confidence can disrupt the payment system and the economy as a whole. Historical episodes of bank runs, including those of the Great Depression and the global financial crisis, illustrate the consequences of failures in the mechanisms designed to preserve confidence.
Narrow Money and Measures of Money
Demand deposits form the core of narrow money measures. Definitions vary across countries, but a common approach includes currency in circulation and demand deposits, sometimes with other highly liquid deposits. Broader measures add savings deposits, time deposits, and money market instruments.
The composition of money matters for the interpretation of monetary aggregates. Changes in the boundary between instruments, driven by financial innovation and regulation, can alter measured money without any change in underlying conditions. Central banks monitor a range of aggregates and use them as indicators rather than as precise targets.
Payment Systems and Settlement
Demand deposits are the foundation of the payment system. Payments are settled by transferring balances between accounts, ultimately through accounts held at the central bank. The efficiency and safety of the payment system depend on the soundness of the banks and on the infrastructure that clears and settles transactions.
Innovations in payment technology, including real-time settlement, mobile payments, and digital currencies, are changing the way demand deposits are used. Some proposals envisage central bank digital currency that would give the public direct access to central bank money, with implications for the role of commercial bank deposits and for financial stability.
Deposit Insurance and Moral Hazard
Deposit insurance protects depositors and reduces the risk of runs, but it creates moral hazard by weakening the incentive of depositors to monitor banks. To contain this, systems combine insurance with prudential regulation, supervision, capital requirements, and sometimes risk-based premiums.
Coverage limits balance the goal of stability against the desire to preserve market discipline. Unlimited coverage can stabilise the system in a crisis but may entrench excessive risk-taking. The design of deposit insurance is therefore a central element of the financial safety net.
Historical Development
The demand deposit emerged with the development of banking and the use of bank notes and cheques. The transformation of banking from a business of safekeeping into a business of credit creation was gradual, and it required the development of institutions, practices, and legal rules that made deposits safe and transferable. The history of banking is in large part the history of managing the fragility inherent in demand deposits.