Interest on reserves, bank runs and investment decisions

Abstract

Purpose This paper aims to study the effects of interest on reserves (IOR) on banks’ behavior in a theoretical framework. Design/methodology/approach This paper introduces IOR into both Cooper and Ross (1998) and Cooper and Ross (2002) and conducts quantitative analysis. It thoroughly examines the effects of IOR on banks’ resource allocation decisions under different assumptions. Findings In the model without deposit insurance, the results of this paper show that paying IOR facilitates the bank to use the run-proof contract. When the run-admitting contract is adopted, there is a set of conditions under which the bank is indifferent between holding illiquid asset and excess liquid reserves. In the model with deposit insurance, the results show that if the riskless illiquid investment is profitable and available, then paying IOR can hardly influence the bank's resource allocation. If the riskless illiquid investment is limited, then a certain level of IOR could fulfill some monetary targets. Originality/value Little research has combined IOR and model of bank runs. It helps to extend the theoretical analysis in this perspective.