Tuesday, January 22, 2013

Why pay interest on deposits if depositors do not ask for interest?

In developing economies, savings decisions are characterized by an important lack of commitment. People are aware of this and try to overcome this with institutions that seem strange to us, like ROSCAs where you pay regularly into a club and you get your investment back without return at a random date. What seems foolish to us makes sense to someone who cannot resist spending (often out of necessity) but need to make a capital purchase. But then, why would banks pay interest on savings deposits, as they appear to do in these countries? People should be willing to save into illiquid savings vehicles for free, right?

Carolina Laureti and Ariane Szafarz show this is no that simple. Indeed, banks need the additional incentive of interest on illiquid savings to meet regulatory requirements for reserves. Also, the banks cannot differentiate well between rich and poor savers. The rich ones do not have this time consistency problem and require a return. Of course, one could have the interest rate increasing with the level of deposits, but that does not seem to be an option. In fact, I notice that, at least in rich countries, it is often the opposite, as if banks do not want large amounts in savings accounts. I wonder why.

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