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1. Discuss how the deposit contract makes banks susceptible to runs, and critically evaluate potential solutions...

1. Discuss how the deposit contract makes banks susceptible to runs, and critically evaluate potential solutions to the problematic features of deposit contracts

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Answer #1
  • Deposits contract is to have money invested with bank where bank honor a fixed interest rate for fixed period of time.
  • Risks of managing liquidity and interest rate related to deposits is what turns bank suspectible.
  • Liquidity is to be maintained to accomodate withdrawals of deposits.
  • Interest Rate Risk is most vital to bank when it comes to deposits. Banks have high volume of deposits when interest rate favors investors.
  • Fixed interest rate obligation is to be fulfilled by bank even when economic interest rate falls in future.
  • From 2000s to today ,Interest Rate has fallen with huge gap but bank is obliged to fulfill its interest obligations.
  • Potential solution to interest rate risk could be:
    • Using derivative contracts
    • Changing of Interest Rate regularly so that banks dont get impacted by delay in rate change.
    • Fixing maximum time limit to deposit contracts.

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