Research

Abstract: In environments where banks have superior information on asset quality and investors update their beliefs based on non-contractible signals over time, I show that Certificates of Deposits (CDs) arise as the optimal contract in bank finance. Essentially, CDs allow for maturity transformation while mitigating solvency risks in case of withdrawals. In other words, they are structured to correlate investors’ withdrawal decisions with asset quality, which minimizes the cross-subsidies from high- to low-quality banks. In addition, their early withdrawal penalties provide insurance to high-quality banks against negative shocks that could cause disintermediation or costly liquidation, thus improving allocative efficiency. Hence, I predict that riskier and less profitable banks rely more on CD funding relative to other types of deposits, which in turn rationalizes the negative correlation between bank size and proportion of CDs in banks liabilities.