Deposit Liquidity and Bank Monitoring

Abstract

Why do banks fund loans embodying considerable borrower-specific information with liquid deposits? I address this question by examining the disciplinary effect of liquid deposits in a framework where banks' production of non-transferable borrower information is explicitly considered. I show that deposit liquidity motivates banks to provide greater monitoring of their loan applicants despite the general lack of observability of bank monitoring and bank loan quality. The analysis provides an important link between the two activities in which banks are viewed as "special" --- their liquidity provision through demand deposits and their lending to information-intensive borrowers.

JEL Classification: G21, G28