Implications of the Imperfect Deposit Market Structure for Micro and Macro Discretionary Prudential Policies

The aim of this study is to theoretically investigate the role of the bank deposit market structure in how effective micro and macro prudential policies in determining the regulatory capital of banks in combination with monetary policy. To achieve this, a partial equilibrium analytical framework has been developed that includes rational economic entities and the possibility of contagion risk in the banking system in order to achieve more explicit and tangible results. In general, it will be shown that the imperfect structure of the bank deposit market as a policy transmission channel (which is less considered in the literature) can significantly change the micro and macro implications of such policies. Specifically, the effects of these policies on allocation and stabilization efficiency will be followed in terms of the types of conceivable equilibria for deposit rates, expected net returns, expected markup, and the level of expected effort of banks operating in the banking system. Expected markup capital elasticity of banking system smaller than one at the micro and macro levels play a special role in prudential policies. Each bank interactively with other banks would shape its solutions and expectations towards upcoming states of the economy (in so doing customizing its balance sheet asset side) along with key determinants for its solvency in respecting its financial obligations to depositors and whereby touching depositors’ confidence in its performance so hard that seizing utmost share in deposit market by bidding appropriate deposit rate. The deposit rate together with the level of monitoring efforts would further hit banking sector contagion risk drawing in its associated externalities and under well-defined conditions could expose the banking system to higher fragility.