When depositors use demand deposits

When depositors use demand deposits for electronic payments, payments will occur between different banks. Whenever a client of one bank makes a payment to a client of another bank, the bank of the paying client sees an outflow while the bank of the receiving client sees an inflow. In other words, payments with demand deposits redistribute liquidity reserves between banks: banks that have more outgoing payments than incoming payments during a day see a daily outflow and hence reduction in their reserves while banks that have more incoming payments than outgoing payments during a day see a daily inflow and hence an increase in their liquidity reserves.The amount of liquidity reserve that is needed to facilitate payments with demand deposits is small in relation to the stock of demand deposits. This result is partly driven by the fact that income is consumed gradually over time and only a fraction of all demand deposits held for transaction purposes are actually used every day. Another reason for this result is that incoming and outgoing payments during a day tend to be equal resulting in zero outflows for individual banks. This result holds naturally in a banking sector where banksare identical in terms of size, customer base and new lending. When banks differ in business models, structural outflows may occur for individual banks. Yet, these outflows are likely to be temporary in normal times since both reserve-losing and reserve-winning banks have incentives to actively adjust their activity.8 Banks that experience frequent daily outflows see their liquidity reserves go down. To manage future potential outflows, these banks have clear incentives to reduce outflows for instance by temporarily slowing down new lending. Similarly, banks that experience frequent daily inflows see their liquidity reserves increase.Since holding more reserves than are needed weighs negatively on banks’ profitability, these banks have an incentive to increase outflows, for instance, by increasing their new lending. In the end, these active choices reduce any structural imbalances between banks, allowing both groups of banks to achieve lending volumes that are large in relation to their liquidity reserves.Even if demand deposits held for payment purposes generate close to zero daily outflows on average, individual banks would still need to hold some liquidity against demand deposits for two reasons. First, there is always some random volatility in outflows even if outflowson average are close to zero. Due to the law of large numbers, this volatility is naturally low when demand deposits are held by a large number of small retail clients, such as households and small and medium-sized enterprises. Second, demand deposits are subject to run risk. The amount of liquidity required to deal with runs is substantial even when referring to retail deposits. When mistrust against a bank or banks occurs, retail depositors may choose to move their funds away from the troubled banks. An outflow from retail deposits thatis typically close to zero can in this case increase significantly for the banks concerned. In practice, it is this possibility of runs that makes banks hold a considerable amount of liquidity reserves against demand deposits held for transaction purposes.2.2.2Outflows from retail deposits that are used for savingsSome income that is received via deposits is saved rather than consumed. Depositors can use liquid demand deposits for savings, but most likely they would look for more attractive savings opportunities.9 Typically, individual retail depositors use intermediaries to allocate their savings. When a few large asset managers receive a large pool of retail deposits, a large part of banks’ retail deposit stock is converted into wholesale deposits controlled by a few actors. These wholesale deposits require larger liquidity reserves than retail deposits. However, instead of holding larger liquidity reserves, banks can manage outflows from these wholesale deposits by offering savings in term deposits and bonds. When these