Download WHAT`S DIFFERENT ABOUT BANKS? * Eugene F

Journal of Monetary Economics 15 (1985) 29-39. North-Holland
WHAT’S DIFFERENT
ABOUT BANKS? *
Eugene F. FAMA
Universi[v
of Chicago,
Chicago,
IL 60637,
USA
Negotiable certificates of deposit (CD’s) trade in the capital market in competition with other
securities like commercial paper and bankers’ acceptances. If CD’s must pay lenders competitive
monetary interest, the reserve tax on CD’s is borne by bank borrowers. Viability of the tax means
there must be something special about bank loans that makes some borrowers willing to pay higher
interest rates than those on other securities of equivalent risk. Moreover, there must be something
special about banks that prevents other intermediaries from competing to assure that it never pays
to finance loans with CD’s,
1. Introduction
Banks are required to hold non-interest-bearing reserves against demand
deposits. The banking literature treats the interests foregone on reserves as a
tax on deposits. [See, for example, Black (1975).] The presumption is that
banks earn the market interest rate on assets so the reserve tax falls on
depositors. The viability of the demand deposit reserve tax is then explained in
terms of special transactions services (redeemability for cash and the checking
system for the transferring claims on wealth) that allow demand deposits to
pay lower monetary interest than other securities of equivalent risk.
There is a problem in this conventional story about the incidence of the
deposit reserve tax. Banks also finance assets with negotiable certificates of
deposit (CD’s). Although called ‘deposits’, negotiable CD’s are transferable
securities that trade in the capital market in competition with other similar
instruments like commercial paper and bankers’ acceptances. Unlike demand
deposits, CD’s provide no apparent transactions or liquidity services not also
obtained from commercial paper or bankers acceptances. Thus, it seems
reasonable to assume that CD’s must yield lenders the same monetary interest
as other securities of equivalent risk. The presumption is buttressed by table 1
which shows that during the 1967-83 period, average yields on high grade
CD’s and bankers’ acceptances of the same maturity are almost identical.
Likewise, the differences between average yields on CD’s and commercial
paper are trivial and not always of the same sign.
*The comments of Charles Plosser and the referee, David Romer, are gratefully acknowledged.
This research is supported by the National Science Foundation.
0304-3923/85/$3.3001985,
JMonE- B
Elsevier Science Publishers B.V. (North-Holland)
30
E. F. Fama,
What’s
differenr
about
bunks?
Table 1
Average, continuously compounded yields to maturity on high-grade certificates of deposit,
bankers’ acceptances, commercial paper, and Treasury bills; January 1967 to May 1983: N = 197.’
Instrument
Certificates of deposit (CD’s)
Bankers’ acceptances (BA’s)
Commercial paper
U.S. Treasury bills
1 month
8.14
8.13
8.25
6.86
Maturity
3 months
8.28
8.25
8.32
7.31
6 months
8.35
8.36
8.34
7.61
“The data for CD’s, BA’s. and commercial paper are from Part IV, Table 1, of the A~~!)~ricul
o/ Yields and Yield Spreodr, published by Salomon Brothers. The monthly data in the
Record are secondary market quotes from Salomon traders for high-grade CD’s and
bankers’ acceptances and for commercial paper rated Al-Pl. The monthly Treasury bill quotes
are from the Center for Research in Security Prices of the University of Chicago. The CD quotes
and the discount quotes for BA’s, commercial paper, and Treasury bills are transformed into
annualized continuously compounded yields to maturity. The yields for each month are then
averaged across months to get the average annualized yields in the table.
Record
Analytical
Unlike commercial paper and bankers acceptances, however, CD’s are
subject to a reserve requirement. If CD’s must pay competitive monetary
interest, the reserve tax on CD’s is borne by bank borrowers. Viability of the
tax then means there must be something special about bank loans that makes
some borrowers willing to pay higher interest rates than those on the other
securities of equivalent risk. Moreover, there must be something special about
banks that prevents other intermediaries, like insurance companies and finance
companies, whose liabilities are not subject to reserve requirements, from
competing with banks to assure that it never pays to finance loans with CD’s.
This paper presents a simple analysis that accommodates reserve requirements on demand deposits and CDs.
2. Reserve requirements and competitive banking
Fig. 1 summarizes demand and supply conditions for a banking sector in
which individual banks are assumed to be perfectly competitive with one
another in making loans and issuing demand deposits. The figure is a bit
unusual in that the vertical axis shows the difference between i,, an interest
rate for a bank asset or liability, and i,, the interest rate observed in the
capital market on a non-bank security with risk equivalent to the bank asset or
liability. Table 2 summarizes the various interest rates or costs in the analysis.
2.1. The supply of loanable funds
The cost to banks of a unit of demand deposits, i,, includes monetary
interest paid to depositors, the cost of unreimbursed services to depositors, and
E. F. Famu,
What’s
d@erettt
uhout
hanks?
31
the interest foregone because of the reserve requirement. The special transactions services of demand deposits (access to a ready inventory of bank cash
and to the checking system of exchange) allow the banking sector to issue
deposits for which the per unit cost in is less than the market interest rate i,.
By raising either direct or service interest paid on deposits (raising i, - i,,),
the banking sector can induce a larger aggregate supply. If direct interest
payments on demand deposits are unregulated, the demand deposit supply
curve is horizontal when direct interest equals the market rate i,, for example,
at the point k in fig. 1. Because of the reserve requirement, the total cost i, of
a unit of deposits in the region where the supply curve is horizontal exceeds the
market interest rate i,. If the direct interest on demand deposits is restricted to
a rate below i,, the demand deposit supply curve is upward sloping throughout
(the curve SD in fig. 1) as long as depositors consider some bank services less
than perfect substitutes for direct interest.
The CD supply curve in fig. 1 is horizontal. This is consistent with the
assumption (buttressed by the evidence of table 1) that CD’s must pay holders
the same monetary interest as other securities of equivalent risk. However, the
total cost i,, of a unit of CD’s exceeds the market rate i, because of the CD
reserve requirement. Since the cost of CD’s in fig. 1 is pictured net of i,, the
igim
“m
0
Demand
Fig. 1. Equilibrium
Deposit
in a competitive banking industry.
32
E. F. Fama,
What’s
disprent
about
banks?
Table 2
Interest rate glossary.
Bank
assets
‘In
4.
Bank
= interest rate observed in the capital market on non-bank securities like commercial
paper.
= interest rate charged on bank loans; does IIOI include costs of making and
monitoring loans.
liabilities
iD
i,,
= cost of a unit of demand deposits; includes (a) direct interest paid to depositors,
(b) interest foregone (paid to the central bank) because of the deposit reserve
requirement, and (c) deposit servicing costs not reimbursed by depositors.
7 cost of a unit of CD’s; includes (a) direct interest paid to CD holders equal to what
holders could get on non-bank securities of equivalent risk, (b) interest foregone
(paid to the central bank) because of the CD reserve requirement, and (c) any
issuing and maintenance costs.
CD supply curve can be horizontal even though the quantity of CD’s issued by
the banking sector can affect i,.
Since the reserve requirement is higher for demand deposits than for CD’s,
there is an aggregate supply of demand deposits beyond which the cost of a
unit of deposits exceeds that of a unit of CDs. This occurs at the point s in fig.
1. Below this point the industry supply curve for loanable funds is the demand
deposit supply curve. At the point s, the banking sector switches from demand
deposits to CD’s. The aggregate supply curve for loanable funds is SsS’.
For simplicity the analysis of the supply of loanable funds is limited to
demand deposits and CD’s. However, the demand deposit supply curve can be
interpreted as the aggregate of the supply curves for the class of liabilities (for
example, small tune deposits) that the banking sector does not issue in perfect
competition with other suppliers. Moreover, the analysis is much the same
when there are other classes of bank liabilities (for example, large time
deposits) which, like CD’s, are subject to reserve requirements but must yield
holders the same return as non-bank securities of equivalent risk.
2.2. Industry equilibrium
2.2.1. Strong loan demand
Banks use CD’s to finance loans when the loan demand schedule crosses the
supply curve for loanable funds in the region where marginal supplies come
from CD’s, that is, to the right of the point s in fig. 1. The loan demand curve
L, is an example.
E. F. Fama,
Whuf ‘s d&$erent
about banks?
33
The interest rate i, is the market rate on securities with risks equivalent to
those of bank loans. Assume that banks can buy all the open-market securities
they want at the rate i,. Thus, the demand curve for loanable funds becomes
horizontal when it hits the quantity axis in fig. 1 (to the right of the point d,
for the demand curve L2).
With the loan demand curve L,, industry equilibrium is at the point E,. In
this case (strong loan demand), equilibrium requires that banks issue loans to
the point where the interest rate on loans, i,, is equal to i,,, the cost of a unit
of CD’s. Since banks always use the cheapest source of funds, they push
demand deposits to the point where the cost of a unit of deposits, iD, is also
equal to icD.
The cost of a unit of CD’s, iCD, includes interest foregone because of the
CD reserve requirement and the market interest rate i, paid to CD holders.
Since CD holders net the market rate i,, the equilibrium condition i, = i,,
implies that the cost of the CD reserve requirement is borne by bank
borrowers. Note that this is just an example of the standard result that an
ad valorem tax is borne on the demand side when the supply curve is
horizontal.
Perhaps more interesting, in equilibrium the banking sector issues deposits
to the point where their cost is equal to the cost of CDs. The equilibrium
condition i, = i,, = i, then implies that bank borrowers also bear the equivalent of the CD reserve requirement on the part of bank loans financed with
demand deposits. This is in contrast to the conventional story in which
demand depositors bear all the cost of the demand deposit reserve requirement. Moreover, since banks must cover all their lending costs, and since the
loan rate i, does not include the costs incurred by banks to issue and monitor
loans, the condition i, = icD = i, implies that such loan servicing costs must
be borne by bank borrowers, in addition to the direct interest i, charged on
their loans.
Perhaps most important, the reserve requirement causes the cost of a unit of
CD’s to exceed the interest rate i, on non-bank securities of equivalent risk.
Thus, there must be something special about bank loans that makes some
borrowers willing to pay interest rates greater than i, on bank loans. Otherwise, CD’s are not a viable means of financing loans. Moreover, there must be
something special about banks that prevents other intermediaries, whose
liabilities are not subject to reserve requirements, from competing with banks
to assure that it never pays to finance bank loans with CDs. Some possible
comparative advantages of banks as lenders are discussed in section 3.
2.2.2. Weak loan demand
The loan demand schedule L, in fig. 1 hits the quantity axis and becomes
horizontal at the point d,, to the left of the point E, where the demand
deposit supply curve hits the axis. In this situation, the open-market interest
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E. F. Fama,
Wharf
d@erent
about
banks?
rate i, reigns supreme. The banking sector issues demand deposits to the point
E, where the cost of a unit of deposits is i, = i,. Loans are issued to the point
d, where the loan interest rate i, is equal to i,. The difference between the
supply of deposits, E,, and d, goes into some mix of loans and open-market
securities. In this weak loan demand equilibrium, all bank assets are financed
with deposits; banks issue no CD’s.
Banks earn i, on open-market securities. Thus, in addition to the interest
rate i, = i,, borrowers again pay the service costs of making and monitoring
their bank loans. I argue later, however, that monitoring services purchased
from banks can actually help to explain the special attraction (comparative
advantage) of bank loans for some borrowers.
The cost i, of a unit of deposits in this weak loan demand equilibrium is
also equal to the interest rate i, on non-bank securities. However, i, includes
interest foregone on deposit reserves. Thus, an implication of i, = i, = i, is
that the cost of the demand deposit reserve requirement is borne by
depositors - the standard conclusion of the banking literature, for example,
Black (1975). It is also an example of the standard conclusion that an
ad oalorem tax is borne by suppliers when an industry demand curve is
infinitely elastic. We saw earlier, however, that the conclusion does not hold
when bank loans are financed with both demand deposits and CD’s. Then
bank borrowers bear a part of the cost of the demand deposit reserve
requirement equivalent to the cost of the CD reserve requirement.
Finally, there is an intermediate case where part of the demand deposit
reserve tax is borne by bank borrowers even though banks do not finance loans
with CD’s. This occurs when the loan demand schedule crosses the demand
deposit supply curve between the points E, and s is fig. 1.
2.3. Side issues
2.3.1. Bank portfolio composition
When banks finance in part with CD’s, the cost of a unit of deposits or CD’s
is i,,, and iCD is greater than the return on open-market securities, i,,
because of the CD reserve requirement. Thus, CD financing implies that bank
assets are concentrated in loans. Banks hold no open-market securities like
Treasury bills. In fact, banks often issue CD’s and hold open-market securities.
This may in part result from the economics of deposit management. Since
there are no active secondary markets for bank loans, an inventory of openmarket securities that can be bought and sold at low cost can stand as a buffer
between currency and loans to absorb unexpected variation in the redemption
of demand deposits. In other words, holding some open-market securities
lowers demand deposit servicing costs. Moreover, banks finance their holdings
of Treasury securities in part with short-term repurchase agreements. Since
E. F. Famu.
Whar’s
dl@ereent about banks?
35
repurchase agreements against Treasury securities are exempt from reserve
requirements, financing Treasury securities in this way, while using CD’s to
finance loans, is consistent with the analysis.
At the end of 1983 commercial banks held $186.9 billion in Treasury
securities and $250.6 billion in other securities. Repurchase agreements
amounted to $85.5 billion, which is not sufficient to explain the Treasury
security holdings. (See Federal Reserve Bulletin, May 1984, tables 1.24 and
1.25.) Whether the difference between total security holdings and repurchase
agreements can be explained by incentives to lower deposit redemption costs is
an interesting topic for future research.
2.3.2. Deposit insurance
Deposit insurance lowers the return required by some holders of CD’s If the
price for the insurance charged to banks is not actuarially fair, the insurance
subsidy helps offset the cost of the CD reserve requirement. If the offset is
complete, we can observe that banks issue CD’s to purchase open-market
securities. In this case, however, the cost of CD’s does not exceed the
open-market rate i,, and most of the interesting differences between weak and
strong loan demand equilibria, for example, conclusions about who bears the
cost of the demand deposit reserve requirement, disappear.
Deposit insurance does not necessarily undermine the analysis. First, it’s not
clear that deposit insurance is underpriced, at least for the banking sector as a
whole. Fairly priced insurance fits easily in the analysis. Second, CD’s are
insured up to $100,000 to holders who. qualify as physical persons, but
negotiable CD’s are commonly denominated in units of $l,OOO,OOOor more.
Finally, table 1 shows that average yields on negotiable CD’s are systematically
higher than those on Treasury bills of the same maturity and almost identical
to those on high-quality bankers’ acceptances and commercial paper. Thus,
insurance is not a dominant factor in the pricing of CD’s.
3. Bank loans and contracting costs in organizations
When the banking sector finances loans with CD’s, interest rates on bank
loans are higher than those on other securities of equivalent risk because of the
CD reserve requirement. Thus, for some borrowers there must be something
special about bank loans. Moreover, on the supply side, there must be
something special about banks that prevents other intermediaries, like insurance companies and finance companies, whose liabilities are not subject to
reserve requirements, from competing with banks to assure that it never pays
to finance loans with CDs. The discussion that follows suggests an explanation
of the comparative advantages of banks as lenders in the context of the more
36
E. F. Fama,
What’s
different
about batiks?
general problem of minimization of information costs in organizations. In
short, information costs are used to explain why the demand curves for bank
loans in fig. 1 are downward sloping rather than horizontal.
3.1. Inside and outside debt
To understand the role of bank loans in an organization’s information
process, it is useful to draw a distinction between outside debt and inside debt.
Inside debt is defined as a contract where the debtholder gets access to
information from an organization’s decision process not otherwise publicly
available. The debtholder may even participate in the decision process, for
example, on the organization’s board of directors. Bank loans are inside debt,
as are the other types of debt commonly classified as private placements. In
contrast, outside debt is defined as publicly traded debt where the debtholder
relies on publicly available information generated by the organization or
information purchased by the organization (for example, independent audits
and bond ratings). Publicly traded bonds, commercial paper, bankers acceptances, and, of course, bank CD’s are in this category. These distinctions
between inside and outside debt are similar to the distinctions between inside
and outside equity in Jensen and Meckling (1976).
3.2. The advantages of short-term inside debt
Fama and Jensen (1983a, b) observe that the contracts of most agents in
organizations promise fixed payoffs or incentive payoffs tied to specific measures of performance. Such fixed payoff contracts are typical for labor, raw
materials suppliers, managers and debtholders. Equity holders then contract
for the right to net cash flows, that is, the time series of differences between
revenues and promised payoffs to other agents.
Lower information costs incurred by agents to monitor their contracts
translate into lower prices for their services. Competition pushes an organization to provide information jointly useful for evaluating the contracts of
different agents to avoid duplication of information costs among agents [Fama
and Jensen (1985)].
Bank loans are especially useful to avoid duplication of information costs.
Bank loans usually stand last or close to last in the line of priority among
contracts that promise fixed payoffs. Bank loans are short-term and the
renewal process triggers periodic evaluation of the organization’s ability to
meet low-priority fixed payoff contracts. Positive renewal signals from bank
loans mean that other agents with higher-priority fixed payoff claims need not
undertake similar costly evaluations of their claims. Bank signals are credible
since the bank backs its opinions with resources, or by declining resources.
E. F. Fama,
What’s
d#erent
about
banks?
31
The value of the signals from a bank about the credit worthiness of an
organization’s fixed payoff contracts is attested by the fact that many organizations pay periodic monitoring fees for lines of credit from banks even though
they do not take the resources offered. Indeed, large corporations often
purchase lines of credit from banks for the sole purpose of providing a signal
about outside debt (commercial paper) to be issued publicly rather than held
by the bank.
Like outside equity, outside (publicly traded) debt is issued predominantly
by large corporations. Fama and Jensen (1983a, b) argue that outside equity
involves high information and contracting costs that make it an uneconomical
means of financing for small organizations. A similar argument applies to
outside debt. In contrast, individuals and organizations of all types and sizes
finance with bank loans. This suggests that contracting costs for bank loans
debt are lower for individuals and small organizations than contracting costs
for outside debt. For individuals and small organizations it’s cheaper to give
one agent (the banker) direct access to the organization’s decision process than
to produce the range of publicly available information that makes outside debt
a viable means of financing.
In short, since a bank loan is a low-priority claim and the banker has access
to inside information, in large and small organizations periodic signals from
short-term bank loans about an organization’s credit worthiness lower the
information costs of other agents in the organization.’ Moreover, for small
organizations (and individuals) information and contracting costs for inside
debt like bank loans are lower than for outside debt. Thus, we can explain why
organizations (and individuals) are willing to pay higher interest rates on inside
debt than we observe in the open capital market on outside debb of equivalent
risk.
3.3. The comparative advantage of banks as inside lenders
These arguments do not explain why the supply side of the picture ever
allows banks to charge higher than open-market interest rates because the cost
of the reserve requirement on CD’s must be passed on to bank borrowers. If
the CD reserve tax is viable, bank costs of making and monitoring some kinds
of inside loans must be lower than the costs of other intermediaries (for
example, insurance and finance companies) by at least the cost of the CD
reserve requirement.
Black (1975) suggests that banks have a cost advantage in making loans to
depositors. The ongoing history of a borrower as a depositor provides informa‘The absence of active secondary markets for bank loans suggests that they are based in part on
inside information which is costly to transfer. See also Leland and Pyle (1977) and Diamond and
Dybvig (1983).
38
E. F. Fuma,
What’s
dlrerent
about banks?
tion that allows a bank to identify the risks of loans to depositors and to
monitor the loans at lower cost than other lenders. The inside information
provided by the ongoing history of a bank deposit is especially valuable for
making and monitoring the repeating short-term loans (rollovers) typically
offered by banks. Information from an ongoing deposit history also has special
value when the borrower is a small organization (or individual) that does not
find it economical to generate the range of publicly available information
needed to finance with outside debt or equity.
Two facts tend to support these arguments. First, banks usually require that
borrowers maintain deposits (often called compensating balances). Second,
banks are the dominant suppliers of short-term inside debt. The inside debt or
private placements offered by insurance and finance companies (which do not
have the monitoring information provided by ongoing deposit histories) are
usually much longer-term than bank loans.
4. Conclusions
Although called deposits, negotiable CD’s are transferable securities that
trade in the capital market in competition with other similar instruments like
commercial paper and bankers’ acceptances. Since CD’s provide no apparent
transactions or liquidity services not also obtained from commercial paper or
bankers’ acceptances, it is reasonable to assume that CD’s must yield lenders
the same monetary interest as other securities of equivalent risk. The assumption is supported by the yield comparisons in table 1.
Unlike commercial paper and bankers’ acceptances, CD’s are subject to a
reserve requirement. If CD’s must also pay competitive monetary interest, then
the reserve tax on CD’s is borne by bank borrowers. Viability of the reserve tax
then means there must be something special about bank loans that makes
borrowers willing to pay higher interest rates than those on open-market
securities (outside debt) of equivalent risk. I suggest that for individuals and
for some organizations, especially small organizations that do not have outside
equity, the contracting costs for inside loans like bank loans are lower than for
outside debt. Moreover, in all types of organizations, signals from short-term
bank loans about an organization’s credit worthiness can lower the information costs of other contracts.
On the supply side, if it pays to finance bank loans with CD’s, then
contracting costs for ban2 loans must be sufficiently lower than contracting
costs for short-term inside loans from other intermediaries to make up the cost
of the CD reserve requirement. I use Black’s (1975) argument that because
bank borrowers are usually also depositors, a bank has a low-cost ongoing
history of financial information that gives it a comparative cost advantage in
making and monitoring repeated short-term inside loans.
E. F. Fama.
What’s
dlyerent
ubout bunks?
39
In short, the CD reserve tax is borne by bank borrowers and its viability
depends on special cost advantages of banks in servicing long-term
depositor-borrowers.
In contrast, the reserve tax on demand deposits is largely
borne by depositors. Its viability depends on special transactions services
(access to a ready inventory of bank cash and to the checking system for
transferring claims on wealth) that allow deposits to pay lower interest than
other securities of equivalent risk.
References
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Fischer,
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in an efficient
market,
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Diamond,
Douglas
W. and Philip H. Dybvig,
1983, Bank runs, deposit insurance,
and liquidity,
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Economy
91,401-419.
Fama, Eugene F. and Michael
C. Jensen, 1983a, Separation
of ownership
and control,
Journal of
Law and Economics
26, 301-325.
Fama, Eugene F. and Michael C. Jensen, 1983b, Agency problems
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Fama, Eugene F. and Michael
C. Jensen, 1985, Organizational
forms and investment
decisions,
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interest payments
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demand
for money, American
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Hayne
E. and David H. Pyle, 1977, Information
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