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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 34 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 Black, Fischer, 1975, Bank funds management in an efficient market, Journal of Financial Economics 2, 323-339. Diamond, Douglas W. and Philip H. Dybvig, 1983, Bank runs, deposit insurance, and liquidity, Journal of Political 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 and residual claims, Journal of Law and Economics 26. 327-349. Fama, Eugene F. and Michael C. Jensen, 1985, Organizational forms and investment decisions, Journal of Financial Economics 14, forthcoming. Jensen, Michael C. and William H. Meckling, 1976, Theory of the firm: Managerial behavior, agency costs, and ownerships structure, Journal of Financial Economics 3, 306-360. Klein, Benjamin, 1974, Competitive interest payments on bank deposits and the long-run demand for money, American Economic Review 65, 931-949. Leland. Hayne E. and David H. Pyle, 1977, Information asymmetries, financial structure, and financial intermediation, Journal of Finance 32, 371-387.