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Journal of Mone tary Econ omics 15 (1985) 29-39. North-Holland

WHATS DIFFERENT ABOUT BANKS? *Eugene F. FAMA

Universi[v of Chicago, Chicago, IL 60637, USA

Negotiable certif icates of deposit (CDs) trade in the capital mark et in compe tition with othersecurities l ike comme rcial paper and bankers acceptan ces. If CDs mu st pay lenders competitivemonetary interest, the reserve tax on CDs is borne by bank borrowers. Viabili ty of the tax meansthere mu st be something special about bank loans that ma kes som e borrowers wil ling to pay higherinterest rates than tho se on other s ecurities of equivalent r isk. Mo reover, there mu st be somethingspecial about banks that prevents other intermediaries from com peting to assure that i t never paysto finance loans with CD s,

1. IntroductionBanks are required to hold non-interest-bearing reserves against demanddeposits. The banking literature treats the interests foregone on reserves as a

tax on deposits. [See, for example, Black (1975).] The presumption is thatbanks earn the market interest rate on assets so the reserve tax falls ondepositors. The viability of the demand deposit reserve tax is then explained interms of special transactions services (redeemability for cash and the checkingsystem for the transferring claims on wealth) that allow demand deposits topay lower monetary interest than other securities of equivalent risk.There is a problem in this conventional story about the incidence of thedeposit reserve tax. Banks also finance assets with negotiable certificates ofdeposit (CDs). Although called deposits, negotiable CDs are transferablesecurities that trade in the capital market in competition with other similarinstruments like commercial paper and bankers acceptances. Unlike demanddeposits, CDs provide no apparent transactions or liquidity services not alsoobtained from commercial paper or bankers acceptances. Thus, it seemsreasonable to assume that CDs must yield lenders the same monetary interestas other securities of equivalent risk. The presumption is buttressed by table 1which shows that during the 1967-83 period, average yields on high gradeCDs and bankers acceptances of the same maturity are almost identical.Likewise, the differences between average yields on CDs and commercialpaper are trivial and not always of the same sign.

*The com me nts o f Charles Plosser and the referee, David R ome r, are gratefully acknowledged.This research is supported by the National Science Foundation.0304-3923/85/$3.3001985, Elsevier Science Publishers B.V . (North-Holland)

JMonE- B

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30 E. F. Fama, Whats differenr about bunks?Table 1

Average, continuously compounded yields to maturity on high-grade certif icates of deposit,bankers accep tances, comm ercial paper, and Treasury bil ls; January 1967 to Ma y 1983: N = 197.MaturityInstrument 1 month 3 months 6 months

Certificates of deposit (CDs) 8.14 8.28 8.35Bankers acceptan ces (BAs) 8.13 8.25 8.36Com mercial paper 8.25 8.32 8.34U.S . Treasury bil ls 6.86 7.31 7.61The data for CD s, BAs. and comm ercial paper are from Part IV, T able 1, of the A~~!)~ricul

Record o/ Yields and Yie ld Spreodr, published by Salomon B rothers. The monthly data in theAnalytical Record are secondary market quotes from Salomon traders for high-grade CDs andbankers ac ceptance s and for comm ercial paper rated Al-Pl. The monthly Treasury bill quotesare from the Center for R esearch in Security Prices of the Univers ity of Chicago. The CD quotesand the discount quotes for BAs, commercial paper, and Treasury bills are transformed intoannualized continuously compounded yields to matu rity. The yields for each month are thenaveraged across mon ths to get the average annualized yields in the table.

Unlike commercial paper and bankers acceptances, however, CDs aresubject to a reserve requirement. If CDs must pay competitive monetaryinterest, the reserve tax on CDs is borne by bank borrowers. Viability of thetax then means there must be something special about bank loans that makessome borrowers willing to pay higher interest rates than those on the othersecurities of equivalent risk. Moreover, there must be something special aboutbanks that prevents other intermediaries, like insurance companies and financecompanies, whose liabil ities are not subject to reserve requirements, fromcompeting with banks to assure that it never pays to finance loans with CDs.This paper presents a simple analysis that accommodates reserve require-ments on demand deposits and CDs.2. Reserve requirements and competitive banking

Fig. 1 summarizes demand and supply conditions for a banking sector inwhich individual banks are assumed to be perfectly competitive with oneanother in making loans and issuing demand deposits. The figure is a bitunusual in that the vertical axis shows the difference between i,, an interestrate for a bank asset or liability, and i,, the interest rate observed in thecapital market on a non-bank security with risk equivalent to the bank asset orliabil ity. Table 2 summarizes the various interest rates or costs in the analysis.

2.1. The supply of loanable fundsThe cost to banks of a unit of demand deposits, i,, includes monetaryinterest paid to depositors, the cost of unreimbursed services to depositors, and

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E. F. Famu, Whats d@erettt uhout hanks? 31the interest foregone because of the reserve requirement. The special transac-tions services of demand deposits (access to a ready inventory of bank cashand to the checking system of exchange) allow the banking sector to issuedeposits 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 interestpayments on demand deposits are unregulated, the demand deposit supplycurve 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, ofa unit of deposits in the region where the supply curve is horizontal exceeds themarket interest rate i,. If the direct interest on demand deposits is restricted toa 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 lessthan perfect substitutes for direct interest.The CD supply curve in fig. 1 is horizontal. This is consistent with theassumption (buttressed by the evidence of table 1) that CDs must pay holdersthe same monetary interest as other securities of equivalent risk. However, thetotal cost i,, of a unit of CDs exceeds the market rate i, because of the CDreserve requirement. Since the cost of CDs in fig. 1 is pictured net of i,, the

ig im

m0

Demand Depos it

Fig. 1. Equilibrium in a comp etitive banking industry.

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32 E. F. Fama, Whats disprent about banks?Table 2

Interest rate glossary.Bank assets

I n = interest rate observed in the capital marke t on non-bank securities l ike comm ercialpaper.4. = interest rate charged on bank loans; does IIO I include cos ts of making andmonitoring loans.

Bank l iabi l i t iesiD = 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 reserverequirement, and (c) deposit servicing cost s not reimbursed by depositors.i,, 7 cos t of a unit of CDs ; includes (a) direct interest paid to CD holders equal to wha tholders could get on non-bank securities of equivalent r isk, (b) interest foregone

(paid to the central bank) because of the CD reserve requirement, and (c) anyissuing and maintenance costs.

CD supply curve can be horizontal even though the quantity of CDs issued bythe banking sector can affect i,.Since the reserve requirement is higher for demand deposits than for CDs,there is an aggregate supply of demand deposits beyond which the cost of aunit 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 demanddeposit supply curve. At the point s, the banking sector switches from demanddeposits to CDs. The aggregate supply curve for loanable funds is SsS.For simplicity the analysis of the supply of loanable funds is limited todemand deposits and CDs. However, the demand deposit supply curve can beinterpreted as the aggregate of the supply curves for the class of liabil ities (forexample, small tune deposits) that the banking sector does not issue in perfectcompetition with other suppliers. Moreover, the analysis is much the samewhen there are other classes of bank liabil ities (for example, large timedeposits) which, like CDs, are subject to reserve requirements but must yieldholders the same return as non-bank securities of equivalent risk.

2.2. Industry equilibrium2.2.1. Strong loan demand

Banks use CDs to finance loans when the loan demand schedule crosses thesupply curve for loanable funds in the region where marginal supplies comefrom CDs, that is, to the right of the point s in fig. 1. The loan demand curveL, is an example.

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E. F. Fama, Whuf s d&$eren t about banks? 33

The interest rate i, is the market rate on securities with risks equivalent tothose of bank loans. Assume that banks can buy all the open-market securitiesthey want at the rate i,. Thus, the demand curve for loanable funds becomeshorizontal 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,. Inthis case (strong loan demand), equilibrium requires that banks issue loans tothe point where the interest rate on loans, i,, is equal to i,,, the cost of a unitof CDs. Since banks always use the cheapest source of funds, they pushdemand deposits to the point where the cost of a unit of deposits, iD, is alsoequal to icD.The cost of a unit of CDs, iCD, includes interest foregone because of theCD 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 bankborrowers. Note that this is just an example of the standard result that anad valorem tax is borne on the demand side when the supply curve ishorizontal.Perhaps more interesting, in equilibrium the banking sector issues depositsto the point where their cost is equal to the cost of CDs. The equilibriumcondition i, = i,, = i, then implies that bank borrowers also bear the equiv-alent of the CD reserve requirement on the part of bank loans financed withdemand deposits. This is in contrast to the conventional story in whichdemand depositors bear all the cost of the demand deposit reserve require-ment. Moreover, since banks must cover all their lending costs, and since theloan rate i, does not include the costs incurred by banks to issue and monitorloans, the condition i, = icD = i, implies that such loan servicing costs mustbe borne by bank borrowers, in addition to the direct interest i, charged ontheir loans.Perhaps most important, the reserve requirement causes the cost of a unit ofCDs to exceed the interest rate i, on non-bank securities of equivalent risk.Thus, there must be something special about bank loans that makes someborrowers willing to pay interest rates greater than i, on bank loans. Other-wise, CDs are not a viable means of financing loans. Moreover, there must besomething special about banks that prevents other intermediaries, whoseliabilities are not subject to reserve requirements, from competing with banksto assure that it never pays to finance bank loans with CDs. Some possiblecomparative advantages of banks as lenders are discussed in section 3.

2.2.2. Weak loan demandThe loan demand schedule L, in fig. 1 hits the quantity axis and becomeshorizontal at the point d,, to the left of the point E, where the demanddeposit supply curve hits the axis. In this situation, the open-market interest

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34 E. F. Fama, Wharf d@erent about banks?

rate i, reigns supreme. The banking sector issues demand deposits to the pointE, where the cost of a unit of deposits is i, = i,. Loans are issued to the pointd, where the loan interest rate i, is equal to i,. The difference between thesupply of deposits, E,, and d, goes into some mix of loans and open-marketsecurities. In this weak loan demand equilibrium, all bank assets are financedwith deposits; banks issue no CDs.Banks earn i, on open-market securities. Thus, in addition to the interestrate i, = i,, borrowers again pay the service costs of making and monitoringtheir bank loans. I argue later, however, that monitoring services purchasedfrom banks can actually help to explain the special attraction (comparativeadvantage) of bank loans for some borrowers.The cost i, of a unit of deposits in this weak loan demand equilibrium isalso equal to the interest rate i, on non-bank securities. However, i, includesinterest foregone on deposit reserves. Thus, an implication of i, = i, = i, isthat the cost of the demand deposit reserve requirement is borne bydepositors - the standard conclusion of the banking literature, for example,Black (1975). It is also an example of the standard conclusion that anad oalorem tax is borne by suppliers when an industry demand curve isinfinitely elastic. We saw earlier, however, that the conclusion does not holdwhen bank loans are financed with both demand deposits and CDs. Thenbank borrowers bear a part of the cost of the demand deposit reserverequirement equivalent to the cost of the CD reserve requirement.Finally, there is an intermediate case where part of the demand depositreserve tax is borne by bank borrowers even though banks do not finance loanswith CDs. This occurs when the loan demand schedule crosses the demanddeposit supply curve between the points E, and s is fig. 1.2.3. Side issues2.3.1. Bank portfolio composition

When banks finance in part with CDs, the cost of a unit of deposits or CDsis i,,, and iCD is greater than the return on open-market securities, i,,because of the CD reserve requirement. Thus, CD financing implies that bankassets are concentrated in loans. Banks hold no open-market securities likeTreasury bil ls. In fact, banks often issue CDs and hold open-market securities.This may in part result from the economics of deposit management. Sincethere are no active secondary markets for bank loans, an inventory of open-market securities that can be bought and sold at low cost can stand as a bufferbetween currency and loans to absorb unexpected variation in the redemptionof demand deposits. In other words, holding some open-market securitieslowers demand deposit servicing costs. Moreover, banks finance their holdingsof Treasury securities in part with short-term repurchase agreements. Since

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E. F. Famu. Whars dl@ereen t about banks? 35repurchase agreements against Treasury securities are exempt from reserverequirements, financing Treasury securities in this way, while using CDs tofinance loans, is consistent with the analysis.

At the end of 1983 commercial banks held $186.9 billion in Treasurysecurities and $250.6 billion in other securities. Repurchase agreementsamounted to $85.5 billion, which is not sufficient to explain the Treasurysecurity holdings. (See Federal Reserve Bulletin, May 1984, tables 1.24 and1.25.) Whether the difference between total security holdings and repurchaseagreements can be explained by incentives to lower deposit redemption costs isan interesting topic for future research.2.3.2. Deposit insurance

Deposit insurance lowers the return required by some holders of CDs If theprice for the insurance charged to banks is not actuarially fair, the insurancesubsidy helps offset the cost of the CD reserve requirement. If the offset iscomplete, we can observe that banks issue CDs to purchase open-marketsecurities. In this case, however, the cost of CDs does not exceed theopen-market rate i,, and most of the interesting differences between weak andstrong loan demand equilibria, for example, conclusions about who bears thecost of the demand deposit reserve requirement, disappear.Deposit insurance does not necessarily undermine the analysis. First, its notclear that deposit insurance is underpriced, at least for the banking sector as awhole. Fairly priced insurance fits easily in the analysis. Second, CDs areinsured up to $100,000 to holders who. qualify as physical persons, butnegotiable CDs are commonly denominated in units of $l,OOO,OOO r more.Finally, table 1 shows that average yields on negotiable CDs are systematicallyhigher than those on Treasury bills of the same maturity and almost identicalto those on high-quality bankers acceptances and commercial paper. Thus,insurance is not a dominant factor in the pricing of CDs.

3. Bank loans and contracting costs in organizationsWhen the banking sector finances loans with CDs, interest rates on bankloans are higher than those on other securities of equivalent risk because of theCD reserve requirement. Thus, for some borrowers there must be somethingspecial about bank loans. Moreover, on the supply side, there must besomething special about banks that prevents other intermediaries, like in-

surance companies and finance companies, whose liabilities are not subject toreserve requirements, from competing with banks to assure that it never paysto finance loans with CDs. The discussion that follows suggests an explanationof the comparative advantages of banks as lenders in the context of the more

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36 E. F. Fama, Whats different about batiks?

general problem of minimization of information costs in organizations. Inshort, information costs are used to explain why the demand curves for bankloans in fig. 1 are downward sloping rather than horizontal.

3.1. Inside and outside debtTo understand the role of bank loans in an organizations informationprocess, 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 toinformation from an organizations decision process not otherwise publiclyavailable. The debtholder may even participate in the decision process, forexample, on the organizations board of directors. Bank loans are inside debt,

as are the other types of debt commonly classified as private placements. Incontrast, outside debt is defined as publicly traded debt where the debtholderrelies on publicly available information generated by the organization orinformation purchased by the organization (for example, independent auditsand bond ratings). Publicly traded bonds, commercial paper, bankers accep-tances, and, of course, bank CDs are in this category. These distinctionsbetween inside and outside debt are similar to the distinctions between insideand outside equity in Jensen and Meckling (1976).

3.2. The advantages of short-term inside debtFama and Jensen (1983a, b) observe that the contracts of most agents inorganizations promise fixed payoffs or incentive payoffs tied to specific mea-sures of performance. Such fixed payoff contracts are typical for labor, rawmaterials suppliers, managers and debtholders. Equity holders then contractfor the right to net cash flows, that is, the time series of differences betweenrevenues and promised payoffs to other agents.Lower information costs incurred by agents to monitor their contractstranslate into lower prices for their services. Competition pushes an organiza-tion to provide information jointly useful for evaluating the contracts ofdifferent agents to avoid duplication of information costs among agents [Famaand 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 amongcontracts that promise fixed payoffs. Bank loans are short-term and therenewal process triggers periodic evaluation of the organizations ability to

meet low-priority fixed payoff contracts. Positive renewal signals from bankloans mean that other agents with higher-priority fixed payoff claims need notundertake similar costly evaluations of their claims. Bank signals are crediblesince the bank backs its opinions with resources, or by declining resources.

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E. F. Fama, Whats d#erent about banks? 31

The value of the signals from a bank about the credit worthiness of anorganizations fixed payoff contracts is attested by the fact that many organiza-tions pay periodic monitoring fees for lines of credit from banks even thoughthey do not take the resources offered. Indeed, large corporations oftenpurchase lines of credit from banks for the sole purpose of providing a signalabout outside debt (commercial paper) to be issued publicly rather than heldby the bank.Like outside equity, outside (publicly traded) debt is issued predominantlyby large corporations. Fama and Jensen (1983a, b) argue that outside equityinvolves high information and contracting costs that make it an uneconomicalmeans of financing for small organizations. A similar argument applies tooutside debt. In contrast, individuals and organizations of all types and sizesfinance with bank loans. This suggests that contracting costs for bank loansdebt are lower for individuals and small organizations than contracting costsfor outside debt. For individuals and small organizations its cheaper to giveone agent (the banker) direct access to the organizations decision process thanto produce the range of publicly available information that makes outside debta viable means of financing.In short, since a bank loan is a low-priority claim and the banker has accessto inside information, in large and small organizations periodic signals fromshort-term bank loans about an organizations credit worthiness lower theinformation costs of other agents in the organization. Moreover, for smallorganizations (and individuals) information and contracting costs for insidedebt like bank loans are lower than for outside debt. Thus, we can explain whyorganizations (and individuals) are willing to pay higher interest rates on insidedebt than we observe in the open capital market on outside debb of equivalentrisk.3.3. The comparative advantage of banks as inside lenders

These arguments do not explain why the supply side of the picture everallows banks to charge higher than open-market interest rates because the costof the reserve requirement on CDs must be passed on to bank borrowers. Ifthe CD reserve tax is viable, bank costs of making and monitoring some kindsof inside loans must be lower than the costs of other intermediaries (forexample, insurance and finance companies) by at least the cost of the CDreserve requirement.Black (1975) suggests that banks have a cost advantage in making loans todepositors. The ongoing history of a borrower as a depositor provides informa-The absence of active secondary markets for bank loans s ugges ts that the y are based in part oninside information which is cos tly to transfer. See also Leland and Pyle (1977) and Diamond andDybvig (1983).

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38 E. F. Fuma, Whats dlrerent about banks?

tion that allows a bank to identify the risks of loans to depositors and tomonitor the loans at lower cost than other lenders. The inside informationprovided by the ongoing history of a bank deposit is especially valuable formaking and monitoring the repeating short-term loans (rollovers) typical lyoffered by banks. Information from an ongoing deposit history also has specialvalue when the borrower is a small organization (or individual) that does notfind it economical to generate the range of publicly available informationneeded to finance with outside debt or equity.Two facts tend to support these arguments. First, banks usually require thatborrowers maintain deposits (often called compensating balances). Second,banks are the dominant suppliers of short-term inside debt. The inside debt orprivate placements offered by insurance and finance companies (which do nothave the monitoring information provided by ongoing deposit histories) areusually much longer-term than bank loans.

4. ConclusionsAlthough called deposits, negotiable CDs are transferable securities thattrade in the capital market in competition with other similar instruments likecommercial paper and bankers acceptances. Since CDs provide no apparent

transactions or liquidity services not also obtained from commercial paper orbankers acceptances, it is reasonable to assume that CDs must yield lendersthe same monetary interest as other securities of equivalent risk. The assump-tion is supported by the yield comparisons in table 1.Unlike commercial paper and bankers acceptances, CDs are subject to areserve requirement. If CDs must also pay competitive monetary interest, thenthe reserve tax on CDs is borne by bank borrowers. Viability of the reserve taxthen means there must be something special about bank loans that makesborrowers willing to pay higher interest rates than those on open-marketsecurities (outside debt) of equivalent risk. I suggest that for individuals andfor some organizations, especially small organizations that do not have outsideequity, the contracting costs for inside loans like bank loans are lower than foroutside debt. Moreover, in all types of organizations, signals from short-termbank loans about an organizations credit worthiness can lower the informa-tion costs of other contracts.

On the supply side, if it pays to finance bank loans with CDs, thencontracting costs for ban2 loans must be sufficiently lower than contractingcosts for short-term inside loans from other intermediaries to make up the costof the CD reserve requirement. I use Blacks (1975) argument that becausebank borrowers are usually also depositors, a bank has a low-cost ongoinghistory of financial information that gives it a comparative cost advantage inmaking and monitoring repeated short-term inside loans.

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E. F. Fama. Whats dlyerent ubout bunks? 39

In short, the CD reserve tax is borne by bank borrowers and its viabilitydepends on special cost advantages of banks in servicing long-termdepositor-borrowers. In contrast, the reserve tax on demand deposits is largelyborne by depositors. Its viability depends on special transactions services(access to a ready inventory of bank cash and to the checking system fortransferring claims on wealth) that allow deposits to pay lower interest thanother securities of equivalent risk.ReferencesBlack, Fischer, 1975, Bank funds mana geme nt in an efficient market, Journal of Financ ial

Economics 2, 323-339.Diamond, Douglas W. and Phil ip H. Dybvig, 1983, Bank runs, deposit insurance, and liquidity,

Journal of Political Economy 91,401-419.Fama, E ugene F. and Michael C. Jensen, 1983a, Separation of ownership and control, Journal ofLaw and Economics 26, 301-325.

Fama, Eugene F. and Michael C. Jensen, 1983 b, Agency problems and residual claims, Journal ofLaw and Economics 26. 327-349.

Fama, Eu gene F. and Michael C. Jensen, 1985, Organizational forms and investment decisions,Journal of Financ ial Economics 14, forthcoming.

Jensen, Michael C. and William H. Meckling, 1976, Theory of the firm: Managerial behavior,agency costs, and ownerships structure, Journal of Financ ial Economics 3, 306-360.

Klein , Benjam in, 1974, Competitive interest payments on bank deposits and the long-run demandfor money, American Economic Review 65, 931-949.

Lela nd. H ayne E. and David H. Pyle, 1977, Informati on asymmetries, financ ial structure, andfinancial intermediation, Journal of Finance 32, 371-387.