COMMERCIAL-BANK TIME DEPOSITS AND SOME OF THEIR IMPLICATIONS FOR FEDERAL RESERVE POLICY*

COMMERCIAL BANKS have made aggressive efforts to expand their time deposits, despite evidence that they are relatively or absolutely unprofitable. Demand deposits are profitable, yet they have grown much more slowly. Previous attempts to explain commercial banks' demand for these two liabilities have usually assumed that banks maximize profits. This study suggests that profit maximization cannot by itself properly account for this behavior. We assume banks use only one instrument to attract time deposits, the interest rate. Similarly, they compete for demand deposits through the offer of payments-related services. Other costs and earning rates are treated as exogenously determined for individual banks. Operational and regulatory considerations specify a need for capital funds, which we assume consists solely of owners' equity. We hold that the cost of capital must be included in assessing deposit (un)profitability. Based on these assumptions, short-run profit-maximization models are derived showing equilibrium levels of demand and time deposits for banks. Subsequent chapters examine the effects on deposit levels of specifying alternative firm goals: long-run profit maximization, constrained sales maximization and constrained growth maximization. Studies by Benston and Gramley indicate that, as bank size increases, there are no substantial economies in dealings with identical customers, but that savings in costs occur as the size of a loan or deposit increases. Gramley, Horvitz, and other sources provide evidence that the net effect of combining differences in variables such as operating costs, tax rates, and required capital with applicable gross earnings rates confers a significant profit advantage, at least on banks large enough to deal in primecustomer markets. Barring widespread mergers, the profits of banks in prime markets are somewhat insulated from effective entry. Regulatory agencies permitting, smaller banks are much more subject to the threat of new entry should they show above-normal profits. Such banks may be induced to practice limit pricing, including the offer of unprofitable time deposits. Use of the "need" criterion for entry fosters this behavior, since existing banks are protected from new competition in profitable outputs. Federal Reserve policy since the Accord of 1951 has been concerned with both the money supply and velocity. Commercial-bank activities affect both variables, since gains in total credit through time-deposit growth and cyclical changes in the composition of bank earning assets influence velocity. In adhering to the "free-reserve doctrine," the Federal Reserve in practice gives banks leeway in determining their growth rates, because rarely does it offset destabilizing changes entirely. This mode of operation, when viewed in conjunction with both the public's demands for bank claims and the mechanisms for deposit competition, has favored the expansion of time deposits. This study uses data available from published sources: (1) "functional cost" tabulations for member banks of small-to-medium size and (2) Federal Reserve costs and