To understand how our current banking system works, we need to think through how an idealized banking system might work – a banking system not too different from what may emerge in the fairly near future in the USA. The central features of this banking system are (a) government–insured deposits; (b) governmentimposed reserve requirements, with reserves held at the central bank in interest–free accounts; and (c) no transactions costs. The banking system must compete against money market mutual funds, which invest in government T–bills, and which provide checking services comparable to those provided by banks. They have no reserve requirements, and they pay an interest rate equal to the T–bill rate. (This follows from assumptions concerning competition in the industry and no transactions costs.) Here, we want to highlight certain fairly obvious implications of the model.

The fact that deposits are government–insured means that depositors should be indifferent between holding their funds in the money market accounts and in banks. This means that the interest rate paid by banks to their depositors must equal that on government T–bills. Each bank thus views itself as facing a horizontal supply curve for funds. If it pays epsilon more than its competitors, it can get as much funds as it wants.

The key to understanding the supply of loanable funds (credit availability) is to understand the behavior of banks. We will argue that banks behave in a risk averse manner.