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  • Print publication year: 2003
  • Online publication date: May 2010

4 - Restricted banking (or, the banking system of today)

Summary

The model of the banking system that we have described in chapter 3 has some similarities with common views of our current banking system, but there are also some important differences. Most importantly, in our model, the interest rate paid on deposits is identical to the interest rate on T–bills. The reason for this assumption is that with modern transactions technologies, money market funds and investing in T–bills can provide essentially the same transaction services provided by banks. With government provided insurance, banks have the same safety, the same liquidity, and provide the same transactions services as money market funds, and thus must pay the same interest rate.

In fact, banks usually pay a lower interest rate. We need to ask why. That question has two components: demand and supply. Why do banks pay lower interest rates? And why do individuals deposit their funds in accounts paying less than they could receive elsewhere? The answer, historically, to the first question is that banks were regulated in the interest rate that they could pay.

One answer to the second question – the one to which we are most attracted – is that there are lags in the market adjusting to the new economic environment. People have always used banks for writing checks. They think that there is something that they are getting in return for the lower interest rates paid. Eventually, it will dawn upon them that there is not.

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