Deposit relationships and bank portfolio selection

Abstract

In most models of bank portfolio selection, relations between the sources of bank funds and the way the funds are invested are ignored. A model is developed in which a bank competes for some of its deposits by offering loans to the depositors who demand loans at interest rates lower than the rates charged other borrowers. In a competitive banking industry, depositors will be offered better loan terms than non-depositors. The bank portfolio selection model is used to determine the effects of a tight money policy on the bank loan market. Under the assumptions used in constructing the model, bankers discriminate in favor of the borrowers who hold demand deposits at their banks as monetary policy becomes more restrictive. Banks are prohibited from paying interest on demand deposits. Since banks can increase their interest earning assets by increasing deposits, bankers have an incentive to compete for demand deposits by indirect means. One way to compete for demand deposits is to offer loans at reduced interest rates to the depositors who demand loans. The bank's revenue from business with a customer includes the interest payment on his loan and the interest income from investing his deposit. The opportunity cost of establishing such a relationship with a depositor is the market rate of interest times the loan to the depositor. Competitive banks reduce the loan interest rate for depositors until the profit from the total business with the depositor is zero. ...