Comment and further evidence on ‘implicit interest on demand deposits’

Abstract

in a recent article, (1979) has made an interesting contribution to the literature concerning the payment of implicit interest on demand deposits by banks. usefully distinguishes between three competing propositions. The first, called the hypothesis' describes the commonly held view that banks pay no interest (explicit or implicit) on demand deposits. The second position is the traditional hypothesis'. This proposition holds that banks pay some implicit interst on demand deposits, although the amount paid is less (50'~o is Startz estimate) than what would be paid if the legal prohibition on the payment of interest was lifted. The third view, that banks pay a rate of implicit interest fully equal to the rate which would be paid in the absence of the legal prohibition, is called the 'competitive hypothesis'. As notes, most work (implicitly) accepts the traditional hypothesis. Startz, though, supports the modified traditional view, while Klein (1974) provides evidence in favor of the competitive hypothesis [see however, Carlson and Frew (1978) for some penetrating criticisms of Klein's work]. The issue of whether banks pay implicit interest and if so, how much they pay, is gaining in importance. There appears to be growing momentum in Congress to pass legislation ending the legal sanction about paying interest on demand deposits. The legislation would either directly repeal the prohibition or else indirectly accomplish the same goal by legalizing the nation~wide offering of interest bearing NOW (negotiable orders of withdrawals) or ATS (automatic funds transfer service) accounts, if the traditional hypotheses, or, to a lesser degree, the modified traditional hypotheses is true, the regulatory changes being considered by Congress would have a large. negative impact on the banking system because competition would force banks to incur substantial amounts as explicit interest. The specter of widespread banking failures and increased riskiness to the public brought