The Commercial Banking Firm: A Simple Model

Abstract

A commercial bank must decide its volume of illiquid loans and investments without full knowledge of its deposits. In case withdrawals exceed its defensive position in liquid assets, the bank incurs extra costs in meeting reserve requirements, penalties in borrowing or losses in disposing of illiquid assets. In case of good luck on deposits, an unnecessarily large defensive position sacrifices profits from more remunerative but less liquid assets. The paper presents a simple model of this precautionary portfolio decision by a profit-maximizing bank. The effects of variations in monetary policy, banking regulations, and competitive structure are traced: reserve requirements, access to central bank credit, deposit interest rate ceilings, monopolistic power in loan and deposit markets, relative importance of capital and time deposit liabilities, size and nature of illiquidity penalties, and degree of deposit uncertainty. Commercial banks are the most important kind of financial intermediary. Their liabilities are the closest privately issued substitutes for government currency. Demand deposits serve as means of payment generally acceptable for most transactions. For several reasons, depositors bear very little of the risks of the loans the banks make. There are economies of scale in pooling of default risks specific to borrowers and in specialized administration and appraisal of the loans. The banks' shareholders assume the residual risk; only after their equity is wiped out would depositors' claims be jeopardized. Finally, the government stands behind bank deposit liabilities, both as ))lender of last resort>> to tide banks over crises of illiquidity and as insurer of deposits against the contingency of insolvency. Government monetary and credit policy operates mainly through the commercial banking system, and this is the main reason today to give special attention to commercial banks. Historically the first reason for government intervention in the banking business was to protect depositors (or in older times bank note holders) against the risks of bank illiquidity and insolvency. But the public regulations and institutions established for this purpose can also be used to regulate credit markets in the interests of economic stabilization, maintenance of the value of the currency, or other government objectives. As the protective purpose of government intervenScand. J. of Economics 1982 This content downloaded from 207.46.13.172 on Fri, 07 Oct 2016 06:13:42 UTC All use subject to http://about.jstor.org/terms