Financial Markets and Institutions (2-downloads)

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Part 5 Financial Markets

Money Market Cost Advantages

Banks must put aside a portion of their deposits in the form of reserves that are

held without interest at the Federal Reserve. Thus, a bank may not be able to invest

100% of every dollar it holds in deposits.

1

This means that it must pay a lower inter-

est rate to the depositor than if the full deposit could be invested.

Interest-rate regulations were a second competitive obstacle for banks. One of

the principal purposes of the banking regulations of the 1930s was to reduce com-

petition among banks. With less competition, regulators felt, banks were less likely

to fail. The cost to consumers of the greater profits banks earned because of the

lack of free market competition was justified by the greater economic stability that

a healthy banking system would provide.

One way that banking profits were assured was by regulations that set a ceiling

on the rate of interest that banks could pay for funds. The Glass-Steagall Act of

1933 prohibited payment of interest on checking accounts and limited the interest

that could be paid on time deposits. The limits on interest rates were not particularly

relevant until the late 1950s. Figure 11.1 shows that the limits became especially trou-

blesome to banks in the late 1970s and early 1980s when inflation pushed short-term

interest rates above the level that banks could legally pay. Investors pulled their

money out of banks and put it into money market security accounts offered by many

1

The reserve requirement on nonpersonal time deposits with an original maturity of less than 

years

was reduced from 3% to 0% in December 1990.

1

1

2

34 36 38 40 42 44 46 48 50 52 54 56 58 60

Year

62 64 66 68 70 72 74

82 84

76 78 80

86

Percent