Academic journal article Journal of Money, Credit & Banking

Capital Market Frictions and Deposit Constraints at Banks

Academic journal article Journal of Money, Credit & Banking

Capital Market Frictions and Deposit Constraints at Banks

Article excerpt

THIS PAPER LOOKS FOR EVIDENCE that bank lending is constrained by the availability of insured deposits because of informational frictions in the market for their uninsured liabilities. While the presence of such frictions in the market for debt of nonfinancial firms has been thoroughly explored by Fazzari, Hubbard, and Peterson (1988) and many others, informational and the resulting constraints may be just as important, if not more so, for banks. The role of banks and other intermediaries, according to theory, is to screen and monitor borrowers (Diamond 1984). If the information they produce about their loans is hard for outsiders to observe, the resulting asymmetry may hamper the ability of banks to fund their lending in capital markets.

In testing for deposit constraints on bank lending, we employ the strategy and tactics used in the large literature that tests for cash flow constraints on investment by nonfinancial firms. If firms have perfect access to capital markets, nonfinancial firms should be indifferent between funding their investment with external funds and internal cash flow. The finding that investment and cash flow are correlated, given investment opportunities, can be taken as evidence of frictions in the market for external funds. Houston, James, and Marcus (1996), one of the few studies of liquidity constraints faced by banks, implement such a test to find that bank lending is cash flow constrained.

This paper focuses on deposit constraints. Banks' access to insured deposits is a crucial difference between banks and nonbanks. Since deposits are federally insured, they are equivalent to cash flows as a form of "internal funds." In fact, insured deposits are a far more important source of funds than are cash flows, as seen in Table 1. Even the larger banks, those in the top quartile, fund nearly three-fourths of their assets using insured deposits. Cash flow, on the other hand, finances no more than 4 percent of bank assets. This is in sharp contrast to industrial firms, for example, that rely far more on retained earnings.


                                          Sources of funds
                                      (percent of total assets
                                          for median bank)

Bank size                          Retained   Insured    Uninsured
(Assets in 1995 dollars)           earnings   deposits     funds

First quartile                       3.3         83          8.3
(25th percentile = $98 million)

Second quartile                      4           82          9.2
(Median = $239 million)

Third quartile                       4.2         80         11
(75th percentile = $754 million)

Fourth quartile                      3.9         72         19

Bank size                          Number of
(Assets in 1995 dollars)           bank-years

First quartile                        1209
(25th percentile = $98 million)

Second quartile                       1208
(Median = $239 million)

Third quartile                        1208
(75th percentile = $754 million)

Fourth quartile                       1208

Source: End-of-year Quarterly Reports of Condition, 1992-95

Our test for deposit constraints also bears on a very basic question about the transmission of monetary policy: can the central bank still reduce the supply of bank loans by draining reserves? In theory, banks could maintain their lending after a loss of reserves by issuing large certificates of deposits (CDs) or other notes that no longer require reserves (Romer and Romer 1990). This basic point seems to rule out the possibility of a significant lending channel in the monetary transmission mechanism.(1) What this point overlooks, however, is that the deposits that still require reserves are also federally insured, whereas a substantial portion of the nonreservable liabilities (large CDs, notes, and debentures) are not. …

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