Sluggish Deposit Rates: Endogenous Institutions and Aggregate Fluctuations

The interest rates that banks pay on deposits move more slowly than money-market interest rates, a phenomenon documented in several recent studies (Flannery [1982], Hannan and Berger [1991], and Neumark and Sharpe [1992]). Understanding deposit-rate sluggishness has important direct consequences for comprehending money demand and bank profitability, as well as indirect consequences for understanding almost all industrial pricing. However, even when this recent work takes an explicitly microeconomic approach, it does not consider market conditions that lead to the existence of banks. It may therefore distort the lessons of sluggishness both for macroeconomics and for industrial structure. This paper approaches the issue in terms of the microfoundations of banking. Although this theory may not be all-inclusive and may work in combination with other effects, ignoring it may mean that previous explanations of interest-rate sluggishness are misleading and that attempts to draw parallels with other industries regarding price rigidities could be biased. The sluggish adjustment of bank interest rates relative to prevailing market rates, as shown in figures 1 and 2, has puzzled economists since at least the mid-nineteenth century. Figure 1 compares the savings bond deposit rate with the commercial paper rate from 1840 to 1899. Figure 2 compares the same rate paid on savings bank deposits with the interest rate charged on call money from 1857 to 1899In both cases, the bank rate shows substantially less movement than the market rate. In fact, bank interest rates appear to be even more rigid than predicted by this paper. The stability of nominal rates, even in the face of the inflation of the 1850s and the deflation preceding resumption of the gold standard in 1879, suggests that for some reason, interest rates did not index to the inflation rate or to the money supply. Many of the price and nonprice constraints producing macroeconomic behavior originate not from an auction market, but from an organization. Banks, labor contracts, and corporations set interest rates, wages, and prices. I contend that such institutions arise to solve problems of risk and private information—precisely those problems associated with a recession, which