This section is from the book "Money And Banking", by William A. Scott . Also available from Amazon: Money and Banking.
The practice of paying interest on deposits is not universal. The Bank of England and the Bank of France do not indulge in it at all, and the laws governing some of the other large European institutions permit it only under special circumstances. For current accounts few banks pay anything, but on other deposits a low rate of some sort is customary in most cases. For a long time it was the rule of the joint-stock and private banks of England to pay one per cent below the published rate of discount of the Bank of England, but their action in recent years has been more independent and less uniform. In the United States most banks pay interest on time deposits, but the rate varies considerably in different parts of the country, though it is apt to be uniform among the banks of the same city.
The purpose of this payment is to increase deposits and to make them more permanent. Without it banks can expect to attract only the money in daily use and the capital temporarily out of employment, but if the rate paid is sufficiently high, they can attract capital from other forms of investment, and with even a small rate they can secure the use of funds in the hands of people who do not know how to use them or who prefer a small income from the bank with a high degree of safety to other investments at the time available. The funds left simply for safe-keeping are, moreover, apt soon to be withdrawn, while those for which interest is paid remain for longer periods, since their owners will only withdraw them when an opportunity for a superior form of investment appears. Banks are tempted to pay as high a rate as possible, since with a large loan-fund a very small percentage of profit may produce a greater total than a larger percentage on a much smaller sum, and the higher the rate the less apt are the deposits to be withdrawn.
The danger of this practice consists in the temptation which a high rate offers to make investments of a hazardous character or those unsuitable for banking purposes. If a bank pays a high rate for a considerable portion of its loan-fund, it must seek investments which bring relatively large returns, and these belong usually to one of the two classes above mentioned. People who are unable to offer first-rate security are obliged to pay high rates, as are the promotors of new and uncertain enterprises. But the paper of such people is a dangerous investment for banks, since it is not apt to be paid at maturity, and a certain portion of it not at all, and in times of difficulty it becomes useless as a means of replenishing the reserves. Many stock-exchange securities bring relatively high returns, but, since they generally mature only after long periods of time, and are subject to great fluctuations in value, especially in times of monetary stringency, they do not automatically turn themselves into cash at regular and short intervals, and they subject the banks to great danger and loss when they attempt to realize upon them. Indeed, it is a rule to which there are few, if any, exceptions, that investments which bring large returns are either insecure or unsuitable for banking purposes.
The problem presented by interest on deposits, therefore, is how to steer a middle course. The terms" low" and "high" rates are purely relative, but the only safe rule is to leave a fair margin between the rate on deposits and that of discount on first-class bills. It is certainly not illegitimate or unsafe for a bank to pay such a rate as will leave it a fair profit on first-class bank investments, but beyond this it is dangerous to go. Whenever obligations to depositors in the form of interest charges force investments which the bank would not otherwise dare to make, the rate is too high, and, if even the lowest rate accomplishes this result, the practice should be abandoned entirely. The Bank of England and the Bank of France are probably precisely in this condition. Without the offer of any attraction, except their reputations for soundness and stability, they secure sufficiently large deposits, and, on account of their peculiar duties towards other banking institutions and the public, the payment of interest is probably inadvisable. Whether it is safe to leave this matter entirely to the discretion of bank officials is a question which has been differently answered in different countries. The Bank of Germany is not forbidden to pay interest on deposits, but the total amount of such deposits cannot exceed the aggregate of the capital and the reserve. The Swedish Bank Act of 1897 forbids the payment of interest on deposits by the Riksbank except to those whose discounted bills are held by it. In the United States these rates are frequently regulated by clearing-house associations, and are commonly a matter of agreement between a number of banks.
Regarding the relation of interest on deposits to the charges made for loans no statement in the form of a law can be made. It may be said, however, that the current rate of discount determines what the banks can afford to pay depositors, though the proportion need not be the same in all cases. A bank whose current accounts form a large proportion of its total deposits can afford to pay a higher rate than one in which this item is relatively small. It is probably true that regarding this relation most banks follow the rule which experience has dictated, unless their action is determined by law or by agreement with other institutions. The rate of discount might be influenced by the interest paid on deposits, instead of vice versa, if the rate in the latter case were so high as to influence the nature of bank investments. It is conceivable, of course, that the regular discount fund might be considerably diminished if bankers were compelled to invest an unusual proportion of their means in long-time securities or even in short loans which yield high returns.
The subject of the bank rates has been nowhere fully and adequately treated, and it is only possible, therefore, to give references on special phases of the question. The rate of discount has been most studied in connection with the English bank rate, and on this subject the most exhaustive work has been published by Mr. R. H. Inglis Palgrave in his book entitled Bank Rate in England, France, and Germany, 1844-1878, and in a paper read before the Institute of Bankers, March 2, 1892, entitled "Bank Acts and Bank Rate, i845-'91." The same subject has also been treated by Mr. Edward Francis Steele in a prize essay published in the Journal of the Institute of Bankers, 1890-'91, entitled "On Changes in the Bank Rate: First their causes; and secondly their effect on the money market, on the commerce of the country, and on the value of all interest-bearing securities." Mr. Robert Giffen treats certain phases of the subject in a general way in his essays on "Gold Supply, the Rate of Discount and Prices" and " Bank Reserves," published in the Second Series of his Essays on Finance. Fluctuations in the English bank rate, especially the autumnal rise, are discussed by Mr. Stanley Jevons in his Investigations in Currency and Finance, ch. v. Interest on deposits is ably discussed by Scharling in his Bankpolitik, pt. II, ch. i. Clare's Money Market Primer, ch. xii, and his A B C 0} the Foreign Exchanges, chs. xvii-xxvii may also be read with profit in this connection. See also Bagehot's Lombard Street, chs. v and vi; and Schraut's Die Organisation des Kredits, ch. x.