banking in the theory of strongfinancestrong - boston university.pdfVIP

Journal of Monetary Economics 6 (1980) 39-57. 0 North-Holland Publishing Company BANKING IN THE THEORY OF FINANCE Eugene F. FAMA* Unirvrsitv of Chicugo, Chicago, 1L 60637, USA Banks are financial intermediaries that issue deposits and use the proceeds to purchase securities. This paper argues that when banking is competitive, these portfolio management activities in principle fall under. the Modigliani-.Miller theorem on the irrelevance of pure financing decisions. It follows that there is no need to control the deposit creation or security purchasing activities of banks to obtain a stable general equilibrium with respect to prices and real activlt In practice, however, banks are forcibly involved in the process by which a pure nominal commodity or unit of account is made to play the role of numeraire in a monetary system. The paper examin the nature of such a nominal commodity and how, through reserve requirements, banks get involved in making it a real economic good. 1. Introduction This paper studies commercial banking from the viewpoint of the theory of finance. We take the main function of banks in the transactions industry to be the maintenance of a system of accounts in which transfers of wealth are carried out with bookkeeping entries. Banks also provide the service of exchanging deposits and other forms of wealth for currency, but in modern banking this is less important than the accounting system of exchange. Moreover, although both can be used to carry out transactions, one of our ma