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[Source:] If banks started simply depositing money with each other, all else aside, then what would happen? Keep in mind that the interest rate is basically the price of money. Supply-and-demand would dictate that ... ♦ a huge inflow of capital => you can lower the interest rate paid on that capital ♦. Banks don't pay high interest (and certainly wouldn't do so to each other) because of their intristic good will; they pay high interest because they cannot secure capital funding at lower rates. This is a large reason why the large banks will generally pay much lower interest rates than smaller niche banks; the larger banks are seen as more reliable in the bond market, so are able to get funding more cheaply by issuing bonds.

I understand (and so ask NOT about:) that interest rate = the price of money = opportunity cost of money, and also the implication that I surrounded with ♦ (a lozenge). What else would result? Please differentiate and segregate the positive and negative effects.

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The purpose of paying interest is to get people to lend you their money (by depositing it) so you can lend it out at a higher rate of interest. The argument here is that if the deposits outstrip the bank's ability to invest/lend, they don't need to offer as much interest to get those deposits. However, given current banking practice i don't think there is ever going to be more deposited funds than the bank can find profitable uses for, so the thought experiment sorta falls apart.

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  • $\begingroup$ Arguably the excess reserves that commercial banks now hold with central banks represent customer deposits that the commercial banks cannot find more profitable uses for. Negative interest rates in Japan, the Eurozone, Switzerland and elsewhere mean commercial banks are actually paying for this. $\endgroup$ – Henry Oct 6 '16 at 17:22
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There is an interesting aspect to this question, which maybe goes beyond the generality of your question but should be mentioned nevertheless. In fact the answer refers to a somewhat technicality concerning the Euro Zone. The ECB introduced negative interest rates their account, i.e. if a bank deposits money on the central bank is subject to these negative interest rates. The idea is that bank withdraw their money and some part of it will flow into the real economy which would lower interest rates.

However, ECB excludes a certain part of banks deposits from negative interest rates, the exact amount which is excluded is defined by the minimum requirement a bank is required to hold. Further, the minimum requirement a bank is forced to hold is defined as certain percentage of provided credits.

Now if banks would start to lend money to each other, banks would increase provided credits, which would increase minimum requirement. This would increase the amount exempted from negative interest rates. Consequently it would undergo ECB intention and interest rate would not fall.

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    $\begingroup$ What would the recipient banks do with the money, if not put it in their account with the central bank? I.e. why would they accept the loan? $\endgroup$ – Jason Nichols Mar 17 '15 at 14:40

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