A Test of the Deposit Relationship Hypothesis

In a recent article, Donald R. Hodgman set forth a framework for analyzing commercial bank lending behavior which emphasized the relationship of customers to their banks as both depositors and borrowers. Specifically, Hodgman links the borrower's contract rate of interest to the profitability of his deposit account, i.e., banks compete for profitable deposit customers by offering the customer a rate which is lower than the comparable open market rate (adjusted for risk). Hodgman uses the terms deposit relationship and customer relationship to describe this behavior. He argues that compensating balance requirements, the prime rate convention, and provision of services below cost may be viewed as a systematic, rational attempt by commercial banks to maximize long-run profit under existing institutional arrangements when viewed from the perspective of the customer relationship.