By Megan L. Desso
July 21, 2011, marked the effective date of the repeal of Section 19(i) of the Federal Reserve Act (FRA), also known as Regulation Q, thereby allowing banks to pay interest on demand deposit balances. Buried on page 715 of 2,319 pages, Section 627(a)(i) of the Dodd-Frank Act (DFA), with only the word “[Repealed],” Section 19(i) of the Federal Reserve Act and the implementing regulations are forever repealed.
Regulation Q is a 75-year-old regulation that is a basic tenet of banking as we know it. The prohibition on paying interest is at the heart of every bank’s business plan and is integral to their pricing process.
A little history on Regulation Q
Regulation Q was passed in 1933. Lawmakers sought to improve economic growth by prohibiting the payment of interest on demand deposits, thereby incentivizing businesses and high net worth individuals to seek investment opportunities that would more directly benefit economic growth.
In 1979, at the beginning of the savings and loan crisis, the industry was challenged by high interest rates, regulatory restrictions on the payment of interest, inflation and the doubling of oil prices, all of which threatened the viability of community banks. Lawmakers responded first with the Monetary Control Act (MCA) of 1980, which established the Depository Institution Deregulation Committee (DIDC), whose primary charge was to phase out Regulation Q.
By 1986, the phase-out of interest rate ceilings was complete. Congress then passed the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). Among other things, the act included the creation of the Office of Thrift Supervision (OTS), and gave both Fannie Mae and Freddie Mac additional authorities to support mortgages for low- and moderate-income families. This latest recession saw the demise of the quasi-governmental facilities, Freddie Mac and Fannie Mae, and the removal of the OTS. In 2001, the legislature introduced the Small Business Interest Checking Act of 2001 (SBICA), which included an element to repeal the last remaining piece of Regulation Q and Section 19(i) of the Federal Reserve Act. The SBICA also intended to allow the Federal Reserve Board (FRB) to pay interest on reserve balances and clearing balances, but not excess balances. Although SBICA did not become law, many of its elements have been incorporated into other regulatory changes over the years.
In 2008 and 2009 amendments were made to Regulation D to allow the FRB to pay interest on reserve and excess balances, and even to establish a program whereby correspondent banks could act as aggregators in the placement of client funds into an excess balance account. These programs have been extremely successful as community banks flee to the safe harbor of government offered, risk-free, overnight investment options that pay on average 20-basis points higher than the open market.
Most recently, the repeal of Section 19(i) was reintroduced in the DFA, lawmakers maintained that the measure was designed to help community banks compete more effectively against the largest banks for deposits.
However, businesses, and highly liquid households, long ago fled the traditional banking system for “smarter” non-bank investments, which paid better rates of return than traditional banking products.
The huge reduction in deposits has also impacted the Federal Reserve System, by reducing the reserves held at the Fed. The Fed is clearly in competition with the private sector as it desperately attempts to raise reserves and increase its balance sheet.
The effects: past,
present and future
Currently, as short-term investments are earning 25 basis points or less, permitting banks to pay interest on demand deposit balances may seem like a nominal overall effect. We need to look forward to the effect in a rising rate environment (as we are, or should be, preparing for now). Banks would typically look to lock in lower funding rates rather than collect deposits with floating rates that will increase their costs of funds quickly when rates begin to rise.
The true impact of this change cannot be understood in this historically low-rate environment. The Fed Funds rate rose almost 400 basis points following the last recession. ALCO committees need to consider what the impact will be when rates go up 200, 300, or 400 basis points.
Regulators are now requiring banks to perform stress testing for 400 and 500 basis point shock scenarios.
This change will squeeze already tight margins, and negatively impact net interest income for community banks, while sending customers to the highest bidder. It will have damaging effects on community banks’ costs of funds and take a toll on the cost of credit for customers.
The historically low rates banks we are now experiencing have played havoc with asset yields, although the decline in the cost of funds has, in part, compensated for this situation. Repeal threatens to tear away the last thread of hope for community banks to have any positive net interest margin, as it will certainly increase their cost of funds as they fight for deposits against the too-big-to-fail banks. Furthermore, the repeal will raise interest rate risk – especially in a rising rate environment.
Community banks across the nation are liquidity flush with nowhere good to place their excess funds. They don’t want to build their balance sheets further. Taking in more deposits without a plan to redeploy the funds is both an ALCO nightmare and a hugely negative impact on capital ratios (which the regulators are expecting financial institutions to increase in line with DFA requirements).
When interest rates move up, the elimination of Reg Q combined with the FDIC’s transaction account guarantee program, the new FDIC assessment base, and the increased cost of funds may cause unintended effects to the flow of capital and the risk profile of the banks. This spells A-L-C-O in my book. ALCO committees across the nation will be hard at work anticipating the effect of this legislative change and the overall impact the collective changes will have on deposits, interest spreads, cost of funds, and capital ratios. Community banks will need to make ALCO pricing decisions without truly knowing the effects of this repeal, and will again be forced to follow suit with what the too-big-to-fail institutions do.
The solution that
creates more problems
The FRB needs ample balances, which are obtained through reserve requirements, clearing balances, excess balances, and so forth, since it is this liquidity that’s necessary to maintain, and not compromise, the float that the FRB uses to clear checks, process wires and perform other functions.
As the industry moves to a more fully electronic and image based clearing environment, additional downward pressure is placed on the FRB because the traditional float gap recognized in the paper-based check clearing system is all but gone. The Fed needs more liquidity, and, subsequently, more monetary tools to attract liquidity in a climbing rate environment.
It’s worthy of noting that the FRB is the very entity driving the industry to become fully image-based. Again, another case of being careful what you wish for – does anyone think for a minute that when Check 21 was passed the FRB fully understood the impact to its bottom line?
The government’s actions have only drawn more liquidity out of the public banking sector as banks react conservatively to the poor economic state and flee to place their excess liquidity in the government sponsored risk-free overnight investments. And of course, it is also the government that is encouraging banks to lend.
Bankers should be asking: What will this do to my cost of funds? What will it do to my service fee income? What will be the impact on my interest yield curve? What services will I have to charge for that I don’t now, to recover costs? How will I compete with the largest banks or will this even be an issue? Will I have to change my account analysis system and, if so, how costly will it be? What will the impact be on wire fee income if the sweep function is no longer needed? And then there’s this: Until December 31, 2012, non-interest bearing transaction accounts will receive 100 percent FDIC coverage on balances. How will this play into the decision for banks?
It’s highly questionable to believe that this repeal will be “good” for community banks and, for that matter, anyone else. Aside from the obvious, such as the increased cost of funds, the additional competition this will cause with the largest institutions, and the possible loss of market share with small businesses, community banks will be forced to charge additional and new fees to recoup the increased cost of funds and other expenses once this change is effective.
Speaking both as a bank employee and as an average consumer, I can thank the government for, once again, increasing my cost of banking. Gone will be the days of free checking and rebated ATM surcharges. Yes, gone will be the days of “cheap banking.” ■
Megan L. Desso is enterprise risk manager at Bankers’ Bank Northeast, Glastonbury, Conn., which provides correspondent banking services to more than 200 community banks in the Northeast. She can be reached at firstname.lastname@example.org.