Magazine article The Journal of Lending & Credit Risk Management

Make It Interesting

Magazine article The Journal of Lending & Credit Risk Management

Make It Interesting

Article excerpt

The Small Business Banking Act of 1997 promises to benefit banks, the Federal Reserve, and the customer. The bill's intention to deregulate interest on all banking deposits is an idea whose time better come soon, if bankers want to use it to competitive advantage. Once passed, the bill also challenges bankers to throw out "typical bank thinking" about products and pricing.

After nearly 20 years, the deregulation of interest on all banking deposits is entering its final phase. The move to pay interest on demand deposits and Federal Reserve balances is almost imperceptible, to the point at which most banks have not really thought about the effect of this previously unthinkable event. Oh, it's not going to happen immediately. But it will happen. A slim possibility in this Congress, but surely in the Congress elected in 1998. It's an idea whose time has come, and the forces behind it are building.

Timing

Among other purposes, H.R. 2323 is a bill designed to:

* Allow depository institutions to offer negotiable order of withdrawal accounts to all businesses.

* Repeal the prohibition on the payment of interest on demand deposits.

* Require the Board of Governors of the Federal Reserve System to pay interest on certain reserves.

One sign of the growing consensus to pass this bill is that it was introduced as The Small Business Banking Act of 1997. A similar bill, Payment of Interest on Business Checking Accounts, has also been introduced. While these bills - as well as proposals to set up new "super money market deposit accounts" or to grant exceptions for "periodic premiums" - are Washington perennials, why the heightened interest now?

The Fed needs it. The rapid growth of so-called "retail sweep accounts" now makes execution of monetary policy more difficult. This problem has been brewing for a long time, ever since money market mutual funds began to disintermediate bank deposits. As shown in Table 1, sweep accounts have markedly decreased Fed reserve balances in the past two years. Raising reserve requirements on demand deposits will not help, since no interest is paid on them and banks are thereby given incentives to cut demand deposits to a minimum. Demand deposits now account for about 20% of total deposits and about 15% of bank total liabilities, reflecting both runoff and increased bank borrowings (see Charts 1 and 2). Thus, the combination of interest on reserves and on deposits is the right solution to restore the Fed's ability to conduct monetary policy.

The Fed has already weighed in with support. In recent letters on this subject, Chairman Alan Greenspan noted, "[The Federal Reserve] would anticipate a considerable increase in demand deposits and associated reserve balances were interest to be paid on both demand deposits and reserve balances." Moreover, "The Federal Reserve has been concerned for some time that the spread of retail sweep accounts...could at some point complicate the implementation of monetary policy...authorizing the payment of interest on reserve balances...would greatly reduce the incentive of depository institutions to implement retail sweep accounts." He also noted that, "Permitting depository institutions to pay interest on demand deposits would eliminate a constraint that serves no purpose and imposes unnecessary costs on both businesses and depository institutions."

Table 1

Date                    January 1995     May 1996      January 1997

Reserves                 $24 billion    $16 billion    $11.7 billion
Sweep Account Balance    $10 billion    $98 billion    $170 billion

Banks need it. Banks are ready and some are even eager to make the adjustments. The securities markets have been eating banking's lunch for at least the last 15 years, draining away deposits into money market funds and savings into stocks, bonds, and other investments. Intermediation volume, leader- ship, and pricing have moved to the capital markets. …

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