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https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Collection: Paul A. Volcker Papers Call Number: MC279  Box 8  Preferred Citation: NOW Accounts [Folder 1], 1973-1976; Paul A. Volcker Papers, Box 8; Public Policy Papers, Department of Rare Books and Special Collections, Princeton University Library Find it online: http://findingaids.princeton.edu/collections/MC279/c133 and https://fraser.sdouisfed.org/archival/5297 The digitization ofthis collection was made possible by the Federal Reserve Bank of St. Louis. From the collections of the Seeley G. Mudd 1Vlanuscript Library, Princeton, NJ These documents can only 13e used for educational and research purposes ("fair use") as per United States copyright law. By accessing this file, all users agree that their use falls within fair use as defined by the copyright law of the United States. They further agree to request permission of the Princeton University Library (and pay any fees, if applicable) if they plan to publish, broadcast, or otherwise disseminate this material. This includes all forms of electronic distribution. Copyright The copyright law of the United States (Tide 17, United States Code) governs the making of photocopies or other reproductions of copyrighted material. Under certain conditions specified in the law, libraries and archives are authorized to furnish a photocopy or other reproduction. One of these specified conditions is that the photocopy or other reproduction is not to be "used for any purpose other than private study, scholarship or research." If a user makes a request for, or later uses, a photocopy or other reproduction for purposes not permitted as fair use under the copyright law of the United States, that user may be liable for copyright infringement. Policy on Digitized Collections Digitized collections are made accessible for research purposes. Princeton University has indicated what it knows about the copyrights and rights of privacy, publicity or trademark in its finding aids. However, due to the nature of arcliival collections, it is not always possible to identify this information. Princeton University is eager to hear from any rights owners, so that it may provide Ilu accurate information. When a rights issue needs to be addressed, upon request Princeton University will remove the material from public view while it reviews the claim. Inquiries about this material can be directed to: Seeley G. Mudd Manuscript Library 65 Olden Street Princeton, NJ 08540 609-258-6345 609-258-3385 (fax) mudd@princeton.edu   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  AMERICAN BOARD OF (111'4- Tit:CRS OF ièk FEDEUI. RESEriVE  BANKERS ASSOCIATION  1976 NOV 12 M110: 36  EXECUTIVE VICE rRESIDENT  RECEIVED OFFICE OF THE CHAIRMAN  \NiIlisW Alexander 202/467-4211  kokii 4,c 11 November 1976  1120 Connecticut Avenue, N V. Washington, D.C. 10036  / 2g  The Honorable Arthur F. Burns Cha'irman Board of Governors of the Federal Reserve System 20th & Constitution Avenue, N. W. Washington, D. C. 20551 Dear Chairman Burns: I am writing because of concerns expressed by several bankers about a Federal Reserve Board staff study, "Effects of NOW Accounts on 1974-1975 Commercial Bank Costs and Earnings," by John Paulus. We realize the paper is merely a study by one of your staff economists and does not represent an official position of the Board. Nevertheless, the wide publicity given the study by the press, Senator McIntyre, and others, has prompted me to express our concern about its cursory treatment of some important policy issues. Specifically, the opening section of the paper says that given "the accumulating evidence that NOWs have not significantly reduced commercial bank market shares, or after tax earnings at the aggregate level, it would appear that the NOW account program has been an almost unqualified success." The paper goes on to say "some weaker banks could experience serious financial difficulLies if NOW pressures on costs and revenues continue. In the event such difficulties disrupt financial markets, the final verdict on NOWs may be less optimistic." Thus, the attitude of the author seems to be that statewide market shares and the stability of financial markets are the only criteria 1 that should be used to evaluate the NOW account program. We disagree. The cost burden of NOW accounts is particularly heavy on smaller consumer oriented banks whose market area typically is smaller than that encompassed by statewide boundaries. The aggregation of all markets in a state would give adequate information about local markets only if NOW accounts impinged equally on all banks in all markets, and the innovation had, in fact, spread throughout the state. Neither of these conditions holds. More importantly, we do not think the problems of individual smaller banks that are hurt by NOW accounts can be summarily dismissed. The banks affected are managed by people who made decisions to serve the needs of their communities under a given set of rules and regulations. They are not responsible   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  AMERICAN BANKERS ASSOCIATION  vse  r4l1ING uo  11 November 1976  SHEET NO.  TWO  for changing the rules, policymakers are. Failure of such institutions for reasons beyond managerial control would be a disservice to the management of these banks and the communities they serve. We believe these institutions deserve due consideration. We shall continue our own evaluation of the NOW account program. As the Board undertakes its evaluation, we hope it will make a balanced consideration of the problems encountered by all financial institutions and their customers.  Sincerely,  Willis  Ale ander  WWA:mfc   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  S.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  0-13- 7LBOARD  OF GOVERNORS OF THE FEDERAL RESERVE SYST EM  Mr. Chairman---  Paul Nelson, chief of staff of House banking called to indicate that Reuss has now received letters from three Reserve Bank presidents and that the letters are almost identical. Paul put forward the thesis that we were co-ordinating the replies and indicated --"w e are going to blast you people':  Ken G.  cc--Joe Coyne  DRAFTED BY:  Ea( sari,  A. atut-wva_ REVIEWED BY:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  T,  QkL-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  September 10, 1976  The Honorable Henry S. Reuss Chairman Committee on Banking, Currency and Housing House of Pepresentatives •ashington, D. C. 20515 Dear Mr. Chairman: In accordance with the request in your letter of April 19, I am pleased to enclose a paper prepared by a member of the Board's staff entitled "Effects of NOV Accounts on 1974-75 Commercial Bank Costa and Earnings. This study analyzes the effects of the introduction of NOV accounts in Massachusetts and New Hampshire on bank profits and market shares. It also contains some comments on the characteristics of the possible long-run balance that might be achieved with the continued payment of interest on transactions balances, and the transition problems that would be associated with such a development. I hope that you will find the study helpful. As indicated, it expresses staff judgments, which have not been reviewed or approved by the Board of Governors. cAncerely yours,  Arthur F. Burns  Enclosure EE:ja cc: Ed Ettin  HOUSE  :»Q  Dixon Prins -NartIlup  2129 RHOB McMahon tI 2136 Weintraub B-371A Sivon 2129 --Feinberg, 212 HOB Annex* Lewis B-371A RHOB Gasper  tJo  3156-HOB-Annex-2-** 3154 HOB Annex 2** 605 HOB Annex* 605 " * " 3154 HOB Annex 2** 2222 RHOB  Secrest DOreMUS Flaherty D'Arista Couch Crews  2129 RHOB B-371A " 2129 " 2129 IT 3154 HOB Annex 2129 RHOB  * N.J. Avenue & C Streets, S.E. ** Independence Avenue & 2nd Street, S.W.  SENATE 5300 DSOB 5310 5230 Abshire A-522, 119 D St., N.E. Henderson 5300 DSOB Mar inaccio 5300 DSOB Rohner A-524, 119 D St., N.E. Kuttnex„, 5300 DSOB  JEC Stark  G-133 DSOB  Krumbhaar   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  G-133 DSOB  Karl ::Th  C-133 DSOB  (House Gov't. °pers.)  B-350A RHOB  House BUDGET Gross Teeters Miller Jewell  5226 DSM 456 R;;33 A-719 Annex 3, 119 D St. 1251 PSOT,', 5300 " 5300 5300 5300  ;  Rosenthal's Subcommittee Barash  Buckley Marcuss Bray Wahlstrom Bachrach Jordan Brooks  Dugger  B-350A RHOB  Senate BUDGET  214 HOB Annex* tl  II  It  It  TI  It  It  II  Boyd Packer  208 Carroll AI:ms Annex It  T.'  -  EFFECTS OF NOW ACCOUNTS ON 1974-75 COMMERCIAL BANK COSTS AND EARNINGS BY JOHN D. PAULUS  August 1976  Staff, Board of Governors of the Federal Reserve System This study represents a joint effort of several members of the Federal Reserve System staff. First, Ralph Kimball of the Federal Reserve Bank of Boston deserves a special thanks. His assistance was invaluable on matters ranging from defining marginal bank groups to conducting bank interviews. At the Board, Edward Ettin, James Kickline, John Mingo and Perry Quick made particularly valuable contributions and improvements to the final draft. Others who read an earlier draft and made valuable coullitents include David Lindsey, Ray Lombra and John Williams from the Board and Paul Anderson, Robert White and Mary Chamberlain from the Boston Fed. Jeff Susskind and Rebekah Wright assisted in gathering data and preparing tables, and Mary McLaughlin and Denise Lancaster typed the final as well as earlier drafts. Despite the assistance of these people, I alone am responsible for any remaining errors of judgment or analysis. NOTE: The judgmentsand conclusionsof this paper are not necessarily those of the Board of Governors of the Federal Reserve System.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  V  CONTENTS  I.  II.  III.  IV.  V.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  INTRODUCTION Regulation and Growth Purpose and Scope Summary and Conclusions  1  FLOWS OF FUNDS AND MARKET SHARES Source of NOW Funds Market Shares of Total Deposits  7  EFFECTS OF NOW ACCOUNTS ON AGGREGATE COMMERCIAL BANK COSTS AND EARNINGS Incremental Costs of NOWs Reductions in Earnings from Demand Deposit Outflows After Tax Reduction in Earnings  15  ADJUSTMENT PROBLEMS OF INDIVIDUAL BANKS High Ratio Banks Runoff Banks Low Income Banks Summary of Marginal Bank Earnings Portfolio Adjustments by Marginal Banks  24  THE LONG RUN ADJUSTMENT PROBLEM OF COMMERCIAL BANKS Characteristics of the Steady State Transtion to the Steady State  36  APPENDIX A Removal of Interest Rate Constraints, Bank Costs of Acquiring Funds, and Portfolio Risk  42  APPENDIX B Short-Run Profit Maximization as a Sub-Optimal Criterion When the Long-Run Supply of Funds Depends on Market Shares Established During a Transition Period  47  •  I.  INTRODUCTION  In May 1972 the Massachusetts Supreme Court ruled that state law did not prohibit mutual savings banks from offering negotiable orders of withdrawal (NOW) from savings accounts.  Following this  ruling several state chartered mutual savings banks (MSBs) in Massachusetts began to issue NOW accounts, and, in September, a savings I.nk in New Hampshire began offering NOWs after determining that New Hampshire law was similar to that of Massachusetts.  Although these  rulings allowed state-regulated MSBs to participate in the NOW market, federally chartered or insured depository institutions could not-under federal regulations--offer NOWs.  The resultant controversy led  to congressional legislation--Public Law 93-100--signed on August 16, 1973, authorizing all depository institutions (except credit unions) in Massachusetts and New Hampshire to offer interest bearing deposits on which withdrawals by negotiable order could be made.  This legis-  lation thus established a formal experiment in the two states in which limited demand deposit powers were extended to thrifts and the payment of interest on  transactions balances was authorized for the first  tiII_ since 1933. Regulation and Growth Regulation of NOW accounts was divided between the Federal Reserve Board, the Federal Home Loan Bank Board, and the Federal Deposit Insurance Corporation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  All institutions were authorized to begin offering  •  -2-  NOWs on January 1, 1974, but NOW accounts were to be issued exclusively to individuals, non-profit organizations and sole proprietorships. Partnerships, corporations, state and local governments, and financial institutions were prohibited from holding NOWs.  Because eligible  individuals and institutions held an estimated one-third of the $6 billion in demand deposits in Massachusetts and New Hampshire in 1974, this prohibition limited to about $2 billion the maximum level of conversions from commercial bank (CB) demand balances to NOW accounts; of course, NOWs could also attract funds from other financial assets, especially savings deposits. The three federal agencies imposed an interest rate ceiling of 5 per cent on NOW accounts offered by all institutions, the same as on savings deposits at CBs but one-fourth of a point less than thrifts are permitted to pay on savings deposits.  At the end of 1975, 97 per  cent of all institutions offering NOWs were paying this 5 per cent ceiling rate of interest. Congress did not include in the law uniform reserve requirements against NOWs.  Because NOWs are technically savings accounts,  members of the Federal Reserve System must hold 3 per cent in required reserves against NOW balances, as compared to reserve requirements averaging about 10 per cent  on demand deposits.  Nonmember banks and  thrifts in Massachusetts and New Hampshire hold negligible reserves in non-interest bearing form against both demand deposits and NOW accounts.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -3-  The popularity of NOWs with consumers is evidenced by the rapid and steady growth of these accounts.  In the first two years of  the experiment, NOW balances grew at an average rate of 7-2/3 per cent per month, advancing from $143 million to $839 million.  As shown in  Figure 1, the monthly growth rates over this period have been quite stable, although during the last half of 1975 the rate of NOW growth declined somewhat, averaging just under 6 per cent per month.  FIGURE 1 NOW BALANCES ON RATIO SCALE ($ millions)  Purpose and Scope NOW accounts have evolved into a very close substitute for personal checking accounts, thereby eroding CBs traditional monopoly   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -4position in the issuance of such  accounts.  With such erosion,CBs  in Massachusetts and New Hampshire have lost the exclusive claim to offering "one-stop banking" to individuals who, for convenience, might be willing to maintain a time or savings account, even at relatively unfavorable interest rates, at an institution that provides checking services.  Moreover, the payment of interest on NOW accounts, many  of which represent direct conversions of zero-interest demand deposits, has raised the average costs to CBs of acquiring funds. These factors suggest that NOW accounts could affect the stability and the viability of coluutercial banking in Massachusetts and New Hampshire as CBs attempt to adjust to the new, more competitive environment.  This issue--the stability of commercial banking in  the two states during the adjustment period--is the subject of the remainder of this study. to analyze  the  Both aggregate and micro data are used  ongoing adjustment of banks in the two states.  In Sections II and III, a broad view is taken of industry wide developments in banking in 1974 and 1975.  Shifts in market shares  are reviewed, and the hypothesis that the spread of one-stop banking to thrifts might cause CBs to lose significant amounts of demand related funds--especially small time and savings deposits--is examined. Rough estimates of the direct effect of NOW accounts on CB costs and earnings since January  1974 are also developed and discussed.  In Section IV the emphasis shifts to the adjustment problem of selected individual CBs.  In any industry, it is the  -5-  Itmarginal" firms--those firms with relatively high costs, or inadequate revenues--that determine the flexibility of the industry in adjusting to changes in the competitive and regulatory environment.  The effect  of NOW accounts on costs and earnings of 40 such marginal banks in the two states are therefore analyzed for 1974 and 1975.  Moreover, adjustments  in asset portfolios are considered to determine whether these banks have attempted to offset lower earnings by undertaking more risky investments. In Section V, characteristics of the steady state--the period after which the industry has had ample time to adjust fully to NOW accounts--are discussed, including implications for increased efficiency in the allocation of resources and the extent to which the public S.nefits, on balance, from the issuance of NOW accounts.  In addition,  future CB adjustment problems are considered as NOW balances continue to grow toward some equilibrium level. Summary and Conclusions Although NOWs represent a relatively expensive source of funds, banks began to compete aggressively for such deposits in 1975, despite low rates of return on money market instruments and weak demand for business loans.  As a result, NOW related flows of funds have had only amodest effect  on the CB share of total deposits in Massachusetts and New Hampshire.  By  the end of 1975, two full years after the NOW experiment began, households in the two states had converted an estimated $370 million in CB demand S.lances to NOW accounts at thrifts.  However, there is no evidence that  significant flows of time and savings deposits have accompanied this demand outflow from CBs.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Thus, NOW induced shifts in deposit flows, confined  mainly to demand deposits, appear to have reduced the CB share of deposits in the two states--which total nearly $40 billion--by about one percentage point. The effects of NOWs on aggregate CB costs and earnings are limited by the relatively small size of the NOW market in the two states-demand balances eligible for conversion to NOW accounts, for example, represent less than 15 per cent of total deposits at CBs.  In 1974,  higher costs and deposit outflows associated with NOWs reduced aggregate CB after tax earnings an estimated 2-1/2 per cent.  Heightened consumer  awareness of NOWs by 1975 caused an acceleration in the growth of these deposits, resulting in substantial increases in bank costs of funds.  As  a result, the estimated earnings reduction attributable to NOWs in 1975 was more than twice that of 1974. It is argued in the final section that after all adjustments are complete--a process that may take several more years--CB costs of acquiring transactions balances could ultimately decline as a result of removing the restriction against the payment of interest on such funds. Given this expectation--which implies that both consumers and banks will be better off in the long run--and the accumulating evidence that NOWs have not reduced significantly either CB market shares or after tax earnings at the aggregate level, it would appear that the NOW experiment has been an almost unqualified success to date. However, an examination of the earnings of those banks that appear to be most vulnerable to competitive pressures from NOWs--the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -7-  "marginal" banks--revealed that the earnings performance of such banks deteriorated significantly in 1975 relative to that of other banks in the two states.  In the next few years the earnings prospects for many  marginal banks in Massachusetts and New Hampshire, which tend on average to be relatively small, may worsen as conversions and outflows of demand deposits continue.  Though NOWs may be only one of many contributing  factors, some weaker banks could eventually experience serious financial difficulties if NOW pressures on costs and revenues continue.  In the  event such difficulties should disrupt financial markets, the final verdict on NOWs may be less optimistic than the 1974-75 aggregate figures would suggest.  However, the likelihood of such disruptions is probably  small because the link between the disappearance or enforced merger of a limited number of weak banks, which is an uncertain event itself, and the stability of financial markets, is very difficult to establish.  II.  FLOWS OF FUNDS AND MARKET SHARES  The share of the NOW market held by CBs, shown in Table 1, has risen steadily since the beginning of the NOW experiment, reaching 43 per cent by the end of 1975.  MSBs held 46 per cent of all NOW  balances at that time, while savings and loan associations and cooperative banks (S&Ls and Coops) held the remaining 11 per cent.  During 1974,  CBs and MSBs each captured 41 per cent of net new NOW balances, with S&Ls and Coops attracting 18 per cent.  In contrast, in 1975 CBs acquired 56  per cent of the increase in NOWs, while MSBs and S&Ls and Coops received 33 and 11 per cent, respectively, of net new inflows.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  TABLE 1 WITHDRAWAL (NOWs) OUTSTANDING BALANCES AND SHARES - NEGOTIABLE ORDERS OF (in thousands of dollars)  COMMERCIAL BANKS MONTH ENDED 1972--Sept. Oct. Nov. Dec. 1973--Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. 1974--Jan. Feb. Mar. Apr. MaJue July Aug. Sept. Oct. Nov. Dec. 175--Tan. ,Pb. Mar. Apr. May Jiine   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Aug. Sept. Oct. Nnv. Dec.  TOTAL OF ALL OFFERING INSTITUTIONS 11.094 22,386 34,823 45,272 60,726 73,451 86,118 94,606 102,045 108,381 113,418 117,005 120,223 130,361 136,872 143,254 143,190 150,447 165,157 174 682 180,637 191,229 204.646 232.386 249,033 270,813 293,305 312,576 339,982 385,190 449,638 472,864 514,018 580,331 630,402 670,790 713,419 761,967 796,533 839,339  TOTAL  2,556 4,338 6,588 9,689 11,052 13,771 17,919 32,955 39.253 46,776 55,994 65,249 82,861 107,481 137,519 150.999 172,653 210,838 233,513 256,992 289,308 305,214 325,519 359,023  MASS.  2,274 3,857 5,916 8,458 9,296 11,156 14,175 28,450 33,597 40,245 48,563 56,989 73,517 96,647 124,706 136,165 155,318 185,923 201,607 217,936 235,029 254,821 271,691 302,112  N.H.  282 481 672 1,231 1,756 2,615 3,744 4,505 5,656 6,531 7,431 8,260 9,344 10,481 12,813 14,834 17,335 24,195 31.096 39,056 45,279 50,393 53,828 56,911  SHARE OF TOTAL NOWS  .02 .03 .04 .06 .06 .07 .09 .14 .16 .17 .19 .21 .24 .28 .31 .32 .34 .36 .37 .38 .39 .40 .41 .43  MUTUAL SAVINGS BANKS  TOTAL 11,094 22,386 34,823 45,272 60,726 73,451 86,118 94,606 102,045 108,381 113,418 117,005 120,223 130,361 132,872 143,254 139,779 143,764 154,007 157,412 159,591 164,733 171,503 180,335 187,721 197,758 206,764 213,661 220,725 236,580 262,797 268,571 283,322 304,633 327,417 337,684 351,612 368,271 378,792 386,560  MASS.  N.H.  11,094 22,386 460 34,363 750 44,522 1,065 59,661 1,476 71,975 1.956 84,162 2,265 92,341 2,412 99,633 2,693 105,688 2,932 110,486 3,153 113,852 3,964 116,259 4,488 125,873 5,077 131,795 5,226 138,028 4,947 134,832 5,311 138,453 6,162 5 147,84 7,103 150,309 8,081 0 151,51 8,787 155,946 9.959 161,544 11,216 169.119 175,340 12,381 184,830 12,928 192,577 14,187 200,083 13,578 206,797 13,928 221,506 15,074 246,259 16,538 250,780 17,791 263,978 19,344 283,134 21,499 303,805 23,612 213,117 25,567 324,005 27,607 338,580 29,691 347,145 31,647 356,319 30,241  SHARE OF TOTAL NOWS  SAVINGS & LOAN ASSOCIATIONS SHARE OF TOTAL NOWS N.H. MASS. TOTAL  a CO  .98 .96 .93 .90 .90 .86 .84 .78 .75 .73 .71 .68 .65 .61 .58 .57 .55 .53 .52 .50 .49 .48 .48 .46  855 2,345 4,562 7,581 9,994 12,725 15,224 19,096 22,059 26,279 30,547 33,666 36,396 41,482 49,322 53,294 58,043 64,860 69,472 76,114 81,499 88,482 92,222 93,756  855 2,345 4,325 6,913 8,351 11,089 13,223 16,781 19,314 23,316 26,689 29,747 32,369 37,215 43,980 47,185 51,388 57,315 61,554 67,519 72,407 78,785 81,863 84,168  237 ' 668 1,143 1,636 2,001 2,315 2,745 2,968 3,858 3,919 4,027 4,267 5,342 6,109 6,655 7,545 7,918 8,595 9,092 9,697 10,359 9,598  .01 .02 .03 .04 .05 .07 .07 .08 .09 .10 .10 .11 .11 .11 .11 .11 .11 .11 .11 .11 .11 .12 .12 .11  •  -9-  The success of CBs in 1975 in attracting  or retaining NOW  funds can be attributed in part to the large increase in the number of offering institutions relative to that of MSBs.  In 1975, the number of  CBs offering NOW accounts increased from 64 to 134, while the number of offering MSBs rose only from 157 to 175.  Though a large number of S&Ls  and Coops entered the NOW market in 1975, their ability to attract NOW balances has been limited by the relatively small size of these institutions in the two states. Source of NOW Funds Establishing the source of NOW funds--whether demand deposits, time and savings deposits, or other--is of considerable importance in examining NOW related market share developments and, as will be shown in Section III, in estimating the aggregate earnings impact of NOWs on CBs. One important type of evidence on this matter concerns the behavior of active NOW accounts and the proportion of NOW funds in active and inactive accounts.  Draft activity against active NOW accounts (i.e., those with at  least one draft drawn in a given month) has increased gradually during the experiment and now averages about 11 drafts per month.  Since the average  number of checks written against personal checking accounts in New England in 1974 was about 14, this suggests that active NOW accounts are being used primarily as checking accounts. As a first approximation it thus seems reasonable to assume that funds in active NOW accounts were acquired largely from demand deposit balances.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  If, as seems plausible, inactive NOW funds originated  -  primarily in sources other than demand deposits--especially time and savings deposits--then total active NOW balances can serve as an estimate of the amount of NOW funds that were converted, or diverted, from demand deposits. Though there are no data on active and inactive balances, estimates can be obtained from data on the number of active and inactive NOW accounts in the two states.  In December 1975, there were 764,984  NOW accounts at banks and thrifts in Massachusetts and New Hampshire, of which 157,136--or 21 per cent--were inactive.  If the average  balance in these inactive accounts was equal to the average balance in savings accounts in CBs in New England, which is $1100, then inactive balances totaled some $170 million in December, or about 20 per cent of  2/  total NOW balances.  This leaves  $670 million, or about 80 per cent,  1/  Of course, the 157,136 inactive accounts include some that were active in earlier months; likewise, some of the accounts that were active in December were inactive in one or more previous months. However, it is believed that the number of drafts written against each account is relatively stable from month-tomonth, so that membership in the two classes of accounts--active and inactive--is also relatively stable. A necessary (though not sufficient) condition for stable membership in the two classes is that the percentage of inactive accounts must be relatively stable. This condition is satisfied adequately in the two states where the percentage of inactive accounts has fluctuated narrowly from month-to-month while declining from 26 per cent in mid-1974 to 20 per cent in December 1975.  2/  Passbook savings balances in thrifts average between $2000 and $3000 in Massachusetts and New Hampshire. However, those savings balances that were converted to NOWs can be expected to be much smaller than this average because of the one-fourth percentage point loss in earnings which becomes significant for large accounts. Moreover, many of the larger savings accounts at thrifts are held by businesses and are therefore ineligible for conversion to N0Ws. Thus, the $1100 figure is applied to both thrifts and CBs.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -11--  in active balances.  This estimate of the proportion of NOW balances  attracted from demand deposits is similar to those offered by banking industry representatives in Massachusetts. In Table 2, estimated active and inactive balances are shown for CBs and thrifts in December 1975.  As shown in column 3, thrifts  held an estimated $370 million in active NOW balances in December. These funds, serving largely as checking balances,-' been obtained primarily from CB demand balances.  appear to have  Of the $110 million  in inactive accounts at thrifts, an undetermined part was no doubt obtained from CB time and savings deposits, with most of the remainder representing conversions from time and savings at thrifts.  This  TABLE 2 ESTIMATED ACTIVE AND INACTIVE NOW BALANCES ($ in millions) December 1975  Massachusetts and New Hampshire  359.0  61.4  297.6  MSBs  386.6  89.6  296.9  93.8  21.8  71.9  839.3  172.8  666.5  TOTAL   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Estimated Active Balances  CBs  S&Ls & Coops  3/  NOW Balances  Estimated Inactive Balances  Draft activity against active NOW accounts at thrifts averages about 9% in the two states, only slightly below the average at CBs.  -12-  suggests that approximately $400 million of NOW balances currently held by thrifts originated in CB deposits. Market Shares of Total Deposits The direct effect of NOW accounts on market shares in the two state area, where deposits at CBs and thrifts total nearly $40 billion, thus amounts to a one percentage point reduction in the 45 per cent share held by CBs.  Although this represents a relatively  modest reduction in the market share of CBs, the indirect effect of NOWs on such shares must also be considered before any judgment can I- reached on whether major shifts are under way. This indirect effect involves the spread of convenient one stop banking to thrifts.  By permitting thrifts to issue what is  essentially a demand deposit, CBs could conceivably lose large amounts of time and, especially, savings deposits as demand deposit funds are S iverted to thrifts.  Commercial bankers are particularly worried  about this possibility in view of the one-fourth percentage point advantage thrifts can offer on passbook savings. The evidence on this issue indicates that no such shift in deposits between institutions has occurred, as yet.  In the upper half  of Table 3 market shares of passbook savings excluding NOWs are shown for the last four Call Report dates, beginning in DecemI,•fore the NOW experiment began. the passbook  As shown in the table, CBs' share of  savings market, in as  Massachusetts and New Hampshire,  has actually grown during the NOW experiment.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  In MassachusetLs the  -13-  TABLE 3 MARKET SHARES OF DEPOSITS HELD BY MAJOR DEPOSITORY INSTITUTIONS IN MASSACHUSETTS AND NEW HAMPSHIRE June 1970  Dec June Dec June 1974 1974 1973 1972 PASSBOOK SAVINGS EXCLUDING NOWs  June 1975  Massachusetts (dollars in ii.,,  13,605  13,815  12,906  13,680  12,882  13,695  Percentage held by CBs MSBs S&Ls  11.9 79.5 8.6  15.5 75.2  16.7 73.8  16.5 74.6  17.7 73.3  19.1 72.6  1,632  1,702  1,784  1,835  1,807  1,937  16.7 68.3 15.0  24.7 59.9 15.4  27.1 57.8 15.1  29.0 55.9 15.1  29.5 55.4 15.1  30.0 54.9 15.1  New Hampshire (dollars in millions) Percentage held by CBs MSBs S&Ls and coops  TOTAL DEPOSITS (dollars in millions) ffT,  Percentage held by CBs MSBs S&Ls New Hampshire (dollars in millions)  21,886  26,856  30,771  31,302  31,819  32,273  43.8 49.6 6.6  43.0 50.3 6.7  45.8 47.8 6.4  46.4 47.2 6.5  46.5 47.1 6.4  43.7 49.5 6.8  2,242  2,850  3,326  3,430  3,462  3,685  36.5 50.3 13.2  41.3 44.9 13.8  42.5 43.7 13.9  42.7 43.3 14.1  42.9 42.8 14.3  41.9 43.5 14.6  Percentage held by CBs MSBs S&Ls and coops  NOTE:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  MSB and CB data are from Assets and Liabilities of Commercial and Mutual Savings Banks (FDIC) with the exception of Massachusetts MSB data which are from Monthly were obtained from the NAMSB in New York. S&L.i. Financial Data (FSLIC).  -14-  share of passbooks held by CBs increased from 16.7 to 19.1 per cent between December 1973 and June 1975, while New Hampshire CBs have increased their share of this market from 27.1 to 30.0 per cent during this period.  CBs have made significant gains in the passbook savings  market during the last twenty years, and this evidence suggests that NOW accounts have not significantly retarded this progress. Comparisons of total market shares are of limited value, since CBs, unlike thrifts, obtain a relatively large and variable part of their deposits from the issuance of large Certificates of Deposit.  Data on  total deposits are, nevertheless, presented in the bottom half of Table 3. Although the CB share of total deposits declined from 46.4 to 43.7 per cent between mid-1974 and mid-1975, this share remains nearly a percentage point above its June 1972 level--recall that NOW accounts have been issued by MSBs in the two states since mid-1972.  In New Hampshire, the market  share of CBs has remained relatively stable over the 1974-75 period, as CBs in that state have successfully protected the gains made in market shares in the early seventies. On the basis of this evidence it appears that, to date, no significant shifts have occurred in market shares beyond those arising directly from transfers of CB deposits into active NOW accounts at thrifts. delayed  However, the possibility of such a shift, occurring on a basis, cannot be totally ruled out, particularly if consumers  adjust slowly to changing conditions in financial markets.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  III. EFFECTS OF NOW ACCOUNTS ON AGGREGATE COMMERCIAL BANK COSTS, EARNINGS, AND PORTFOLIOS: 1974-1975  In attempting to establish a permanent share of the NOW market, CBs in Massachusetts and New Hampshire have absorbed higher costs through the conversion of demand deposits to NOW accounts and have thus experienced a reduction in net earnings.  Moreover, CB  net earnings have been further reduced by the loss of relatively profitable demand deposit funds to thrifts offering NOWs.  Estimates  of the effect of NOWs on aggregate CB earnings must therefore include both the inhouse cost of converting noninterest bearing demand deposits to NOWs, as well as earnings reductions associated with NOW related outflows of demand deposits. In the remainder of this section rough estimates are produced which, it should be emphasized, are indicative only of basic magnitudes.  For reasons to be discussed later, these estimates are  probably biased in the sense that the true depressing effect of NOWs on CB earnings is more likely to be smaller than the estimates, rather than larger.  Incremental Costs of NOWs In estimating the added costs to CBs of acquiring and retaining NOW funds, costs of converting time and savings deposits   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -16-  to NOWs are ignored, since such costs are likely to be small.  Thus  incremental costs are calculated by multiplying estimated NOW balances at CBs which were converted from demand deposits by the difference between the average cost of NOW funds and that of demand deposit funds.  For this purpose, active NOW balances at CBs, as calculated  in Section II, will be used to estimate the level of conversions from demand deposits to NOWs. For nonmember banks the average cost of NOW funds is equal approximately to the sum of the interest payment, which averages  4/  In equating conversions of demand deposits to estimated active NOW balances, the consolidation of savings and demand deposit accounts into one active NOW account creates a minor problem, since treating the balance in the active NOW account as originating in a demand deposit causes an upward bias in the estimated level of demand deposit conversions. Because average NOW balances at CBs significantly higher than at thrifts--$1600 at CBs to $900 at thrifts--it might appear that the effect of account consolidation on average NOW balances at CBs is large. However, this is somewhat misleading, since NOW accounts at CBs include conversions of so called D/B/A--"doing business as"--demand deposit accounts of sole proprietorships. These accounts typically carry very large balances ranging up to $50,000 and more. According to knowledgable observers, most of these D/B/A accounts have been converted to NOWs, thereby raising NOW average balances relative to those of demand deposits. For a few CBs whose D/B/A accounts were examined, average NOW balances after excluding D/B/A accounts were much smaller and more consistent with average demand deposit balances. Thus, the effect on average balances of consolidating savings and demand deposit accounts into one active NOW account may be quite small, and active NOW balances, as calculated in Section II, probably serve as a reasonably accurate, though slightly biased estimate of demand deposit conversions.  ii   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -17nearly 5 per cent, and the net cost of servicing NOW accounts.  This  latter cost consists mainly of expenditures on account maintenance (statement preparation, etc.) and costs associated, to a lesser extent, with clearing drafts and handling deposits to NOW accounts. For Federal Reserve members, the NOW cost is equal to this sum, less the earnings from funds released by the lower required reserve ratio on NOWs relative to demand deposits. The per dollar marginal cost of demand deposit funds is approximately equal to the net cost of servicing demand deposit accounts.  This service cost is similar to that of NOW accounts, though  probably slightly smaller because a higher proportion of CBs offer free checking than offer free NOWs.  If the service cost differential  is ignored because of its relative smallness, the incremental cost of NOW funds converted from demand deposits is equal to the rate of interest on NOWs minus, where applicable, the additional earnings frS m lower reserve requirements against NOWs. In calculating incremental costs, the interest rate on NOWs is set at 5 per cent and the 3 month Treasury bill rate is used to measure earnings from lower reserve requirements for member banks. These estimated costs are presented in Table 4 on a monthly basis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -18-  1/ beginning in January 1974.  For 1974, the estimated incremental cost  of NOWs totaled $830,000, while for 1975, this total is $9.3 million, reflecting the large growth in NOW balances at CBs this past year. In 1974, before tax CB earnings in Massachusetts and New Hampshire totaled $194 million, while in 1975 such earnings totaled $124 million; thus estimated incremental costs were about equal to one-half per cent of 1974 earnings, while 1975 incremental costs are estimated to I- about 7/ 1 2 per cent of such earnings. incremental costs were equal  By 1975 year-end, moreover,  to about $14 million at an annual rate  ($1.182 million times 12), or about 11 per cent of 1975 earnings. As noted earlier, however, there are several reasons why these estimates probably overstate actual incremental costs. First, the small savings on service charges of NOWs relative to demand deposits are ignored and, second, active balances are used to estimate demand deposit conversions and this estimate is biased upward.  Also, the consolidation of savings and demand deposit  accSunts into a single NOW account reduces CB's costs, since the I.intenance cost of a NOW account is smaller than the sum of the costs of maintaining separate demand and savings deposit  accounts.  5/ Syillmbolically, the per dollar NOW cost for a Federal Reserve member bank can be expressed as:  wherethe interest rate paid on NOWs, sn is the annual cost per dolar of servicing a NOW account, r is rate of interest on Y some asset into which the funds derived from the lower NOW reserve requirements will be invested, and the constant .07 is the difference between the average reserve requirement against demand deposits and NOW accounts. If s is ignored on the grounds that NOW service cS sts are similar t8 those of demand deposits, the incremental cost of NOW funds is equal to in - .07 r for Federal Reserve members, and to i for nonmembers. These expressions are used in calculating estimateR c5sts in Table 4.  -19TABLE 4 ESTIMATED INCREMENTAL COSTS TO CBs OF NOW ACCOUNTS (in thousands 0  1974-Jan  MEMBER BANKS Monthly Incremental IncreActive mental Cost Balances per Dollar Cost 1,215.5 4.5 .00371  NONMEMBER BANKS Monthly TOTAL Incremental IncreCB Cost mental Incremental Active Cost Cost Balances per Dollar 6.7 '2-.2 .00417 519.9  Feb  1,129.5  .00375  4.2  1,412.2  .00417  5.9  10.1  Mar  2,010.1  .00370  7.4  2,685.9  .00417  11.2  18.6  Apr  2,770.8  .00369  10.2  4,392.6  .00417  18.3  28.5  May  3,148.1  .00367  11.6  4,704.0  .00417  19.6  31.2  Jun  4,279.7  .00360  15.4  5,691.9  .00417  23.7  39.1  Jul  6,783.7  .00371  25.2  7,032.3  .00417  29.3  54.5  Aug  12,588.0  .00366  46.1  7,838.6  .00417  32.7  78.8  Sep  11,554.0  .00368  42.5  16.528.0  .00417  68.9  111.4  Oct  11,524.0  .00374  43.1  18,815.0  .00417  78.5  121.6  Nov  15,756.0  .00372  58.6  21,449.0  .00417  89.4  148.1  Dec  19,994.0  .00375  75.0  25,168.0  .00417  104.9  179.9 828.9  1975-Jan  31,248.0  .00379  118.4  29,175.0  .00417  121.7  240.1  Feb  46,098.0  .00384  177.0  34,810.0  .00417  145.2  322.2  Mar  62,754.0  .00384  241.0  45,720.0  4.00417  190.7  431.6  Apr  70,121.0  .00383  268.6  51,462.0  .00417  214.6  483.2  May  80,021.0  .00386  308.9  60,001.0  .00417  250.2  559.1  Jun 103,083.0  .00386  397.9  68,747.0  .00417  286.7  684.6  Jul 118,220.0  .00381  450.4  75.699.0  .00417  315.7  766.1  Aug 127,962.0  .00379  485.0  83,326.0  .00417  347.5  832.5  Sep 140,017.0  .00379  530.7  92,286.0  .00417  384.8  915.5  Oct 153,315.0  .00381  584.1  99,918.0  .00417  416.7  1,000.8  Nov 163,813.0  .00385  630.7  107,302.0  .00417  447.4  1,078.1  Dec 183,221.0  .00385  705.4  114,385.0  .00417  477.0  1,182.4   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  9,325.0  -20--  Reductions in Earnings from Demand Deposit Outflows The second way in which NOW accounts can reduce CB earnings is through the loss to thrifts of funds which would otherwise have provided positive net earnings for CBs.  As noted earlier, the major  identifiable loss of CB funds amounts to about $370 million in demand deposit balances through December 1975. In attempting to estimate earnings reductions at CBs attributable to NOW induced outflows of funds, active NOW balances at thrifts are used to approximate demand deposit outflows.  Savings deposit out-  flows, which are essentially unknown, are ignored because the earnings from such funds would have been small, especially in 1975 when market interest rates were low, relative to those of demand deposits. For nonmember banks, per dollar earnings on demand deposits are equal to the average yield on invested funds minus the net cost of acquiring such funds (in the case of demand deposits, the cost of servicing an average account).  /  For Federal Reserve member banks, net  earnings on demand deposit funds are equal to the average yield on invested funds multiplied by 0.9 (the proportion, on average, of each demand deposit dollar that can be invested after reserve requirements are met) minus the net cost of acquiring funds.-'  6/  7/   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Of course, nonmember banks maintain small precautionary reserves against deposits. Since such reserves are negligible, they are ignored in all calculations Symbolically, net demand deposit earnings for member banks are expressed by rD(1 -rr) -sD = [r(1 - rr) -s]D, where r is the yield on invested funds, rr is the average reserve requirement against demand deposits, s is the service cost per dollar of demand balances, and D is the stock of demand deposits. This expression also holds for nonmember banks, of course, with rr = 0.  -21-  Studies by Donald Hester and James Pierce indicate that a high proportion of demand deposit funds are invested in short-term market securities; thus the Treasury bill rate was used to measure 13! the yield on demand deposit funds lost to thrifts.  The average cost  of servicing a demand deposit account was, somewhat arbitrarily, set at 3 per cent of the average balance.  This rough estimate is based on  functional cost data from the Federal Reserve Bank of Boston.  These  data indicate the cost of servicing a checking account in New England averages between 3 and 4 per cent.  Since a substantial portion of CBs  in Massachusetts and New Hampshire offer free checking (implying only a small part of servicing costs are born by customers), 3 per cent was chosen as the average net cost of servicing such deposits. Estimates of the earnings reduction attributable to NOW induced demand deposits outflows are presented in Table 5.  For each  month the estimated total outflow is shown for both member and nonmember banks.  These outflows are cumulative--that is, they include all funds  lost in previous months as well as those lost in the current month. For both member and nonmember banks, estimated outflows are multiplied by monthly per dollar earnings on demand deposit funds to obtain an  8/ 9/   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  See Hester, Donald and James L. Pierce, Bank Management and Portfolio Behavior, Yale University Press, 1975. This method of calculating demand deposit earnings implies the marginal return on demand balances exceeds the average return on all balances. Although for a hypothetical bank issuing only one type of deposit, the marginal return should be below the average return, such a relationship need not hold for any particular type of deposit for banks issuing more than one type of deposit.  -22TABLE 5 ESTIMATED LOST EARNINGS FROM DEMAND DEPOSIT OUTFLOWS (in thousands $)  1974-Jan Feb  MEMBER BANKS CB EARNINGS NONMEMBER BANKS Monthly Monthly Cumulative Cumulative Reduction Lost from Earnings Estimated Lost Earnings Estimated Outflows Per Dollar Earnings Outflows Per Dollar Earnings Outflows 94,209 17,735 .00396 .00332 312.4 70.3 382.7 95,314 .00279 266.4 60.8 17,959 .00338 327.2  Mar  103,085  .00349  359.7  19,456  .00415  80.8  440.6  Apr  105,906  .00367  388.9  20,026  .00436  87.3  476.1  May  107,994  .00382  412.8  20,478  .00453  92.7  505.5  Jun  111,187  .00361  401.3  21,121  .00429  90.6  491.8  Jul  116,941  .00331  387.5  22,264  .00396  88.2  475.7  Aug  122,692  .00406  497.9  23,404  .00479  112.0  609.9  Sep  127,487  .00377  480.9  24,368  .00447  108 91:4 9  4 58 89 7,8 9  Oct  135,191  .00293  396.5  25,838  .00354  Nov  143,460  .00319  457.5  27,469  .00382  104.9  562.4  Dec  151,598  .00288  437.2  28,949  .00348  100.8  538.1 5,887.6  1975-Jan  155,605  .00237  368.7  28,376  .00291  Feb  170,420  .00169  287.5  31,075  .00215  Mar  195,432  .00166  324.0  35,646  Apr  206,168  .00177  365.0  May  219,731  .00149  Jun  236,247  Jul  82.6  451.3  .00212  676:96 5  59 416 4 39  37,647  .00225  84.5  449.5  326.6  40,128  .00193  77.4  404.0  .00139  329.5  43,193  .00183  78.9  408.4  252,305  .00212  535.6  46,079  .00264  121.5  657.1  Aug  257,973  .00235  605.5  47,222  .00289  136.3  741.8  Sep  276,384  .00229  632.2  50,622  .00282  142.7  774.9  Oct  293,152  .00206  604.1  53,729  .00257  137.9  742.1  Nov  303,838  .00160  A86.4  55,725  .00206  114.6  601.1  Dec  311,801  .00163  507.6  57,082  .00209  119.1  626.7 6,611.0  NOTE:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Outflows from memb2r and nonmember CBs are assumed to be proportional to market shares of demand deposits (averaged over each year) of these banks. For example, if member CBs held 80 per cent of demand deposits in a given year, then 80 per cent of active balances at thrifts for that year are assumed to have come from member banks and the remaining 20 per cent from nonmembers.  -23-  estimate of earnings lost each month.  For 1974, these estimated earnings  reductions totaled $5.9 million, which is much larger than the 1974 estimate of incremental costs from Table 4.  This, of course, reflects the  fact that thrifts--especially MSBs--held a large percentage of active NOWs in 1974.  The 1975 estimated earnings reduction from demand deposit  10 outflows, shown at the bottom of Table 5, totaled $6.6 million.--I After Tax Reduction in Earnings Adding the estimates of incremental costs of conversion of demand deposits to NOWs at CBs to the reduced earnings from demand deposit outflows from CBs to thrifts yields a rough estimate of the total before tax reduction in earnings attributable to NOW accounts.  For 1974 this  total was $6.7 million, while for 1975 the total was $15.9 million. To obtain an after tax reduction in earnings it is necessary to reduce these figures by the amount of the tax savings accruing from lower CB earnings.  In 1974 more than 90 per cent of Massachusetts and  New Hampshire CBs had before tax earnings exceeding $25,000.  The mar-  ginal tax rate for these banks was therefore 48 per cent, while for the remaining banks the marginal rate was either 25 or zero per cent, depending on whether earnings were positive or negative.  10/   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The weighted  Concerning the robustness of these estimates to changes in the assumed average balance in inactive accounts, if instead of $1100 this average was twice as large--$2200--the earnings reduction from demand deposit outflows would have been about 30 per cent smaller. For example, assuming a $2200 average balance in inactive accounts at thrifts reduces estimated active balances from $370 million to $260 million in December 1975. Thus, earnings reductions from demand deposit outflows would be only 26/37, or about 70 per cent, of those shown in Table 5 for that month.  -24-  average of these marginal rates, with weights equal to the proportion of banks in each class, is equal to about 44 per cent.  Reducing the  estimated $6.7 million 1974 earnings reduction by this amount produces an after tax reduction in earnings of $3.8 million.  Since after tax  profits in Massachusetts and New Hampshire totaled $142 million in 1974, this represents a reduction in total after tax earnings of a little over 2% per cent. For 1975 the weighted average marginal tax rate for Massachusetts and New Hampshire banks was 40 per cent.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Reducing the $15.9  milliS n 1975 before tax earnings reduction by this factor thus produces an after tax reduction of $9.5 million.  Total after tax earnings in  the two NOW states declined by $35 million to $107 million in 1975. NOWs thus appear to account for a little more than one-quarter of the earnings drop in the two states last year.  IV.  ADJUSTMENT PROBLEMS OF INDIVIDUAL BANKS  Analysis of aggregate data suggests that at worst, industrywide earnings in Massachusetts and New Hampshire may have been depressed by a few percentage points in 1974 and 1975 by the introduction of NOW accounts.  Consequently, the industry IS  I.rticularly serious adjustment problems. often conceal important information.  not appear to be experiencing However, aggregate data can  In particular, when an industry  is adjusting to a change in basic costs or revenues, certain segments S f that industry--those so-called marginal firms--may suffer disproportionately high losses of earnings and capital.  The adjustment  A  -25-  experience of these firms can often reveal far more about the stability of the industry than aggregate S. The remainder of this section is therefore devoted to a study of costs, earnings, and portfolio adjustments of selected banks whose earnings and capital positions appear to be most vulnerable to NOW related changes in costs and revenues.  The banks selected for special  attention--40 of the 226 banks in the two states--belong to at least one of the following categories:ratio" banks, defined as those banks having 10 per cent or more of total deposits in NOW accounts in June 1975, (2) "runoff" banks, defined as those banks not offering NOWs in mid-1975 and experiencing significant losses of demand deposits between January 1974 and June 1975, and  earnings" banks, defined  as those banks offering NOWs in mid-1975 with 1974 before tax earnings to total deposit ratios in the lowest 20 percentile in the two states. These 40 banks tend to be relatively small--the median bank having only million in deposits--and include only one very large bank. High Ratio Banks In June 1975, there were eight "high ratio" CBs--banks with more than 10 per cent of total deposits in NOW accounts.  Five of these  I.nks were either established banks with a history of aggressive management prior to the introduction of NOW accounts, or were new banks. In interviews conducted by the Federal Reserve Bank of Boston, it was found that the former group of banks tended to be aggressive in offering NOWs, often introducing them before their competitors and promoting them   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  A  -26-  heavily through advertising.  In general, the management of these banks  viewed NOW accounts as a means of increasing their market shares by attracting new customers.  For these banks, the high proportion of NOWs  resulted from a deliberatet aggressive policy by the banks' management. The remaining three banks tended to be older banks which introduced NOW accounts as a defensive measure.  These banks, for one  reasS n or another, found themselves under severe competitive pressures and were forced to introduce NOWs to maintain their deposit base. Two of these banks have an abnormally high ratio of personal demand deposits to total deposits, and thus were particularly vulnerable to competition from thrifts offering NOWs. Table 6 displays the recent aggregate earnings pattern of six of the eight "high ratio" banks--those six that have been in operation since 1973.  The largest of the six banks had negative earnings in  the 1972-1973 base period, and positive but low earnings in 1974 and 1975.  On balance, the remaining five banks  in 1974, but suffered substantial earnings  increased their earnings declines in 1975 relative  tS the 1972-1973 pre-NOW base period. Of the six banks in Table 6, three indicated that their high cS ncentration of NOWs reflected a deliberate policy of attempting to increase market shares. S efensively.  The remaining three banks were acting  It is dcult to judge for any of these banks the  relative importance of NOW costs in the 1975 overall reduction in high ratio bank earnings.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  However, calculations similar to those  -27-  of Section III suggest that one large bank experienced an increase in NOW costs exceeding $600,000 in 1975, while two other banks lost at least 10 per cent of 1975 income due to higher NOW costs and outflows of demand deposit funds. It seems reasonable to surmise that the six high ratio banks-at least in the short run--probably suffered the largest earnings reductions from the NOW experiment.  The three banks that acted defensively  appear to have had little choice in the matter of whether to offer NOWs; their earnings problems could be severe and could well continue for some time.  The remaining three banks were also hard hit by higher NOW costs;  however, their aggressive strategies may prove successful in the longer run. TABLE 6 SUMMARY OF HIGH RATIO BANK EARNINGS  Average Size 1974 Assets (in $ Millions) 40.3  Average Ratio of NOWs to Deposits Dec 1975  1972-73 Average After Tax Earnings per Bank (in $ Thousands)  23.7  139  Per Cent Change from 1972-73 After Tax Earnings 1974 1975 42.0  -28.2  Runoff Banks In contrast to the "high ratio" banks that had a high ratio of NOWs to total deposits, 16 so-called "runoff" banks lost at least 10 per cent of their demand deposit base between January 1974 and June 1975 and did not offer NOW accounts over this period.  Of the  16 runoffs, all but three indicated in interviews that they believed   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -28-  demand deposit outflows were at least partly attributable to NOWs. However, four of the 13 banks that blamed NOWs for demand outflows also inI icated that their demand deposit losses due to NOWs were very small. Most of the 16 runoff banks cited added costs as the reason for not introducing NOWs.  Some banks also indicated that they lacked  necessary computer facilities required to handle NOW accounts and one S.nk, which IS  not pay the ceiling interest rate on savings accounts,  expressed concern that offering NOWs would cause added expenses by forcing the savings rate to the ceiling. Table 7 displays separately the average earnings of those nine I.nks that felt that NOWs had contributed to demand deposit runoffs and of the seven banks that believed that NOWs had contributed little if anything to runoffs.  The earnings records of the two groups of  runoff banks in 1975 are quite similar, with both groups of banks experiencing one to two per cent increases in 1972-1973 average earnings.  Over the two years, five banks in each category experienced  lS wer earnings relative to 1972-1973 in at least one year, with one bank in the latter category suffering lower earnings in both years. Again it is difficult to judge how much of the earnings impact of "runoff" banks was due to NOWs.  Generally, the earnings of these  I.nks held up better than those of "high ratio" banks that aggressively sS ught NOWs or defensively acquiesced in offering NOWs.  However, the  lS ng run earnings potential of runoffs could still be less favorable than that of the high ratio banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -29-  TABLE 7 RUNOFF BANK EARNINGS 1972-73 Per Ceut Avera8e Averdge Size Reduction After Tax 1974 in Demand Earnings Per Bank Deposits Assets 12/73-12/75 ($000s)  % Change From 1972-73 After Tax Earnings 1975 1974  Attributed to NOWs  13.5  22.6  41.2  110.6  1.8  Not Attributed to NOWs  26.2  19.5  351.0  23.5  1.5  Total  19.0  20.9  176.8  34.9  1.5  Low Income Banks Low income banks are defined as those banks offering NOWs in June 1975 whose ratio of 1974 before tax earnings to total deposits falls in the lowest 20 percentile for the two states.  There were 18  banks in this category, with 13 in Massachusetts and five in New Hampshire.  These banks all had ratios of before tax earnings to  deposits below 0.7 per cent in 1974, a year in which the two-state average for all banks was about 1.2 per cent. As shown in Table 8, the low earnings banks suffered substantial reductions in earnings in IS  1974 and 1975.  In 1974, 11 of the 18  lS w earners experienced a drop in earnings from 1972-1973, while in 1975 the earnings of 14 of these banks were lower than in 1972-1973.  However,  it cannot be concluded that NOWs were primarily responsible for this sharp decline in earnings for the low earners, because many of these S.nks, which were selected precisely because their 1974 earnings were  -3I-  low, suffered from relatively large loan losses in 1974 and 1975. Generally low 1975 earnings, moreover, appear to reflect a continuation of 1974 earnings problems as well as increased pressures from NOWs.  TABLE 8 LOW INCOME BANK EARNINGS  Average Size 1974 Assets (in $ Millions)  Average Ratio of NOWs to Deposits Dec 1975  1972-73 Average After Tax Earnings per Bank (in $ Thousands)  141.£3  2.5  657  Per Cent Change from 1972-73 After Tax Earnings 1974 1975 -26.7  -103.1  * excludes earnings record of largest bank in "low income" group  Summary of Marginal Bank Earnings Table 9 compares the 1974-75 earnings of the 40 Massachusetts and New Hampshire marginal banks to those of the remag 186 CBs in the two states,to CBs in the four other New England states,and to CBs in the balance of the nation.  From this table it is seen that in 1975  even banks in Massachusetts and New Hampshire not included in the marginal bank category generally performed more poorly than other New England S. nks.  Part of this poor earnings performance is attributable to NOWs,  since nearly all banks in the two states were affected adversely to varying degrees by NOW pressures in 1975.  However, as noted in Section III, NOWs  can account for only a small part--an estimated one-fourth--of the drop in after tax earnings in the two states last y--r.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Other factors, including  -31-  TABLE 9 Weighted Average Changes in Earnings  Category  High Ratio Banks  Per Cent Change in Earnings from 1972-73 1974 1975 42.0  -28.2  Run-off Banks Runoff attributed to NOWs Runoff not attributed to NOWs  34.9 110.6 23.5  1.5 1.8 1.5  Low Earnings Banks Low Earnings Banks - adjusted*  -26.7 -46.2  -103.1 -62.8  All Marginal Banks All Marginal Banks - adjusted*  -11.8 -10.3  -80.0 -37.8  9.2  -16.6  CB's in Other 4 New England States  16.7  9.8  CB's in 44 Other States  18.5  19.5  Other Banks 186 Other CB's in Massachusetts and New Hampshire  Excludes earnings record of largest bank in "low income" group   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -32-  large loan losses resulting from the depressed economies of the two states, presumably account for the remainder of the drop in earnings. It is clear from Table 9 that the earnings performance of the 40 marginal banks, particularly in 1975, was significantly worse than that of other banks, including the 186 Massachusetts and New Hampshire banks not included in the marginal bank category.  However,  it would be incorrect to attribute this poor earnings performance totally or even largely to NOWs.  According to reports of bank examiners,  the major problem for the low income banks has been excessive loan losses and inefficient management.  In no case was it concluded in  bank examination reports that NOWs were a principal contributor to the earnings problems of low earnings banks.  The examiners reports also  indicate that NOWs played a relatively minor role in the overall earnings reductions of "high ratio" and "runoff" banks.  Indeed, NOWs  were mentioned in only a few of the latest examination reports of the 40 marginal banks and in most cases, the examiner's comments were limited to factual observations on NOW growth. More generally, while earnings were clearly lower for the 40 banks selected for special analysis, it does not appear that NOWs have as yet had a significant adverse effect on the soundness of the Massachusetts and New Hampshire marginal banks.  However, NOW-related  problems could become severe for some of these banks in the future, particularly those that, for reasons unrelated to NOWs, are presently experiencing earnings difficulties.  Reduced revenues from demand  deposit outflows or higher costs associated with conversions of demand   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -33--  balances to NOWs could threaten the already weakened condition of these banks.  Indeed, although evidence suggests that NOWs per se  did not cause the problems of any of these 40 banks, the NOW experiment appears to have, in the short run at least, exacerbated more basic problems faced by several banks.  Such banks clearly present  the most difficult problem for the banking system in adjusting to financial innovations and regulatory changes.  Portfolio Adjustments by Marginal Banks to offset higher NOW CBs with earnings problems can attempt costs and lower earnings in two basic ways:  by lowering costs by  accounts, and by raising imposing relatively high service charges on NOW revenues in any number of ways.  As indicated briefly in Section III,  there is limited evidence, mostly of a  judgmental nature, that CB  average than those imposed service charges on NOW accounts are higher on small, of increased NOW costs on demand deposits; thus a part, probably charges. are being recovered through higher service CBs can attempt to increase revenues by raising loan rates. However, in Massachusetts and New Hampshire, where stiff competition exists from banks in neighboring states and from money market instruments--including commercial paper--such a strategy would likely be counterproductive.  CBs can also attempt to raise earnings by including  in their portfolios more risky, higher yielding assets. For example, a CB can usually increase revenues by selling short-term, highly liquid  •   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -34-  assets such as Treasury bills, and using the proceeds to acquire nonprime business or real estate loans.  The problem with this strategy  is that the acquisition of more loans increases both the level of average earnings and the variation of these earnings.  Increased  variation in earnings, moreover, generally increases the probability of bank failure.  Thus, portfolio adjustments by CBs attempting to  maintain a target level of earnings are of considerable importance in examining the stability of commercial banking. Before reviewing empirical evidence on this matter, it should be  noted that, on theoretical grounds, costs and portfolio risk  will, under some conditions, be directly related.  11/ Portfolio theory  as developed in the last 25 years, however, suggests that rational wealth holders seek to balance benefits of higher rates of return against the disadvantages of additional risk when selecting an optimal portfolio of assets.  This behavior, though implying under  some conditions that somewhat more risk will be assumed when the return on bank capital declines, is generally incompatible with attempting to maintain a target level of earnings independent of portfolio risk whenever costs or revenues change.  This suggests  a willingness of  bank shareholders to accept somewhat lower earnings in the event of a temporary increase in costs; thus only modest increases in the riskiness of the bank portfolio may result.  11/  See Carl Gambs, "Interest Bearing Demand Deposits and Bank Portfolio Behavior", Southern Economic Journal, July 1975.  -35-  The hypothesis that the 40 marginal banks in Massachusetts and New Hampshire have increased portfolio risk in order to offset NOW related lower earnings can be examined by using the ratio of loans to total assets as a very rough measure of risk for each bank.  In the  left panel of Figure 2, ratios of loans to total assets are shown for each of the three classes of marginal banks.  Since early 1974 these  ratios have been gradually declining, and this would appear to contradict the "target rate of earnings" hypothesis of CB behavior. However, the economies of Massachusetts and New Hampshire were depressed during the 1974-75 period, and loan demand was generally weak. Therefore, a comparison of loan ratios of marginal banks relative to  FIGURE 2  High ratio Industry less marginal banks  IMINOT  4  Low income   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Margin 1 banks I/ /\/ — Runoffs  gn :1 7 •  -36-  all other Massachusetts and New Hampshire banks is shown in the right panel of Figure 2.  Because marginal banks experienced greater than  average NOW related earnings losses, it might be conjectured that under the target rate of return hypothesis their loan to asset ratios might decline less than that of the industry.  Instead, since late 1974 the  aggregate marginal bank ratio, as shown in the right panel of Figure 2, has declined more than the industry ratio.  Based on this evidence, the  40 marginal banks IS not appear to have increased the riskiness of their portfolios, as measured by the ratio of loans to assets, as a result of the NOW experiment.  V.  THE LONG-RUN ADJUSTMENT PROBLEM OF COMMERCIAL BANKS Conversion of time and savings deposits to NOW accounts causes  negligible cost increases for CBs.  Thus, the problem banks face in the  long run is that of absorbing, or offsetting, higher costs associated with conversions from demand deposits to NOWs, and the loss of funds to thrifts.  Because CBs have become quite successful in retaining NOW  funds, and hence face escalating costs of acquiring funds  in the short  run, the problem of absorbing such costs will be examined in some detail in the remainder of this section. Characteristics of the Steady State The Federal Reserve Board's Demand Deposit Ownership Survey indicates that one-third of all demand deposits are held by households; thus only about $2 billion of the $6 bon in demand balances in Massachusetts and New Hampshire could ultimately be converted to NOWs.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  In Table 2 it  -37-  was shown that an estimated $670 million of demand depo sits had been converted to NOWs as of December 1975.  Thus, approximately one-third  of all eligible transactions balances were at that time in NOW accounts. It would be grossly incorrect, however, to attempt to obta in an estimate of the effect of NOWs on CB profits in the steady state-that period after which NOW market shares have stabilized and CBs have made all desired adjustments--by multiplying the Dece mber 1975 estimated earnings reductions (Tables 4 and 5) by some number such as 3.  Such a  calculation would be misleading because it ignores potential adjustments that CBs can make in competing for NOW funds. Before the payment of interest on NOWs was permitte d, CBs competed for transactions balances by offering supplier s of funds various nonpecuniary services, such as free checking, branch banking, longer hours of operation, and larger numbers of tellers to redu ce waiting time.  At  the margin, however, the cost of providing such services generally exceeds the value attached to these services by customers.  It is a widely accepted  proposition, for example, that whenever the price of a service is set at zero, that service will be consumed by customers until the value to the customer of the last unit is zero.  However, there is a positive cost  associated with providing, or producing each service unit (e.g., the cost of clearing checks written against a "free" chec king account is positive for each check).  Thus, the provision of such services is ineffici ent in  the sense that valuable resources are used up in prod ucing services which, on the margin, have relatively low value.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -38-  By substituting pecuniary returns--the payment of interest on NOWs--for nonpecuniary services, CBs can eliminate the waste , or inefficiencies, associated with providing nonpecuniary services that have low marginal values relative to cost.--  Indeed, by permitting  the payment of interest on NOW balances, both customers and banks can be expected to benefit.  This can be shown by supposing that banks  initially offer free checking services to the public and pay no interest on demand deposit balances.  The total return on demand funds derived  by customers is thus equal to the value of check cashing services, while the cost to the bank of acquiring demand balances is equal to the cost of servicing their customers' free checking accounts.  If banks are  allowed to make explicit interest payments to customers with deman d funds on deposit, customers will be better off even if they are requi red to pay for check cashing services as long as the interest rate is set high enough.  Moreover, bank costs can be lowered due to reduced costs  of servicing checking accounts--which are no longer "free" to customers-if the interest rate is not set too high.  Indeed, it can be shown--see  Appendix A--that there is a range of interest rates for which both customers and banks are better off--i.e., the total value of bank services to the customer, including interest earned, is higher, while bank costs of providing these services are lower.  12/   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  For the pre-1933 period, when CBs were permitted to pay interest on demand balances, banks with higher average interest payme nts tended also to have lower average expenses other than inter est. This presumably reflects the substitution of pecuniary for nonpecuniary services by banks offering higher rates of in-_erest on deposits. See George Benston,"Interest Payments on Deman d Deposits and Bank Investment Behavior," Journal of PitiL1 Ecolomvs. October, 1964.  -39-  One very important implication of this result--as shown in Appendix A--is that the cost to CBs of acquiring transactions balances can conceivably decline if banks are permitted to pay interest on such balances.  This paradoxical result arises from the fact that removing  a constraint on the way in which banks can compete for transactions balances allows CBs to select a more efficient (lower cost) strategy for attracting such funds. Transition to the Steady State As previously noted, banks began to compete aggressively for NOW funds in 1975.  As also noted, continuing competitive pressures may  l make the transition to the steady state a long, and for many margina banks, a difficult process.  However, after NOW growth begins to moderate  the aggresand NOW market shares of individual CBs and thrifts stabilize, sive competition for NOW funds should gradually disappear.  This will prob-  ably occur through a reduction in the level of free nonpecuniary services. To establish that rational pricing of NOW balances will indeed occur at some future date, it is necessary to show that the pricing (including policy now in effect of offering relatively high rates of return ty such as a NOW both pecuniary and nonpecuniary returns) on a new liabili n account is neither surprising nor irrational, but represents a short-ru ted strategy consistent with maximizing the sum of current plus discoun future earnings.  13/   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Indeed, it can be shown--see Appendix B--that when the  Early evidence on service charges on NOWs in Vermont, Rhode Island, Connecticut, and Maine, which began issuing such accounts in March 1976, indicates that depository institutions in those states are pricing NOWs more in accordance with long-run profit maximizing criteria. For example, while in Massachusetts and New Hampshire over half of all issuing institutions offer free NOWs, only about one-quarter of the issuing institutions in the remaining four New England states are similarly offering free NOWs.  -40-  future supply of funds arising from a new liability is related positively to market shares established during the transition period before such shares have completely stabilized, a bank seeking to maximize the value of stockholder's equity will temporarily  pay higher rates for these  funds than is consistent with short-run profit maximization.  As market  shares begin to stabilize, moreover, the rate of return offered will decline to the profit maximizing level.  This implies that current CB  behavior in competing aggressively for NOW funds is not inconsistent with stockholder objectives, and more important, as the NOW market settles down", total rates of return offered on NOW accounts will decline. The major type of nonpecuniary return offered by CBs which can be easily adjusted is free checking, including free drafts and free account maintenance.  In table 10, estimates of NOW costs based on  Functional Cost Data from the Federal Reserve Bank of Boston are shown.  Table 10 NOW COSTS FOR A $1000 ACCOUNT Item Cost  Number of items per Month  Monthly Cost  Annual Cost  $.09  11  .99  11.88  Deposits made  .15  2  .30  3.60  Outside checks Handled  .04  4  .16  1.92  2.00  1  2.00  24.00  Total servicing cost per account  3.45  41.40  Interest cost, $1000.00 Account  4.17  40.00  .,.62  $91.40  Drafts  Account Maintenance (Statements, etc.)  Total cost per account   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -41-  The total annual cost of servicing a NOW account with a $1000 average balance is about $90, of which nearly half ($41.40) is attributable to non-interest related costs.  If a 10 cent charge were imposed on drafts,  the cost of servicing an average NOW account would decline to about $80. Moreover, if account maintenance charges were introduced, this cost would drop further to about $55.  Since the cost of servicing a free checking  account averages about $40, CBs offering such accounts would thus experience, as the transition period proceeds, only moderate increases in costs Of acquiring transactions balances if customers are required to absorb draft and account maintenance charges. Other adjustments which take longer to make--such as reducing the number of branches, constructing less elaborate bank buildings, and the like--will be made later as competitive pressures force CBs to adopt more efficient strategies for acquiring deposits.  These adjust-  ments, as noted earlier, will lower CB costs and thereby provide a net gain to the economy through more efficient resource utilization.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -42-  APPENDIX A REMOVAL OF INTEREST RATE CONSTRAINTS, BANK COSTS OF ACQUIRING FUNDS, AND PORTFOLIO RISK*  Suppose that banks can initially offer only non pecuniary services--free checking, long hours, impressive buildings, etc.--in order to attract transactions deposits.  The demand for these services is given  by the curve DD in figure A-1, while the MC curve represents the marginal cost to the bank of providing such services.  Price  FIGURE A-1  A  Quantity 0  Q0  Qi  If the price of non pecuniary services is set at zero--as it is for all banks that offer free checking--the quantity demanded of such services will be 0Q1.  The area under the DD curve--the area of triangle  ODQ --thus represents the total value of these services to the customer. 1  The  cost of providing this level of services, ignoring fixed costs, is equal to the area under the MC curve--the area of OAEQ1.  * It is assumed throughout this appendix that bank customers are relatively homogenous and that the number of checks written is positively related to the average balance of each account.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -43-  From figure A-1 it is clear that the cost of providing services beyond 0Q0 exceeds the value attached to such services by customers.  If  permitted to pay interest on these funds, banks can eliminate this inefficiency, and still provide customers with the same or greater level of total--pecuniary plus nonpecuniary--services.  Moreover, the cost of  providing this level of services will be lower. For example, suppose banks charge customers Po for nonpecuniary services (e.g., check cashing and statement preparation).  The level of  such services "purchased" by customers will then drop to 0Q0, which yields a net return to customers equal to the area of the triancle PoDB (which is equal to the area under the demand curve between 0 and Q0 less the cost paid for services--equal to OP0BQ0).  Suppose further that the  interest rate is set at a level to yield customers a pecuniary return equal to the area of OP0CQ1.  The total return to customers is then equal  to the area under the demand curve between 0 and Q1 plus the area of the triangle BCQ1.  The area of BCQ1 thus represents a net gain to customers.  The cost to the bank of providing this higher level of services is equal to the area under the marginal cost curve between 0 and Q0 plus the area of the rectangle BCQ1Q0.  This is less than the area under MC between 0  and Q1--the original cost of nonpecuniary services--by the area of BEC. Thus, by paying this particular interest rate on funds, total returns to customers are increased, while bank costs have declined.  Moreover, any  interest payment greater than OP0BQ1 but less than OP0BEQ 1 will similarly raise total returns to customers while lowering bank costs.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -44-  This result can be easily extended to show that the cost of funds will decline if banks are permitted to pay interest on deposits. In the northeast quadrant of figure A-2, let the curve CR describe the relationship between bank costs of providing services and the valuation of those services by customers.  Next, in the southeast quadrant, let  the curve S represent the customers' supply function of deposits.  This  curve has the usual property that as total returns offered by banks increase, the supply of funds rises.  C  figure A-2 total Cost  C  CR CR  a  Co  a  Ds R  o  Valuation of Services (Net Return)  45° D o  Ds The cost of acquiring funds is depicted by the curve C in the northwest quadrant of figure A-2.  This curve is derived from the CR  and S curves by use of the 45 degree translation line in the southwest quadrant.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  For example, if bank costs are Co' thc level of services  -45-  offered to customers will be R . According to the supply function S, o s . customers will then supply Do in funds. Thus, deposits totaling D: as indicated by the point a in the are supplied when bank costs are C, S northwest quadrant. The payment of interest on deposits shifts the CR curve to the right to  since, as shown, a higher return to customers can be  achieved by a given expenditure of bank funds. figure A-2  It is easily seen from  that this shift causes the C curve to shift downward to  Thus, by removing the constraint against the payment of interest on transactions balances--and thereby permitting banks to adopt a more efficient strategy for attracting funds--the cost to banks of acquiring funds will decline. Finally, the lowering of the C curve has implications for the amount of portfolio risk a bank will undertake.  1/ It has been shown- in  2J that if bank owners the context of a mean-variance portfolio model have a quadratic utility functiodj the amount of portfolio risk a bank will undertake rises whenever the risk-return curve shifts downward, and declines when an upward shift occurs.  The lowering of the C curve  in the steady state would tend to raise the mean-variance curve.  1/ 2/  3/   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Thus,  See Carl Gambs, op. cit. The mean-variance portfolio model was developed by Harry Markowitz, Portfolio Selection, Efficient Diversification of Investments, New quidity Preference York: John Wiley & Sons, 1959 and James Tobin, as Behavior Towards Risk", Review of Economic Studies, February 1958. For a comprehensive review of portfolio theory including recent I- velopments, see Michael Jensen, "Capital Markets: Theory and Evidence Bell Journal of Economics and Management Science, 1972. Quadratic, that is, in the mean and variance of the distribution of expected returns.  -46-  in the long run, bank portfolio risk might be lowered as a result of the payment of interest on transactions balances.  In the short run,  the C curve is raised and the mean-variance curve is lowered, thus implying that portfolio risk might increase.  However, as noted in  Section IV, there is no evidence as yet of such a change in the riskiness of bank assets in Massachusetts and New Hampshire.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  p  -47-  APPENDIX B SHORT-RUN PROFIT MAXIMIZATION AS A SUB-OPTIMAL CRITERION WHEN THE LONG-RUN SUPPLY OF FUNDS DEPENDS ON MARKET SHARES ESTABLISHED DURING A TRANSITION PERIOr  Suppose a new bank liability is introduced and that the long run supply of funds to each bank depends positively on the market share established during a transition period.  Suppose further that the bank  wishes to maximinize the sum of current plus future discounted profits. For a two-period world the formal problem is: maximinimize where  H  t  H  W = H  t  + 1 —  H s  = (i - r ) D t t t  profits during the transition period  = (i - r ) D s S s  profits in the steady state  p is a discount rate i is the rate earned on investments during the transition period. t r  t  is the offering rate on the new liability (including both pecuniary and nonpecuniary services) during the transition period  i is the rate earned on investments in the steady state s r is the offering rate (also includes both pecuniary and nons pecuniary services) in the steady state (rs < is) The deposit supply functions are of the forms:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  D  t  (Supply function during transition)  = D (r ) t t  t S  = D (r , D ) s s t  s S  31) s 3D t  >0 (Supply function in steady state)  1  •  -48-  Note that the supply of funds during the transition period depends positively on the offering rate, while the supply in the steady state, or long run, depends positively on the market share--D --established during the transition t period in addition to the offering rate. To maximinize W (wealth), we differentiate with respect to r  t  and r and set both expressions to zero: s 311 3r  1  @il 3r  t II 0  0 t  an s 3r s  = o  Rs with respect to rt yields  Differentiating  WOO  (i - r ) 3D s s s  3D t > 0  Because 311 /3r is positive, the partial derivative 311 /3r must be negative t t t s if the first order profit maximinization conditions are to be satisfied (first equation above).  This implies that if the first period profit  function is concave with respect to r , as is usually assumed, then the t rate r  t  that maximizes wealth is greater than the first period profit  maximizing rate.  This is shown in figure B-1, where rP and rw  are the transition period profit and wealth maximizing prices,respectively. w Notice that r --the rate offered by a bank maximizing wealth (or  equiva-  lently, stockholders equity)--is higher than rt; this follows from 3y9rt being negative.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -49-  Figure B-1  rP t  r  t  r  t  Finally, the condition ails/ars = 0 implies that in the steady state, after market shares have stabilized, rate setting will be based on traditional profit maximizing considerations.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  BOARD OF GOVERNORS OF THE  FEDERAL RESERVE SYSTEM  Office Correspondence To  Chairman Burns  Date  August 30, 1976  Subject:  ,A FronL_Theodore E. Allison, By letter of April 19, 1976, Congressman Reuss requested copies of any studies or analyses prepared by the staff on NOW account developments. Members of our Research Division  (His letter and your response are attached.)  subsequently indicated to the House Banking Committee staff that it might be late summer before such a study was available, and the Banking Committee staff was agreeable with that timetable. I have enclosed for your review a study that has been prepared by Mr. Paulus and reviewed by Governor Partee.  Governor Partee's suggestions  have been fully incorporated into the final draft, and he had no objection to sending the study to the Congress. Ken Guenther wants you to know that this study could figure in discussion of the "Williams amendment" (which would extend the NOW account experiment to New York and New Jersey), but that doesn't concern him; Reuss' office calls regularly to inquire about the study, and he thinks it should be sent. If you concur in the sending of this study, the attached letter to Congressman Reuss may be used to transmit it. appropriate distribution among staff of k  Ken's office will make an f the House and Senate.  Governor Gardner will send the study to the other members of the Interagency Coordinating Committee.  Also, given the relatively large numbers of requests  for copies of studies of NOWs, the staff has suggested that the paper be released to the general public as one of a series of "staff studies,"  Attachments  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  DRAFTED BY:  Lyle Gramley Normand Bernard  REVIEWED BY:  Ken Guenther Gov. Parteer-lep   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -15f/  April 26, 1976  The donoreble Henry S. Reuss Chairman Committee on Banking Currency and Housing douse of Representative Washington, D.C. 20515 Dear Mr. Chairman: A Board staff study of the NOU account experiment in Mossachusetts and New nampshiro has been underway for several months, but it has not yet been completed. I hope the study will be of sufficient interest, and of high enough cuality, to merit distribution, but that has not yet been Pacertained. Our awn staff work on the NOW account experiment has been independent of the work done at the Federal Reserve r.ank of Boston. We have been in touch with the &fink and they will send otudies published by their staff directly to your office. Please let me know if I can be of further assistance. Sincerely yours,  Arthur F. Burns Arthur P. 'urns bee: Mr. risenmenger—Boston Fed LLG:UB:pjt (#B-154) bcc: Mr. Gramley Mrs. Mallardi (2)  FR-7 (Rev. 9/75) Daee. 747/77 cc/BOAR2  F  Control No.  GOVERNORS  OF THE  FEDERAL  13 -/sV  RESERVE  SYSTEM  MAIL CONGRESSIONAL HANDLING PRIORITY  To: Please review promptly he attached correspondence _... and let s-manfrom me have your suggestions in rough draft. In order to meet the Chairman's requirement for a response within five (5) working days, it will be q necessary for me to have your reply by The final letter will be signed by: Chairman Burns Governor Mr. Guenther or Mr. Brenneman Please indicate below the name and extension of the person who drafts the reply. When reviews are required within your Division, please complete these before forwarding the draft reply to me. Reply drafted by:  Ext.  If there are any problems or questions please give me a call; otherwise, please return this form directly to me with the draft reply and any attachments that are appropriate. Many thanks. Carol O'Brien Room B-2214   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Ext. 2735  .. .USS, WIS.. CHAIRMAN S. "."A WRIGHT PA...MAN, TEX. WILLIAM A. BARRETT, PA. 6p".ir,O.Z ". tf:IRS. JOHN B.) SULLIVAN, MO. ASHLEY, OHIO THOMAS WILLIAM S. MOORHEAD, PA. ROBERT G. STEPHENS. JR., GA. FERNAND J. ST GERMAIN. R.I. HENRY B. GONZALEZ, TEX. JOSEPH G. MINISH, N.J. FRANK ANNUNZIO, ILL. THOMAS M. REES, CALIF. JAMES M. HANLEY, N.Y. pARREN J. MITCHELL. MD. WALTER E. FAUNTROY. D.C. LINDY (MRS. HALE) BOGGS,LA. STEPHEN L. NEAL, N.C. JERRY M. PATTERSON, CALIF. JAMES J. BLANCHARD, MICH. CARROLL HUBBARD. JR., KY. JOHN J. LAFALCE, N.Y. GLADYS NOON SPELLMAN, MD. LES AuCOIN, OREG. PAUL E. TSONGAS, MASS. BUTLER DERRICK, S.C. PHILIP H. HAYES, IND. MARK W. HANNAFORD, CALIF. DAVID W. EVANS, IND. CLIFFORD ALLEN, TEN N.  U.S. HOUSE OF REPRESENTATIVES COMMITTEE ON BANKING, CURRENCY AND HOUSING NINETY-FOURTH  2129 RAYBURN  CONGRESS  HOUSE OFFICE BUILDING  WASHINGTON, D.C.  20515  ALBERT W. JOHNSON.PA. J. WILLIAM STANTON, OHIO GARRY BROWN. MICH. CHALMERS P. WYLIE, OHIO JOHN H. ROUSSCLOT, CALIF. EWART B. McKINNEY, CONN. JOHN B. CONLAN, ARIZ. GEORGE V. HANSEN, IDAHO RICHARD T. SCHULZE, PA. WILLIS D. GRADISON, JR., OHIO HENRY J. HYDE. ILL. RICHARD KELLY, FLA. CHARLES E. GRASSLEY, IOWA MILLICENT FENWICK, N.J. 22$-4247  April 19, 1976  Honorable Arthur F. Burns Chairman Board of Governors Federal Reserve System Washington, D.C. 20551 Dear Mr. Chairman: As you know, P.L. 93-100 which was signed into law on August 16, 1973, provided for the issuance of NOW accounts in the States of Massachusetts and New Hampshire. It is my understanding that the Federal Reserve Bank of Boston, along with the staff of the Board of Governors of the Federal Reserve System, have been engaged in a detailed economic study of the so-called NOW account experiment.  1(  I would appreciate it if you could send us any studies or analyses which the Boston Fed or your staff has completed on the subject, or any studies that might be available in the near future.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Sincerely,  Henry S. Reuss Chairman  •  .4• -411  If •  •-••  , 0••• 40/0  •  August 24, 1976 President Volcker -- N.Y. President Morris -- Boston  Subject:  Senate Banking Committee Language Re-NOW Accounts for New York and New Jersey  H.R. 12934 (Federal Reserve Reform Act) and H.R. 3035 (Payment of Interest on Public Demand Deposits) have now been reported.  Both bills contain identical language extending a mini-  NOW account experiment to New York and New Jersey. Langunge of the bill as reported states: "Section 2(a) of Public Law 93-100 is amended-(1) by inserting "(1)" immediately after "(a)"; (2) by inserting "New York, New Jersey," immediately after "Vermont,"; and  (3) by adding at the end thereof the following new paragraph: "(2) Notwithstanding paragraph (1)--  "(A) a federally chartered depository institution (other than a national bank) which is located in  New  York or New Jersey may allow  the owner of a deposit or account tomake withdrawals by negotiable or transferable instruments for the purpose of making transfers to third parties if all depository institutions which are chartered by the same   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ••   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  PAGE 2  State in which that federally chartered depository institution is located are authorized by or under State law to allow such withdrawals or to pravide checking accounts; and federally chnrtered depository institution which is located in New York or New Jersey may pay interest or dividends on such a deposit or account if all such State-chartered depository institutions are authorized by or under State law to pay interest or dividends °a such a deposit or account." la strongly stated additional 7iews Senators McIntyre and Brooke crcized Committee action as "unnecessary and undesirable." They object to the "attitude that the Federal Government should only go so far as the States, and no farther in granting new powers to financial institutions chartered under Federal Law," 'note that the Committee action  es in the face of action taken by the Senate last  December" when it passed the FIA, and contend that this actionrepresents an inexcuaable step backward in terms of the public interest." McIntyre and Brooke indicate that when either bill is considered on the floor that they "intend to support an amendment to incorporate the proposal originally offered in Committee to do the same for New York and New Jersey, with a one year delay in the ability of NOW accounts in New York and New Jersey to pay interest."   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  4  PAGE 3  They note that in the absence of such an amendment "that the Congress would better refrain from taking any action with respect to New York and New Jersey at the present time." Copy of bill and report is being airmailed.  K. Guenther  • . -1 ".;X4--. •'  •  . •‘.'A :16*  .  IPA".  %Too;  • ••••  •  -1...OF to.""Mr7  "%t411. 45,fr  .• • . -  •,••  •  • ..,••• • ,  Vv.•••• •  ------... MOM .1  CHAIRMAN OF THE BOARD OF GOVERNORS FEDERAL RESERVE SYSTEM WASHINGTON, D. C. 20551  June 30, 1976  The Honorable William Proxmire Chairman Committee on Banking, Housing and Urban Affairs United States Senate 20510 Washington, D. C. Dear Mr. Chairman: Thank you for the opportunity to comment on the proposed amendment to legislation extending the moratorium on the authority of States and localities to levy "doing business" taxes on out-of-state financial depositories. The proposed amendment would make many of the provisions of the Financial Institutions Act (S. 1267) applicable to eight Northeastern States. The Board has not had an opportunity to consider carefully the ramifications of applying a modified FIA to one region of the United States and consequently has no overall position on this proposed amendment at this time. However, the Board believes that careful consideration should be given to certain problems raised by regional application of the FIA.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  One such problem results from the authorization, in one area of the country only, for corporations and State and local governments, as well as individuals, to maintain NOW accounts. In the Board's view, this authorization has the potential of inducing substantial flows of deposits into the affected region. For example, even with the proposed geographic restrictions, national corporations with headquarters in one of the Northeastern States, such as New York, would be likely to shift demand balances held outside the region into NOW accounts. Such shifts could have a serious detrimental effect on banks in other areas of the country. The Board is also uncertain about the implications of including State officials in deliberations of the Federal regulatory agencies on matters relating to interest on deposits. The difficulties raised by such a required procedure could significantly impede the ability of the Federal regulators to deal effectively with financial issues of national significance.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  .•  The Honorable William Proxmire  - 2  The Board notes that the provision contained in S. 1267 that would remove the current prohibition on the payment of interest on demand deposits has been deleted from the current proposal. The Board regards this change as a prudent step and is prepared to conduct further study on the effects of permitting interest to be paid on demand deposits. We stand ready to assist the Congress in any way that we can in the course of its consideration of this legislation. Sincerely yours,  Arthur F. Burns  •  March 5, 1976  TO:  Eisenmenger,Kimball, Basch, SUBJECT: Andersen and White (FRB of Boston)  NOW Accounts  Kichline Mingo Boltz Quick Lindsey Salop Williams Susskind Winn Gunther  FROM:  EDWARD C. ETTIN  Attached is a draft of Paulus' paver on NOW accounts.  Lyle  Gramley has not yet seen it. Would you please send any conuaents you may have directly to Paulus no later than March 15.  A final version will them be  sent to Lyle with a recommendation that it, and the attached covering memo, be sent to the Board.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  To: Board of Governors Subject:  From: Lyle Gramley  NOW Accounts  The attached staff memorandum,prepared by Mr. Paulus, analyzes the effect of the NOW experiment on commercial bank market shares, costs, earning, and portfolios.  His conclusions are summarized  on pages 5-7. In testimony before the Subcommittee on Financial Institutions, Supervisors, Regulations, and Insurance of the House Banking Committee, Governor Mitchell irdicated last fall to Congressman St. Germain that it was time for such a study to be prepared. may wish to transmit  .p.uus  The Board  paper to the appropriate Congressional  Committee as staff views regarding the impact of the NOW experiment on cS mmercial banking in Massachusetts and New Hampshire   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  S   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  DRAFT February, 1976  EFFECTS OF NOW ACCOUNTS ON GOMMEE=4:AAKE CCZ:5 An EARNINGS by • ,  I.  INTRODUCTION  In June 1972 the Massachusetts Supreme Court ruled that state law did not prohibit negotiable orders of withdrawal (NOW) from savings accounts.  Following this ruling, several State chartered  Mutual Savings Banks (MSBs) in Massachusetts began to issue NOW accounts, and, in September, a savings bank in New Hampshire began offering NOWs after determining that New Hampshire law was similar to that of Massachusetts.  Although these rulings allowed state-  regulated MSBs to participate in the NOW market, federally chartered or insured depository offer NOWS.  institutions  could  not—uncle,-  The resultant controversy led to congressional legislation--  public law 93-100--signed into law on August 16, 1973, authorizing all depository institutions (except credit unions) in Massachusetts and New Hampshire to offer interest bearing deposits on which withdrawals by negotiable order could be made.  This legislation thus  established a formal experiment in the two states in which limited demand deposit powers were extended to thrifts and the payment of interest on transactions balances was authorized for the first time since 1933.  *  Acknowledgments: Ralph Kimball, Edward Ettin, Jeff Suskind, Rebecca Wright, John Williams, Paul Boltz, Perry Quick.  •   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 2 Regulation and Growth Regulation of NOW accounts was left to the Federal Reserve Board, the Federal Home Loan Bank Board, and the Federal Deposit Insurance Corporation.  All institutions were authorized to begin  S ffering NOWs on January 1, 1974, and NOW accounts were to be issued exclusively to individuals, non-profit organizations and sole proprietorships--partnerships, corporations and financial institutions were prohibited from holdings NOWs.  Because eligible individuals  and institutions held an estimated one-third of the $6 hillion in demand deposits in Massachusetts and New Hampshire in 1974, this prohibition limited to about $2 billion the maximum level of conversions from commercial bank (CB) demand balances to NOW accounts. The three agencies imposed an interest rate ceiling of 5 per cent on NOW accounts, the same as on savings deposits at CBs but one-fourth of a point less than thrifts are permitted to pay on savings deposits.  Presently, nearly 98 per cent of all institutions  offering NOWs pay this 5 per cent ceiling rate of interest. Congress did not include in the law uniform reserve requirements against NOWs.  Thus, members of the Federal Reserve System  treat NOWs as savings deposits for purposes of calculating required reserves.  Member banks must therefore hold 3 per cent in required  reserves against NOW balances, as compared to reserve requirements averaging 10 per cent on demand deposits.  Nonmember banks and  thrifts in Massachusetts and New Hampshire essentially hold no   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 3 reserves in non-interest bearing form against either demand deposits or NOW accounts. The popularity of NOWs with consumers is evidenced by the rapid and steady growth of these accounts.  In the 20 months between  January 1974 and September 1975, NOW balances grew at an average rate of about 7 per cent per month, advancing from $143 million to $713 million.  As shown in Figure 1, the monthly gcoith rates over this  period have been quite stable, though during August and September, the last two months for which data are available, the rate of NOW growth declined slightly to 6-1/2 per cent per month.  However, there  is no reason to expect a significant slowing in NOW growth in the next  few months. figure ] NOW BALANCES ($ Millions) Now Balances (Ratio Scale) 707 500 354  6.9 per cent trend line NOW Balances  250 177 125  time 1974  Purpose and Scope NOW accounts have evolved into a very close substitute for personal checking accounts, thereby eroding CBs traditional monoply   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 4 position in the issuancP. pi 4ese o.counts. in Massachusetts and Neufl'a  With such erosion,CBs  ave lost the exclusive claim to  offering "one-stop banking" to customers who, for convenience, might be willing to maintain a time or savings account, even at relatively unfavorable interest rates, at an institution that provides checking services.  Moreover, the payment of interest on NOW accounts, many  of which represent direct conversions of zero-interest demand deposits, has raised the average costs to CBs of acquiring funds. These factors suggest that NOW accounts could affect the stability and the viability of commercial banking in Massachusetts and New Hampshire as CBs attempt to adjust to the new, more competitive environment.  This issue--the stability of commercial banking in  the two states during the adjustment period--is the subject of the remainder of this memorandum.  Both aggregate and micro  data are used to study the adjustment of banks in the two states. In Sections II and III, a broad view is taken of industry wide developments in banking in 1974 and 1975.  Shifts in market shares  are reviewed, and the hypothesis that the spread of one-stop banking to thrifts might cause CBs to lose significant amounts of demand related funds--such as small time and savings deposits--is examined. Rough estimates of the direct effect of NOW accounts on CB's costs and earnings since January  1974 are also developed and discussed.  In Section IV the emphasis shifts to the adjustment problem of selected individual CBs.  In any industry, it is the  •  -5 "marginal" firms--those firms with relatively high costs, or inadequate revenues--that determine the capability of the indus try to adjust to changes in the competitive and regulatory envir onment. The effect of NOW accounts on costs and earnings of 39 such banks are therefore analyzed for 1974 and 1975.  Moreover, adjustments to  asset portfolios are considered to determine whether these banks have attempted to offset lower earnings by undertaking more risky investments. In Section V, characteristics of the steady st(:te--the period after which the industry has had ample time to adjust fully to NOW accounts--are discussed, including implications for the allocation of resources and the extent to which the public benefits, on balance, from the issuance of NOW accounts.  In addition, future  CB adjustment problems are considered as NOW balances continue to grow toward some steady state value. Summary and Conclusions NOW related flows of funds have had only a modest effect on the CB share of total deposits in Massachusetts and New Hampshire. By September 1975, some 20 months after the NOW experiment began, households in the two states had converted an estimated $330 million in CB demand balances to NOW accounts at thrifts.  However, there is no  evidence that significant flows of time and savings deposits have accompanied this demand outflow  from CBs.  Thus, NOW induced shifts  in deposit flows, limited mainly to demand deposits, appear to have   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  a   https://fraser.stlouisfed.org • Federal Reserve Bank of St. Louis  - 6 reduced the CB share of deposits in the two states--which total nearly $40 billion--by about one percentage point. The effects of NOWs on CB costs and earnings are limited by the relatively small size of the NOW market in the two states.  Demand balances eligible for conversion to NOW  accounts represent less than 15 per cent of total deposits at CBs.  Higher costs and deposit outflows associated with  NOWs reduced CB after tax earnings an estimated 2.5 per cent in 1974. In 1975, heightened consumer awareness of NOWs caused an accelerati on in the growth of these deposits, resulting in substantial incre ases in bank costs of funds.  For the first nine months of the year, the  estimated earnings reduction attributable to NOWs is more than twice that ot 1974.  An examination of those banks that appear to be most  vulnerable to competitive pressures from NOWs revealed that, altho ugh a few--perhaps a half dozen--are suffering from significant earni ngs reductions due to NOWs, most so called marginal banks are not exper iencing severe adjustment problems. Although NOW funds remain relatively expensive, banks and thrifts continue to compete aggressively for such deposits, despite low rates of return on money market instruments and continuing weak demands for business loans.  Over the longer term, however, such  competition should diminish as NOW growth moderates and market shares stabilize.  It seems plausible, moreover, that this stability  will produce more rational pricing of NOW funds, including the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  I - 7 imposition of higher servirr Jaanger,rthat should help to relieve cost pressures on CBs. Finally, it is argued that after all adjustments are complete--a process that might take several years --CB costs of acquiring transactions balances could ultimately decline as a result of removing the restriction against the payment of interest on such funds.  By permitting banks to select a more efficient strategy in  competing for funds--i.e. by permitting banks to substitute pecuniary for lower valued nonpecuniary services as a means of attracting deposits --it is shown that the allocation of resources in banking will improve. II.  FLOWS OF FUNDS AND MARKET SHARES  The share of the NOW market held by CBs, shown in Table 1, has risen steadily since the beginning of the NOW experiment, reaching 39 per cent last September.  MSBs now hold 49 per cent of all NOW  balances, while savings and loan associations and cooperative banks (S&Ls and Coops) hold the remaining 11 per cent.  During 1974, CBs  and MSBs each captured 41 per cent of net new NOW balances, with S&Ls and Coops attracting 18 per cent.  In contrast, in the first  9 months of 1975, CBs acquired 53 per cent of the increase in NOWs, while MSBs and S&Ls and Coops received 35 and 12 per cent, respectively, of net new inflows. The success of CBs in 1975 in attracting, or retaining NOW funds can be attributed in part to the large increase in the number  TABLE 1 OUTSTANDING BALANCES AND SHARES - ECOTIABLE ORDERS OF WITHDRAWAL (NOWs) (in thousands of dollars)  ' MONTH ENDED  COMMERCIAL BANKS  TOTAL OF ALL OFFERING INSTITUTIONS  TOTAL  MASS.  N.H.  1972--Sept. Oct. Nov. Dec. 1973--Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. 1974--Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct.. Nov. Dec. 1975--Jan. Feb. Mar.  11,094 22,386 34,823 45,272 60,726 73,451 86,118 94,606 102,045 108,381 113,418 117,005 120,223 130,361 136,872 143,254 143,190 150,447 165,157 174,682 180,637 191,229 204,646 232,386 249,033 270,813 293,305 312,576 339,982 385,190 449,638  2,556 4,338 6,588 9,689 11,052 13,771 17,919 32,955 39,253 46,776 55,994 65,249 82,861 107,128 137,519  2,274 282 481 3,857. 5,916 672 8,458 1,231 9,296 1,756 11,156 2,615 14,175 3,744 28,450 4,505 33,597 5,656 40,245 6,531 7,431 48,563 56,989 8,260 73,517 9,344 96,647 10,481 124,706 12,813  Apr. May June July Aug. Sept.  472,864 514,018 580,331 630,402 670,790 713,419  150.999 172,653 210,838 233,513 256,992 280,308  136 165 155,318 185,923 201,607 217,936 235,029  14,834 17,335 24,195 31,906 39.056 45,279  SHARE OF TOTAL NOWS  MUTUAL SAVINGS BANKS  TOTAL  MASS.  SAVINGS & LOAN ASSOCIATIONS  TOTAL  MASS.  N.H.  SHARE OF TOTAL NOWS  .02 .03 .04 .06 .06 .07 .09 .14 .16 .17 .19 .21 .24 .28 .31  11,094 22,385 34,823 45,272 60,725 73,451 86,118 94,605 102,045 108,381 113,413 117,005 120,223 130,361 132,872 143,254 139,779 143,764 154,307 157,412 159,591 164,733 171,503 180,335 187,721 197,758 206,764 213,561 220,725 236,80 262,797  11,094 22,386 34,363 44,522 59,661 71,975 84,162 92,341 99,633 105,688 110,486 113,852 116,259 125,873 131,795 138,028 134,832 138,453 147,845 150,309 151,510 155,946 161,544 169,119 175,340 184,330 192,577 200,083 206,797 221,506 246 259  460 750 1,065 1,476 1,956 2,265 2,412 2,693 2,932 3,153 3,964 4,488 5,077 5,226 4,947 5,311 6,162 7,103 8,081 8,787 9,959 11,216 12,381 12,928 14,187 13,578 13,928 15,074 16,538  .98 .96 .93 .90 .98 .86 .84 .78 .75 .73 .71 .68 .65 .61 .58  855 2,345 4,562 7,581 9,994 12,725 15,224 19,096 22,059 26,279 30,547 33,666 36,396 41,482 49,322  855 2,345 4,325 6,913 8,351 11,089 13,223 16,781 19,314 23,316 26,689 29,747 32,369 37,215 43,980  --237 668 1,143 1,636 2,001 2,315 2,745 2,968 3,858 3,919 4,027 4,267 5,342  .01 .02 .03 .04 .05 .07 .07 .03 .09 .10 .10 .11 .11 .11 .11  .32 .34 .36 .37 .38 .39  268,571 283 322 304,533 327,417 337,584 351,612  250,780 263,978 283,134 303,805 213,117 324,005  17,791 19,344 21,499 23,612 25,567 27,607  .57 .55 .53 .52 .50 .49  53,294 58,043 64,860 69,472 76,114 81,499  47,185 51,388 57,315 61,554 67,519 72,407  6,109 6,655 7,545 7,918 8,595 9,092  .11 .11 .11 .11 .11 .11  Statistical Section, Research Department, Federal Reserve Bank of Boston. Prepared by: Includes three member commercial banks. The above adjustments were made to insure the confidentiality of individual tnstitution data.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  N.H.  SHARE OF TOTAL NOWS  . • .  A   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  9 of offering institalrianclative to that of MSBs. September, th  In 1975, through  marthomm b,L -,,;itt;Wifering NOW accounts increased from 64  to 123, while the number of offering MSBs rose only from 157 to 173. Though a large number of S&Ls and Coops entered the NOW market in 1975, their ability to attract NOW balances has been limited by their relatively small size. Source of NOW Funds Establishing the source of NOW funds--whether demand deposits, time and savings deposits, or other--is of considerable importance in examining NOW related market share developments and, it will be shown in Section III, in estimating the earnings impact of NOWs on CBs.  One important type of evidence on this matter  concerns the behavior of active NOW accounts and the proportion of NOW funds in active and inactive accounts.  Draft activity against  active NOW accounts (i.e. those with at least one draft drawn in a given month) has increased gradually during the experiment, and now averages about 10-1/2 drafts per month.  Since the average number of  checks written against personal checking accounts in New England in 1974 was about 14, this suggests that active NOW accounts are being used primarily as checking accounts. As a first approximation it thus seems reasonable to assume that funds in active NOW accounts were acquired largely from demand deposit balances.  If, as seems plausible, inactive NOW funds originated  primarily in other sources--presumably time and savings deposits--   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 10 then total active NOW balances can serve as an estimate of the amount of NOW funds that were caPnvarte  diverted, from demand  deposits. Though there are no data on active and inactive balances, estimates can be obtained from data on the number of active and inactive NOW accounts in the two states.  In September, 1975, there  were 656,000 NOW accounts at banks and thrifts in Massa chusetts and :/ New Hampshire, of which 140,000, or 21 per cent were inact ive)  If  the average balance in these inactive accounts were equal to the average balance in savings accounts in CBs in New England, which is $1100, then inactive balances totaled some $154 million in September, or 2/ about 20 per cent of total NOW balances.—  This leaves $559 million,  or about 80 per cent, in active halnnees. Evidence on growth rates of demand and savings deposits in New England supports the credibility of these figures as estimates 1/  Of course, the 140,000 inactive accounts include some that were active in earlier months; likewise, some of the accounts that were active in September were inactive in one or more previous months. However, it is believed that the number of drafts written against each account is relatively stable from month -tomonth, so that membership in the two classes of accounts--active and inactive--is also relatively stable. A necessary (through not sufficient) condition for stabile membership in the two classes is that the percentage of inactive accounts must be relatively stable. This condition is satisfied adequately in the two states where the percentage of inactive accounts has fluctuated narrowly from month -to-month while declining from 26 per cent in mid-1974 to 20 per cent in September 1975.  2/  Passbook savings balances in thrifts average between $2000 at $3000 in Massachusetts and New Hampshire. However, those savin gs balances that were converted to NOWs can be expected to be much smaller than the average because of the one-fourth percentage point loss in earnings which becomes significant for large accou nts. Moreover, many of the larger savings accounts at thrif ts are held by businesses and are therefore ineligible for conversion to NOWs. Thus, the $1100 figure is applied to thrifts as well as to CBs.  A   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 11 of the share of NOW funds attracted from demand relative to other types of deposits.  Since January  1974, demand deposits have declined  relatively more in Massachusetts and New Hampshire than in neigh boring New England states, while savings deposits have continued to grow at rates similar to those of Connecticut, Maine, Rhode Island, and Vermont.  In fact, after adjustment for cyclical and regional factors,  demand deposits in Massachusetts and New Hampshire appear to have been reduced since January 1974, by an amount which is about equal to the growth in NOWs.  This suggests that some high proportion of  NOWs, perhaps three-fourths or more, has been attracted from deman d 2/ deposits. In Table 2, estimated active and inactive balances are slInwn for clIQ and thrifts In Scptcabcr 1975.  As showa in Column 3,  TABLE 2 ESTIMATED ACTIVE AND INACTIVE NOW BALANCES September, 1975 Massachusetts and New Hampshire IS in millions) CBs I MSBs S&Ls and Coops Total  NOW Balances  Estimated Inactive Balances  Estimated Active Balances  280.308  48.005  232.303  351.612  86.598  265.014  81.499  19.507  61.992  731.419  154.110  559.309  For details on demand and savings deposits growth in Massachuse tts and New Hampshire relative to other New England states, see Appendix A.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 12 thrifts held an estimated in September.  $330 million in active NOW balances  These_iiinfic, serving largely as checking accou nts,  appear to have been obtained primarily from CB deman d balances.  Of  the $100 million in inactive accounts at thrif ts, an undetermined part was no doubt obtained from CB time and savin gs deposits, with most of the remainder representing conversions from time and savings at thrifts.  This suggests that between $300 and $400 million of NOW  balances currently held by thrifts originated in CB deposits. Market Shares of Total Deposits The direct effect of NOW accounts on market shares in the two-state area, where deposits at CBs and thrifts total nearly $40 billion, thus amounts to, perhaps, a one percentage point reduction in the 45 per cent share held by (1 - 3.  9111rNi7gh  a  relatively modest reduction in the market share of CB's, the indirect effect of NOWs on such shares must also be considered before any judgment can be reached on whether major shifts are under way. This indirect effect involves the spread of convenient one stop banking to thrifts.  By permitting thrifts to issue what is  essentially a demand deposit, CBs could lose large amoun ts of time and, especially, savings deposits as demand deposit funds are diverted to thrifts.  Commercial bankers are particularly worried about this  possibility in view of the one-fourth point advantage thrif ts can offer on passbook savings.  4/  Draft activity against active NOW accounts at thrifts averages about 9-1/2 in the two states, only slightly below the avera ge at CBs.  - 13 The evidence on this issur, indicates that no such shift in deposits between instita  ii  as yet.  In the upper  half of Table 3, market shares of passbook savings are shown for the last four call report dates, beginning in December 1973--just before the NOW experiment began.  As shown in the table, CBs share of  the passbook savings market, in both Massachusetts and New Hampshire, has actually risen during the NOW experiment.  In Massachusetts the  share of passbooks held by CBs increased for 16.7 to 19.1 per cent between December 1973 and June 1975, while New Hampshire CBs have increase their share of the market from 27.1 to 31.1 per cent during this period.  CBs have made significant gains in this market during  the last 20 years, and this evidence suggests that NOW accounts have not retarded this progress. Comparisons of total market shares are of limited value, since CBs, unlike thrifts, obtain a relatively large and variable part of their deposits from large Certificates of Deposit.  Data on total deposits are,  nevertheless, presented in the bottom half of Table 3.  Though the  CB share of total deposits declined from 46 to 44 per cent betwe en mid -1974 and mid-1975, this share remains a percentage point above its June 1972 level (recall that NOW accounts have been issue d by MSBs in the two states since mid-1972).  In New Hampshire, the market  share of CBs has remained relatively stable over the last year, as CBs have successfully protected the gains in market shares made in the early seventies.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 14 TABLE 3 MARKET SHARES OF DEPOSITS HELD BY MAJOR DEPOSITORY INSTITUTIONS IN MASSACHUSETTS AND NEW HAMPSHIRE June 1970  June 1972  Dec. 1973  June 1974  Dec. 1974  June 1975  PASSBOOK SAVINGS EXCLUDING NOWs Massachusetts (dollars in millions)  12,906  13,680  12,883  13,695  CBs  16.7  16.5  17.7  19.1  MSBs  73.8  74.6  73.3  72.6  9.5  8.9  8.9  8.3  1,781  1,824  1,806  1,930  CBs  27.1  79.2  29.5  30.1  MSBs  57.1  55.6  55.3  54.8  S&Ls and coops  15.2  15.1  15.2  15.1  Percentage held by  S&Ls and coops New Hampshire (dollars in (millions) Percentage held by  TOTAL DEPOSITS Massachusetts (dollars in millions)  21,952  26,956  CBs  43.6  43.0  46.0  44.0  MSBs  49.8  50.3  47.6  49.2  6.0  6.7  6.4  6.8  2,234  2,840  3,425  3,693  CBs  36.7  41.4  42.8  42.3  MSBs  50.1  44.7  43.1  43.1  S&Ls and coops  13.2  13.9  14.1  14.6  31,563  32,426  Percentage held by  S&Ls and coops New Hampshire (dollars in millions) Percentage held by   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 15 On the basis of this evidence it appears that, to date, no significant shifts have occurred in market shares beyon d those arising directly from transfers of CB deposits into active NOW accounts at thrifts.  However, the possibility of such a shift, occurring on a  delayed basis, cannot be totally ruled out, particular ly if consumers adjust slowly to changing conditions in financial marke ts. III. EFFECTS OF NOW ACCOUNTS ON AGGREGATE COMMERCIAL BANK COSTS AND EARNINGS: 1974-1975 In attempting to establish a permanent share of the NOW market, CBs in Massachusetts and New Hampshire have absor bed higher costs through the conversion of demand deposits to NOW accounts and have thus experienced a reduction in net earnings.  Moreover, CB  net earnings have been further reduced by the loss of relat ively profitable demand deposit funds to thrifts offering NOWs.  Estimates  of the effect of NOWs on aggregate CB earnings must there fore include both the cost of converting noninterest bearing deman d deposits to NOWs and earnings reductions associated with NOW related outfl ows of demand deposits. In the remainder of this section rough estimates are produced which, it should be emphasized, are indicative only of basic magnitudes.  For reasons to be discussed later, these estimates are  probably biased in the sense that the true depressing effec t of NOWs on CB earnings is more likely to be smaller than these estimates, rather than larger.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 16 Incremental Costs of NOWs In estimating the added costs.,to CBs of acquiring and retaining NOW funds, costs of converting time and savings deposits to NOWs are ignored, since such costs are likely to be small.  Thus,  incremental costs are calculated by multiplying estimated NOW balanc es at CBs which were  converted from demand deposits by the difference  between the average cost of NOW funds and that of demand deposit funds.  For this purpose, active NOW balances at CBs, as calculated  in Section II, will be used to estimate the level of conversions from demand deposits to NOWs. For nonmember banks the average cost of NOW funds is equal approximately to the sum of the interest payment, which averages  In equating conversions of demand deposits to estimated active NOW balances, the consolidation of savings and demand deposit accounts into one active NOW account creates a minor problem, since treating the balance in the active NOW account as originating in a demand deposit causes an upward bias in the estimated level of demand deposit conversions. Because NOW balances at CBs are significantly higher than at thrifts--$1600 at CBs to $900 at thrifts--it might appear that the effect of account consolidation on average NOW balances at CBs is large. However, this is somewhat misleading, since NOW accounts at CBs include conversion of so called D/B/A--"doing business as"--demand deposit accounts of sole proprietorships. These accounts typically carry very large balances ranging up to $50,000 and more. According to knowledgable observers, most of these D/B/A accounts have been converted to NOWs, thereby raising NOW average balances relative to those of demand deposits. For a few CBs whose D/B/A accounts were examined, average NOW balances after excluding D/B/A accounts were much smaller and more consistent with average demand deposit balances. Thus, the effect on average balances of consolidating savings and demand deposit accounts into one active NOW account may be quite small, and active NOW balances, as calculated in Section II, probably serve as a reasonably accurate, though slightly biased estimate of demand deposit conversions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  a  - 17 nearly 5 per cent, and the net cost of servicing NOW accounts.  This  latter cost consists mainly of expenditures on account maintenance (statement preparation, etc.) and costs associated, to a lesser extent, with clearing drafts and handling deposits to NOW accounts. For Federal Reserve members, the NOW cost is equal to this sum, less the earnings from funds released by the lower required reserve ratio on NOWs relative to demand deposits. The per dollar marginal cost of demand deposit funds is approximately equal to the net cost of servicing demand deposit accounts.  This cost is similar to that of NOW accounts, though  probably slightly smaller because a higher proportion of CBs offer free checking than offer free NOWs.  If this service cost differential  is ignored because of its relative smallness, the incremental cost of NOW funds converted from demand deposits is equal to the rate of interest on NOWs minus, where applicable, the additional earnings from lower reserve requirements against NOWs. In calculating incremental costs, the interest rate on NOWs is set at 5 per cent and the Treasury bill rate is used to measure earnings from lower reserve requirements for member banks. These estimated costs are presented in Table 4 on a monthly basis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 18 beginning in January 1974.  For '1974, the estimated incremental cost  of NOWs totaled $8201thour-ffnd.  For the first 9 months of 1975, this  total is $50 2 million, reflecting the large growth in NOW balanc es at CBs this past year.  In 1974, before tax CB earnings in Massachusetts  and New Hampshire totaled $ costs were about equal to  million; thus estimated incremental per cent of 1974 earnings, while  1975 incremental costs for the first 9 months of the year are estimated to be about  per cent of such earnings.  As noted  earlier, however, there are several reasons why these estimates probably overstate actual incremental costs.  First, the small savings  on service changes of NOWs relative to demand deposits are ignored and, second, active balances are used to estimate demand deposit conversions and this estiiAate is biased upward.  Also, the con-  solidation of savings and demand deposit accounts into a single NOW account reduces CB's costs, since the maintenance cost on a NOW account is smaller than the sum of the costs of maintaining separate demand deposit accounts.  6/  Symbolically, the per dollar NOW cost for a Federal Reserve bank can be expressed as: c = i + s n 11  - .07 r  where in is the interest rate paid on NOWs, sn is the annual cost per dollar of servicing a NOW account, r is rate of interest on some asset into which the funds derived from the lower NOW reserve requirement will be invested, and the constant .07 is the difference between the average reserve requirement against demand deposits and NOW accounts. If sn is ignored on the grounds that NOW service costs are similar to those of demand deposits, the incremental cost of NOW funds is equal to in .07 r for Federal Reserve members, and to in for nonmembers. These expressions are used in calculating estimated costs in Table 4.  - 19 TABLE 4 ESTIMATED INCREMENTAL COSTS TO CBs OF NOW ACCOUNTS (in thousands $)  Active Balances 1974:Jan.  1,159.0  MEMBER BANKS Monthly Incremental Cost Incremental Per Dollar Cost  NONMEMBER BANKS Monthly Incremental IncreActive Cost mental Balances Per Dollar Cost  TOTAL CB Incremental Cost  .00371  4.3  575.5  .00417  2.3  6.7  Feb.  .00375  6.1  1,271.0  .00417  5.3  11.4  Mar.  .00370  9.0  2,278.2  9.5  18.4  Apr.  .00369  12.5  3,765.0  15.7  28.2  May  .00367  13.8  4,076.7  17.0  30.9  June  .00360  17.8  5,155.9  21.5  39.3  July  .00371  27.0  6,546.8  27.3  54.3  Aug.  .00366  47.4  7,506.6  31.3  78.7  Sept.  .00368  51.0  14,220.6  59.3  110.3  Oct.  .00374  59.2  14,508.4  60.5  119.7  Nov.  .00372  74.8  31,390.9  130.9  205.6  Dec.  .00375  92.6  20,479.6  85.4  178.0  1975:Jan.  .00379  134.0  25,083.9  .00417  104.6  881.5 238.5  Feb.  .00384  190.3  31,366.9  .00417  130.8  321.0  Mar.  .00384  255.9  41.822.5  174.4  430.3  Apr.  .00383  283.2  47,649.9  198.7  481.9  May  .00386  324.6  55,947.2  233.3  557.9  June  .00386  407.6  66,235.0  276.2  683.8  July  .00381  455.5  74,364.5  310.1  765.6  Aug.  .00379  489.9  82,278.2  343.1  832.0  Sept.  .00379  533.8  91,438.8  381.3  915.1   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  5,226.1   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 20 Reductions in Earnings from Demand Deposit Outflows The second way in which NOW accounts can reduce CB earnings is through the loss to thrifts of funds which would otherwise have provided positive net earnings for CBs.  As noted earlier, the major  identifiable loss of CB funds amounts to about $330 million in demand deposit balances through September, 1975. In attempting to estimate earnings reductions at CBs attributable to NOW induced outflows of funds, active NOW balanc es at thrifts are used to approximate demand deposit outflows.  Savings  deposit outflows, which are essentially unknown, are ignored becaus e the earnings from such funds would have been small, especially in 1975 when market interest rates were low, relative to those of demand deposits.  For nonmember banks, per dollar earnings on demand deposits are equal to the average yield on invested funds minus the net cost of acquiring such funds (in the case of demand deposits, the cost of servicing an average account).  For Federal Reserve member banks,  ITt earnings on demand deposit funds are equal to this amount multiplied by 9, the proportion, on average, of each demand deposit dollar that can be invested after reserve requirements are met. Studies by Donald Hester and James Pierce indicate that a high proportion of demand deposit funds are invested in short term market securities; thus the Treasury bill rate was used to measure the yield  - 21 TABLE 5 ESTIMATED LOST EARNINGS FROM DEMAND DEPOSIT OUTFLOWS ($ thousands) MEMBER BANKS Cumulative Monthly Estimated Earnings Outflows Per Dollar  NONMEMBER BANKS  Lost Earnings  Cumulative Monthly Estimated Earnings Outflows Per Dollar  Lost Earnings  CB EARNINGS Reduction from Outflows  1974:Jan.  94,831.5  .00356  337.6  17,121.2  .00396  67.8  405.4  Feb.  95,953.4  .00304  291.7  17,337.3  .00338  58.6  350.3  Mar.  103,663.1  .00374  387.7  18,750.0  .00416  78.0  465.7  Apr.  106,607.1  .00392  417.9  19,311.9  .00436  84.2  502.1  May  108.725.5  .00408  443.6  19,735.1  .00453  89.4  533.0  June  111,631.7  .00429  478.9  20,272.5  .00477  96.7  575.6  July  117,752.8  .00356  419.2  21,439.4  .00396  84.9  504.1  Aug.  122,573.1  .00431  532.6  22,526.1  .00479  107.9  640.5  Sept.  128,408.0  .00402  516.2  23,445.2  .00447  104.8  621.0  Oct.  136,175.5  .00319  434.4  24,858.8  .00354  88.0  552.4  Nov.  144,505.8  .00344  497.1  26,361.3  .00382  100.7  597.8  Dec.  154,568.7  .00313  483.8  27,844.8  .00348  96.9  580.7 6,298.6  1975:Jan.  155,610.7  .00262  407.7  28,384.9  .00291  82.6  490.3  Feb.  170,412.4  .00194  330.6  31,064.8  .00216  67.1  397.7  Mar.  195,418.7  .00203  396.7  35,663.7  .00226  80.6  477.3  Apr.  206,157.6  .00203  418.5  37,654.9  .00226  85.1  503.6  May  219,712.6  .00174  382.3  40,103.6  .00193  77.4  459.7  June  236,242.4  .00165  389.8  43,169.4  .00183  79.0  468.8  July  252,310.9  .00238  600.5  46,098.5  .00264  121.7  722.2  Aug.  257,961.5  .00260  670.7  47,231.8  .00289  136.5  807.2  Sept.  276,378.0  .00254  702.0  50,638.3  .00282  142.8  844.8  5,171.6 NOTE: Outflows from member and nonmember CBs are assumed to be proportional to market shares of demand deposits of these banks. For example, if member CBs held 80 per cent of demand deposits in a given month, than 80 per cent of active balances at thrifts are assumed to have come from member banks and the remaining 20 per cent from nonmembers.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 22 on demand deposit funds lost to thrifts. ' The average cost of servicing a demand deposit acr....out-q- mr.a, ',ret at 3 per cent of the average balance.  This estimate is based on functional cost data from  the Federal Reserve Bank of Boston.  These data indicate the cost of  servicing a checking account in New England averages between 3 and 4 per cent; since a substantial portion of CBs in Massachuse tts and New Hampshire offer free checking, 3 per cent was chosen as the average net cost of servicing such deposits. Estimates of the earnings reduction attributable to NOW induced demand deposit outflows are presented in Table 5.  For any  given month, the estimated total outflow is shown for both member and nonmember banks.  These outflows include all funds lost in previous  months as well as those lost in thp current month.  -re-NY  1‘,,41,.. . •...4  1lA.N...11LLI  .L  and nonmember banks estimated outflows are multiplied by monthly per dollar earnings on demand deposit funds to obtain an estim ate of earnings lost each month.  For 1974, these estimated earnings reductions  total $6.2 million, which is much larger than the 1974 estim ate of incremental costs from Table 4.  This, of course, reflects the fact  that thrifts--especially MSBs--held a large percentage of active NOWs in 1974.  The 1975 estimated earnings reduction from demand  deposit outflows, which covers only the first 9 months of this year, 7/  See Hester, Donald and James L. Pierce, Bank Management and Portfolio Behavior, Yale University Press, 1975.  - 23 8/ totaled $5.4 million.— After Tax Reduction in Earnings Adding the estimates of incremental costs of shifts from demand deposits to NOWs at CBs and reduced earnings from demand deposit outflows from CBs to thrifts yields a rough estimate of the total before tax reduction in earnings attributable to NOW accounts. For 1974 this total is $7.2 million, while for the first nine months of 1975, the total is $10.4 million. To obtain an after tax reduction in earnings it is necessary to reduce these figures by the amount of the tax savin g accruing from lower CB earnings.  In 1974 more than 90 per cent of Massachusetts  and New Hampshire CBs had before tax earnings excee ding $25,000.  The  marginal tax rate fnr these banks were therefore 48 per euilL, while for the remaining banks the marginal rate was 25 per cent.  The  weighted average of these marginal rates, with weights equal to the proportion of banks in each class, is thus equal to about 46 per cent.  Reducing the estimated $6.8 million 1974 earnings reduction by  this amount produces an after tax reduction in earnings of $3.7 million.  Since after tax profits in Massachusetts and New Hamsphire  totaled $142 million in 1974, this represents a reduction in total after tax earnings of about 2-1/2 per cent.  8/   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Concerning the robustness of these estimates to changes in the assumed average balance in inactive accounts, if instead of $1100 this average was twice as large--$2200--the earni ngs reduction from demand deposit outflows would have been about 30 per cent smaller. For example, assuming a $2200 avera ge balance in inactive accounts at thrifts reduces estimated activ e balances from $330 million to $230 million in September, 1975. Thus, earnings reductions from demand depos it outflows would be only 23/33, or about 70 per cent, of those shown in Table 5 for that month.  a   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -24Since no income figures are yet available for 1975, a similar calculation cannot be made for that year.  However, if the  1974 tax reduction is applied to the $10.4 million in reduced 1975 earnings, the after tax reduction in earnings attributable to NOWs for the first 9 months of the year is $5.6 million. IV.  ADJUSTMENT PROBLEMS OF INDIVIDUAL BANKS  Analysis of aggregative--industry wide--data suggests that, at worst, aggregate CB earnings may have been depressed by a few percentage points in 1974 Pnd 1975.  These data, therefore, do not  indicate that the industry is experiencing particularly serious adjustment problems.  However, aggregative data can often conceal  important information.  In particular, when an industry is adjusting  to a change in basic costs or revenues, certain segments of the industry--those so called marginal firms--may suffer disproportionat ely high losses of earnings and capital.  The adjustment experience of  these firms can often reveal far more about the stability of the industry than aggregative data. The remainder of this section is therefore devoted to a study of costs, earnings, and portfolio adjustments of several such banks in Massachusetts and New Hampshire.  Each of these banks belongs  to one of the following categories; (1) "high impact" banks having 10 per cent or more of total deposits in NOW accounts in June 1975, (2) banks having low earnings in 1974, or (3) banks not offering NOWs, but experiencing significant losses of demand deposits betwe en  I •   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 25 January 1974 and June 1975.  W-1-,y-rdnine,cf).the  states fall into one or more df-tkestomitiegories.  banks in the two Obviously, the  earnings and capital positions of these banks are especially vulnerable to NOW related changes in costs and revenues. To estimate the cost and earnings impact of NOWs it is first necessary to project for each bank a level of demand deposits that would have been observed in the absence of NOWs.  After this projection  is made, actual demand deposits are compared to projected balances. Then, if the actual demand deposit balances of a bank offering NOWs exceed projected deposits, the earnings reductions for that bank from the advent of NOWs is zero, since all NOW balances are, in effect, net new funds.  However, for a CB offering NOWs and having  actual demand deposits below the projected level, the cost of converting demand balances to NOWs and, possibly, the earnings reduction from an outflow of demand funds both will reduce total earnings.  For banks not offering NOWs but experiencing large run-  offs of demand balances (category 3), the earnings reduction attributable to NOWs is calculated as the lost earnings from NOW induced outflows of funds as measured by the difference between projected and actual demand deposits. To illustrate, assume in the absence of NOWs demand deposits are projected to grow from do to d suppose deposits actually grow to da.  in Figure 2, and  If NOW balances at this bank  - 26 deposits  figure 2  do  time  to are equal to the distance dp - b at time t, then NOW conversions from demand deposits are assumed to total dp - d , which is, of a course, the amount by which projected deposits exceed actual demand deposits.  The remaining NOWs--d a - b--are thus assumed to have been  attracted from other institutions. of NOW accounts is equal to d  - a.  Alt  sl_ippncn  the level  This amount is then assumed to  represent inhouse conversions from demand deposits.  However, in this  case, NOW balances are less than the "deficiency" in demand deposits as measured by d  d  a  The difference, a - d a) is assumed to  represent demand balances lost to another institution offering NOWs, and the earnings reduction from this outflow is added to the direct cost of converting demand deposits to NOWs. Actual projections of demand deposits were based on a comparison of demand deposit growth for each bank relative to the average growth in demand deposits in Maine, Connecticut, Vermont, and Rhode Island during 1972 and 1973.  This established a differential  between the demand deposit growth rate of each bank and the average   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 27 growth rate of demand deposits in these four New Engla nd states not affected by NOWs.  During 1974 and 1975 projected demand deposit  growth for each bank was set equal to the average growth in these deposits in the four New England states plus the 1972-73 differential. This method of projection thus assumes that demand depos its of those banks that were growing more rapidly than the average rate in the four New England states in 1972-73 would continue to do so in the absence of NOWs, while those banks whose demand deposit growth was below that of the average would continue to exper ience slower growth. As in Section III, the per dollar cost of converted demand deposits is assumed to equal the interest payment on NOWs less, where applicable, the increased earnings from released reserves. The per dollar earnings reduction from lost funds is also calculated  as the difference between the Treasury bill rate and the average cost of servicing demand deposits-- which is assumed, again, to be 3 per cent. High Impact Banks— In June 1975, there were 8 CBs with more than 10 per cent of total deposits in NOW accounts.  Five of these banks were either  established banks with a history of aggressive management prior to the introduction of NOW accounts or new banks.  In interviews  conducted by the Federal Reserve Bank of Boston, it was found  -9/  See Ralph C. Kimball," Federal Reserve Bank of Boston, for a similar analysis of high impact, low income, and run-off banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 28 that the former group of ,b.alaks terA-? .t-ck..e aggressive in offering NOWs, often introducing them bt:t± competitors and promoting them heavily through advertising.  In general the management of these  banks viewed NOW accounts as a means of increasing their market shares by attracting new customers.  For these banks, the high  proportion of NOWs resulted from a deliberate aggressive policy by the banks' management. The remaining three banks tended to be older banks which introduced NOW accounts as a defensive measure.  These banks, for  one reason or another, found themselves under severe competitive pressures and were forced to introduce NOWs to maintain their deposit base.  Two of these banks have an abnormally high ratio of personal  demand deposits to total deposits, and thus were particularly vulnerable to competition from thrifts offering NOWs. Individual bank names and data are not reported in this study.  Instead, the number of banks whose before tax income was  reduced by various percentages is given in Table 6.  Of the eight  high impact banks, only five have been in operation long enough to permit a projection of the level of demand deposits which is required to make the cost and earnings reduction calculations.  Of  these five banks, it is estimated that four had their earnings reduced by less than 10 per cent in 1974, while one had a percentage reduction of about 50 per cent.  - 29 In 1975, two of the banks are expected to continue to experience income reductions of less than 10 per cent, two are projected to suffer 10 to 20 per cent reductions, while NOW related changes in costs and revenues are expected to produce negative net earnings in 1975 for one bank.  However, it should be noted that this  bank is one of the five "high impact" banks whose management was classified as very aggressive.  This bank has experienced impressive  growth over the past decade and does not appear to be endangered by the added costs from NOW accounts. Low Income Banks Low income banks are defined as those banks offering NOWs whose ratio of 1974 before tax earnings to total deposits falls in the lowest 10 per cent for the this category, with 13 being New Hampshire. below  two  ctnta.c.  10  4J_LL  Massachusetts CBs and five operating in  These banks all had earnings to deposit ratios  per cent in 1974, while the two-state average for all  banks was about  per cent.  As shown in. the "low earnings" columns of Table 6, about one-half of these banks had 1974 earnings reduced by less than 20 per cent.  One bank had negative earnings in 1974 on account of NOW  related costs; however, this bank would have had very low earnings-less than $5 thousand--even without added NOW costs which were estimated at about $10 thousand. In 1975, about half of the low income banks are expected to experience earnings reductions from NOWs of less than 10 per cent,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -30 TABLE 6 EARNINGS REDUCTIONS FROM NOW ACCOUNTS: Income Reduced by (per cent)  High Impacts 1974 1975  Low Earnings 1974 1975  MARGINAL BANKS Runoffs 1974 1975  Total 1974 1975  0-10  4  2  5  9  7  7  16  18  10-20  0  2  4  3  4  4  8  9  20-30  3  2  1  0  4  2  30-40  1  0  1  1  2  1  40-50  1  2  3  1  4  3  1  2  2  2  60-70  1  0  1  1  1  70-80  1  0  1  1  1  80-90  0  0  0  90-100  0  0  0  50-60  1  100 Total NOTE:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  5  1  1  5  18  18  16  1  1  2  16  39  39  One bank belonged to both the "high impact" and the "low earnings" group. This bank is included only in the high impact category in the Table.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 31 while four banks are projected to lose about one-half of their 1975 earnings. Since many of the low income banks are probably experiencing temporarily low earnings, these banks can be expected to show significantly improved earnings in the next few years even after NOW related costs are fully absorbed.  Thus, even the distribution of  earnings reductions shown in Table 6, which do not appear to indicate widespread and serious adjustment problems among these banks, probably overstates the impact of NOWs on basic--or permanent-earnings for such banks. Runoff Banks Runoff banks are defined as those banks  not offering NOWs  that lost 10 per cent or more of their demand deposit base between January 1974 and June 1975.  Of the 16 runoff banks, only about one half  believe that demand deposit outflows are at least partly caused by competitors offering NOW accounts.  Most of these banks cited  added expenses as the reason for not introducing NOWs.  Some banks  also indicated that they lacked necessary computer facilities required to handle NOW accounts and one bank, which does not pay the ceiling interest rate on savings accounts, expressed concern that offering NOWs would cause added expenses by forcing the savings rate to the ceiling. Although about half the runoff banks do not believe that competition for NOW accounts is responsible for their demand deposit  - 32 outflows, earnings reduction estimates are shown for all 16 banks in Table 6. Runoff banks have no conversion costs, so the percent earnings reduction estimates shown in Table 6 are based strictly on earnings losses from NOW induced demand deposit outflows.  Of the 16  runoff banks, 11 experienced estimated earnings losses from NOWs of less than 20 per cent of total earnings in both 1974 and 1975. In 1975, earnings reductions exceeding 50 per cent of total earnings are projected for three banks, with one of these banks suffering greater than a 100 per cent reduction. Summary of Marginal Bank Earnings Reduction& As shown in the last two columns of Table 6, about 40 per cent of the 39 marginal banks experirnrPa NOW related earningQ reductions of less than 10 per cent in 1974, and 60 per cent suffered less than 20 per cent reductions.  Five banks--or less than 15 per  cent of the 39 banks--are estimated to have lost 50 per cent or more of 1974 earnings, including one bank which lost more than 100 per cent.  However, as noted, this bank had only small NOW costs,  but suffered from abnormally low earnings even without the NOW offset. In 1975, about two-thirds of the 39 banks are estimated to have suffered relatively modest--less than 20 per cent--earnings reductions.  Many banks experienced healthy demand deposit growth in  1975, thus helping to reduce estimated NOW losses.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Also, Treasury   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 33 bill rates--which are used to measure earnings losses from outflows-have been significantly lower in 1975 than in 1974.  Six CBs, however,  are projected to lose 50 per cent or more of 1975 earnings, and of these, two could lose more than 100 per cent. The distribution of earnings reductions in these two columns suggests that even within the class of marginal banks, only a small number, perhaps 15 per cent, are presently experiencing significant adjustment problems.  Of these, some may continue to experience  severe adjustment problems, while others, such as those with temporarily low income due to other causes, many recover from NOW related earnings reductions without further problems.  In addition,  several runoff banks, by their own admission, have not really suffered NOW related deposit and earnings losses, but rather have lost demand deposits for other reasons. 10 Portfolio Adjustments by Marginal Banks---/ CBs an attempt to offset higher NOW costs and lower earnings in two basic ways; by lowering costs by imposing relatively Itigh service charges on NOW accounts, and by raising revenues in any number of ways.  As indicated briefly in Section III, there  is limited evidence, mostly of a judgmental nature, that CB service charges on NOW accounts are higher on average than those imposed on demand deposits; thus a part, probably small, of increased NOW costs are being recovered through higher service charges.  10/  For a discussion of portfolio adjustments of thrifts, see Appendix B.  -34 -  CBs an attempt to increase revenue by raising loan rates.  However,  in Massachusetts and New Hampshire, where stiff competition exists from banks in neighboring states and from money market obligations, such as strategy would likely be counterproductive.  CBs can also attempt to raise  earnings by including in their portfolios more risky, higher yielding assets. For example, a CB can usually increase revenues by selling short-term highly liquid assets such as Treasury bills, and using the proceeds to acquire nonprime business or real estate loans.  The problem with this strategy is that  the acquisition of more loans :!ncreases both the level of average earnings and the variation of these earnings.  Increased variation in earnings, moreover,  increases the probability of bank failure.  Thus, portfolio adjustments by  CBs attempting to maintain a target level of earnings are of conRiderahlP, importance in examining the stability of commercial banking. Before reviewing empirical evidence on this matter, it should be noted that, on theoretical grounds, costs and portfolio risk should be directly 11/ related. Portfolio theory as developed in the last 25 years, however, suggests that rational wealth holders seek to balance benefits of higher rates of return against the disadvantages of additional risk when selecting an optimal portfolio of assets.  This behavior, though implying somewhat more risk will  be assumed when the return on bank capital declines, is generally incompatible with attempting to maintain a target level of earnings independent of portfolio risk whenever costs or revenues change.  This suggest a willingness of  bank shareholders to accept lower earnings in the event of a temporary increase in cost; thus only modest increases in the riskness of the bank 11/   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  See Ralph Gambs, "Interest Bearing Demand Deposits and Bank Portfolio Behavior", Southern Economic Journal, July 1975.  - 35 -  portfolio may result. The hypothesis that the 39 marginal banks in Massachusetts and New Hampshire have attempted to increase portfolio risk in order to offset NOW related lower earnings can be examined by using the ratio of loans to total assets as a rough measure of risk for each bank.  In the left panel of Figure 39 ratios of loans to total  assets are shown for each of the three classes of marginal banks. Figure 3 Pct. High Impact  Pct. `ma  65  65 -  1  60-  60 rr  55F Low income 5   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  f7/  ."7"1 Marginal)' banks// '  50  Runoffs/  'Industry less ginal  45 . 1W  19/3  1974  7547-5  1973  1974  1975  Since early 1974 these ratios have been gradually declining, and this would appear to contradict the "target rate of earnings" hypothesis of CB behavior.  However, the economies of Massachusetts and New  Hampshire were depressed during the 1974-75 period, so that loan demand was generally weak.  Therefore, a comparison of loan ratios  of marginal banks relative to all other Massachusetts and New Hampshire banks is shown in the right panel of Figure 3.  Because  the marginal banks experienced greater than average NOW related earnings losses, it might be expected that under the target rate of return   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 36 hypothesis  their loan to asset ratios might decline less than  that of the industry.  Instead, since late 1974, the aggregate  marginal bank ratio, as shown in the right panel of Figure 3,has declined more than the industry ratio.  Based on this evidence, the  39 marginal banks do not appear to have increased the riskiness of their portfolios, as measured by the ratio of loans to assets, as a result of NOW accounts.  V.  THE LONG RUN ADJUSTMENT PROBLEM OF COMMERCIAL BANKS  Conversion of time and savings deposits to NOW accounts causes negligible cost increases, so the problem CBs face in the long run is absorbing, or offsetting, higher costs associated with conversions from demand deposits to NOWs and the loss of funds to thrifts.  Because CBs have become quite successful in retaining NOW  funds and hence face escalating costs of acquiring funds, the problem of absorbing such costs will be examined in some detail in the remainder of this section.  Characteristics of the Steady State The Federal Reserve Board's Demand Deposit Ownership Survey indicates that 1/3 of all demand deposits are held by households; thus only about $2 billion of the $6 billion in demand deposits in Massachusetts and New Hampshire could therefore be converted to NOWs.  In Table 2  it was shown that an estimated $550 million of demand deposits had been converted to NOWs as of September 1975.  Thus, between 25 and 30 per  cent of eligible transactions balances were at that time in NOW accounts.  •  -37 -  It would be grossly incorrect, however, to attempt to S.in an estimate of the effect of NOWs on CB profits in the steady   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  state--that period after which NOW market shares have stabilized and CBs have made all desired adjustments--by multiplying the September 1975 estimated earnings reductions (Tables 4 and 5) by some number such as 3 or 4.  Such a calculation would be nisleading because it ignores  potential adjustments that CBs can make in competing for NOW funds. Before the payment of interest on NOWs was permitted, CBs competed for transactions balances by offering suppliers of funds various non pecuniary services such as free checking, branch banking, lS nger hours of operation, and larger numbers of tellers to reduce waiting time.  At the margin, however, the cost of providing such services  exceeds the value attached to these services by custamers.  It is a  widely accepted proposition, for example, that whenever the price a service is set at zero, that service  of  will be consumed by customers  untilthe value of the last unit is zero.  However, there is a positive  cost associated with providing, or producing each service unit (e.g. the cost of clearing checks written against a "free" checking account is positive for each check).  Thus, the provision of such services is  inefficient in the sense that valuable resources are used up in producing serices which, on the aargin, have relatively low value. By substituting pecuniary returns--the payment of interest on NOWs-for non pecuniary services, CBs can eliminate the waste, or inefficiencies, associated with providing non pecuniary services that have low marginal  '  values relative to cost. *Indeed, by"permktting the payment of interest on NOW balances, both customers and banks can be expected to benefit. This can be shown by supposing that banks initially offer free checking services to the public and pay no interest on demand deposit balances. The total return on demand funds derived by customers is thus equal to the value of check cashing services, while the cost to the bank of acquiring demand balances is equal to the cost of servicing their customers' free checking accounts.  If banks are allowed to make explicit interest  payments to customers with demand funds on deposit, customers will be better off even if they are required to pay for check cashing services as long as the interest rate is high enough.  Moreover, bank costs can  be lowered due to reduced costs of servicing checking accounts if the interest rate is not set too high.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Indeed, it is shown in Appendix  C  that there is a range if interest rates for which both customers--suppliers of demand deposits--and banks are better off--i.e. the total value of bank services to the customer, including interest earned, is higher and bank costs of providing these services are lower. One important implication of this result--also discussed in Appendix C -- is that the cost to CBs of acquiring transactions balances will decline if banks are permitted to pay interest on such balances. This paradoxical result arises from the fact that removing a constraint on the way in which banks can compete for funds allows CBs to select a more efficient strategy for attracting funds.  -3I -  Transition to the Steady State Competitive pressures may make the transition to the steady state a long, and for some banks, a difficult process.  However, after NOW  growth begins to moderate and NOW market shares of individual CBs and thrifts stabilize, the aggressive competition for NOW funds should gradually disappear as the level of non pecuniary services is reduced. To establish that rational pricing of NOW balances will indeed occur at some future date, it is necessary to show that the pricing policy now in effect of offering relatively high rates of return (including both I-cuniary and non pecuniary returns) on a new claim  such as a NOW account  is neither surprising irrational, but represents a short run strategy consistent with maximizing the sum of current plus discounted future earnings. In Appendix D, a formal argument is presented showing that when the future suIIly of funds arising  from a new claim is related positively to market  shares established during the period before such shares have completely stabilized, a bank seeking to maximize the value of stockholder's equity will temporarily pay higher rates for these funds than is consistent with short run profit maximization.  As market shares begin to stablize, moreover, the  rae of return offered will decline to the profit maximizing level.  This  implies that current CB behavior in competing aggressively for NOW funds is not inconsistent with stockholder objectives, and more important, as the NOW market settles down"  total rates of return offered on NOW accounts will decline.  The major type of non pecuniary return offered by CBs which can be easily adjusted is free checking, including free drafts and free account maintenance.  In table 7, estimates of NOW costs based on Functional  Cost Data from the Federal Reserve Bank of Boston -are shown.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The  •   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  total annual cost of servicing a NOW account with a $1000 average balance is about $90, of which nearly half ($41.40) is attributable to non interest related costs.  If a 10 cent charge were imposed on drafts, the cost  of servicing an average NOW account would decline to about $80.  TABLE 7 NOW COSTS FOR A $1000 ACCOUNT  Item Cost  Number of items per Month  Monthly Cost  Annual Cost  $.09  11  .99  11.88  .15  2  .30  3.60  .16  1.92  2.00  24.00  Total cost per account  3.45  41.40  Interest cost, $1000.00 Account  4.17  50.00  $7.62  $91.40  Drafts Deposits made Outside checks Handled Account Maintenance (Statements, etc.)  2.00  1  Total cost per month  Moreover, if account maintenance charges were introduced, this cost would drop to about $55.  Since the cost of servicing a free checking  account averages about $40, CBs offering such accounts would thus experience, as the transition period proceeds, only moderate increases in costs of acquiring transactions balances if customers are required to absorb draft and account maintenance charges. Other adjustments which take longer to make—such as reducing the number of branch banks, constructing less elaborate bank buildings and  the like--will be made  later .as competitive pressures force CBs to  adopt more efficient strategies far-mequiring deposits. as noted earlier, will lower CB  These adjustments,  costs and thereby provide a net  gain to the economy through more efficient resource utilization.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -42 APPENDIX A EVIDENCE ON THE SOURCE OF NOW DEPOSITS  If a substantial portion of NOW balances represent conversions from demand deposits, then demand deposit levels in Massachusetts and New Hampshire should have been lowered by NOW accounts.  Similarly,  savings deposits, being only marginally affected, should have grown at normal rates during the last two years.  As shown in columns 1 and 2 of  Table A-1, demand deposit balances in Massachusetts and New Hampshire did decline some $300 million in 1974.  Moreover, balances in savings  accounts increased about $300 million over this period.  Part of the decline  in demand deposits and part of the increase in savings, however, can be attributed to cyclical and regional economic factors.  An attempt  to adjust for these factors is therefore made in column 3 where projections of demand and savings deposit growth are shown.  These projections are  based on the assumption that in the absence of NOWs, demand and savings balances would have grown at the same rate as the average of those two series in the four neighboring New England states which did not offer NOWs.  Thus, the projected levels represent an estimate of demand and  savings balances that would have occurred had NOWs not been introduced, and the difference between columns 2 and 3 represents a rough estimate of the effect of NOW accounts on demand and savings deposit balances.  -43 TABLE A-1 SOURCE OF NOW DEPOSITS ($ billions)  JIMMOOPOINI1   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  IPC demand Savings deposits excluding NOWs NOW accounts  (1) 1973.4  (2) Actual 1974.4  (3) Proj. 1974.4  6.329  6.025  6.244  13.885  14.160  14.194  .143  .340  (5) (4) Diff. Actual (2)-(3) 1975.2  (6) (7) Diff. Proj. 1975.2 (6)-(7)  6.280  5.853  -.427  -.028 15.268  15.100  -.168  -.219  .197*  .437*  .580  * Actual growth.  This difference, as shown in column 4, indicates that actual demand deposit growth in 1974 was some $220 million less than projected in Massachusettz, and New Hampshire.  Moreover, balances in savings accounts were only abouL  $30 million below expected levels.  The $220 million reduction in demand  deposits in 1974 is almost completely offset by the $197 million increase in NOW balances, shown in the last row of Table A-1, suggesting that a significant portion of NOWs originated in CB demand deposits.  Similar  calculations, appearing in columns 6 and 7, for the 18 month period from January 1974 to June 1975 also indicate that, over the longer period, demand deposits have probably been the major source of funds for new NOW balances.  APPENDIX B PORTFOLIO ADJUSTMENTS BY THRIFTS Several important-impld,cations for thrift asset management arise from permitting MSBs and S&Ls to issue NOW accounts.  Since they  have developed as a very close substitute for checking accounts, NOW accounts should have short run and cyclical stability characteristics similar to those of demand deposits.  Specifically, NOWs can be expected  to be relatively more stable over the business cycle than time and savings deposits.  For example, figure 4 presents some evidence on the cyclical  Seasonally Adjusted Annual Rates 20  FIGURE B-1  -10  1975  1970  stability of demand deposits relative to that of time and savings deposits at CBS and thrifts.  Comparing the movements of the two series over the period  shown, there is a clear indication that demand deposits are more stable over long periods of time than time and savings deposits.  This evidence is  supported by econometric studies which indicate that the sensitivity of time   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -45--  and savings flows to changes in market interest rates is much greater than that of demand deposits. The acquisition of transactions balances by thrifts in the form of NOW accounts should, therefore, reduce the severity of the so-called disintermediation problem usually experienced by these institutions during periods of high market interest rates and, thereby, reduce the variation of earnings over the business cycle.  However, the implications of thrift  issuance of NOWs for mortgage lending are less clear.  Research by Hester  and Pierce-'suggests that depository institutions tend to allocate a significantly larger proportion of time and savings funds to real estate loans than demand funds.  For example, using a model of CB asset management,  Hester and Pierce estimate that approximately 30 ccnts  .L  aLL ctuu.L.  dollar derived frOm time and savings deposits will be invested in real estate loans, while only 5 to 10 cents of an additional dollar of demand deposits will be similarly invested.--' Permitting thrifts to issue NOW accounts should, therefore, result in greater diversification of thrift asset portfolios as relatively large proportions of NOW funds are invested in short-term assets such as Treasury bills and consumer loans.  1/ Hester, Donald and James Pierce, op. cit. 2/ Though demand deposits are more stable than time and savings deposits over the business cycle, they are much more volatile over shorter periods of time such as a week. Thus, portfolio managers are reluctant to invest large proportions of demand funds in mortgages, since a demand deposit run-off within a few weeks might require that such assets be sold at a loss.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -46-  Total mortgage lending by all depository institutions might still increase, however, as a result of permitting thrifts to issue NOW accounts. The net effect on such lending of flows of funds between CBs and thrifts, through small, should be positive, since thrifts have a comparative advantage in mortgage lending.  More important, however, is the extent to which CB  tiLa and savings deposit funds accompany the outflows of demand funds from CBs to thrifts.  If, through the issuance of NOWs, thrifts are able to  increase their share of the time and savings market, the net effect on mortgage lending could be significant, since thrifts invest more than 70 per cent of such funds in mortgages, compared to perhaps 30 per cent by CBs. As noted in Section II, there is no,evidence, as yet, of such a shift in market shares in Massachusetts and New Hampshire; thus there is no reason to expect that major changes in mortgage lending are imminent.  However,  if the present 1/4 point differential on passbook savings between CBs and thrifts is maintained, large outflows of CB savings funds associated with demand deposit flows might occur after the adjustment to NOWs is complete. Such a change in market shares could then significantly increase mortgage lending at the expense of other types of loans traditionally provided by CBs.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  APPENDIX C REMOVAL OF INTEREST RATE CONSTRAINTS, BANK COSTS OF ACQUIRING FUNDS, AND -PORTFOLIO RISK*  Suppose that banks can initially offer only non pecuniary services--free checking, long hours, impressive buildings, etc.--in order to attract transactions deposits.  The denand for these services is given  by the curve DD in figure C-1, while the MC curve represents the marginal cost to the bank of providing such services.  Price  FIGURE C-1  Quantity 0  Qo  Qi  If the price of non pecuniary services is set at zero--as it is for all banks that offer free checking--the quantity demanded of non pecuniary services will be 0Q1.  The area under the DD curve--the area of triangle  ODQ --thus represents the total value of these services to the customer. 1  The  cost of providing this level of services, ignoring fixed costs, is equal to the area under the MC curve--the area of OAEQ1.  * It is assumed throughout this appendix that bank customers are relatively homogenous and that the number of checks written is positively_related to , the average balance of each account.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -48—  FrSm figure C-1 it is clear that the cost of providing services I- yond OQ  S  exceeds the value attached to such services by customers.  If  permitted to pay interest on these funds, banks can eliminate this inefficiency, and still provide customers with the same or greater level of total--pecuniary plus non pecuniary--services.  Moreover, the cost of  providing this level of services will be lower. For example, suppose banks change customers P for non pecuniary o services. be OQ  S  The level of such services "purchased" by customers will then  which yields a net return to customers equal to the area.of the  triangle PDBn o (which is equal to the area under the demand curve be twee 0 and Q less the cost paid for services--equal to OP BQ ). S o o  Suppose  further that the interest rate is the set at a level to yield customers a pecuniary return equal to the area of OPCQ . The total return to S 1 customers is then equal to the area under the demand curve plus the area of the triangle BCQ1.  The cost to the bank of providing these  services is equal to the area under the marginal cost curve between 0 o. This is le ss than the C and Q plus the area of the rectangle By o 'arela under MC between 0 and Q --the original cost of non pecuniary ser1 vices--by the area of BEC.  Thus, by paying this particular interest  rate on funds, total returns to customers are increased, while bank costs have declined.  Moreover, any interest payment greater than  OPBQ but less than OPBEQ will similarly raise total returns to 1 o 1 o customers while lowering bank costs. This result can be easily extended to show that the cost Sf funds will decline if banks are permitted to pay interest on   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -4S -  deposits.  In the northeast quadrant of figure C.2, let the curve CR  describe the relationship between bank costs of providing services and the valuation of those services by customers.  Next, in the southeast  figure C-2 total Cost  Ds  Valuation of Services (Net Return)  Ds quadrant, let the curve S represent the customers' supply function of funds.  This curve has the usual property that as total returns offered by  S.nks increase, the supply of funds rises. The cost of acquiring funds is depicted by the curve C in the northwest quadrant of figure C-2.  This curve is derived from the CR and  S curves by use of the 45 degree translation line in the southwest quadrant.  For example, if bank costs arelevel of services offered O  to customers will be R . o  According to the supply function S, customers  o in funds. will then supply Ds  s Thus, deposits totaling D are supplied  when bank costs are C , as indicated by the point a in the northwest o quadrant.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -50-  The payment of interest on deposits shifts the CR curve to the sbowri a higher return to customers can be achieved right to C R, since, as, by a given expenditure of bank funds.  It is easily seen from figure C-2  that this shift causes the C curve to shift downward to C'.  Thus, by re-  moving the constraint against the payment of interest on transactions balances--and thereby permitting banks to adopt a more efficient strategy for attracting funds--the cost to banks of acquiring funds will decline. Finally, the lowering of the C curve has implications for the amount of portfolio risk a bank will undertake.  1/ It has been shown- in the  / context of a mean-variance portfolio model that if bank owners have a 3/ quadratic utility function , the amount of portfolio risk a bank will undertake rises whenever the risk-return curve shifts downward, and declines when  an  nnranl-r1  shift  The  lnwerinq of the C curve in  state would tend to raise the mean-variance curve.  the stendy  Thus, in the long  run bank portfolio risk might be lowered as a result of the payment of interest on transaction balances.  In the short fun, the C curve is raised  1/See Ralph Gambs, 22. cit. 2/The mean-variance portfolio model was developed by Harry Markowitz, Portfolio Selection, Efficient Diversification of Investments, New York: John Wiley & Sons, 1959 and James Tobin,"Liquidity Preference as Behavior Towards Risk", Review of Economic Studies, February 1958. For a comprehensive review of portfolio theory including recent developments, see Michael Jensen, "Capital Markets: Theory and Evidence", Bell Journal of Economics and Management Science, 1972. 3/Quadratic, that is, in the mean and variance of the distribution of expected returns.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  „ - 51 -  and the mean-variance curve is lowered, thus implying that portfolio risk might increase.  However, as noted in Section IV, there is no evidence  yet of such a change in the riskiness of bank assets.  4   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  as  APPENDIX ,D PROFIT MAXIMIZATION AS A SUB-OPTIMAL CRITERION WHEN THE LONG RUN SUPPLY OF FUNDS DEPENDS ON MARKET SHARES ESTABLISHED DURING A TRANSITION PERIOD  Suppose a new bank liability is introduced and that the long run supply of funds to each bank depends positively on the market share established during a transition period.  Suppose further that the bank  wishes to maximinize the sum of current plus future discounted profits. For a two period world the formal problem is: maximinimi4eW=E+11I t — s where  t  r )D t t  H = (i - r ) D s s s s  profits during the transition period profits in the steady state  p is a discount rate i is the rate earned on investments during the transition period. t is the offering rate on the new liability during the transition t (r < i ) period t t  r  i is the rate earned on investments in the steady state s r is the offering rate in the steady state (r < i ) s s s The supply functions have the forms:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  D = D ) tt t  D = D (r , D ) s s s t  (Supply function during transition)  ar t DD s Dr s  2  aps >o 3D  t  (Supply function in steady state)  -53-  ,;-titt.. -LIansition period depends positively Note that the supply of funds duon the offering rate, while the supply in -the steady state, or long run, depends positively on the market share--D --established during the transition t in addition to the offering rate. To maximinize W (wealth), we differentiate with respect to r t and r and set both expressions to zero: s  t+ @r t  Differentiating  1  Hs Dr t  = 0  H with respect to r s (i s  r) s  s  yields  0 t > 0  Because DR /@r is positive, the partial derivative s t  /3r must be negative t t  if the first order profit maximinization conditions are to be satisfied (first equation above).  This implies that if the first period profit  functiSn is concave with respect to r , as is usually assumed, then the t rate r  t  that maximizes wealth is greater than the first period profit  maximizing rate.  This is shown in figure D-1, where rP and rw  are the transition period profit and wealth maximizing prices respectively. w Notice that r --the rate offered by a bank maximizing wealth (or, equivalently, stockholders equity)--is higher than rP; this follows from nt/rt being negative.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  an'  it-  -54Figure D-1  nt ,  D  rt  w r t  r t  Finally, the condition all2/rs = 0 implies that in the steady state, after market shares have stabilized, rate setting will be based on triditional profit maximizing considerations   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •••oF GOved •i• • 0  FEDERAL  4, press  RESERVE  release  LI   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  March 1, 1976  For immediate release  The Board of Governors of the Federal Reserve System today amended its Regulation Q to permit member commercial banks throughout New England to offer NOW accounts to their customers. The action was taken in light of legislation effective February 27, 1976,authorizing NOW accounts in four additional New England States.  Congress previously authorized NOW accounts in  Massachusetts and New Hampshire on an experimental basis. A customer holding a NOW account may write Negotiable Orders of Withdrawal (NCIWs) against the account and at the same time receive interest on the funds retained in the account. Attached is a copy of the amendment to Regulation Q, which governs the payment of interest on deposits by member S.nks.  - 0 -  11,  TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM SUBCHAPTER A--BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM [Regulation Q] Part 217--Interest on Deposits Technical Amendments for Deposits Subject to Negotiable Orders of Withdrawal  The Board of Governors of the Federal Reserve System has amended Regulation Q (12 CFR 217) in light of recent legislation (P.L. 94-222)  authorizing negotiable orders of withdrawal (NOW)  accounts in the States of Maine, Connecticut, Rhode Island, and Vermont. The amendments are technical in nature and are intended only to extend the existing provisions of Regulation Q regarding the offering of NOW accounts to member banks in those States in which Federal law permits such accounts.  The amendments also clarify the types of  depositors that may be offered NOW accounts by member banks. The first amendment adds a sentence to  217.1(e)(3) to  make clear the fact that NOW accounts may not be maintained where any beneficial interest is held by a corporation, partnership, association, or other organization operated for profit or not operated primarily for religious, philanthropic, charitable, educational, fraternal, or other similar purposes.  In addition, the provision relating to  maintenance of NOW accounts established prior to May 16, 1975, by   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -2-  certain governmental units has been eliminated because all such accounts were required to have been terminated by December 31, 1975 (see 40 FR 17885). The second amendment eliminates the reference to the States of Massachusetts and New Hampshire contained in  217.5(c)(3) to  provide that the restrictions relating to manner of payment of savings deposits do not apply to deposits subject to negotiable orders of withdrawal, the issuance of which is  authorized by Federal law.  The final amendment modes  5  217.6(i) to limit NOW account  advertising of member banks, to the extent practicable, to media directed toward residents of the States in which Federal law authorizes such accounts and eliminates references to Massachusetts and New Hampshire. The provision also restricts all other solicitations of NOW accounts, to the extent practicable, only to persons residing or employed in the States in which Federal law authorizes such accounts and to persons who are customers of member banks in those States on the effective S.te of this amendment. This action was taken pursuant to the Board's authority unS.r  q  19 of the Federal Reserve Act371b) to prescribe  rules governing the payment and advertisement of interest on deposits. Because these amendments are technical in nature only and do not result in any substantive changes to the provisions of Regulation Q, the Board finds that good cause exists for dispensing with notice and public participation referred to in   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  5  553(b) of Title 5 of the  -3-  United States  Coc!-  with respect to these amendments.  The Board has  determined that such procedures are unnecessary in view of the nature of the amendments.  In addition, in view of the technical nature of  the amendments and in order to enable member banks to offer NOW accounts to the public as soon as possible, the Board finds good cause to make the amendments effective immediately. Pursuant to effective  .arch 1,  5 19 of the Federal Reserve Act (12 U.S.C. 371b) 1976,  5 217 of Regulation Q (12 CFR 217) is  amended to read as follows:  5 217.1--DEFINITIONS   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  (e)  Savings deposits  (3) In those States where banks are permitted to offer deposits subject to negotiable orders of withdrawal, such deposits may be maintained if such deposits consist of funds deposited to the credit of or in which the entire beneficial interest is held by one or more individuals, or - corporation, association, or other occlization operated primarily for religious, philanthropic, charitable, educational, fraternal, or other similar purposes, and not operated for profit. Deposits in which any beneficial interest is held by a corporation, partnership, association or other organization operated for profit or not operated primarily for religious, philanthropic, charitable, educational, fraternal, or other similar purposes may not be classified as deposits subject to negotiable orders of withdrawal.  -49 217.5—WITHDRAWAL OF SAVINGS DEPOSITS  (c)  Manner of payment of savings deposits  (3) The provisions of this paragraph do not apply to deposits subject to negotiable orders of withdrawal -Ar Federal that are authorized '  217.6--ADVERTISING OF INTEREST ON DEPOSITS  (i) Negotiable orders of withdrawal. In addition to compliance with the other paragraphs of this section, member banks offering accounts subject to negotiable orders of withdrawal, to the extent practicable, shall limit every advertisement, announcement or solicitation made in any newspaper, magazine, radio, television or other media to such facilities directed toward residents of the States in which Federal law authorizes the issuance of such accounts. All other advertisement, announcements and solicitations of such accounts, including direct mailing, circulars, and notices, whether written or oral, to the extent practicable, shall be directed only to persons residing or employed in the States in which Federal law authorizes the issuance of accounts subject to negotiable orders of withdrawal and to persons who are customers of member banks in those States on the effective date of this amendment. By order of the Board of Governors, effective Mrch 1, 1976. (Signed) Theodore E. Allison Theodore E. Allison Secretary of the Board  [SEAL]  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  February 10, 1976  To:  Board of Governors  From:  Don Winn  The House has now given final approval to S. 2672 thereby clearing the measure for the President. This is the bill which extends the moratorium on the interstate taxation of depository institutions, allows NOW accounts in all six New England States, and makes certain changes in the Fair Credit Billing Act. The NOW account provision goes into effect immediately upon date of enactment.  cc:  Messrs. Allison, Garwood, Coyne, O'Brien, Hawke, Gramley, Raiken, F. Solomon, Kluckman, Kichline, Eckert, Ettin, and Ms. Hart   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  • February 9, 1976  To: From:  Board of Governors \tt Don Winn  On Friday, February 6, the Senate, after adding minor amendments, agreed to the House version of S. 2672, the bill which would extend the moratorium on interstate taxation of depository institutions to September 12, 1976. This bill would also allow all Federal financial institutions in the 6 New England states to offer NOW accounts. It is the third section of the bill with its provisions amending the Fair Credit Billing Act that has been the subject of disagreement between the House and Senate. •••  •••  MR Mil  The Senate has now agreed to the House provision authorizing the Federal Reserve Board to delegate to staff the authority to issue binding interpretations and approvals. The Senate has also agreed to the House provision to specifically prohibit the imposition of surcharges on credit card customers. The Senate, however, has added the modification that the ban on surcharges would be limited to a 3 year period so that Congress would review the matter at a later time. The House bill would have eliminated the 5 per cent limitation on permissible cash discounts. The Senate disagreed with this provision and has added an amendment to reinstate the 5 per cent limit.  The bill naw returns to the House for final approval, which is expected without further changes.  cc:  Messrs. Allison, Garwood, Coyne, O'Brien, Hawke, Gramley, Raiken, Kichline, Eckert, Ettin, and Ms. Hart k F. Solomon, Klucman,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  b 4.10  December 8, 1975  To:  Board of Governors  From:  Don Winn  The Senate today approved an extension of the moratorium on interstate taxation of national banks from December 31, 1975, to September 12, 1976. It also accepted by a voice vote an amendment by Senator Brooke authorizing NOW accounts in all the New England states. Also, the Senate passed legislation repealing provisions of the Real Estate Settlement Procedures Act. An amendment recommended by the Board was adopted to allow advance disclosure of credit costs. The language of the amendment reads as follows: (c) For the purposes of subsection (a), the Board is authorized to require by regulation the disclosure of all or part of the information required to be disclosed under this Chapter at the time a creditor makes a written commitment with respect to a consumer credit transaction involving real property which is used or is expected to be used as the principal residence of the person to whom the credit is extended.  cc:  Messrs. Allison, Garwood, Coyne, O'Brien, Hawke, Solomon, Raiken, Kluckman, Kichline, Ettin, Boltz, Eckert, and Ms. Hart.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  November 18, 1975  To: Thru: From:  Chairman Burns Ken Guenther Don Winn  At your request I have talked to Governor Mitchell about the possible McIntyre legislation to extend NOW account powers to Federal S&L's in states like Maine and Connecticut which are giving demand deposit powers and NOW account powers to state chartered thrift institutions. Governor Mitchell feels that in New fngland the S&L's are A relatively small part of the market so that extending NOW account powers to Federal S&L's would not have an important effect on commercial banks and it would equalize the Federal S&L's with the state chartered thrifts. He feels that it would be entirely different if the extension were to ppply to states outside New Lngland where S&L's have a much larger market share. Attached is a table showing market shares in Connecticut and Maine, which Governor Mitchell referred to. Governor Mitchell also suggested that we say to McIntyre that we would have to consider remavims the differential if the change were to result in a worsening of competitive positions. Shall I indicate to McIntyre's staff (and this would be off the record) that the Board would not object to extending NOW account powers to Federal S&L's in New England, but that the Board would take a different position if the legislation affected other saographic areas? Yes No  4.41111.111.111.6.1111.0  take the position that I asked Governor Mitchell if we should to commercial banks. He did not NOW account powers should also be given the commercial bank share of think this was necessary. He said that there was no evidence they would the market was increasing and that be hurt.  Attachment  BOARD OF GOVERNORS OF THE  FEDERAL RESERVE SYSTEM  Office Correspondence To  From  Board of Governors  Date Subject:  February 20, 1975  NOW account developments in  Paul W. _Boltz  December 1974  After one full year of the Congressionally-mandated NOW account experiment in Massachusetts and New Hampshire, outstanding balances in NOW accounts in the two states have more than doubled to $313 million, and the pace of growth accelerated in the second half of the year.  At the present  rate, outstanding NOW account balances will double approximately every 8 months.  However, although they have spread at a rapid rate, they still are  less than 1 per cent of total deposits and less than 4 per cent of demand deposits at depository institutions in the two states. At the end of the year, 75 per cent of the 201 mutual savings banks in the two states were offering NOW accounts, up from 50 per cent at the beginning of the year.  Savings and loan associations entered the field  very rapidly in 1974, and at the end of December over 40 per cent of the 197 S&L's in the two states were offering NOW accounts.  Commercial banks  have not matched the aggressive entry of the S&L's into the NOW market, and at the close of the year only 28 per cent of banks had NOW accounts. Altogether, 47 per cent of the 627 depository institutions in the two states were offering NOW accounts as of December 31, 1974.  The more rapid entry  of thrift institutions into the NOW market likely reflects their desire to compete with commercial banks in the payments market.  Since banks already  had demand deposits, their slower entry may reflect their prior position of '1 strength in this market.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -2-  Activity levels at NOW accounts gradually rose over the year.  New  Hampshire MSB's, which pioneered NOW accounts with no-charge drafts that paid low interest, had the highest average level of NOW account activity in January 1974 when data were first collected.  At that time, 75 per cent  of New Hampshire's MSB's that offered NOW accounts provided free drafts, and tne proportion of other institutions offering free NOW drafts in the two states was much lower.  Other institutions switched to free drafts as  the year progressed or offered them when they first entered the NOW market. Most institutions switching to free drafts continued paying the ceiling rate of 5 per cent, and to compete with them, institutions just entering the field also paid the ceiling rate on their free-draft NOW accounts.  Consequently,  the accounts have evolved into very attractive accounts for transactions balances.  As the following table shows, NOW account activity at New Hampshire  MSB's is being approached at other institutions. 1974 NOW Account Activity in Massachusetts and New Hampshire Average number of Percentage of NOW NOW drafts per accounts with over account 20 drafts January December January December Massachusetts Commercial banks MSB's S&L's Total Massachusetts  6.8 6.8 4.9 6.8  8.5 9.2 10.6 9.3  0.0 3.8 0.0 3.7  11.0 7.8 10.8 8.7  4.1  11.0  0.0  15.5  12.6 **  12.2 10.3 11.7  25.0 **  16.6 14.0 16.0  New Hampshire Commercial banks MSB's S&L's Total New Hampshire  12.6  24.6  Total Massachusetts and New Hampshire 7.3 5.4 9.5 9.4 ** In January, only one S&L in New Hampshire was offering NOW accounts, and its data were included with data on MSB's in New Hampshire by the Boston Federal Reserve Bank to protect the confidentiality of the report.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -3Interest Rates and Charges for Drafts on Now Accounts in Massachusetss and New Hampshire, 1974 Percentage of institutions at ceiling rate January December  Percentage of institutions with free NOW drafts January December  Massachusetts Commercial banks MSB's S&L's Total Massachusetts  100.0 100.0 100.0 100.0  98.0 100.0 100.0 99.6  27.3 25.9 36.4 27.1  19.6 70.2 78.6 62.3  66.6 13.3  0.0 75.0  21.0  83.3 45.0 90.9 67.4  63.2  50.0 70.0 45.4 58.1  88.1  94.9  32.5  61.7  New Hampshire Commercial banks MSB's S&L's Total New Hampshire Total Massachusetts and New Hampshire **  **  **  In January, only one S&L in New Hampshire was offering NOW accounts, and its data were included with data on MSB's in New Hampshire by the Boston Federal Reserve Bank to protect the confidentiality of the report.  One feature of the NOW accounts which has remained relatively stable over the year is the predominant method of interest calculation--from day of deposit to day of withdrawal.  Almost all the mutual savings banks offering  NOW accounts in January 1974 calculated interest in this way, and since then over 90 per cent of the institutions which began offering NOW's also calculated interest from day of deposit to day of withdrawal.  Most institutions also  cS mpound the interest either continuously or daily, but the proportion has been falling slightly as the number of institutions compounding quarterly or monthly has grown.  At the end of December about 70 per cent of the offering  institutiS ns compounded continuously or daily.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  TABLE 1 NUMBER OF INSTITUTIONS OFFERING NOWS AND NOW BALANCES AS OF  DECEMBER 319 1974  RS ) ( DOLLAR AMOUNTS IN 1tuIIMI!J.']'I'1ILII  I I I I I I  I I I I I I --- .... -I I I MASSACHUSETTS I I COMMERCIAL BANKS I MEMBERS NON—MEMBERS I I I MUTUAL SAVINGS BANKS I I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED — MEMBERS FHL8 I STATE INSURED — MEMBERS FHLB I STATE INSURED — NON—MEMBERS FHLB I I TOTAL MASSACHUSETTS I I I NEW HAMPSHIRE I I COMMERCIAL BANKS I I I I MUTUAL SAVINGS BANKS I  I  SAVINGS E. LOAN ASSOCIATIONS AND COOPERATIVES FSLIC INSURED — MEMBERS FHL8 STATE INSURED — MEMBERS FHLR STATE INSURED — NON MEMBERS FHLB TOTAL  NEW HAMPSHIRE  I TOTAL MASSACHUSETTS AND NEW HAMPSHIRE  TRANSACTIONS DURING MONTH I I I-NOW I I I BALANCES 1 AMOUNT I OF I DEPOSIT I ALL WITH— I I PREVIOUS I I INTEREST I INFLOWS I DRAWALS I OFFERING I MONTH I I CREDITED I I NOWS I  NUMBER OF INSTITUTIONS  TOTAL  I I I NOW I I BALA^!CES I I CURRENT I I MONTH I I I I I I I I I I I I I I I I I I I I I I I I I I I I I  153 92 61  51 33 18  489563 239876 249687  188 71 117  459870 21 9504 249366  379626 16,482 21,144  6 5 1  569989 28,964 28,025  167  131  1929577  787  1139401  1069656  26  2009083  179 35 28 116  70 21 11 38  269689 119534 59639 99516  116 63 21 32  249894 129018 4,510 89366  219952 109409 49264 79279  0 0 0 0  299747 13,206 5,906 109b35  499  252  2679829  19091  1849165  1669234  32  2869819  76  12  79431  27  69104  59302  0  89260  34  20  149187  42  129716  139366  1  139578  18 0 0  11 0 0  39858 0 0  16 0 0  39312 0 0  39267 0 0  0 0 0  128  43  259476  85  229132  219935  1  259757  I  627  295  2939305  19176  2069297  1889169  33  3129576  I  PREPARED BY STATISTICAL SECTION, RESEARCH DEPARTMENT+ FEDERAL RESERVE BANK OF BOSTON   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  I I I SERVICE I CHARGES I 1  39 I'I'JLI?IIIIIIIII 0 1 0 I  TABLE 2 NUMBER OF NOW ACCOUNTS AT OFFERING INSTITUTIONS AS OF  I NUMBER OF I NOW ACCOUNTS I PREVIOUS MONTH  DECEMBER 31' 1974  I NEW ACCOUNTS OPENED DURING MONTH I I I BY EXISTING I BY NEW I CUSTOMERS MI CUSTOMERS  NUMBER OF ACCOUNTS CLOSED DURING MONTH  NUMBER OF NOW ACCOUNTS CURRENT MONTH  MASSACHUSETTS COMMERCIAL BANKS MEMBERS NON-MEMBERS MUTUAL SAVINGS RANKS SAVINGS 6. LOAN ASSOCIATIONS AND COOPERATIVES FSLIC INSURED - MEMBERS FHLB STATE INSURED - MEMBERS FHLB STATE INSURED - NON-MEMBERS FHLB TOTAL MASSACHUSETTS  39,986 18,550 21,436  3,637 1,783 1,854  2,718 2,005 713  673 544 129  45,668 21,794 23,814  196,125  6,583  5,422  2,426  205,704  34,048 16,283 6,329 119436  1,967 988 175 804  1,587 712 281 594  354 187 50 117  379248 179796 6,7_35 12,717  270,159  12,187  9,727  3,453  288,6e0  4,991  319  156  70  5,3(o6  18,475  662  224  166  199195  3,586 0 0  194 0 0  232 0 0  48  3,964 0 0  27,052  1,175  612  284  28,555  13,362  10,339  3,737  317,175  NEW HAMPSHIRE COMMERCIAL BANKS  MUTUAL SAVINGS RANKS SAVINGS Fs LOAN ASSOCIATIONS AND COOPERATIVES FSLIC INSURED - MEMBERS FHLB STATE INSURED - MEMBERS FHLB STATE INSURED - NON MEMBERS FHLB TOTAL  NEW HAMPSHIRE  TOTAL MASSACHUSETTS AND NEW HAMPSHIRE  297,211  (1) EXISTING CUSTOMERS ARE DEFINED AS THOSE HAVING AN ACCOUNT AT THE INSTITUTION AT THE TIME THE NOW ACCOUNT WAS OPENED. PREPARED BY STATISTICAL SECTION, RESEARCH DEPARTMEN T, FEDERAL RESERVE BANK OF BOSTON   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  TABLE 3 A NOW ACCOUNT ACTIVITY DURING THE MONTH OF DECEMBER 319 1974  NUMBER OF NOW ACCOUNTS WITH ACTIVITY DECEMBER 319 1974 DURING MONTH OF: I  NO DRAFTS  I  1-9  DRAFTS  I 10-20 DRAFTSI  I  > 20 DRAFTS I  TOTAL NUMBER OF NOW DRAFTS  AVERAGF I NUMBER CF I NOW DRAFTS I I I PER ACCOUNT(2)I  I MASSACHUSETTS I  COMMERCIAL BANKS MEMBERS NON-MEMBERS  17,279 139050 49229  169142 49920 119222  79204 29264 49940  59043 1,560 3,483  2419438 96,328 145,110  8.5 11.0 7.3  I I I  I  MUTUAL SAVINGS BANKS  489551  1029171  389840  169142  194559646  9.2  I  I  SAVINGS & LOAN ASSOCIATIONS AND COOPERATIVES FSLIC INSURED - MEMBERS FHLB STATE INSURED - MEMBERS FHLB STATE INSURED - NON-MEMBERS FHL8  89442 59112 19240 29090  159578 69964 29983 59631  99193 39769 19720 39704  49035 19951 792 19292  3069140 1459919 599822 1009399  10.6 11.5 10.8 9.4  I I I I  749272  1339891  55,237  259220  290039224  9.3  I  982  29425  19154  835  489591  11.0  I  39075  79956  4,987  3,177  1979175  12.2  I  641  19905 0 0  863  555 0 0  349302 0 0  10.3 0.0 0.0  I I  49698  129286  79004  49567  280,068  11.7  I  789970  1469177  629241  299787  292839292  9.5  I  I  TOTAL MASSACHUSETTS  I NEW HAMPSHIRE I  COMMERCIAL BANKS  I  MUTUAL SAVINGS BANKS  I  SAVINGS & LOAN ASSOCIATIONS AND COOPERATIVES FSLIC INSURED - MEMBERS FHLB STATE INSURED - MEMBERS FHLB STATE INSURED - NON MEMBERS FHL8  I  TOTAL  NEW HAMPSHIIl RE  TOTAL MASSACHUSETTS AND NEW HAMPSHIRE  w•Ron•••••=....orms  (2) AVERAGE EXCLUDES THOSE ACCOUNTS WHICH HAD NO ACTIVITY DURING THE MONTH. PREPARED BY STATISTICAL SECTION, RESEARCH DEPARTMENT, FEDERAL RESERVE BANK OF BOSTON   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  TABLE 3 B NOW ACCOUNT ACTIVITY DURING THE MONTH OF DECEMBER 31, 1974  ,11•1114•=11,  I I I I  I I I I  PERCENTAGE OF NOW ACCOUNTS WITH ACTIVITY DURING MONTH OF: DECEMBER 31, 1974 NO DRAFTS  I  1-.9  DRAFTS I 10-20 DRAFTS I  I NUMBEk OF I NOW ACCOUNTS CURRENT I MONTH > 20 DRAFTS I (3)  1 1 I I  AVERAGE BALANCE PER ACCOUNT  I I I I  I MASSACHUSETTS I  COMMERCIAL BANKS MEMBERS NONMEMBERS  37•8 59.9 17.7  35.3 22.6 47.0  15.8 10.4 20.7  11.0 7.2 14.6  45,668 21,794 23,874  I  MUTUAL SAVINGS BANKS  23.6  49.7  18.9  7.8  205,704  I  SAVINGS I. LOAN ASSOCIATIONS AND COOPERATIVES FSLIC INSURED - MEMBERS FHLB STATE INSURED - MEMBERS FHLB STATE INSURED - NON-MEMBERS FHLB  22.7 28.7 18.4 16.4  41.8 39.1 44•3 44.3  24.7 21.2 25.5 29.1  10.8 11.0 11.8 10.2  37,248 17,796 6,735 12,717  I 1,247.90 I 1,328.99 I 1,173.87 I I 972.67 I I I 798.62 I 742.08 I 878.91 I 836.28 I  TOTAL MASSACHUSETTS  25.7  46.4  19.1  8.7  288,620  993.76 I  I  I NEW HAMPSHIRE I  COMMERCIAL BANKS  18.2  44.9  21.4  15.5  5,396  1,530.76 I  I  MUTUAL SAVINGS BANKS  16.0  41.4  26.0  16.6  19,195  707.37 I  I  SAVINGS & LOAN ASSOCIATIONS AND COOPERATIVES FSLIC INSURED - MEMBERS FHLB STATE INSURED MEMBERS FHLB STATE INSURED - NON MEMBERS FHLB  16.2 0.0 0.0  48.1 0.0 0.0  21.8 0.0 0.0  14.0 0.0 0.0  3,964 0 0  988.65 I 0.00 I 0.00 I  TOTAL  16.5  43.0  24.5  16.0  28,555  902.01 I  24.9  46.1  19.6  9.4  317,175  985.50 I  I  NEW HAMPSHIRE  I TOTAL MASSACHUSETTS AND NEW HAMPSHIRE  (3) PERCENTAGES MAY NOT TOTAL EXACTLY 100  PERCENT DUE TO ROUNDING  PREPARED BY STATISTICAL SECTION, RESEARCH DEPARTMENT, FEDERAL RESERVE BANK OF BOSTON   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  S  TABLE 4 A RATES PAID ON NOW ACCOUNTS AS OF  DECEMBER 31' 1974  ( DOLLAR AMOUNTS IN THOUSANDS OF DOLLARS )  I I I I I  I I I I I I I MASSACHUSETTS I COMMERCIAL BANKS I MEMBERS I NON-MEMBERS I I I MUTUAL SAVINGS BANKS I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED - MEMBERS FHLB I STATE INSURED - MEMBERS FHLB I STATE INSURED - NON-MEMBERS FHLB I I I TOTAL MASSACHUSETTS I I I NEW HAMPSHIRE I I COMMERCIAL BANKS 1 I MUTUAL SAVINGS BANKS I I I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED - MEMBERS FHLB I STATE INSURED - MEMBERS FHLB STATE INSURED - NON MEMBERS FHLB I I I NEW HAMPSHIRE TOTAL I I TOTAL MASSACHUSETTS AND NEW HAMPSHIRE I  3.0% NO OF INST  I I  DOLLAR AMOUNT  I I I I I  OVER 3.0% AND LESS THAN 4.0% NO OF INST  I I  DOLLAR AMOUNT  I 1 I I I  I I I I I  4.0% NO OF INST  I I  DOLLAR AMOUNT  NO OF INST  I I  DOLLAR AMOUNT  0 0 0  0 0 0  0 0 0  0 0 0  1 0 1  316 0 316  0 0 0  0 0 0  0  0  0  0  0  0  0  0  0 0 0 0  0 0 0 0  0 0 0 0  0 0 0 0  0 0 0 0  0 0 0 0  0 0 0 0  0 0 0 0  0  0  0  0  1  316  0  0  0  0  0  0  2  569  0  0  4  1,806  0  0  7  5,046  0  0  0 0 0  0 0 0  0 0 0  0 0 0  1 0 0  160 0 0  0 0 0  0 0 0  4  1,806  0  0  10  5,775  0  0  4  1,806  0  0  11  6,091  0  0  Immlommlm  PREPARED BY STATISTICAL SECTION, RESEARCH DEPARTMENT, FEDERAL RESERVE BANK OF BOSTON   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  I I I I I  OVER 4.0% AND LESS THAN 4.'30%  .IM.M.OIMA.M.imwd.mmOmMe.mmomeninaso  I 1 I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I  F  TABLE 4 El RATES PAID ON NOW ACCOUNTS AS OF  DECEMBER 319 1974  ( DOLLAR AMOUNTS IN THOUSANDS OF DOLLARS )  .....m.......m...m...  gmliam...........m,  I I I I I  I I I I I  I I I I I  4.50% NO OF INST  1 I  DOLLAR AMOUNT  OVER 4.5% AND LESS THAN 5.0% NO OF INST  I I  DOLLAR AMOUNT  I I I I I  5.0% NO OF INSTS  I I  DOLLAR AMOUNT  I I I I I  WEIGHTED AVERAGE RATE (4) ..1......01•  I I MASSACHUSETTS I I COMMERCIAL BANKS I MEMBERS I NON-MEMBERS I I MUTUAL SAVINGS BANKS I I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED - MEMBERS FHLB I STATE INSURED - MEMBERS FHLB I STATE INSURED - NON-MEMBERS FHLB I I TOTAL MASSACHUSETTS I I I NEW HAMPSHIRE I I COMMERCIAL BANKS I I I I MUTUAL SAVINGS BANKS I I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED - MEMBERS FHLB I STATE INSURED - MEMBERS FHLB I STATE INSURED - NON MEMBERS FHLB  1  I TOTAL NEW HAMPSHIRE I I TOTAL MASSACHUSETTS AND NEW HAMPSHIRE I I mor  (4)  •=.111•01,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  molm.......  I I I I I I I 1 I I I I I I I I I I I I I I I I I I I I 1 I  0 0 0  0 0 0  0 0 0  0 0 0  50 33 17  56,673 28,964 27,709  4.994 5.000 4.988  0  o  o  o  131  200,083  5.000  0 0 0 0  o  o  o  0 0 0  0 0 0  0 0 0  70 21 11 38  29,747 13,206 5,906 10,635  5.000 5.000 5.000 5.000  0  0  0  0  251  286,503  4.998  o  o  o  o  10 7  7,691  4.931  o  0  o  o  9  6,726  4.362  0 0 0  0 0 0  0 0 0  0 0 0  10 0  3,759 0  4.959 .000  o  0  .000  0  o  o  o  1 1  29  18,176  4.635  0  o  o  o  280  304,679  4.968  I I 1 I I  ...NI  .....1.410,  WEIGHTED BY DOLLAR AMOUNT  PREPARED  I I I I 1  By STATISTICAL SECTION, RESEARCH DEPARTMENT, FEDERAL RESERVE BANK OF BOSTON  TABLE 5 METHOD OF INTEREST RATE CALCULATION AS OF  DECEMBER 31, 1974  ( NUMBER OF INSTITUTIONS )  •=1•NII.  I INTEREST CALCULATED ON: I I AVG DLY MIN DAY OF DEP DAY OF DEP TO DIV DT BAL BAL TO WITH I  I I I I I I MASSACHUSETTS I COMMERCIAL BANKS I I MEMBERS NON-MEMBERS I I MUTUAL SAVINGS BANKS I I SAVINGS & LOAN ASSOCIATIONS AND I I COOPERATIVES I FSLIC INSURED - MEMBERS FHLB I STATE INSURED - MEMBERS FHLB I STATE INSURED - NON-MEMBERS FHLB I I TOTAL MASSACHUSETTS I I I NEW HAMPSHIRE I COMMERCIAL BANKS I I I I I MUTUAL SAVINGS RANKS I I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED - MEMBERS FHLB I STATE INSURED - MEMBERS FHLB I STATE INSURED - NON MEMBERS FHLB I I TOTAL NEW HAMPSHIRE I I TOTAL MASSACHUSETTS AND NEW HAMPSHIRE I I  I I OTHER I I  DAILY  CONT  MONTHLY  QTERLY  OTHER  I I I I I I I I I I I I I I I  8 5 3  2 0 2  40 27 13  0 0 0  1 1 0  11 7 4  11 6 5  17 11 6  12 9 3  0 0 0  3  1  126  0  1  86  27  13  4  1  3 1 0 2  0 0 0 0  65 19 11 35  1 0 0 1  1 1 0 0  37 10 6 21  13 7 1 5  9 1 2 6  11  0  3  0  I  2 6  0 0  14  3  231  1  3  134  51  39  27  1  0  1  10  0  1  0  2  10  0  0  0  0  19  0  1  18  0  2  0  0  0 0 0  1 0 0  10 0 0  0 0 0  0 0 0  5 0 0  4 0 0  2 0 0  0 0 0  0 0 0  0  2  39  0  2  23  6  14  0  0  14  5  270  1  5  157  57  53  27  1  I I I I I I I I I I I I I I I I I I I I I I I I I  PREPARED BY STATISTICAL SECTION, RESEARCH DEPARTMENT, FEDERAL RESERVE BANK OF BOSTON   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  FREQUENCY OF COMPOUNDING  •  TABLE 6 SIZE DISTRIBUTION BY NUMBER OF INSTITUTIONS AS OF  DECEMBER 31. 1974  ( BASED ON TOTAL ASSETS )  I I I  I I I  I I MASSACHUSETTS I I COMMERCIAL BANKS I MEMBERS NON-MEMBERS I I I MUTUAL SAVINGS BANKS I I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED - MEMBERS FHLB I STATE INSURED - MEMBERS FHL9 I STATE INSURED - NON-MEMBERS FHLB 1 I TOTAL MASSACHUSETTS I I I NEW HAMPSHIRE I I COMMERCIAL BANKS I I I I MUTUAL SAVINGS BANKS I I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED - MEMBERS FHL3 I STATE INSURED - MEMBERS FHLB I STATE INSURED - NON MEMBERS FHLB I I TOTAL NEW HAMPSHIRE I ITOTAL MASSACHUSETTS AND NEW HAMPSHIRE I I  < $50 m  ALL INSTITUTIONS I I I S50-250 M I  > $250 m  INSTITUTIONS OFFERING NOWS I I < $50M $50-250 m I I > $250 M  101 57 44  41 25 16  11 10 1  21 12 9  23 15 8  7 6 1  69  84  14  43  74  14  156 22 25 109  22 12 3 7  1 1 0 0  51 10 7 34  18 10 4 4  1 1 0 0  326  147  26  115  115  e2  71  5  0  12  0  0  22  11  1  9  10  1  16 0 0  2 0 0  0 0 0  10 0 0  1 0 0  0 0 0  109  18  1  31  11  1  435  165  27  146  126  23  PREPARED By STATISTICAL SECTION, RESEARCH DEPARTMENT, FEDERAL RESERVE BANK OF BOSTON   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  I I I  I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I 1 I I I I I I  TABLE 7 SOURCE OF NEW ACCOUNTS AND CHARGES PER DRAFT AS OF  DECEMBER 31, 1974  ( DOLLAR AMOUNTS IN THOUSANDS OF DOLLARS )  DEPOSITS TO NEW NOW ACCOUNTS FROM: (5) I DEM DEPOSITS I I I MASSACHUSETTS I I COMMERCIAL BANKS I MEMBERS I NON-MEMBERS I I MUTUAL SAVINGS BANKS I I SAVINGS & LOAN ASSOCIATIONS AND COOPERATIVES I I FSLIC INSURED - MEMBERS FHLR I STATE INSURED - MEMBERS FHLB I STATE INSURED - NON-MEMBERS FHLB I I TOTAL MASSACHUSETTS I I I NEW HAMPSHIRE I I COMMERCIAL BANKS I I I I MUTUAL SAVINGS BANKS I I SAVINGS & LOAN ASSOCIATIONS AND I COOPERATIVES I FSLIC INSURED - MEMBERS FHLR I STATE INSURED - MEMBERS FHLR I STATE INSURED - NON MEMBERS FHLB I NEW HAMPSHIRE I TOTAL I ITOTAL MASSACHUSETTS AND NEW HAMPSHIRE I I  TIME & SAV  I I I  FREE  I  CHARGES  PER  DRAFT  $.10  1  1.15  OTHER (6)  I I I I I I I I I I I I I I I I I I I I I I I I I I I I I  272 132 140  350 272 78  10 6 4  10 6 4  12 8 4  19 13 6  0  1,849  92  13  13  13  0 0 0 0  337 178 16 143  55 15 6 34  7 4 2 1  2 0 0 2  6 2 3 1  272  2,536  157  30  27  38  21S  39  6  0  6  0  0  78  14  1  0  5  0  87  5  1 0  4 0  1 0  1 I  I I I I I I I  0  0  0  0  0  0  0  0  0  215  204  25  2  10  6  487  2,740  182  32  37  44  (5) THESE ARE TRANSFERS TO NEW NOW ACCOUNTS OPENED DURING THE MONTH FROM THE INSTITUTIONS OWN DEMAND DEPOSITS OR TIME AND SAVINGS DEPOSITS. (6) "OTHER" INCLUDES INSTITUTIONS USING A COMBINATION OF FREE DRAFTS PLUS A CHARGE FOR EACH DRAFT OVER A SPECIFIED NUMBER. PREPARED By STATISTICAL SECTION, RESEARCH DEPARTMENT, FEDERAL RESERVE BANK OF BOSTON   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  I  Table 8 OUTSTANDING BALANCES - NEGOTIABLE ORDERS OF WITHDRAWAL (NOWs) (in thousands of dollars) MONTH ENDED 1972 Sept. Oct. Nov. Dec. 1973 Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. 1974 Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec.  TOTAL OF ALL OFFERING INSTITUTIONS 11,094 22,386 34,823 45,272 60,726 73,451 86,118 94,606 102,045 108,381 113,418 117,005 120,223 130,361 136,872 143,254 143,190 150,447 165,157 174,682 180,637 191,229 204,646 232,386 249,033 270,813 293,305 312,576  TOTAL  2,556 4,338 6,588 9,689 11,052 13,771 17,919 32,955 39,253 46,776 55,994 65,249  COMMERCIAL BANKS MEMBER MASS. N.H.  1,511 2,060 2,882 3,638 3,891 4,587 6,511 13,707 14,837 18,969 23,876 28,964  ---------  ---  MUTUAL SAVINGS BANKS NON-MEMBER MASS. N.H.  763 1,797 3,034 4,820 5,405 6,569 7,664 14,743 18,760 21,276 24,687 28,025  282 481 672 1,231 1,756 2,615 3,744 4,505 5,656 6,531 7,431 8,260  TOTAL  MASS.  N.H.  11,094 22,386 34,823 45,272 60,726 73,451 86,118 94,606 102,045 108,381 113,418 117,005 120,223 130,361 136,872 143,254 139,779 143,764 154,007 157,412 159,591 164,733 171,503 180,335 187,721 197,758 206,764 213,661  11,094 22,386 34,363 44,522 59,661 71,975 84,162 92,341 99,633 105,688 110,486 113,852 116,259 125,873 131,795 138,028 134,832 138,453 147,845 150,309 151,510 155,946 161,544 169,119 175,340 184.830 192,577 200,083  460 750 1,065 1,476 1,956 2,265 2,412 2,693 2,932 3,153 3,964 4,488 5,077 5,226 4,947 5,311 6,162 7,103 8,081 8,787 9,959 11,216 12,381 12,928 14,187 13,578  ., .... . _ rueparea y. -tatisticaj bection, Kesearch Department, Federal Reserve Bank of Boston *Includes three member commercial banks. The above adjustments were made to insure the confidentiality of individual institution   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  data.  SAVINGS & LOAN ASSOCIATIONS I MASSACHUSETTS TOTAL COOPS S&Ls  855 2,345 4,562 7,581 9,994 12,725 15,224 19,096 22,059 26.279 30,547 33,666  470 1,315 2,340 3,374 4,045 4,843 5,446 7,313 8,044 9,979 11,534 13,206  385 1,030 1,985 3,539 4,906 6,246 7,777 9,468 11,270 13,338 15,155 16,541  N.H.  --237 668 1,143 1,636 2,001 2,315 2,745 2,963 3,858 3,919  '''411411  Table 9 NUMBER OF INSTITUTIONS OFFERING NEGOTIABLE ORDERS OF WITHDRAWAL (NOWs)  MEINTH ENDED 1972 Sept. Oct. Nov. Dec. 1973 Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. 1974 Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec.  TOTAL OF ALL OFFERING INSTITUTIONS 23 35 52 59 63 67 69 69 69 69 70 72 74 80 86 90 126 141 171 188 204 227 238 248 257 277 285 295  TOTAL TOTAL  14 15 21 24 26 35 37 41 42 53 58 63  MUTUAL SAVINGS BANKS  COMMERCIAL BANKS NON-MEMBER MEMBER N.H.* MASS. N.H. MASS.  5 5 8 9 9 14 15 18 18 28 31 33  1 1 3 3 4 7 8 8 9 9 9 9  6 7 8 10 11 12 12 13 13 14 16 18  2 2 2 2 2 2 2 2 2 2 2 3  TrIlk23 35 52 59 63 67 69 69 69 69 70 72 74 80 86 90 100 104 114 121 126 133 137 140 142 148 148 151  Prepared by: Statistical Section, Research Department, Federal Reserve Bank of Boston   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  MASS. 23 35 46 50 53 55 57 57 57 57 58 60 61 66 71 75 85 89 98 104 108 114 118 120 122 128 128 131  N.H. _ -6 9 10 12 12 12 12 12 12 12 13 14 15 15 15 15 16 17 18 19 19 20 20 20 20 20  SAVINGS & LOAN ASSOCIATIONS N.H. MASS. COOPS S&Ls TOTAL  12 22 36 43 52 59 64 67 73 76 79 81  4 6 9 12 12 15 17 18 20 20 21 21  7 15 23 27 35 38 39 41 45 46 48 49  1 1 4 4 5 6 8 8 8 10 10 11  MR. RIPPEY  FOR INFORMATION PRIOR TO CONSIDERATION AT A BOARD MEETING  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  • February 4, 1975  To:  hoard of Governors  From:  Legal Division (Messrs. Raiken and Schwartz)  ACTION_REQUESTED:  Subject: Summary of Comments on the Board's proposed amendment to prohibit governmental NOW accounts.  None at this time.  This memorandum is a summary of the  coments received in response to the Board's publication of a proposed amendment to Regulation Q to prohibit member banks from conti nuing to offer governmental NOW accounts. BACKGROUND:  On November 26, 1974 the Board (and the FDIC) amended  Regulation Q to permit member banks to off-r savings accounts to governmental units.  That action also had the effect of permitting governmental  units in Massachusetts and New Hampshire to obtain NOW accounts.  After  reviewing requests from the ABA, the Massachusetts Bankers Associatio n and Senator iicIntyre, the Board and the FDIC agreed to reconsider that part of the amendment which permitted governmental units to hold NOW accounts. COMMENTS RECEIVED:  The comment period expired on January 20, 1975.  Approx-  imately 145 comments have been received on the subject proposal as of January 29, 1975.  Comments were received from four groups:  (1) commercial  banks throughout the United States, (2) bankers associations, (3) Federal Reserve Banks and (4) other interested parties including government al treasurers, Congressmen, and the Public Interest Research Group.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  2-  These groups expressed the following positions: Number of Respondents I. II. III. IV.  Commercial Banks Bankers Associations Federal Reserve Banks Others TOTAL  124 10 6 6 146  Favor Proposal 120 7 4 ___ 1_ 132  Against Proposal 4 3 2 5 14  Attachment A presents the major comments received and the number of times mentioned by members of the above groups. I. cPRIPLqYCAR1 13..4nk§. Of 124 banks commenting on the proposal, 120 were in favor of the Board prohibiting governmental NOW accounts and 4 were opposed.  1ost  of the comments (77) came from the First Federal Reserve District, which Includes the States of -plassachusetts and rew Lampshire  all 77 banks were  in favor of prohibiting governmental NOWs. The most frequently cited reason by banks for their position was that governmental NOWs would result in commercial banks losing a substantial amount of governmental deposits to thrifts.  The resulting loss would affect  bank liquidity and result in a depression of bank earnings.  This comment  was mentioned by 73 banks. Fifty-seven banks stated that it was their belief that the NOW experiment was originally authorized solely for individuals. Forty-nine banks noted that governmental NOWs would result in a lessening in the support they provide to the governmental securities markets, with the result that governments will incur an increase in the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  3  interest rates they must pay on such aligations. lany of these respondents stated that they would aIiilso eliminate  ,%IL4 banking services they now  provide without charge to governmental bodies. Ten respondents mentioned that it would be improper to authorize NOWs in light of the severe economic hardship which the Northeast is undergoing at present. Nine banks cited their belief that governmental NOW deposits would not result in an increase in mortgage funds because governmental NOW funds would be essentially transactional in nature. Those banks in favor of governmental NO-Cs (4) expressed their belief that NOW accounts would assist public treasurers in obtaining a higher return on their money and that governmental NOWs are a logical 1/ extension to the basic NOW experiment. II.  Banker'  Associations  Ten bankers associations commented on the proposal.  Those  organiW ations representing commercial banks were in favor of the proposed amendment to prohibit governmental NOWs. • • • • • • •  These groups included:  American Bankers Association Long Island Bankers Association Massachusetts Bankers Association New liampshire tankers Association New York State Eankers Association Massachusetts Independent tankers Association Pennsylvania Bankers Association  1/ First National City Bank; Peoples Trust of New Jersey, Iowa-Des Noines National Bank; First National Bank of Clayton, Hissouri.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  These associations stressed their belief that Congress intended NOWs to be available solely to individuals and that governmental NOWs would adversely affect bank liquidity.  The Massachusetts Bankers Association  particularly vocal, having submitted a 25 page comment.  CMBA ) was  The MBA contends  that it was the intent of Congress that NOWs be made available to viduals, not corporations or governmental bodies.  They also cite  adverse competitive effect governmental NOWs would have upon commercial banks, especially in light of the severe economic hardships which the thTI northeastern U.S. is undergoing at present. The National Association of Mutual Savings Banks, the Savings Bank Association of Nassachusetts and the Nassachusetts Co-operative Bank League oppose the proposed amendment, and express the belief that governmental NOWs would aid the investment programs of government treasurers, stimulate competition for public funds among the various financial institutions, and would serve the public interest by providing additional interest revenue to governments. III.  Federal Reserve Banks Comments in favor of the amendment to prohibit governmental NOW  accounts were received from the Atlanta, Dallas, Philadelphia and Richmond Reserve Lanks.  These banks believe that NO0 accounts are intended to be  solely for individuals. Two of these Reserve Banks also expressed their belief that governmental NOUs would adversely affect bank liquidity.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  5  • IMO  The New Yorir Reserve Bank is opposed to the adoption of the amendment, contending that extension of the experiment would provide useful data for analysis purposes as well as stimulate competition for governmental deposits.  The Chicago Reserve Bank also opposes the amend-  ment, stating that governmental NOWs would, after consideration of the negative and positive effects, be in the public interest. IV.  Other Respondents Senators IlcIntyre and Proxmire have commented on the concept  of governmental NOW accounts.  Senator McIntyre stated his belief that L  ret_e  NOWs were never intended to be available to Imoi-iy'itittirks  while Senator  Proxmire opposed the amendment, stating that the extension of the NOW experiment to governmental deposits would have a number of significant or beneficial results, not the least of which would be increased interest earned by governmental bodies.  Senator Proxmire sees nothing in the law  to prohibit governmental NOWs. The Treasurers of the States of Illinois and Iowa as well as the Treasurer of the City of Rockford, Illinois expressed opposition to the proposed amendment, contending that governmental 1;0Ws would aid governmental investment programs. Other comments opposinE the proposed amendment were received from the Public Interest Research Group which, although in favor of governmental NOWs, alleged that the Board may not adopt the proposed amendment because the original amendments authorizing governmental savings accounts were adopted in violation of the public notice requirements of the Administrative Procedure Act.  Attachment   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ATTACHMENT A COillEiiTS BY RESPONDUTTS (Number of times mentioned)  Commercial Banks 1.  2.  3.  4.  5.  6.  Lankers Associations  Federal Reserve 111.11.gi  Others  1  NOW account experiment was originally authorized by Congress to be offered exclusively to individuals.  57  5  2  If governmental NOI• accounts are authorized, commercial banks may incur a substantial loss of governmental deposits to thrifts, thereby adversely affecting bank liquidity and resulting in a depression of bank earnings.  73  3  2  Loss of governmental deposits by banks will result in decreased bank participation in governmental securities markets, increases in rates of interest governments must pay; elimination of free banking services being offered to governments, and increased service charges and loan rates to other bank customers.  49  2  Governmental NOW account balances will be transactional in nature and are maintained for too short a period of time to be invested in long-term mortgages. Lxpansion of NOWs to governmental units is unwise in light of severe economic hardships which NEUS is undergoing at present. Governmental NOWs will assist the investment programs of public treasurers and are a logical extension to the NOW experiment.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  • 10  1  3  3  1  5  Return this py to Legal Division as soon as origind is maiied showing on copy the date of moiling.  NMI  irs=-0-cT?  DE.0 2 17 1974  The Honorable Thomas .I. te.Intyre United States Senate Washinzton, D. C. 20510 Dear Senator McIntyre; Thank you for your letter of December 20, 1974, in which you urge the Locrd to modify its ref;ulatiolis on governmental unit scvings deposits to continue to prohibit member banks from offeriug NOW accounts to such entitif:s. The hoard and the FDIC have received several request that their respective rezulations be nedified in the manner you recommend. As a result of receipt of theso comments, the Lord has agreed to reconsider this matter. On Decelber 23, 1974, the Board issued the enclosed press release and Federal Register notice soliciting public conts until Januziry 20, 1975, on the question of whether member banks should continue to be able to offer E01:s to goverment/21 units. The Board's announcement also advises that until a final determination is wide by the board, rerber banks should not offer EOW eccouets to governmental units. The Board wv4.314 welcome any further comments you might have on this Datter. Sincerely, W. rItchell  George W. Mitchell  Enclosures • ALR:iks 12/26/74   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  JOHN SPARKMAN, ALA., CHAIRMAN WILL.1•M PROXMIRE WIS. HARRISON A. WILLIAMS, N.J. THOMAS J. MC ITFYRE, N.H. vr.ALAN CrfANSTON, CALIF. ADLAI E. STEVENSON III, ILL. J. BENNETT JOHNSTON, JR., LA. WILLIAM D. HATH‘WAY, MAINE  O  JOHN TOWER, TUX. WALLACE F. UNNE AN EDWARD W. BROOKE, SS. RODERT W. PACKWOOD, OREG. BILL BROCK, TENN. LOWELL P. WEICKER, JR.. CONN.  JOSEPH R. BIDEN, JR., DEL. DUDLEY L. O'NEAL, JR. STAFF DIRECTOR AND GENERAL COUNSEL WM. HOWARD BEASLEY III, DIRECTOR OF MINORITY STAFF OTHELLA C. POM PIER, CHIEF CLERK  ?JCI-rifeb  Zertate  COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS WASHINGTON,D.C.  20510  December 20, 1974  The Honorable George Mitchell Vice Chairman Board of Governors Federal Reserve System 20th and Constitution Avenue Northwest Washington, D. C. 20551 Dear Governor Mitchell: It has come to my attention that the Federal Reserve and the other financial regulatory agencies are contemplating permitting the acceptance of public unit deposits in the form of NOW accounts by commercial banks and thrift institutions in the States of Massachusetts and New Hamps hire. This development arises from efforts to implement Section 101 of the "Depository Institutions Amendments of 1974", Public Law 93-495. I believe that this development is unwarranted and that regulation s should continue to insure that NOW accounts are confined to individual s and nonprofit corporations. The legislative history is clear that Congress' intent was to limit NOW accounts to individuals. These are family financial accou nts. While their ownership by non-profit groups is deemed to be a permissible extension of this purpose, there is no mention of authorizing NOW accounts for governmental entities or public units, and, in fact, Congress' intent was exactly to the contrary. Moreover, nothing in the legislative histo ry surrounding Public Law 93-495 alters this result. Congress labored long and hard during the NOW account controversy, and finally adopted a compromise providing for the experimental use of NOW accounts in the States of Massachusetts and New Hampshire. In both the Committee report and debate on the Senate floor, it was made clear that NOW accounts were intended to benefit consumers; and therefore, they shoul d be limited solely to individuals. In the Committee report itself, the following language appears: "The Committee, however, is convinced that such accounts should only be offered and limited solely to individual persons." This position was maintained throughout Congress' consideration of this legislation; and the action contemplated by your agency and the other bank regulatory agencies in expanding the NOW account service to governmental entities is directly contrary to the stated purpose of the legislation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  P  VO  The Honorable George Mitchell December 20, 1974  Page 2  It should be noted that this issue arose earlier this 7.ear when the Federal Home Loan Bank Board sought to allow savings and loan associations in Massachusetts and New Hampshire to accept NOW deposits from governmental entities. At that time, I raised similar objections, and the Board subsequently modified its regulations to prohibit the acceptance of NOW accounts from governmental bodies by such savings and loan associations. I urge you to conform your regulations on public unit savings accounts to continue the prohibition on the acceptance of NOW deposits from governmental entities by commercial banks and thrift institutions in Massachusetts and New Hampshire. The concept of permitting public unit depositors to have NOW accounts should be given serious consideration at the appropriate time. Such accounts may very well be in the public interest. However, since NOW accounts are still in an experimental stage, that experiment should be left as it is until an overall policy on NOW accounts is established. Just such a policy is contained, for example, in the Financial Institutions Act. Therefore, it would be inappropriate for the regulatory agencies to broaden the base of NOW accounts in this manner at this time. Your prompt attention to this matter will be appreciated greatly, and I hope to have a response from you at your earliest convenience.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Sin  /444este omas J. Mein Irte te" Chairman Subcommittee on Financial Institutions  .1•••  ••'of GOv ••. ti?4,•. 0 ••q-  FEDERAL  •P  It.,•..0  ESERVE  October 17, 1974  For Immediate Release  The Board of Governors of the Federal Reserve System today s of removed the 150-item limitation on the number of Negotiable Order Massachusetts Withdrawal (NOWS) that may be accepted by a member bank in and New Hampshire in any one year.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  A copy of the Board's order in this matter is attached. - 0 -  • TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM [REG. Q] PART 217--INTEREST ON DEPOSITS Negotiable Orders of Withdrawal  Effective January 1, 1974, the Board of Governors amended Regulation Q (Interest on Deposits) to prescribe rules governing the use of Negotiable Orders of Withdrawal (NOWs) within Massachusetts and New Hampshire as authorized by section 2(a) of P.L. 93-100.  These rules include  a limitation on the number of NOWs that may be accepted by a member bank from a customer to 150 per year.  NOW accounts in other institutions have  not been made subject to an item limitation. Since the adoption of NOW account amendments to Regulation Q, the Board of Governors and the other Federal financial supervisory agencies have conducted a surveillance program designed to monitor NOW account activity.  Data received for the first eight months of NOW activity in Massachu-  setts and New Hampshire since Federal regulations were adopted indicate that NOW account activity has developed in a gradual manner without the wholesale conversion of checking accounts to NOW accounts.  On the basis  of its evaluation of current NOW account data and pursuant to P.L. 93-100 and the Board's authority under section 19 of the Federal Reserve Act to prescribe rules governing the payment of interest on deposits, the Board has amended Regulation Q to remove the 150 per year limitation on the number of NOWs that may be accepted from a customer by a member bank.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  As a result  -2-  of this action, member banks and NOW depositors will be permitted to amend existing NOW account deposit agreements to remove item limitation provisions. There was no notice, public participation and deferred effective date with respect to this amendment because such procedure would result in delay that would be contrary to the public interest and serve no useful purpose.  See § 262.2(e) of the Board's Rules of Procedure (12 CFR  § 262.2(e)). Effective immediately, the Board has amended section 217.5(c) of its Regulation Q (12 CFR Part 217) to read as follows: § 217.5  Withdrawal of Savingp Deposits  (c) Manner of payment of savings deposits (1) Subject to the provisions of subparagraphs (2) and (3) of this paragraph, *  (3) The provisions of this paragraph do not apply to deposits subject to negotiable orders of withdrawal authorized by Federal law to be issued in the states of Massachusetts and New Hampshire. (4) By Order of the Board of Governors, October 17, 1974.  (Signed) Theodore E. Allison  Theodore E. Allison Secretary of the Board [SEAL]   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  BOARD OF GOVERNORS Or THE • FEDERAL RESERVE SYSTEM  Office Correspondence To From  Board  Date October 8, 1974 Subject:  of Governors  NOW accounts data for  August 1974  Bankihg Section (Paul W. Boltz)  This memorandum is for information only and concerns developments in NOW accounts in New Hampshire and Massachusetts in August 1974. Inflows to NOW accounts at member banks were up sharply in August, principally due to a single bank's transferring a block of its savings accounts to NOW status.  The Third National Bank of Hampden County, Springfield,  Massachusetts, began offering NOW accounts by notifying the holders of over 4,000 savings accounts representing deposits of $6.3 million that they could write NOW drafts on their accounts.  The bank is one of 10 weekly  reporting banks in Massachusetts and has total deposits of over $200 million. The Boston Federal Reserve is investigating the unorthodox method of introducing NOW accounts by the Third National Bank, but there appears to be nothing illegal in the procedure and other banks may follow. Another large member began offering NOW's on October 1 and initiated a heavy statewide advertising campaign in Massachusetts.  The  Shawmut Association with nine banks (total deposits $1.7 billion) is promoting its new NOW accounts as part of a marketing strategy that includes a package of services of free checking, free checks, and over-draft privileges for a flat monthly fee.  This is the first time a commercial  bank has advertised NOW accounts statewide in either New Hampshire or Massachusetts.  In contrast, the largest banking organization in  Massachusetts, First National Bank of Boston, has been advertising locally against NOW accounts.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -2the With the sharp growth of NOW balances associated with r banks in Third National Bank of Hampden County, NOW balances at membe small initial Massachusetts more than doubled during August, given their size.  tts However, the growth of NOW deposits at MSB's in Massachuse  banks. still nearly equaled the expansion of balances at commercial  The  tutions in the two 10 percent rate of growth of NOW balances at all insti states in August was the highest of the year.  Three commercial banks,  in New Hampshire three MSB's and three S&L's began offering NOW accounts 70 percent of and Massachusetts in August, and by the end of the month for S&L's the MSB's were offering NOW accounts, while the proportion was 34 percent and for banks 18 percent. ficantly NOW accounts at commercial banks continue to be signi activity appears larger than accounts at competing institutions, and their thrift institutions. to be declining relative to the activity of accounts at nt at commercial banks In August, the average number of drafts per NOW accou at the Hampden was likely lowered by the sudden creation of such accounts but a declining County bank for depositors unfamiliar with the account, banks has been average level of activity of NOW accounts at commercial observed since May.  The 150 item limitation may be responsible for the  available data. lower level of drafts, but this has not been confirmed by have had a At other institutions in Massachusetts, the MSB's accounts accounts have relatively stable level of activity, but the S&L's NOW the most active accounts. become progressively more active and in August were New Hampshire, the NOW accounts at the MSB's had  the highest average  . number of drafts, followed by the accounts at S&L's and banks   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  In  APR -3There has developed a noticable and predictable relationship the between level of activity of accounts at the competing institutions and proportion of such institutions offering free draft privileges.  In the  two states, the highest level of activity is found in NOW accounts at the MSB's in New Hampshire, three-quarters of which offer free drafts; at ial other end of the scale, the lowest level of activity is found at commerc banks in Massachusetts where only 17 percent of the banks offer free drafts.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  BOARD OF GOVERNORS OF T}-4E  FEDERAL RESERVE SYSTEM  Office Correspondence To  Board of Governors  From  Banking Section (Paul W, Boltz)  Dee Subject:  September 6, 1974  NOW account data for July 1974  This memorandum is for information only and concerns developments in NOW accounts in New Hampshire and Massachusetts in July 1974. Net inflows into NOW accounts at all offering institutions continue at a rapid pace in the two states.  Deposits in NOW accounts at commercial  banks increased 30 per cent in July, although only two more commercial banks began offering NOW accounts for the first time during the month, and NOW deposits at savings and loan associations expanded by 20 per cent, as 5 additional S&L's began offering such accounts during July.  The NOW  balances at mutual savings banks grew at the lower rate of 7 per cent in July, but in spite of the competition from banks and S&L's, NOW balances at MSB's accounted for almost 84 per cent of all NOW balances in the two states in July, seven months after competing institutions were allowed to offer NOW accounts.  In fact, since January 1 of this year, more mutual  savings banks have begun offering NOW's than commercial banks (47 versus 37), and at the end of July almost 70 per cent of all mutual savings banks were offering NOW accounts.  The fastest spread of the NOW accounts, however,  has been at the S&L's in 1974.  At the end of July, 64 S&L's--almost one-  third of all the S&L's in the two states--were offering NOW accounts. Nonbank financial institutions are moving much more quickly into NOW accounts than commercial banks.  (Tables 1 and 9)  In July, commercial banks offering NOW accounts were more successful in attracting new customers through NOW accounts.  Almost 60 per cent  of NOW accounts opened at commercial banks during the month were opened   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 2 -  by new customers.  In recent months, the proportion of new customers  opening accounts had tended toward about 45 per cent at all types of NOW-offering institutions, and in July the proportion of new customers opening NOW accounts at S&L's was slightly higher than this, and at MSB's was slightly lower.  (Table 2)  Member bank NOW accounts  continue to be larger and less actively  used than NOW accounts at competing institutions, including nonmember commercial banks.  And although member bank NOW accounts are gradually  becoming more active, the differential between the average balance in member bank NOW accounts and other NOW accounts widened in July.  Commercial  S. nks, member and nonmembers alike, encourage the use of their NOW accounts as.savings accounts by placing charges on drafts and paying the ceng rate on the deposits.  While well over one-third of the  and MSB's  that offer NOW accounts have free draft privileges, at the end of July only 16 per cent of commercial banks offering NOW's provided free drafts. Moreover, a majority of banks compound interest on NOW accounts monthly or quarterly, rather than continuously or daily as most competing institutions do.  One-fourth of the NOW-offering member banks IS not pay interest from  day of deposit to day of withdrawal while only 5 per cent of competing instititions pay interestway other than from day of deposit to day of withdrawal.  Thus, the commercial banks have been slow to offer NOW  accounts and, when  offered, have tended to adopt a combination of charges  on drafts and interest calculations that induce the use of NOW accounts as a savings accounts. (Tables 3A, 3B, 4A, 4B, and 5)   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  I  A - 3_  Over 90 per cent of all NOW-offering institutions pay the ceiling rate of 5 per cent.  The major exceptions are the mutual savings banks in  New Hampshire which have a history of low interest rates with no charges for drafts.  Almost 70 per cent of them pay at or below 4 per cent on  NOW balances.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  ...41114  BOARDOFGOVERNORS OF THE  FEDERAL RESERVE SYSTEM  Office Correspondence  Dee  July 15, 1974  Subject: NOW Account data for May  To  Board of Governors  From  Banking Section (Paul W. Boltz)  This memorandum is for information only and suIII. rizes developments in NOW accounts in New Hampshire and Massachusetts during May 1974.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  3s5ciations continue to --Savings and loan 3, move aggressively into offering NOW accounts. S&L's accounted for 9 of the sixteen institutions which began offering NOW accounts in May, along with 2 commercial banks and 5 I utual savings banks.  At the end of May more  than a quarter of the S&L's were offering NOW accounts in the two states, while less than one out of eight commercial banks were offering NOW's.  Relatively few member banks have begun  to offer NOW's; at the end of May only 13 out of the 143 member banks in the two states were offering such accounts.  Thus, the 63  I- r cent of mutual savings banks that offer NOW's continue to hold the large majority of NOW deposits--88 per cent of the total. (Tables 1 and 8) --Outstanding balances of NOW accounts grew 3.4 per cent in May, the slowest rate since January.  However, the not seasonally adjusted  annual rate of growth of NOW account balances  %  Alkv   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  _  2  -  at all institutions in the first five months of 1974 was almost 50 per cent.  Though the  MSB's did not maintain the extremely rapid pace of growth of 1973 (over 300 per cent), in the first five months of 1974 their NOW balances grew at a not seasonally adjusted annual rate of 27 per cent.  (Table 8)  --Commercial banks were more successful than MSB's or S&L's in attracting new customers to their NOW accounts.  Less than half the new  accounts in May at S&L's and MSB's were opened by new customers, while almost 60 per cent of accounts opened at commercial banks in May were opened by new customers.  (Table 2)  --The level of activity of NOW accounts at member commercial banks is far less than activity at other institutions, including nonmember commercial banks.  Over 70 per cent  of NOW accounts at member banks in Massachusetts had no drafts written on them in May.  At all  other NOW-offering institutions in Massachusetts, the proportion was less than 30 per cent.  Also,  the balances in accounts at member banks are considerably larger than balances in accounts at competing institutions, and thus the NOW accounts at member banks appear to be used   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  3  as savings accounts, rather than as demand deposits.  The sharpest contrast to this are  the NOW accounts at mutual savings banks in New Hampshire where the balances are on average less than half the balances at member banks in Masachusetts and the level of activity makes the accounts appear to be checking accounts. These institutions offer low rate,no service charge NOW accounts.  (Tables 3A and 3B)  --The proportion of institutions offering free draft privileges on NOW accounts has been gradually increasing, and most of the increase has been due to more MSB's offering free drafts. Since January, the proportion of S&L's and commercial banks offering free draft privileges has been relatively volatile, but as the number of S&L's and CB's offering NOW's becomes larger, the trend will become clearer and not so easily affected by small changes at the margin.  By the end of May, 55 per cent  of NOW-offering institutions in New Hampshire were offering free drafts and 32 per cent in Massachusetts.  BOARD OF GOVERNORS  •  OF THE  3„p  FEDERAL RESERVE SYSTEM  '.Office Correspondence To  Board of Governors  Date  June 5, 1974  Subject: NOW Account data for April  From. Banking Section (Paul W. Boltz) This memorandum is for information only and summarizes developments in NOW accounts in New Hampshire and Massachusetts during April 1974.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  IMMO  In April, 17 more institutions began offering NOW accounts in New Hampshire and Massachusetts--3 commercial banks, 7 mutual savings banks, and 7 savings and loan associations.  Savings and loan  associations have moved very quickly into offering NOW accounts.  Although there are fewer S&L's than  either CB's or MSB's, the number of S&L's which began offering NOW accounts since the end of January equals the number of CB's and MSB's combined which began offering NOW's in the same period.  At the end of April,  more than 20 per cent of S&L's was offering NOW's in the two states, compared to about 10 per cent of the commercial banks.  Mutual savings banks continue to  dominate the field with 60 per cent of them offering NOW accounts and holding 90 per cent of total NOW deposits. IMMO  (Tables 1 and 8)  NOW balances at all institutions in the two states grew 5.8 per cent in April, with more than half the growth occurring at CB's and S&L's.  Except for  an unexplained spurt of growth in March, NOW accounts  - 2 at MSB's have been growing at depressed rates since commercial banks and S&L's began offering NOW accounts in January 1974.  (Table 8)  About 45 per cent of NOW accounts opened in April were opened by new customers at commercial banks and mutual savings banks.  S&L's did not attract  as many new customers, as only 35 per cent of their new accounts were opened by new customers. mately 20 per cent of the  Approxi-  al NOW deposits at  commercial banks made by existing customers were from time and savings deposits.  (Tables 2 and 7)  NOW accounts at commercial banks continued to be less actively used on average than NOW accounts at competing institutions.  Commercial banks have a relatively  large proportion of accounts that have no activity, S  17-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ut the average number of drafts of accounts at  commercial banks that have any activity is rising. In Massachusetts, the average approached the level of activity of comparable accounts at MSB's in April. same is true  The  of the NOW accounts atMassa-  chusetts, which like the commercial banks have a large S roportion of completely inactive accounts.  On the  other hand, in New Hampshire the NOW accounts at and commercial banks with any activity are less active by a good margin than NOW accounts at the MSB's. (Tables apt and 3B)   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  3 Almost all institutions offering NOW accounts in Massachusetts were paying the ceiling rate of 5 per cent, and all the banks and S&L's in New Hampshire were paying the ceiling rate in April.  But  only 2 of the 17 mutual savings banks in New Hampshire offering NOW accounts were at this rate, and the others were paying 4 per cent or below.  The majority  of institutions were paying interest from day of deposit to day of withdrawal.  (Tables 4A and 4B)  In April the number of CB's offering free drafts did not change, but two MSB's and two S&L's began offering free drafts.  Thus, while 17 instituitions  began offering NOW accounts in April, only 4 additional institutions provided free draft privileges.  Of all  institutions offering NOW accounts, the proportion with free drafts at the end of April was 34 per cent.  The  trend is uncertain in this regard, however, since the proportion of NOW-offering institutions with free draft privileges had risen noticeably in the previous month. (Table 10)  •  •  BOARD OF GOVERNORS  FEDERAL RESERVE SYSTEM  Office Correspondence To  Board of Governors  From  Frederic Solomon   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •Areft--3 Date  Subject: Spread  May 29, 1974.  of NOW-type Accounts.  For Information Only There appears to be a growing tendency fcr NOW-type accounts to spread to areas beyond New England. The attached clipping from the New York Times of Monday, May 27, describes such accounts being offered by certain mutual savings banks in New York.  One of these mutual savings banks called  its accounts WOW accounts, standing for "Written Order of Withdrawal." Mr. Piderit, Vice President of the Federal Reserve Bank of New York, indicated that these accounts are offered under c long neglected provision of law and that the State Banking Department has no plans to discourage them. Also attached is a copy of an advertisement forwarded by Senior Vice President Morrison of the Chicago Reserve Bank.  This advertisement,  issued by First Federal Savings and Loan Association of Wisconsin, offers what it calls a "telephone savings account," which pays 5 1 cS mpounded daily.  interest  The S&L has established procedures by which the customer  can telephone at any time and have funds transferred to his bank to meet checks which he has drawn.  While the approach is not new, it might have  increased appeal at the present time and could be available to anyone, including corporations.  •  , FEISTJEDERAL MIAS OHIISCONSIN • •,1  ••• Oa• suot•.1.4re us  Manitowoc 0flic• ••0 Noar. AT.. A  May 8, 1974  wore  VOSraEf TS  •••••••TCA,04:. W.SCONS.N )./20 0114i NU Qui  Wisconsin Aluminum Foundry Co., Inc. 836 So. 16th St. Manitowoc, Wisconsin Dear Mr. Schwartz: We would like to introduce you to a new plan offered by First Federal Savings and Loan of Wisconsin for corporations, mall businesses, and the self-employed. It's called our "Telephone Savings Account." It was designed with several objectives in mind: To provide a temporary and liquid short term investment for cash balances which earn no interest in checking accounts. To provide with this service, the convenience of handling your transactions by telephone. The Telephone Savings Account will pay 57, interest, compounded daily on all funds, from the date of deposit to the date of withdrawal. Deposits may be made by simply drawing a check payable to First Federal Savings and Loan, for credit to the account of (name) (account number) , and mailing it to First Federal Savings and Loan, 724 - York Street, Manitowoc, Wisconsin. When you need funds to cover checks drawn on your checking account, call the First Federal "Telephone Savings Account Teller" any time between 10:00 A.M. and 3:00 P.M., at 682 - 6812 and give her the following information: Your Name (Authorized Person) Account Number Name of Firm Amount of Withdrawal A check for the withdrawal will be personally delivered to your bank the following morning. The monthly statement furnished will itemize each transaction and state current balance of your account following posting of all transactions for the month. We welcome an opportunity to further discuss with you interest dollars you can earn with our Telephone Savings Account. Very truly yours, FIRST FEDERAL SAVINGS AND LOAN ASSOCIATION of WISCONSIN  •  LJ  Beatrice E. Klein, Branch Manager Enc:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Removal Notice The item(s) identified below have been removed in accordance with FRASER's policy on handling sensitive information in digitization projects due to copyright protections.  Citation Information Document Type: Newspaper article Citations:  Number of Pages Removed: 1  Cole, Robert J. "Personal Finance: Savings Banks' 'Checks.'" New York Times, May 7, 1971.  Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  https://fraser.stlouisfed.org  BOARD OF GOVERNORS OF THE  FEDERAL RESERVE SYSTEM  Office Correspondence To From  Board of Governors  Mae April 30, 1974 Subject:  NOW Account data for March  Banking Section (Paul Boltz)  This memorandum is for information only and summarizes the major developments regarding NOW accounts in March 1974.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  During March, 30 additional institutions began offering NOW accounts in Massachusetts and New Hampshire (6 commercial banks, 10 mutual savings banks, and 14 saving and loan associations).  By the end of the month, 9.2  per cent of the commercial banks, 18.7 per cent of the savings and loan associations, and 56.7 per cent of the mutual savings banks were offering NOW's (Table 1). a die  NOW balances at all institutions increased 9.7 per cent in March and reached $165.2 million.  Of that total  only 4 per cent were deposits at commercial banks and 2.8 per cent were deposits at S & L's, but deposits at these institutions are growing very rapidly in percentage terms ONION  (Tables 1 and 8).  The increase of NOW account balances at mutual savings banks in the first quarter of 1974 was sharply below the average quarterly increases in 1973.  However, the  total quarterly increase of NOW accounts balances at all offering institutions was almost as high as the 1973 average.  The first quarter rise in NOW balances at  all institutions was $21.9 million, of which $10.8 million was the mutual savings banks' share of the increase.  The   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  • 2 average quarterly increase of NOW balances in 1973, when only MSB's offered NOW's, was $24.5 billion. While part of this reduced rate of growth at MSB's can be attributed to one-time portfolio adjustments which were occurring during the early part of 1973, part should also be attributed to the introduction of competition from other depository institutions. Slightly more than 40 per cent of the NOW accounts opened at commercial banks in March were opened by existing customers.  About 55 per cent of the initial deposits  in NOW accounts were from time and savings deposits, up sharply from January and February when less than onethird of new deposits by existing customers were from time and savings deposits (Tables 2 and 7). ••••=1.  Commercial bank NOW balances continued to be both larger and less actively used than NOW accounts at competiting institutions  (Tables 3A and 3B).  The average NOW account  balance in March at commercial banks was $1786  ($2008  for members and $1623 for nonmembers), far higher than the average of $1295 at MSB's and the average balance of $852 at S&L's.  The accounts at both S&L's and commercial banks  are becoming more active as each month passes, but slightly less than half (46.6 per cent) of NOW accounts at commercial banks had no activity in March, with most of the inactive accounts at member banks.  In contrast, only 26 per cent  Amok   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 3  of NOW accounts at MSB's and 36 per cent of NOW accounts at S&L's had no activity.  The most active accounts are  those at mutual savings banks in New Hampshire; 19 per cent of these had more than 20 drafts written on them in March. --  As in earlier months, virtually all NOW-offering institutions in Massachusetts were paying the ceiling rate of 5 per cent (Tables 4A and 4B).  In New Hampshire, however, while all  commercial banks and S&L's were at the ceiling rate only 2 of the 16 mutual savings banks ofeering NOW's were at that rate, and the others were paying 4 per cent or below.  The majority of institutions are paying interest  from day of deposit to day of withdrawal (Table 5). --  About one-third of the MSB's and S&L's in Massachusetts offering NOW accounts provide unlimited free draft privileges to depositors.  This proportion is up from  January and may reflect competition to attract depositors. The large majority  of MSB's in New Hampshire (81.3 per cent)  also offer free drafts, and this high proportion may account for the considerable activity reported for these accounts.  Less than 15 per cent of the banks offering  NOW's in the two states offer free drafts (Table 10).  A111 ,  • April 29, 1974  To:  Board of Governors  From:  Legal Division (Messrs. Nicoll and Raiken)  BANK REQUEST:  Subject: Request by First National Bank of Boston to suspend Regulation Q limitation: on transfers from savings accounts.  The First National Bank of Boston ("Bank") has requested  Q that the Board suspend operation of section 217.5(c)(2)(i) of Regulation the in the States of Massachusetts and New Hampshire in conjunction with  1/ States. operation of the NOW account experiment currently underway in those h payment This paragraph prohibits withdrawals from savings deposits throug same to the bank or transfer of credit to another deposit account of the authorizing depositor made pursuant to an advertised plan or agreement or such payments as a normal practice to cover the depositor's drafts checks. RECOMMENDED ACTION:  It is recommended that the requested suspension of  s summarized the savings deposit transfer limitations be denied for the reason as follows: 1.  A question exists as to the Board's legal authority to  non-NOW accounts suspend (or amend) the present transfer limitations as to only in Massachusetts and New Hampshire. 2.  of Removal of the transfer limitations would permit use  accounts and savings deposits to cover drafts drawn on token checking t of interest thereby, for all practical purposes, result in the paymen on demand deposits. President Morris 1/ A copy of Bank's request is attached as Attachment A. 22 recommends of the Federal Reserve Bank of Boston by letter of April The General Counsel approval of the requested suspension (Attachment B). request (Attachment C). of the Boston Reserve Bank recommends denial of Bank's   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  46.  S  • 2  3.  Removal of the transfer limitations would result in a major  change in the character of savings deposits in Massachusetts and New rized Hampshire and thereby alter the environment in which Congress autho a limited experiment to be conducted. 4.  mers Bank presently has the ability to offer NOWs to its custo  the Board's and has not presented any evidence supporting its contention that market NOWs. 150 item limitation is seriously inhibiting its ability to rized as follows: Arguments in favor of Bank's proposal may be summa 1.  NOW experThe suspension action may be taken as part of the  sustainable iment authorized by Congress and therefore would be legally accounts. under the Board's authority to issue regulations for NOW 2.  more to permit The suspension of transfer limitations will do no  nt NOW account the payment of interest on demand deposits than the prese as sanctioned by Congress. 3.  banks to Removal of transfer limitations will permit member  which does not offer a comparable alternative to NOW accounts, but one not result in additional require the creation of an additional account and does items entering the payments mechanism. COORDINATING CONIITTEE CONSIDERATION:  At a recent meeting of the Inter-  informed the representatives agency Coordinating Committee, Governor Mitchell ved and would of the other agencies that the subject request had been recei be considered by the Board in the near future.  No objections were expressed  ng Committee. regarding Bank's request by members of the Coordinati  Chairman  is apparently attempting Bomar of the FHLBB expressed the view that since Bank   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  3  to develop a means to offer services similar to NOWs but without the Board's 150 item limitation, if the Board is inclined to grant relief, such action should more appropriately take the form of a removal or modification of the item limitation itself.  It was also confirmed at this meeting that  the FDIC, without formal announcement, has for more than a year permitted withdrawals or transfers from a savings deposit to a depositor or to another 2/ account of the same depositor by means of telephone requests. DISCUSSION:  Bank states that suspension of the transfer limitations would  (1) enhance deposit experiments currently in progress regarding NOW accounts 3/ and automatic withdrawals from S&L savings deposits and (2) enable commercial banks to compete on a more equal basis with thrift institutions which offer NOW accounts. The requested action appears related to the effect of the 150 item limitation contained in the Board's NOW account regulations.  In its  advertising copy (Attachment B) the Bank has stressed the concept of an account for saving and an account for spending.  The proposed arrangement  would enable it to offer both types of accounts with a link to cover overdrafts or excessive balances in the "spending" account.  2/ A memorandum from the Legal Division recommending reconsideration of the Board's 1936 interpretation against telephone transfers will be presented to the Board within the next few weeks. 3/ The FHLBB has authorized a cash dispensing deposit-withdrawal "POS" pilot project to be conducted in Lincoln, Nehraska. In addition, FriLBB regulations permit preauthorized payments to third parties from savings accounts to (1) purchase U.S. obligations, (2) purchase mortgagor or savings member insurance, (3) transfer funds to a relative of the depositor, (4) purchase a housing or housing-related item, pay loans for such items, including real estate mortgages, taxes and insurance, rent, utilities, home improvements, fixtures, home furnishings or major appliances and similar items (12 C.F.R. 545.4(2)).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  k  • -4  Origin of Present Transfer Limitations:  /ID  The present savings deposit transfer  limitations that Bank requests be suspended were adopted in January 1962 primarily in view of the practice developed by Citizens Bank and Trust Company of Park Ridge Illinois, whereby that bank permitted a depositor maintaining a savings account to draw checks against the bank.  Under the  agreement between the bank and the depositor, checks not covered by remittance from the depositor within seven days would be covered by the bank's automatic withdrawal of sufficient funds from the depositor's savings account.  The  Board considered that such a practice constituted misuse of savings deposits and involved a payment of interest on a demand deposit in contravention of section 19 of the Federal Reserve Act.  The Board therefore adopted the  transfer limitations to preserve a meaningful difference between demand deposits and savings deposits.  Board Authority to Remove Transfer Limitations in Two States:  Absent a  clearer showing of the relevance and benefit of removal of transfer limitations to the current NOW experiment (or some exigent circumstances necessitating Board action to protect the public) we believe there exists a significant question as to whether the Board's authority under section 19 of the Federal Reserve Act (to define various deposits and prescribe regulations as it may deem necessary to effect the purposes of that section), also includes authority to establish withdrawal or transfer rules in two states different from those applied in the rest of the country. The Board has the authority to establish different interest rate limitations for different classes of deposits  . . according to the nature  and location of member banks or their depositors' but no such specific   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  5  authority to establish different rules applicable to savings accounts is contained in the Act.  Clearly, uniformity of System rules and regulations  regarding various types of deposits held by member banks was one of the intended goals of Congress when it placed authority in the Board to define various types of deposits for member banks. Legislative history relevant to NOW account legislation (and the bulk of public comment on NOW accounts) indicates a desire for uniformity of NOW regulations among institutions in the experiment area.  In our view,  removal of the present transfer limitations will create disequbrium among institutions by restructuring all savings deposits held at member banks in Massachusetts and New Hampshire. Such action at this time may have a disruptive rather than beneficial effect on the NOW experiment.  Suspension of transfer limitations is not  essential to the experiment commissioned by Congress.  Because such action  II.y in fact impede the NOW experiment through the introduction of transfer privileges for all savings deposits four months after NOW authorization by the agencies, we believe that amendment of Regulation Q only in the two state ar -is  S tnecessary and therefore may be subject to successful challenge in  the courts. We believe the likelihood of a disruptive effect on the NOW experiment outweighs the possibly valid assertion that making all savings accounts in the test area subject to some form of transfer procedure may provide a clearer indication of the consequences of removal on a nationwide S.sis of the prohibition on the payment of interest on demand deposits.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  • 6  Payment of Interest on Demand Deposits:  The Board's notice of adoption of  the present savings deposit transfer limitations (effective January 15, 1962) stated that, "the purpose of the amendment is (1) to prevent certain practices that facilitate the use of a savings deposit as a regular means of drawing checks on the depository bank . . Board action removing or suspeLding savings deposit withdrawal limitations from Regulation Q would not in itself constitute authorization for Bank to pay interest on demand deposits.  Such action would, however, have  the practical effect of permitting the use of savings deposits in a manner closely resembling demand deposits. Prior to adoption of the present transfer limitations it was the view of the Legal Division that a deposit may be classified as a savings deposit if (in addition to meeting requirements such as depositor eligibility) It was subject to an agreement under which the depositor is or may be required by a bank to give notice in writing of an intended withdrawal not less than 4/ 30 days before the withdrawal is made. We concur with the Division's previously expressed view that limitations on transfers from savings deposits are not essential for maintaining the statutory distinction between savings and demand deposits. effect However, because removal of the limitations would have the practical recommend of permitting payment of interest on funds used to cover checks, we face of that such action not be taken during the NOW experiment in the recent Congressional consideration of NOW legislation.  Reference to that  Payment of Interest 4/ Memorandum, "A Legal History of Federal Regulation of on Demand Deposits," by Howard H. Hackley, September 30, 1955.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  • -7  consideration indicates a reluctance on the part of Congress to remove the distinction between demand and savings deposits without first reviewing the effects of the NOW experiment which, in the form approved by Congress, falls short of permitting the payment of interest on demand deposits.  Now Experiment:  Bank contends that such action would "enhance" the exper-  iment, presumably by permitting member banks to more easily compete with institutions which can offer NOWs without a 150 item limitation  As  recognized by the Boston Reserve Bank, if savings deposits were made automatically transferable to a demand deposit by prior agreement, such action would provide the convenience of the NOW account without requiring the creation of a separate account.  It can be expected, however, that altering  the character of savings accounts to provide transfer privileges similar to NOWs would convince many potential NOW customers not to open a NOW account. An element of the NOW experiment--to determine the appeal of NOWs over present savings accounts--would be lost.  It can be argued however, that  making all savings accounts as convenient as NOWs may enhance the results of the experiment by providing a more accurate indication of the extent of depositor willingness to convert from demand deposit to interest bearing accounts subject to either transfer or negotiable order. As noted by President Morris, suspension of transfer limitations will provide depositors with a convenient means to write drafts while maintaining separate interest bearing thrift accounts. consistent with the NOW rationale.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  This result appears  On balance, however, we believe that  S -8 the NOW experiment, as authorized by Congress and as currently in process, should remain undisturbed at least during the remainder of this year to provide Congress an opportunity to review the acceptance and effect of NOW accounts in the form originally authorized by the agencies.  This review  can be expected later this year when agency interest rate control authority is again considered by Congress. Confining the suspension of transfer limitations to the present NOW account area in order to "enhance" that experiment is certain to be labeled discriminatory and unreasonable by member banks in other states. NOW accounts are prohibited in all states except Massachusetts and New Hampshire, therefore, the Board is directed by statute to limit NOWs to those states.  No such limitation exists on the Board's authority to amend  its rules regarding savings deposits to permit transfers.  Judging from  comments received when the Board considered NOW regulations, commercial banks throughout the country and especially those in states bordering Massachusetts and New Hampshire which have been seeking methods to offer more convenient thrift accounts will urge strongly that the suspension action apply System-wide. Application of the proposed suspension to all member banks nationwide, during the NOW experiment, would subject the Board to Congressional criticism for taking action which may have the effect of permitting savings accounts to be used in a manner resembling NOWs before Congress and the agencies have seen the results of the NOW experiment.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -9 CONCLUSION:  For the reasons discussed above we believe Bank's request  should be denied.  Bank is able to offer NOWs and as indicated in the  attached draft response (Attachment D), the Board has previously expressed its willingness to review the 150 item limitation should current monitoring efforts indicate that member banks are unable to compete on an equal basis with other institutions offering NOWs.  1   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ATTACHMENT A  , . TON  HE \FIRST NATIONAL BANK OIROS RICHARD D. HILL  Chairman of the Board  February 19, 197) ! 111••••••••• • •  Board of Govern ors Federal Reserve System Washington, D. C. 20551 Attention:  Mr. Chester L. Feldberg, Secret ary  Gentlemen: /In recent mont hs changes have taken ph-Ice in th regulations whic e Federal h apnly to the sa vings deposits deposits of fina and demand ncial institutions For example, ne in th e Un ited States. w legislation ha s permitted bank institutions in s and thrift New Hampshire an d Massachusetts negotiable orders to offer of withdrawal an d the Board of Go has issued regu vernors lations covering the NOV account in those states exneriment . Automatic wi thdrawals from sa in Federal Savi vings accounts ngs and Loan As sociations have al authorized, on so been an interim basi s. In order to experiments, the enhance these following reques t is made. EV this letter The First Nation al Bank of Boston requests the Bo respectfully ard to suspend the operation of (c)(2)(i) of Re Se ction 217.5 gulation Q. The Regulation curr as follows: ently provides "(2) Notwiths tanding the prov isions of subnar (1) of this pa agraph ragraph, no with di.awal shall be mitted by a memb perer bank to be ma de from a saving deposit, throug s h payment to the bank itself or transfer of cred through it to a demand or other deposit ac of the same depo count sitor (other than of interest on th savings deposit) e if such payment or transfer is ma pursuant to any de advertised plan or any agreemen ten or oral, t, writ(i) which auth orizes such 'pay ments or transfer . of credit tr s be made as a no rmal practice in to cover checks :.-der or drafts drawn by the deposi:D upon the bank." r • The purpose to be served by suspension of Is to enable subsection (c)( co=ercial blinks 2)(1) to co2pete on a with thrift in more even foot stitutions which ing offer I:0Y acco In such an in unts. A deposi stitution is no tor t bound rigidly by the concept of Boston, Massachusetts 02  110  • THE FIRs r NATIONAL BANK OF BOSTON iroseP ••••  Board of Governors  February 19, 1974  -2-  •  genuine thrift, 1-,ut rathr is permitted to take advantage of the time value of money drawing interest on his balance in savings, but able to make tranfers to third persons periodically without „presenting a signed withd2aval order in person or by mail. The same, functional result .should, we feel, be allowsd to customers of commercial banks who have both savings and checking accounts in the same bank. With the suspension of the provision cited above, a commercial bank; upon receipt of checks, could dcbit the customer's checking account in the normal way and then when insufficient funds remain in his checking account automatically move funds from his savings account to his demand deposit account. Such autbmatic transfers would be made pursuant to an agreement with each participating customer. We believe that this request is fully in the public interest, since it would permit com-nercial banks to offer, on a fair competitive basis, benefi.tc to the public. .The proposed suspension of the subsection would simplify the customer's bookkeeping since he would receive one .tatement for his checking account and savings account. Furthermore, by permitting commercial banks to make transfers between the accounts automatically, the efficiencies of their computer operations could be more fully realized. This should amount to a significant improvement in the payments mechanism. st, If we can furnis.h further information in support of this reque please let me know. Yours truly „. /,,  47  /  L  •  -4-4•  Richard D. Hill k Chairman Copy to: Mr. Frank Morris, President Federal Reserve Bank of. Bo_,ton   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  ATTACHMENT B  FEDERAL RESERVE BANK OF BOSTON FRANK E. MORRIS   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  PRESIDENT  BOSTON, MASSACHUSETTS 02106 TELEPHONE (617) 426-7100  April 22, 1974  Mr. Chester B. Feldberg, Secretary Board of Governors of the Federal Reserve System Washington, D. C. 20551 Dear Mr. Feldberg: The First National Bank of Boston has requested suspension of Regulation Q prohibitions on transfers from a savings account to a demand deposit account of the same depositor as a normal practice in order to cover checks drawn by the depositor. This Bank believes that the requested suspension is warranted, subject to qualifications discussed below which relate to the NOW account experiment. The proposed change in Regulation Q would permit commercial banks to offer their customers checking accounts in combination with savings accounts so that an overdraft of the depositor's checking account would be covered by automatic transfer from the depositor's savings account. First National argues that commercial banks would then be able "to compete on a more even footing with thrift institutions which offer NOW accounts." Since banks in Massachusetts may themselves offer NOW accounts on an exactly equal footing with thrift institutions, First National's request really signals a preference fS r an alternate form of account arrangements. The customer would benefit since there would be no need to open a separate NOW account; instead, savings and demand accounts would be combinedsingle statement account. From the banks' point of view, it is argued that computer handling of combination accounts would be more efficient. The computer efficiency argument is more pertinent to First National's present circumstapces than to commercial banks generally. In recent advertising, the bank has aggressively promoted free checking accounts tied to savings accounts (minimum balance $5.00; see attachment.) Thus, its computer operations are presently set up with the capacity to handle demand and savings accounts in combination. If an automatic transfer provision were permitted and the bank continued to offer the combination free of charge, the resulting package would represent the functional equivalent of no-service-charge NOW accounts, which are offered in Massachusetts by 3 commercial banks and 31 thrift institutions (as of March 29.)   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  • Mr. Chester B. Feldberg  -2-  April 22, 1974  We see no compelling reason to deny the requested change in Regulation Q, provided that the suspension is effected explicitly as part of the NOW account experiment in Massachusetts and New Hampshire. Therefore, we would not favor the suspension if it could not be limited to the two states. Similarly, in the event that commercial banks' savings account interest rate ceilings are increased in the future, we would require that interest on savings deposits in a combination account with automatic transfer provisions be paid at a rate no higher than the permissible rate payable on NOW accounts. Sincerely,  Frank E. Morris  Attachment  Removal Notice The item(s) identified below have been removed in accordance with FRASER's policy on handling sensitive information in digitization projects due to copyright protections.  Citation Information Document Type: Advertisement Citations:  Number of Pages Removed: 1  The First National Bank of Boston. "What's the Quickest Way to Spend Away Your Savings Account?" 1974.  Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  https://fraser.stlouisfed.org  F2DEAAL RESERVE BANK F BOSTON •  Date  EMORANDUM  Mr. Morris  ):  om:  ATTACHMENT C  Subject  March 14, 1974  Request re Reaulation Q from First National BankcZ Boston  Mr. Stone  By letter of February 19 to the Board of Governors, copy to you, The First National Bank of Boston requested suspension of that portion of Regulation Q that prohibits transfers from a savings deposit to a demand deposit of the same depositor if such transfer is made pursuant to any advertised plan or any agreement which authorizes such transfers 4„..„ be made as a normal practice in order to cover checks drawn by that depositor. . In my opinion that request should be denied. The section of Reaulation Q in question is sometimes referred to as the Park Ridge section, designed to prevent the regular use of savings deposits and withdrawals therefrom to cure deficits in demand deposits, as had been proposed in the early 1960's by the Citizens Bank and Trust Company, Park Ridge, Illinois. As you know, the Regulation Q section in question was a compromise of what the Park Ridge Bank first proposed; and that bank, at the present time, markets a deposit plan that takes full advantage of that compromise provision. The request of the First does not limit itself to Massachusetts tnd New Hampshire; I recommend denial of the request whether it is construed as limited to those two states or to the nation as a whole. The general thrust of the First's position in support of its request is that commercial banks should be able to compete on a more equal footing with thrift institutions which offer NOW accounts. It points out, quite correctly, that the depositor in a commercial bank may not arrange for transfers to be made from his savings deposit to his demand deposit, and when coupled with the statutory prohibition against the payment of interest on demand deposits, the commercil bank is placed at a competitive disadvantage vis-a-vis the savings -a_ :ks offering a NOW account. You will recall that this disadvantage was a major point in the brief by the Massachusetts Bankers Association in presenting its views during the period Congress was wrestling with the question of what to do with NOW accounts. The clearest answer tc :he First is to suggest that it might compete with the thrift institutions by offering NOW accounts. It .> could not do .so prior to the federal legislation that permits the regional experiment, hut it is cuite clear that both under the statute and under the amended. Regulation Q a commercial bank in the two states can offer NOW accounts and provide for automatic transfers therefrom to a checking account of the same depositor.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  •  page  It is clear that a suspension of the ReglIktion Q provision as requested by the First would mean that the member banks would, in effect, be able to pay interest on demand deposits. Removal of the statutory prohibition aq-ainst that practice may be forthcoming,and Governor Mitchell may be quite right in suggesting a "family account" that would permit easy transfers to and from checking accounts--but until those changes take place, it is premature to grant the request of the First.  yb   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ATtACHMENT D  Mr. Richard D. Hill Chairman of the Board The First National Bank of Boston Boston, Massachusetts 02100 Dear Mr. Hill: This responds to your letter of February 19, 1974, requesting that the Board suspend the operation of Section 217.5(c)(2)(1) of Regulation Q which provides limitations on the transfer of funds from a savings deposit to the depository bank or through transfer of credit to a demand or other deposit account of the same depositor. The Board has reviewed your request in light of the NOW experiment presently being conducted in Massachusetts and New Hampshire and has determined that such action to suspend the present transfer limitations should not be taken at this time.. As you know the Board and the other Federal financial supervisory agencies have jointly instituted a monitoring program to enable these agencies and Congress to assess the acceptance and financial effects of the use of NOWS in the experiment area. Because the NOW experiment as authorized by Congress and the agency monitoring effort have been in place for only four months, data thus far received are inadequate to permit accurate assessment of the use of NOWS in the form existing in the two States at the time Congress considered NOW legislation and authorized continued NOW usage under experimental conditions.  Removal of the transfer limitations as to all sav-  ings deposits at this time would significantly change the NOW experiment environment and thereby may make more difficult accurate evaluation of the date received thus far.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ,•••  2  IMMO  These considerations, in addition to the fact that data thus far available do not indicate that the Board's item limitation is inhibiting member banks' ability to offer NOW services on an equal footing with other financial institutions, convince the Board that the suspension of transfer limitations for all savings deposits is not warranted at this time.  The Board is continuing to monitor closely the use of NOWS and is  prepared to review its present regulatory requirements should data indicate that additional regulatory actions appear necessary.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Very truly yours,  Chester B. Feldberg Secretary of the Board
Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102