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a n eco n o m ic re v ie w b y th e F e d e ra l R eserve B a n k o f C hicago Hedging interest rate fluctuations 3 With the introduction o f GNMA and T-bill futures trading, businesses now have a new means o f hedging against unanticipated interest rate fluc tuations. The transfer o f such risks to speculators should result in cost savings that can be passed on to the consuming public. Deposit service— new tool for cash management 11 Regulatory changes and tech nological developments are permit ting depository institutions to offer services that enable customers to in crease their interest income. Subscriptions to Business Conditions are available to the public free of charge. For information concerning bulk mailings, address inquiries to Research Department, Federal Reserve Bank of Chicago, P. 0 . Box 834, Chicago, Illinois 60690. Articles may be reprinted provided source is credited. Please provide the bank’s Research Department with a copy of any material in which an article is reprinted. Business Conditions, April 1976 3 edging interest rate fluctuations In recent months two new “commodities” have been added to the list already traded on the organized futures markets. These new commodities are unique to the futures markets in that they bear explicit rates of interest. On October 20, 1975 futures trading in Government National Mort gage Association (GNMA) modified pass through mortgage-backed certificates1 began on the Chicago Board o f Trade. Treasury bills (T-bills) made their debut January 6, 1976 on the International Monetary Market, a division of the Chicago Mercantile Exchange. The primary function of futures markets is to allow businessmen to hedge, i.e., to transfer the risks o f unanticipated com modity price changes to those eager to assume these risks—namely speculators, who hope to profit from correctly fore casting price swings. Hedging involves taking a position in the futures market op posite that in the cash market so that losses in one will be offset by gains in the ‘These certificates are issued by FHA-approved private financial enterprises, such as mortgage bankers, and are backed by pools of FH A- or V A guaranteed mortgages. Fixed monthly payments of principal and interest on the mortgages plus prepayments and proceeds from foreclosures are paid or “ passed through” to the certificate holders. G N M A , a wholly owned government corporation within the Department of Housing and Urban De velopment, guarantees that these payments will be made even if the certificate issuer has not actually collected the amounts due from its mortgagors. Although the original maturity of the mortgages backing the G N M A certificates is usually 30 years, yields are quoted on the basis of a 12-year maturity due to F H A actuarial experience o f prepayment patterns. other if prices move in either direction. A farmer who will have wheat to sell in September might want to sell a September wheat futures contract at today’s price. If the price of grain falls, he will lose on the grain sale but will be able to cover his posi tion in the futures market at a lower price. Why a futures market in interest rates? Prices of financial assets, such as securities and mortgages, fluctuate in versely with market interest rates. As yields on new obligations rise, outstanding instruments with lower coupon rates can be sold only at a discount that will increase their effective yield, resulting in a capital loss for the sellers. In recent years the yields on a wide variety of interest-bearing securities have shown increased volatility. Although this increased volatility has posed problems for many groups of borrowers and lenders, few have suffered more than the builders, thrift institutions, and mortgage bankers in volved in residential construction. Given the large dollar volume of transactions and the relatively small capital bases of par ticipants, the industry is vitally dependent on credit, and a critical element in its operation is the forward commitment of funds at fixed rates o f interest. Both borrowers and lenders stand to lose large sums of money if they incorrectly forecast interest rates over the life o f a commit ment. The greater the fluctuation in in terest rates, the more difficult it is to make accurate forecasts. At times of heightened 4 uncertainty parties on both sides of the residential construction credit bargain have grown reluctant to enter into fixedprice, mandatory-delivery commitments, thereby exerting a depressing influence on building activity. Because a futures market in mortgage or mortgage-related instruments offers protection against losses associated with unanticipated changes in interest rates, it might be ex pected to improve the flow o f funds into the industry. Borrowers and lenders in other sectors also risk higher costs or losses in the value of their assets from fluctuations in interest rates. For example, corporate treasurers face increased difficulties in managing cash balances when short-term borrowing and lending rates are changing rapidly. The sale of an investment in order to meet an immediate need for cash entails a capital loss if interest rates have risen since the investment was made, while in come may be lost if rates fall before cash is available. Thus, persistently inaccurate forecasts of short-term rates can lead to significant reductions in corporate profits. A futures market in a short-term, interestbearing security whose yield is closely cor related with those o f other money market instruments would afford participants in these credit markets some protection against losses due to the volatility of short term interest rates. The mechanics o f futures trading Trading in the futures market does not involve the buying and selling of an actual physical commodity or security but rather contracts that specify the delivery of a standardized quantity and quality o f a commodity at a designated price at some future date. In the GNMA futures market the trading unit is $100,000 principal balance of GNMA modified pass-through mortgage-backed certificates bearing a stated interest rate (coupon rate) o f 8.00 Federal Reserve Bank of Chicago percent.2 Delivery months are March, June, September, and December; and con tracts extend forward as much as one and one-half years. The standard contract in the Treasury bill futures market is $1,000,000 face value at maturity o f 90-day Treasury bills. The delivery months are March, June, September, and December with contracts extending forward one year. To buy or sell futures contracts, an in dividual or institution must first open an account with a brokerage firm that has membership on the exchange on which the particular commodity is traded. Assume that an investor on March 1 wanted to purchase a June contract o f GNMA 8s that was selling at 92-223 to yield 9.00 percent. The investor’s broker would execute the buy order which would then obligate the in vestor to accept delivery in June o f GNMA 8s with $100,000 principal balance upon payment of $92,687.50. The investor would be “ long” in GNMA futures since his first transaction was to purchase a contract. On the other side of the transaction, the seller of the contract agrees to deliver the GNMA 8s in June upon receiving payment of $92,687.50. In the case when the futures market participant’s first transaction is a contract to sell, the seller is “ short” in futures. A futures contract can be fulfilled by accepting or making delivery o f the com modity on the specified date, which occurs in only about 2 percent of all futures con tracts. Usually, buyers and sellers o f con tracts make opposite or offsetting transac tions in the futures market, thereby deliverers at their option m ay substitute GNM A s with a stated interest rate other than 8.00 per cent provided the G N M A s delivered bear the same yield as the 8.00 percent G N M A when calculated at par under the assumption of a 30-year mortgage pre paid in the 12th year. 3G N M A contract prices are quoted in terms of points and 32nds. For example, 92-22 m eans 92 and 22-32nds or 92.6875. Business Conditions, April 1976 eliminating their obligations for delivery or acceptance o f delivery. Contracts in the futures market are bought and sold on margin. The margin deposit, while tangentially related to the value o f the commodity, is more a function of the historical price volatility of a com modity. The minimum amount of initial margin for GNMA and T-bill futures con tracts is $1,000 and $1,500, respectively, although individual brokerage houses may require larger amounts. Additional margin, called “maintenance” or “ varia tion” margin may be required from the buyer o f interest rate futures contracts if contract prices decline (i.e., yields rise) or from the seller if prices rise (yields decline). In addition to putting up margin when trading in the futures market, a customer must pay a brokerage commission. Al though this fee may vary among brokers, the most common charge quoted on a GNMA or T-bill futures “round turn” transaction4 is $60 per contract. Hedging A businessman who holds an inven tory of some commodity faces possible losses due to the risk of unanticipated price declines. On the other hand, those who in tend to purchase commodities in the future run the risk o f having to pay higher than current prices at the time of purchase. Futures markets enable businesses to transfer price-change risks to speculators through the technique known as hedging. Hedging is defined as taking a posi tion in the futures market equal to and op posite an existing or developing position in the cash or spot market. Consider the case of a mortgage banker who in March holds an inventory of F H A /V A mortages or has entered into a commitment with a builder 4“ Round turn” is the term used to describe both the customer’s initial and offsetting transactions in the futures market. 5 to accept delivery o f mortgages in Sep tember at a specified yield. The mortgage banker is long in cash mortgages. Assum ing that he intends to form a GNMA mortgage pool and then sell the resulting mortgage-backed securities to permanent mortgage investors, the mortgage banker faces the risk that interest rates may in crease between March and September, thereby reducing the capital value of the mortgage pool. In order to reduce the risk of capital loss due to a rise in interest rates, the mortgage banker can sell GNMA futures contracts in March for delivery in September. By so doing, he has hedged his long position in cash mortgages by going short in GNMA futures. In September when the mortgage banker sells his GNMA mortgage-backed securities to per manent investors, he will simultaneously offset his short position in GNMA futures by purchasing contracts. If the prices of interest-bearing securities have fallen (i.e., yields have risen) between March and September and if cash market and futures market prices have moved in the same direction (which they usually do), then the losses that the mortgage banker ex periences in the cash market will be offset by his gains in the futures market. If, in stead, yields had declined, the mortgage banker would have experienced a capital gain in the cash market but would have sustained a loss in the futures market. By selling contracts o f GNMA futures to hedge his long cash position, the mortgage banker has shifted the risk associated with unanticipated changes in interest rates to the purchaser of the futures contracts—generally, a speculator. The mortgage banker has thus constrain ed his potential losses but also has implicit ly agreed to limit his potential gains. He is content with his usual profits earned from mortgage origination and servicing fees. The speculator, who feels that he has a special expertise in forecasting interest rate movements, agrees to assume the risk 6 of interest rate fluctuations because of the potentially large profits he can reap if his forecasts are correct. Basis A successful hedge requires that cash or spot market prices and futures market prices move in the same direction over time. Fortunately for hedgers, this is generally the case. The difference between the futures price and the cash or spot price is called the “ basis.” In futures markets for interest-bearing securities, the key ele ments in determining the basis are the fac tors that enter into the current cost of borrowing money and expectations of what borrowing costs will be in the future. In hedging, if the basis remains constant—that is, both the futures and spot prices move in the same direction by the same amount—then the hedge is perfect. The gain in one market exactly offsets the loss in the other. In actuality, it is rare that the basis will remain constant. Hedgers must be aware of the possibility of a change in the relationship between futures and spot prices—called basis risk— which may expose them to a loss (or gain) on the hedging transaction. Nevertheless, any losses will usually be much less than would have otherwise occurred had a posi tion in the cash market not been hedged. Cross-hedging A futures market in one commodity can be used to hedge against adverse price movements of some other commodity. This technique is called cross-hedging. For cross-hedging to be effective, the spot prices of the two commodities have to move in tandem. Unless the correlation between the two commodities’ spot prices is perfect, the cross-hedger exposes himself to higher potential basis risk since market con ditions determining the price of one com modity could change significantly relative to the other. Federal Reserve Bank of Chicago The GNMA futures market would seem to provide a cross-hedging vehicle to those institutions that have exposed positions in mortgage debt and long-term, fixed-income securities. Statistical studies have shown that the correlation between GNMA certificate yields and conventional mortgage yields ranges from approximate ly 84 percent to 93 percent, depending on the particular mortgage yield series con sidered. The correlation between GNMA certificate yields and long-term govern ment bond yields is about 93 percent. The T-bill futures market is more ap propriate for cross-hedging positions in short-term obligations such as certificates o f deposit, commercial paper, bankers’ acceptances, and bank loans tied to the prime rate. Correlations between yields on 13-week Treasury bills and yields on these types of short-term credit market in struments are generally in the neigh borhood o f 85 percent. Despite these relatively high correlations of yields on GNMAs and T-bills vis-a-vis other interestbearing debt instruments, the cross-hedger would still be exposed to substantial basis risk. Potential participants Institutions that have a significant portion of their assets and/or liabilities in the form of interest-bearing debt in struments may find an interest rate futures market an effective means o f hedg ing exposure to unanticipated fluctuations in yields. Those who expect to borrow at some future date can use the new markets to establish their future borrowing costs with a relatively high degree o f certainty, likewise, future lenders now have a new vehicle which allows them to lock in a current rate of return prior to the time that the actual lending or investing takes place. The GNMA futures market was developed primarily for participants in the residential mortgage market—builders, in Business Conditions, April 1976 terim lenders, and permanent investors. Consider the situation where a builder ob tains a forward mortgage commitment from a lender such as a mortgage banker for a certain dollar amount at a specified interest rate. For this commitment the builder may have to put up “ earnest money” or “liquidation damages.” At the agreed upon time the builder “ sells” or delivers mortgages to the mortgage banker at the prevailing mortgage rates. If mortgage rates have declined in the in terim, the builder will lose money on the delivery because the mortgage banker will discount the lower-yielding mortgages that he has received by the amount necessary to produce the higher yield specified in the terms of the commitment. Rates may have fallen so much that the builder will minimize his losses by “ walk ing away” from the commitment, that is, not delivering the mortgages and thereby forfeiting his earnest money. The builder can then seek financing from another lender at the lower prevailing yields. If, on the other hand, mortgage rates have risen, then the mortgage banker suffers an “ op portunity” loss in that he is committed to making loans at a yield below which he can earn in the current market. If the mortgage banker sells these mortgages to a permanent investor at prevailing yields, then his opportunity loss becomes a real ized capital loss. Both the builder and the mortgage banker could have protected themselves against the risk o f adverse interest rate movements by hedging their positions in the GNMA futures market. In this par ticular example the builder would have covered his short position in cash mort gages5 against interest rate declines by ex ecuting a long hedge, i.e., by purchasing futures contracts. If yields did, in fact, decline between the commitment date and 5The builder is short cash mortgages because he has entered into an agreement to sell or deliver mortgages at some future date. 7 the delivery date, then profits in the futures market would compensate the builder for losses in the cash market. (See Box I, Ex ample 1.) The mortgage banker would have protected his long position against interest rate increases by executing a short hedge through the sale o f GNMA futures. A rate increase would produce losses for the mortgage banker in the cash market but gains in the futures market. (See Box I, Example 2.) Permanent investors in the mortgage market—such as pension funds—might also use the GNMA futures market to hedge their positions. For example, a pen sion fund that had entered into a commit ment with a mortgage banker to purchase GNMA mortgage-backed securities of a certain face value at a given yield at some specified later date might protect its long cash position in GNMA certificates against interim rate increases by placing a short hedge in the futures market. The futures market could also be used to lock in the current rate o f return on in vestments by investors who anticipate having funds available at a later date but who do not wish to enter into a formal com mitment. This could be accomplished by purchasing GNMA futures. If yields have declined by the time the investor is ready to purchase GNMA certificates, then the profits in the futures market obtained by selling the futures contracts at a price higher than at which they were purchased would compensate for the lower prevailing yield in the cash market, thus raising the effective rate o f return to the investor. Participants in the T-bill futures market are expected to include a wide spec trum of institutions that wish to hedge ex posed positions in short-term credit market instruments. For example, a corporate treasurer who expects to issue commercial paper at some time in the future could protect his firm against unanticipated higher borrowing costs by selling T-bill futures contracts. If short-term rates have 00 Box I. Hedging examples--GNMA futures market Box II. Hedging examples—T-bill futures market The follow ing examples illustrate the use o f the G N M A futures market in hedging the risk inherent in unanticipated interest rate fluctuations. The yields represent simple, uncompounded m onthly paym ents o f principal and interest on a 30-year security bearing a coupon rate o f 8.00 percent, assum ing that the security is redeemed in the 12th year. Because o f the G N M A 15day interest-free servicing delay provision, an 8.00 percent G N M A yields 8.00 percent at a price o f 99-21 (99.65625). For expository purposes this ad justment is also made with regard to m ortgage yields and prices. The follow ing exam ples illustrate the use o f the T-bill futures market in hedging the risk inherent in unanticipated short-term interest rate fluc tuations. The yields presented are calculated on a bank discount basis, which is essentially the difference between the face value o f a security and its market value on an annualized basis. 1. The long hedge Assume that in March a builder enters into a com m itm ent with a mortgage banker to deliver in September $996,562.50 principal balance o f mortgages to yield 8.00 percent. If m ortgage rates should drop between the commitment date and the delivery date, the lower yielding m ortgages delivered to the mortgage banker will be discounted to yield the rate specified in the commitment. In this case the builder will suffer a capital loss. In order to protect against a capital loss as a result o f a fall in m ortgage rates, the builder would execute a long hedge in the G N M A futures market. Cash market March—Builder enters into com mitment with mortgage banker to d e liv e r in September $996,526.50 principal value o f mortgages to yield 8.00 percent. Futures market M a rc h — B u i l d e r b u y s 10 September GN M A 8 contracts to yield 8.00 percent. Assum e that in March a corporate treasurer expects to have ac cumulated approxim ately $1 million o f investable funds by June at which time he anticipates buying 91-day T-bills with these funds. The treasurer finds the current yield o f 8.00 percent on 91-day T-bills attractive and desires to lock in this yield for the anticipated future investment. T o protect against a decline in bill rates between March and June, the corporate treasurer ex ecutes a long hedge in the T-bill futures market. Cash market March—Corporate treasurer an ticipates buying $1 m illion face value o f 91-day T-bills in June and decides to lock in the current yield o f 8.00 percent. Current price: $979,777.80 Futures market March—Corporate treasurer buys 1 September 90-day T-bill contract to yield 8.25 percent. Price: $979,375.00 Assum e that in June the spot yield on 91-day T-bills has declined to 7.50 percent. Price: 99-21 (99.65625) Total value: $996,562.50 Total value: $996,562.50 1. The long hedge delivers $996,562.50 principal value o f 7.50 percent mortgages discounted to yield 8.00 percent. Price: 95-29 (95.90625) Total value: $959,062.50 Loss: $37,500.00* September—Builder June —Corporate treasurer sells 1 Price: $980,638.90 Gain: $1,263.90* sells 10 September GN M A 8 contracts to yield 7.50 percent. Price: 103-13 (103.40625) Total value: $1,034,062.50 Gain: $37,500.00* By placing a long hedge, the loss incurred in the cash market by the builder as a result o f the decline in m ortgage rates was offset by a gain in the futures market. Had rates risen rather than fallen, then the builder would have experienced a gain in the cash market but a loss in the futures market. 2. The short hedge The mortgage banker in Exam ple 1 also faces a risk o f loss from unan ticipated interest rate fluctuations, but his loss will occur if m ortgage rates rise above the specified commitment rate. In this event the m ortgage banker would have to pay a premium for the m ortgages he received from the builder. The mortgage banker would suffer an “ opportunity loss” in the sense that he would be lending at below-market rates. If the m ortgage banker were to sell in the secondary market the m ortgages acquired from the builder, his opp ortunityjoss would betome a realized capital loss. In order to protetig September 90-day T-bill contract to yield 7.744 percent. Although the corporate treasurer bought in June $1 million face value o f 91-day T-bills for $981,041.70 to yield 7.50 percent, the “ effective” price paid was $979,777.80 when the profits earned in the futures market are sub tracted from the cash market price ($981,041.70-$1,263.90). At this lower “ effective” price the rate o f return on the corporate treasurer’s investment is increased to 8.00 percent, the spot yield on 91-day T-bills in March. 2. The short (cross-) hedge Assume that in March a corporate treasurer anticipates borrow ing ap proxim ately $1 m illion via 90-day com m ercial pap er in June. Fearing that short-term interest rates m ay increase by June, the corporate treasurer decides to lock in the spot rate o f 8.00 percent on 90-day com m ercial paper by executing a short hedge in the T-bill futures market. Cash market March—Corporate treasurer an ticipates selling $1 m illion face Futures market M arch — C o r p o r a te treasu rer sells 1 June 90-day T-bill futures value o f 90-day com m ercial paper in June and decides to lock in the current borrowing cost o f 8.00 percent. M Federal Reserve Bank of Chicago September—Builder J u n e —Corporate treasurer b u ys $1 million face value o f 91-day Tbills to yield 7.50 percent. Current price: $981,041.70 Assume that mortgage rates fall in the March-September period so that the average yield on the m ortgages that the builder delivers in September is 7.50 percent. contract to yield 7.75 percent. Price: $980,625.00 against l,M ies due .-*ra risW n m o r tg a g e rates, the m o r tg a g e ba n k e r w ou ld e I ecute a snort hedge. ® Cash market Total value: $996,562.50 June—Corporate treasurer sells June—Corporate treasurer buys 10 September G N M A 8 contracts to yield 8.00 percent. $1 million face value o f 90-day commercial paper at a yield of9.00 percent. 1 June 90-day T-bill futures con tract to yield 8.75 percent. Price: 99-21 (99.65625) Total value: $996,562.50 Price: $977,500.00 Price: $978,125.00 Gain: $2,500.00* Assume that mortgage rates rise in the March-September period so that the average yield on the m ortgages bought in September by the m ortgage banker is 8.50 percent. S e p t e m b e r — Mortgage banker b u ys $996,562.50 principal value o f 8.50 percent m ortgages at a premium to yield 8.00 percent. Price: 103-07 (103.21875) Total value: $1,032,187.50 “ Opportunity loss” : $35,625.00* S e p t e m b e r — Mortgage banker b u y s 10 September G N M A 8 con tracts to yield 8.50 percent. Price: 96-03 (96.09375) Total value: $960,937.50 Gain: $35,625.00* If the mortgage banker were to sell his recently acquired m ortgages in the secondary market at the prevailing rate o f 8.50 percent, his opportunity loss would become a capital loss since he would receive only $996,562.50 for the mortgage pool rather than the $1,032,187.50 that he had paid for it. *The effect o f m argin costs and com m issions on the financial outcom e o f hedging transactions is not taken into account. Assume that short-term interest rates have risen during the MarchJune period. CP C D H g Proceeds from sale o f com m ercial paper plus Profit in futures market Total proceeds $977,500.00 2,500.00 $980,000.00 Interest cost (discount on $1 m illion face value o f com m ercial paper) $ 22,500.00 “ Effective” interest rate 8.00 percent When the profits from the futures market transactions are added to the proceeds o f the com m ercial paper sale, the interest cost o f $22,500.00 translates into an “ effective” borrow ing cost o f 8.00 percent, the rate that prevailed in March. Business Conditions, April 1976 March—Mortgage banker enters into a commitment with a builder to buy in September $996,562.50 principal value o f m ortgages to yield 8.00 percent. " Futures market March—M ortgage banker sells *The effect o f margin costs and com m issions on the financial outcome o f hedging transactions is not taken into account. i-J < > Jr* m . o T m. 3 ®C c L O “ — r. *d 2 £ ^ S-S 8 § « 8 ?§■ " & S' I " 5 « I Mo o < 3 g? s £§ £s 3 ' a pw s sr s 5- (a (S- 7 * i t t r to 10 seekers will result in increased output and/or lower prices. The developers of the GNMA futures market expect these favorable output and price outcomes to accrue to the residential construction industry. With the ability to hedge, builders can reduce the risk premium that they have been inclined to add to the prices of their houses in order to protect their profits from adverse movements in interest rates. It is also hoped that the availability of mortgage funds will increase and the cost of these funds will decrease as a result of the GNMA futures market. Interim mortgage lenders—such as mortgage bankers—may be willing to commit a larger volume of funds to builders at lower interest rates now that these lenders can hedge against unanticipated rate fluctuations. Likewise, the ability to cover cash market mortgage positions in the futures market may make permanent mortgage investors more will ing to enter into larger commitments with interim lenders. In addition, the flow of funds into the mortgage market may be enlarged by commercial banks’ willing ness to provide a greater quantity of in terim “ w areh ou sin g” 6 financing to 6“ Warehousing’- refers to the practice by m ortga ge b an kers o f holding inventories of mortgages before delivery to a permanent investor. Federal Reserve Bank of Chicago mortgage bankers whose inventories of mortgages are hedged since it is these mortgages that serve as collateral for the bank loans. Bankers have usually been willing to commit a larger quantity of funds to a business for inventory financing when that inventory was hedged in the commodities futures markets because the business is at least partially protected against losses arising from a drop in the value of its inventory and thus is less likely to default on its loan. The T-bill futures market is expected to produce similar benefits. By using the futures market to establish a future borrowing cost, a corporation can lower the price of its product—all other things being equal—because the risk premium associated with interest rate uncertainty, which is included in the product price, has been reduced. Conceivably, the flow of bank credit could increase as a result of the new futures market. For example, banks can reduce the uncertainty as to what their borrowing costs via the CD market will be by hedging in the T-bill futures market. This reduced uncertainty could increase banks’ willingness to enter into forward loan commitments. Paul L. Kasriel Business Conditions, April 1976 11 Deposit service—new tool for cash management Competition for deposits is taking a new form. Instead of paying higher interest rates on savings deposits, depository in stitutions are offering services which enable customers to increase income by keeping less funds in noninterest-bearing checking accounts. These services are be ing facilitated by regulatory changes and technological developments. More consumers and small businesses have become interest rate conscious. Depository institutions, unable to pay higher rates on deposits under current legal restrictions, are offering daily in terest and making it more convenient for customers to withdraw savings or transfer funds from savings accounts to checking accounts. Faced with the increased costs of both the higher proportion of interestbearing deposits and the additional ser vices, these institutions are hard pressed to reduce other costs. An important avenue is through technological improvements, es pecially the developing electronic funds transfer systems (EFTS). Extending a trend Rising interest rates during the post war period caused large corporations to manage their cash balances more efficient ly to minimize borrowing costs and in crease income through short-term money market investments. Demand deposits were reduced to the lowest possible work ing level or the minimum balance nec essary to compensate commercial banks for services. Commercial banks, faced with the slow growth in corporate demand deposits, sought to attract corporate short term investment funds by offering cer tificates of deposit (CDs) at competitive rates. In addition, competition for the funds of consumers and small businesses with limited access to the money market was intensified as these groups gradually grew more interest-sensitive and began to seek higher-yield investments and pare down noninterest-bearing transactions balances. Nonbank financial intermediaries, particularly savings and loan associa tions (S&Ls), have long been active so licitors of the savings of individuals and, more recently, small businesses. During the fifties and early sixties interest rates paid on regular savings deposits at S&Ls were su b sta n tia lly higher than those available on passbook savings accounts at commercial banks. This differential has decreased as much as regulations permit— from 75 basis points in September 1966 to 25 basis points currently. Most commercial banks and S&Ls offer long maturity time deposits on which higher rates can be paid. Many offer interest from day o f deposit to day o f withdrawal. Although these features were adopted mainly to reduce the outflow of savings deposits during periods of tight money when yields on market instruments were high, they are now standard. NOW accounts Nonbank savings institutions early recognized that third-party payment ser vices would not only be a stimulus to savings deposit growth, but would be necessary to induce the direct deposit of 12 payrolls and transfer payments in an en vironment of electronic systems. Federal laws and regulations state explicitly that savings accounts shall not be subject to check or to negotiable or transferable order of withdrawal. Excepted are the negotiable orders of withdrawal (NOW accounts) per mitted in the New England states. The Housing Act of 1968 authorized federal S&Ls to accept an order from a depositor to withdraw money from his savings account and to issue an S&L check to pay a third party. In September 1970 when the original regulation on third-party pay ment orders was proposed by the Federal Home Loan Bank Board (FHLBB), a spe cial memorandum to associations urged that very careful cost studies be under taken prior to the offering o f third-party payment arrangements. Final regulations issued by the FHLBB in early 1971 restricted orders for periodic or specific third-party payments primarily to expen ditures related to housing. Payments for any purpose were permitted in April 1975. Recently, the FHLBB has proposed that savings depositors in federal S&Ls be allowed to authorize payment from their accounts to third parties by orders elec tronically transmitted through automated clearing houses. A major innovation in the payment of interest on the equivalent of demand deposits was the introduction o f NOWs by mutual savings banks in Massachusetts and New Hampshire in 1972. The follow ing year Congress authorized all federally regulated institutions in those states to offer such accounts. The successful ex perience there led nonbank financial in stitutions to seek similar powers in other states. The law was amended to include federally regulated institutions in all New England states effective February 27,1976 and pressures have developed to extend the NOW account nationw ide. Illinoischartered savings and loan associations were permitted to offer NOW accounts Federal Reserve Bank of Chicago beginning January 1, 1976 (sometimes called N IN O W s—noninterest-bearing negotiable orders of withdrawal). Such ac counts (except in New England) must be noninterest-bearing because o f the prohibi tion of interest on demand deposits. Transfers, however, can readily be made into the NOW account from a separate regular savings account. Role of technology T ech n olog ica l cap a b ilities for the elec tronic transfer o f funds are supporting the new deposit services o f both commercial banks and S&Ls. Current major com ponents are the automated teller machine (ATM ), point-of-sale (POS) terminal, automated clearing house (ACH), and sup porting networks. ATMs may dispense cash from checking or savings accounts or from credit card advances and enable the customer to transfer funds between ac counts at any time. They may be located on or off the premises and may or may not be connected on-line to the bank’s customer data base. Most are activated by the customer using an encoded plastic card. A POS terminal does not dispense cash and it requires an operator, usually a clerk in the retail store where it is located. It is generally part of an on-line network and may provide credit authorization or check verification, data collection, or the transfer of funds from the customer’s ac count to the merchant’s account. Both ATMs and POS terminals are considered customer-bank communication terminals (CBCTs). A regional automated clearing house enables commercial banks to exchange debits and credits among themselves elec tronically as a substitute for the exchange o f paper checks and other interbank transfers. Primary emphasis has been on the direct deposit o f payrolls and on preauthorized bill payments. The Treasury Department is sponsoring pilot projects us 13 Business Conditions, April 1976 ing ACHs for the direct electronic deposit o f social security payments and United States Air Force payrolls. Bank regulations adjusted Commercial banks, subject to the restrictive rules adopted in the thirties to enforce the prohibition o f interest pay ments on demand deposits, have been at a competitive disadvantage relative to S&Ls that are promoting the use of savings deposits for transactions. To achieve greater equity am ong financial in stitutions and to expand the services offered to depositors, three amendments to Federal Reserve and FDIC regulations were adopted during the past year, and a fourth has been proposed for comment. On April 7, 1975 commercial banks were authorized to permit customers to use the telephone to withdraw funds from their savings accounts or to transfer funds from savings to checking accounts. Security and record-keeping devices made possible by new technology were considered suf ficient to keep errors and unauthorized use to a minimum and to permit the rule in effect since 1936 to be rescinded. Regulations were amended effective September 2, 1975 to permit depositors to authorize the transfer o f funds from savings accounts to third parties for payments of any type, except bank over drafts. Previously, this type o f bill-paying service could be offered by commercial banks only for the payment o f principal, interest, or other charges related to a real estate loan or mortgage. Corporations, partnerships, and other profit-making organizations were per mitted to maintain savings accounts at commercial banks up to a maximum of $150,000 beginning November 10, 1975. The ceiling amount was intended to make such accounts attractive primarily to small businesses that do not have access to the money markets to earn interest on tem porarily idle funds. Thrift institutions were already offering business savings ac counts, and the amended regulations allow commercial banks to compete more effec tively for these funds. An amendment to Regulation Q proposed on March 15,1976 would permit a commercial bank to agree to transfer funds automatically from a depositor’s savings account to a demand deposit account or directly to the bank itself when the demand deposit balance is insufficient to permit payment of presented checks or falls below a certain specified amount. The proposal would allow transfers in multiples of $100 or more with at least 30 days interest to be forfeited on the transferred funds. Although the amendment is intended to present an alternative to the costly prac tice of returning checks drawn on insuf ficient accounts, it is also likely, if adopted, to encourage depositors to reduce demand deposit account balances. Arrangements already exist whereby S&Ls have agreed to transfer depositors’ funds automatically or otherwise to the customer’s demand deposit at a commercial bank. Growth o f business savings The amount o f funds held by busi nesses in regular savings accounts at com mercial banks has grown rapidly since the regulation was amended in November. A national survey on January 7, 1976 in dicated that there was $1.6 billion out standing at member banks alone. Business savings accounts at the weekly reporting banks, which were $1.0 billion at the time of survey, had increased to $2.6 billion by April 7, 1976. Nationally, about nine-tenths of the member banks reported in the survey that they were offering or planning to offer business savings accounts. The other 10 percent were primarily banks with total deposits o f less than $10 million. About three-fifths of the banks offering these 14 Federal Reserve Bank of Chicago savings accounts accepted telephone orders for transfers between savings and demand deposit accounts. Because service was more common at the larger banks, rou ghly 80 percent of outstanding business savings are estimated to be subject to telephone transfer. Concern has been expressed that business savings accounts may consist primarily of funds which would normally have been held at less cost to the bank in a demand deposit. Respondents estimated on average that initially about 60 percent of savings represented a shift from a de mand deposit although individual bank es timates ranged from none to all. Modera tion in savings gains at S&Ls prior to the survey suggests that some part of the in flow to commercial banks was from ex isting corporate savings accounts at S&Ls. Reports from Seventh District banks indicate somewhat faster growth than nationally except in Indiana, where the state law did not permit banks to accept business savings accounts until January 14, 1976. In the other four states almost three-fourths o f the banks were providing telephone transfer service, and over 90 per cent of the business savings were subject to telephone transfer. Most Seventh District member banks offer business savings accounts . . . State Illinois Indiana* Iowa Michigan Wisconsin United States Percent offering or planning to offer Percent of those offering w ith telephone transfer 93 71 94 98 94 68 58 74 78 84 90 61 Note: As of January 7, 1976. ’ Indiana state law did not perm it business savings deposits at banks until January 14, 1976. Business savings accounts are of par ticular importance to the smaller banks that offer these accounts. In just two months after inception these deposits ac counted for more than 5 percent o f total savings deposits at almost one-fourth of the Seventh District banks with total deposits of less than $10 million. None of the big banks (deposits over $500 million) reported business savings proportionately that large. Their large corporate customers have long had access to other outlets for idle cash, such as large certificates of deposit, commercial paper, or short-term government securities. A greater propor tion of the customers o f the smaller banks are small- and medium-sized firms for whom savings accounts provide a con venient investment for short-term funds. Road ahead unclear There are a number of unresolved problems in connection with the in creasing payment of interest on funds formerly held in demand deposits. One is the added cost to commercial banks. Currently, in lieu of interest payments, some free services have generally been provided to depositors. Added interest costs may require more explicit pricing for those services. Full scale electronic funds transfer systems offer promise o f substan tial processing cost savings, but implemen. . . with the service more common at larger banks Total deposits Percent offering o r planning to offer Percent of those offerin g w ith telephone transfer (m illio n dollars) Less than 10 10 - 50 50 - 100 100 - 500 500 and over 78 93 98 96 100 Note: As of January 7,1976. 69 68 80 83 95 Business Conditions, April 1976 tation entails problems of consumer accep tance, start-up costs, and legal obstacles. Custom ers have generally been satisfied with the current paper check system. Acceptance of a paperless transfer system will depend on perceived con venience and the realization that the depositor stands to benefit in interest earn in g s from p ossible processing cost reductions. Electronic funds transfer systems generally involve large capital outlays and require substantial transaction volume to be economically feasible. Some commer cial banks establishing POS networks are sharing the systems with other commer cial banks and nonbank financial in termediaries. In some districts Federal Reserve banks are providing computer and software support to ACHs. C o m m e r c ia l banks have been hindered in the expansion of off-premise electronic facilities by the question of whether or not these facilities are branches and thus subject to the regulations and state laws on branching. The Comptroller of the Currency in December 1974 ruled that CBCTs may be operated by national banks without regard to the restrictions on branch banks. The ruling was subsequent ly modified to limit such facilities to within 50 miles of a home or branch office unless the facility was shared with a local finan cial institution. Challenges to facilities es tablished under this ruling are currently in the courts. Meanwhile a number of state legislatures have adopted or are con sidering legislation exempting off-premise electronic facilities from branching laws and regulations. Some contain provisions requiring shared access by other commer cial banks and, in some cases, nonbank financial intermediaries. However, the status of shared access under antitrust 15 legislation, even when required by state law, remains uncertain. Savings and loan associations have been less affected by the branching con troversy. Under a temporary regulation issued in January 1974, the FHLBB stated that off-premise information processing devices (such as ATMs and POSs) were not branch offices and authorized experimen tal systems subject to FHLBB approval. Originally issued to expire in July 1974, the regulation was extended through July 1976. Extension is currently proposed through December 31, 1977, with applica tions accepted through March 31, 1977. These so-called remote service units (RSUs) may be used to store and transmit information on authorized financial trans actions to an association and must be dependent on a machine-readable instru ment for access. Authorized financial ser vices to the public by RSUs include deposits or transfers of funds to savings ac counts, withdrawals, and loan payments. Opening accounts and obtaining loans and overdrafts are specifically prohibited. RSUs may be located in any place of business within the state in which the home office of the association is located or within the primary service area of any branch office located outside o f that state. As of April 15, 1976 the FHLBB had ap proved 65 applications for 22 individual and nine shared projects in 18 states. Seventy-two federally chartered and 46 s ta te -c h a r te r e d savin gs and loan associations, four mutual savings banks, and one commercial bank were involved. The projects were for both fully automated teller terminals and/or merchant-operated terminals. Most of the RSUs are in customer service centers in grocery stores. Eleanor Erdevig
@FedFRASER