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October 20, 1978
What CertificatesPay
Since June 1, commercial banks and
thrift institutions have been offering
six-month certificates of deposit at
yields far above those that savers
could previously earn under deposit
interest-rate ceilings. Following a rule
change by the major regulatory authorities, commercial banks can pay a
ceiling rate on the new certificates
that equals the average discount rate
on newly-issued six-month bills, while
thrift institutions can pay 1h-percentage point more. Once that maximum
interest rate is determined, it remains
fixed throughout the life of the certificate, regardless of what happens in
subsequent T-bill auctions.
Allowing rate ceilings to float with market rates is a new regulatory concept,
and of course is still limited in scope to
the six-month maturity category. But
prior to the recent change in the Federal Reserve's Regulation Q and the corresponding rules of other regulatory
agencies, yield ceilings on all deposits
were set at fixed levels that usually fell
below T-bill and other money-market
yields of equivalent maturity. Now, almost five months after the shift, we
can get some indication of how well
savers are faring under the new system.
Why rate ceilings?
But why impose rate ceilings in the first
place? Proponents of Reg Q ceilings - perhaps most small banks and
thrift institutions - claim that ceilings
are necessary to maintain the safety of
their institutions. Otherwise, they
claim, firms would compete too stren-
uously for loanable funds by raising
their deposit interest rates, and would
thus imperil their profit position and
even their stability. Also, thrifts maintain that the continuation of their 1hpoint differential over commercialbank deposit rates is essential to protect the flow of credit to the housing
market.
Opponents of rate ceilings - who by
now include most economists - argue
that these restrictions prevent depository institutions as a whole from competing effectively for deposits
whenever unregulated interest rates
rise above deposit-yield ceilings. Ceilings in this case tend to restrict the
flow of funds to housing, and also can
lead to a decline in the nation's supply
of money and bank credit, and in that
way aggravate or even precipitate
economic recessions.
Opponents also contend that rate
ceilings impose a "'tax'" on small or unsophisticated savers. These individuals
cannot meet the rather large minimumdenomination requirements for money-market investment, or else they
simply do not know about alternative
investment opportunities. Then, when
faced additionally with rate ceilings,
they are frequently unable to obtain interest rates close to those available on
money-market securities.
How successful are the recent regulatory changes in reducing this "'tax'" on
small savers? First, the $10,000 minimum-purchase requirement prohibits
the smallest savers from benefitting
(continued on page 2)
do not
necessarily reflect the views of the management of the
Feclerai Reserve BaJli<of Sar1
nor of tIle Boafci
ot
from the higher yields, in the same way
that it limits their purchases of T-bills.
(Actually, T-bills must be purchased in
$10,000 units, while certificate purchasers may invest any sum above
$10,000.) What about savers with the
necessary $10,000, but without the
knowledge of the possibilities inherent
in purchasing money-market securities? The answer is not immediately
obvious because of the complex tax
and other rules affecting the yields in
question. But an answer can be gained
by actually calculating maximum aftertax yields on the new six-month certificates and on six-month time deposits
available prior to the regulatory
change, and comparing them with
after-tax yields on six-month T-bills. Although not intended as an investment
guide, these calculations provide a
rough indication of the effects of the
new regulations on savers and on the
economy as a whole.
Comparingcertifk:aftes
...
Prior to the regulatory change, ,banks
were allowed to pay at most 5.50
percent on six-month time deposits,
while thrift institutions were permitted
a 5.75-percent-maximum. With daily
compounding of interest, these rates
would increase to 5.73 and 6.00
percent, respectively . To calculate the
typical after-tax income, we may take
the case of a m'arried taxpayer who
lives in California and files a joint return with taxable income of $24,000.
2
For this representative taxpayer, marginal Federal and state tax rates are 32
and 8 percent, respectively. That
means that the taxpayer retains 60
percent of his deposit interest income - or more precisely, 62.6
,percent, after adjustment for the fact
that state income ta?<esare deductible
on Federal income-tax returns. Thus,
on an after-tax basis, the six-month deposits would yield 3.59 percent at
, commercial banks (5.73 x .626) and
3.76 percent at thrift institutions (6.00
x .626).
Under the new regulations, both
types of depository institutions can pay
far higher interest rates on six-month
deposits, because rates on the new
certificates are tied to the discount
rate on six-month T-bills. At the October 6 auction, for example, the T-bill
rate was 8.42 percent. With daily compounding of interest, maximum before-tax yields on six-month certificates
were 8.91 percent for banks and .9.19
percent for thrifts during the week beginning October 12. On an after-tax
basis, these yields would convert to
5.58 percent and 5.75 percent, respectively, for our representative saver. This saver thus could earn about 2
percentage points more on the new
certificates than on the old six-month
deposits.
...and T-bills
But how do the maximum yields on the
new certificates compare with the
yields on six-month T-bills, an obvious
alternative savings outlet ? To answer
that, we must first express the T-bill discount rate in terms of a yield. (These
securities are sold on a discount basis,
which means that the investor earns
interest by buying the bill at less than its
face value.} The discount rate expresses the T-bill' s
as a percentage of its face value, based on a
360-day year; the yield expresses its
as a percentage of its purchase price, based on a 365-day year.
With the help of a rather complicated
formula, the 8.42 percent discount rate
at the October 6 auction converts to
an investment yield of 9.11 percent.
Several further adjustments are necessary to permit comparability between
T-bills and the new certificates. Interest on Treasury bills is not subject to
state (and local) income tax, so that
our representative saver would keep
68.0 percent of the interest earned on
T-bills, as compared with 62.6 percent
of the interest earned on certificates.
T-bill purchasers must also pay
brokerage fees, which generally run
around $25 per transaction, and they
can avoid these fees only if they take
the time and trouble of purchasing directly from a Federal Reserve Bank.
After adjustment for taxes and fees,
$10,000 T-bills recently would have
yielded in the range of 5.51 to 5.94
percent.
T-bills have the advantage of providing
greater liquidity than the new sixmonth certificates, which must be issued in non-negotiable form. This is an
important feature for savers who are
forced to liquidate investments before
maturity. Early withdrawal of any timedeposit funds incurs substantial interest penalties. However, the same need
3
not be true of T-bills sold prior to maturity. The price the seller obtains
might be higher or lower than the face
value of the T-bill, depending on market conditions at the time of the sale,
but a loss on the sale is only a possibility
rather than a certainty as is the case
with the certificates. It should be added, however, that a time depositor
may be able to mitigate the interest
if the bank or thrift is willing to
make a loan on the deposit in lieu of
early withdrawal, at a minimum interest rate one-percent above the deposit
rate.
Reducill1g the "tax"
In any event, yields on Treasury bills
and on the new time certificates are
now in the same
park, even
after adjusting for such things as differences in tax treatment. In contrast, before the recent regulatory change, T- .
bill purchasers generally came out far
ahead of certificate purchasers. The
new certificates thus are a step In the
direction of reducing the
imposed on small unsophisticated savers
by the traditional fixed deposit-rate
ceilings. Of course, this is only an initial
step, since the new certificates may be
purchased only in six-month maturities
and in minimum denominations of
$10,000. The interesting question is
when, or whether, this floatirg-ceiling
concept will be applied to other types
of deposits.
N
JohnP.Judd
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BANKING D ATA- TWlElFTHFlEDlERAllRlESlERVlE
DISTRICT
(Dollar amounts in millions)
Selected Assets and liabilities
large Commercial Banks
Loans(gross,adjusted)and investments*
Loans(gross,adjusted)- total
Securityloans
Commercialand industrial
Realestate
Consumerinstalment
U.s. Treasurysecurities
Other securities
Deposits(lesscash items)- total*
Demand deposits(adjusted)
U.s. Government deposits
Time deposits- total*
Statesand political subdivisions
Savingsdeposits
Other time deposits:j:
Large negotiableCD's
Weekly Averages
of Daily Figures
Amount
Outstanding
Change
from
10/4178
9127178
118,962
95,876
2,002
28,025
33,260
17,819
9,035
14,051
114,348
31,582
607
80,226
6,455
32,067
38,543
18,871
+
+
+
+
+
+
-
+
+
+
-
+
+
-
-
Changefrom
year ago
Dollar
Percent
+ 17,589
+ 16,888
- 428
+ 4,028·
+ 7,415
+ 3,995
914
+
213
+ 14,090
+ 2,646
153
+
+ 11,456
+ 1,178
154
+
+ 9,313
+ 7,295
895
986
75
204
221
145
243
152
375
1,303
435
504
7
229
267
839
Week ended
Week ended
10/4178
9127178
Member Bank Reserve Position
109
42
151
ExcessReserves(+)/Deficiency(-)
Borrowings
Net free(+ )/Net borrowed (-)
+
67
86
19
17.35
21.38
17.61
16.79
28.69
28.90
11.25
1.49
+ 14.05
9.14
+
+ 33.70
+ 16.66
+ 22.32
0.48
+
+ 31.86
+ 63.02
+
+
+
+
+
+
Comparable
year-agoperiod
+
+
90
38
52
Federal Funds-Seven large Banks
Interbank Federalfund transactions
. Net purchases(+)/Net sales(-)
Transactionswith U.s. security dealers
Net loans (+)/Net borrowings (-)
243
+
555
947
+
503
590
+
171
*Includes items not shown separately.:j:lndividuals,partnershipsand corporations.
Editorial comments may be addressed to the editor (William Burke) or to the author . ••.
Free copies of this and other Federal Reserve publications can be obtained by calling or writing the Public
Information Section, Federal Reserve Bank of San Francisco, P.o.. Box 7702, San Francisco 94120. Phone
(415) 544-i184.
@FedFRASER