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December 9 _ 1983

Deregulation and Withdrawal Penalties
Deposit deregulation often is thought of as
synonymous with removing interest-rate
ceilings. While deposit interest-rate ceilings
certainly have attracted most of the attention, many other aspects of deposit account
contracts also have been affected by deregulation. One of these is the early withdrawal
penalty. Following the removal of rate ceilings and the reduction in the regulatory
minimum withdrawal penalties on October
1, 1983, some institutions established their
own more stringent withdrawal provisions,
when, before deregulation, they moreor-less routinely adopted the minimum
penalties specified by regulations as
maximum penalties.

establishing withdrawal penalties, regulatory minimums may never have been
needed since depository institutions could
be expected to set their own penalties or
make other arrangements to be compensated for allowing premature withdrawals.

To provide some perspective on the changes
in withdrawal penalties, we will examine
the role early withdrawal penalties have
played in deposit regulation and how the
easing of the regulatory minimums fits into
the overall scheme of deposit deregulation.
We also will review the recent changes in
the regulatory minimums and illustrate why
the new minimum penalties do much less
than the old ones to discourage withdrawals
from time deposits during periods of rapidly
rising interest rates. Finally, we will look at
what commercial banks and thrift institutions are doing with regard to early withdrawal penalties.

Minimum early withdrawal penalties,
however, had another function that made
them an important adjunct to interest-rate
ceilings on deposits. For many years smalldenomination deposits (less than $100,000)
were subject to fixed interest rate ceilings.
These ceilings were structured so that
maximum rates payable were lower on
short-term accounts than on longer-term
accounts. In this context, early withdrawal
penalties were needed to enforce the rateceiling differentials on the various time
and savings accounts. For example, in the
absence of regulatory minimum penalties,
an institution would have been able to circumvent the lower cei I ing On passbook
savings accounts by issuing a higher-ceiling
long-term time deposit that allowed immediate access to the funds without penalty.
In the late 1970s and early 1980s, as fixed
ceilings on some time deposits were replaced by indexed ceil ings Orwere removed
completely, early withdrawal penalties also
were required to prevent de facto deregulation of all time and savings deposits.

Role of minimum penalties
Minimum early withdrawal penalties have
been an integral part of deposit regulation .
. One of the arguments usually raised in support of setting regulatory minimum penalties
is that they are necessary to protect depository institutions from liquidity and earnings
pressures stemming from withdrawals of
time deposits when interest rates increase
substantially. Such protection often has
been thought to be particularly important for
thrift institutions and some smaller commercial banks that tend to invest in longer-term
assets. But, if this were the only basis for

For the most part, minimum early withdrawal penalties appear to have been, or
at least were perceived to have been, sufficiently harsh to discourage massive early
withdrawals by depositors merely to take
advantage of sharp rises in interest rates.
Data available on penalty income associated with premature withdrawals suggest
that, while early withdrawals responded to
increases in interest rates, the volume of
withdrawals in the aggregate never represented a large fraction of total smalldenomination time deposits. Minimum
early withdrawal penalties also may have

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minimum penalties apply only to time
deposits issued on or after October 1, 1983.
For time deposits with maturities of 7 to 32
days, the regulations concerning early withdrawal were not changed.

been successful to a certain extent in enforcing the interest-rate ceiling differentials.
However, evaluating the impact of withdrawal penalties in this regard is difficult
because incentives to circumvent ceilings
were dampened by regulatory changes that
permitted depository institutions to pay
"market rates" on short-term deposits.

The effects of lowering the minimum earlywithdrawal penalties are illustrated in the
charts. They show "break-even" yields for
time deposits with original nominal yields of
1 0 percent under the new and old penalty
rules. A "break-even" yield represents the
annualized nominal interest rate necessary
on an alternative instrument with a maturity
equal to that remaining on the deposit withdrawn to compensate the depositor for the
penalty incurred. These figures do not take
into account that the tax-laws allow the
penalties to be deducted from taxable
income. This tax advantage would reduce
the break-even yields under both sets of
withdrawal penalties in relation to an
individual's marginal tax rate.

However well regulatory minimum withdrawal penalties performed in the past, they
are not likely to be particularly useful in the
future. On October 1, 1983, the deregulation of interest rates on deposits neared
completion when the Depository Institutions Deregulation Committee lifted rate
ceilings on time deposits with maturities of
32 days to 2% years. The only remaining
"rateceilings for non-transaction accounts
are those on passbook savings and time
deposits in denominations of less than
$2,500 and with maturities of 7 to 32 days.
Obviously, once these ceilings are gone,
regulatory early withdrawal penalties will
not be needed to enforce the ceiling-rate
structure.

The charts show that the new minimum
penalties do much less to deter early withdrawals than did the old ones. As can be
seen in Panel A, for al O percent, 11-month
time deposit that already has been held for 3
months, the interest rate on a time deposit
account (or other interest-bearing instrument with the appropriate 8-month maturity) would have to be only about 11.2 percent, or 1.2 percentage points higher, for a
depositor to be compensated forterminating
the existing account and establishing a new
one under the current minimum penalty.
Given the same set of circumstances, the
minimum withdrawal penalty effective
before October 1 would have required the
interest rate differential on the new and old
deposit accounts to have been three times
larger, or 3.7 percentage points higher,
before a depositor could have taken advantage of the higher yields.

In addition, since the move to deregulate
deposits reflects in part the desire of the
Congress to reduce government involvement in private markets, it would be inconsistent to continue to regulate early withdrawal penalties as a means of "protecting"
depository institutions. Finally, as will be
shown below, the regulatory minimum early
withdrawal penalties may have been reduced to the point where they already have
little practical importance in the current
deregulated environment.

New minimumpenalties
Effective October 1 ,1 983, the minimum
regulatory early-withdrawal penalty on
deposits with maturities of 32 days to 1 year
was reduced to the loss of 1 month of simple
interest from the previous 3 months of
simple interest. The penalty for time deposits
with maturities of 1 year or more was lowered from the loss of 6 months of simple
interest to the loss of 3 months. The new

For the longer-term deposit (3 %-year
account) shown in Panel B, the differences
in the break-even yields under the old and
new rules are particularly noticeable as an
2

BREAK·EVENYIELDS FOR DEPOSITACCOUNTS
WITH NOMINAL RATESOF 10 PERCENT
A. OrIgInal maturtly: 11 months

Sroak·evan
yield
(parcenl)

S",ak.aven
yield
(percent}

8. Original maturity: 3\1, years

35

30
30

Old regulatory
withdrawal panalty

2'

,.

25

20

i

20

15

13.7%
1t2%

-----------0

Old reguletory
withdrawal penaltx.

1

2

3

New regulatory
wllhdrawal penalty

/1

15

-----_##-,,">-

10.9% 11.9%
__________ ...

,,_ .......Naw regulatory
wlthdr/lwal panalty

10
0

4

5 6 7 8 9 1 0
Monthsheld
"Lut obsal'lellon lor a depoeltaccounthaldlos 9 months
Is

6 1 2 1 8 2 4
30
36
Monthsheld
"Lul obsal'lallonla lor a deposItaccount
hatdlor 40 months

account approaches maturity. Under the
new rules, rates would not have to rise by
very much for early withdrawals to be profitable even for long-term deposits that have
been held for some time. For example, applying the current minimum penalty, even a
year after opening a 3V,-year account, a
depositor could earn a higher return by
investing the funds in a new account if rates
were to increase by a little more than one
percentage point. Such an increase is small
compared to the movements in interest rates
over the past few years.

With other withdrawal penalties which do
not vary with interest rates, commercial
banks and thrift institutions continue to bear
some of the risk of a rise in interest rates.
However, depository institutions still could
be compensated for providing withdrawal
options and bearing risk il depositors were
willing to accept a lower explicit interest
rate. The rate concession required by an
institution would depend in part on the
stringency of the withdrawal penalty and
expectations concerning the volatility and
the direction of changes in interest rates.

Reactionof institutions

Conclusion

The combination of reducing regulatory
early withdrawal penalties and lifting interest rate ceilings has given depository institutions greater flexibility in setting their own
provisions on withdrawals. Among institutions in the West, many apparently have
incorporated the new regulatory minimum
penalties in their deposit account agreements, but a number of institutions have
selected more stringent measures. Among
the institutions adopting more forceful
stances, some have set the penalties equal
to the regulatory minimum in effect before
October 1, 1983. Other depository institutions have established withdrawal penalties
that are between the new and the old regu latory minimums. At least one institution has
instituted withdrawal penalties that virtually
wipe out any gains related to a rise in interest
rates when funds are withdrawn from a time
deposit prior to maturity. It accomplishes
this by applying the greater of either the
regulatory minimum penalty or a penalty
based on the diffe'rence between the interest
rates on the deposits to be withdrawn and
the interest being paid on new deposits, the
amount withdrawn, and the time remaining
to maturity on the deposits withdrawn.

Regulatory minimums on early withdrawal
penalties were logical companions to
interest-rate ceilings on deposits. As deposit
rate cei Iings were removed, relaxing
minimum penalties was equally logical.
Although further reduction and the eventual
elimination of regulatory minimum penalties can be expected, they already may
have shrunk to the point where they are no
longer binding.
The fading importance of regulations on
withdrawal penalties does not mean the
disappearance of such penalties, however.
Commercial banks and thrifts have an
incentive to provide compensation to themselves for offering withdrawa.1 options. With
policies decided on an individual basis,
withdrawal penalties are not likely to be
as uniform as they have been in the past.
As deposit deregulation approaches completion, depositors may find that there are
tradeoffs between the interest rates offered
on deposits and the stringency 01early withdrawal penalties.

Frederick T. Furlong
and Gary C. Zimmerman

Under the last arrangement, depositors have
access to funds held in time accounts when
interest rates rise, but they must incur an
explicit penalty equal to the value of the
withdrawal option, much like the discount
on a bond traded in the secondary market.
3

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BANKING DATA..,-TWELFTH
FEDERAL
RESERVE
DISTRICT
( Dollar amounts in millions)

SelectedAssets Liabilities
and
Large Commercial Banks

Loans'(gross,
adjusted) investments'"
and
loans (gross,adjusted)- total#
Commercialand industrial
Realestate
loans to individuals
Securities loans

U.S.Treasury
securities*
Other securities·
Demanddeposits total#
Demanddeposits- adjusted
Savingsdeposits - totalt
Time deposits - total#
Individuals,part.& corp.
(large negotiable
CD's)

WeeklyAverages
of Daily Figures
Member BankReserve
Position
Excess
Reserves )/Defidency (-)
(+
Borrowings
Net freereserves l/Net borrowed{
(+
-)

Amount

Outstanding
11/23/83
163,112
142,976
43,588
57,500
25,096
2,830
7,701
12,434
41,550
28,300
66,032
70,290
64,596
17A84

Change from

Change·
from '

11/16/83
135
- 114
44
8
83
30
9
- 30
-1,919
-1,480
43
869
749
525

year ago

Dollar

Percent

851
1,197
- 1,399
250
1,538
401
1,111
1,457
847
684
33,646
- 28,853
- 24,448
- 17,860

0.5
0.8
3.1
0.4
6.5
16.5
16.9
10.5
2.1
2.5
103.9
29.1
27.5
50.5

Weekended

Weekended

11/23/83

11/16/83

38
5
33

135
13
122

-

-

Comparable
year-ago
period
118

o

118

* Excludes
tradingaccount
securities.
# lnc;!udes
itemsnot shownseparately.
t IncludesMoneyMarketDepositAccounts;
Super-NOW
accounts, NOWaccounts.
and
Editorialcomments
maybeaddressed theeditor (GregoryTong) to theauthor.... Free
to
Or
copies
of
this and other Federal
Reserve
publicationscanbe obtainedby callingor writing the PublicInformation Section,Federal
Reserve
Bankof SanFrancisco, Box7702,SanFrancisco
P.O.
94120.Phone
(415)
974·2246.

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