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July 1, 1977 N O W at the Fed Federal Reserve Chairman Arthur Burns told the Senate Banking Committee last week that the Federal Reserve supported an Administration bili that wouid permit depository institutions nationwide to pay interest on consumer checking;. type accounts (N OW accounts) and to receive interest on their required reserve balances. He said that the proposed legislation would help solve two problems: "First, the distortions caused by the rather haphazard spread of the payment of interest by depository institutions on transactions balances; and second, the withdrawal of banks from Federal Reserve membership because of a growing sensitivity to the financial costs of membership." C(),lI11lterrni§ of package The draft bill authorizes N OW accounts (negotiable orders of withdrawal) for all insured commercial banks, mutual savings banks, savings and loan associations, and credit unions. (The latter could sue both NOWs and share-draft accounts, or SDAs.) These interestbearing checking accounts would be limited to the use of individuals. The ceiling rate payable on NOWs or SO would be set (for a threeAs year period) by an inter-agency committee at a uniform figure below the bank savings-deposit ceiling rate, currently 5 percent. In another major innovation, the legislation would impose uniform reserve requirements on N OWs and SDAs for all depository institutions. The Federal Reserve Board of Governors would set these requirements, within specified limits ranging from 3 to 12 percent of deposits. The reserve requirements against NOWs and SDAs would be phased in over a three-year period for those institutions offering NOVVsand SDAs which do not now belong to the Fed. The reserves could be held directiy with the federal Reserve, or indirectly with other regulatory institutions for redeposit with the fed. The other major feature of the bill involves the authorization of payment of interest on reserve balances, at rates determined by the federal Reserve Board. However, the aggregate interest paid in any year could not exceed 10 percent of Reserve Banks' net earnings for the previous year, before payment of interest on reserve balances. N OW eX!p@!1l§HOrfl The proposal for interest-bearing checking accounts regulari'zes it financial trend that has been developing for some time. In Burns' words, uThe prohibition on the payment of interest on demand deposits enacted in the 1930's did not actually end such payments; rather it changed their form." Commercial banks have provided individuals with an implicit return on demand accounts in the form of (continued on page 2) ---'.----free or below-cost services, equivalent to about a 5-percent rate of return on demand deposits. Of course, banks have also provided an implicit return for corporations and governmental units, However; the latter, through their financial sophistication, have long since developed the ability to minimize the balances on which they receive an implicit return-and thus have obtained an e)(plicit return on a large part of their transactions balances through the investment of surplus funds in money-market instruments. Consumers and small businesses have only recently begun to develop this ability, but they too are now receiving explicit returns on transactions balances, because of all the recent innovations which directly authorize interest payments or at least facilitate shifts between savings and demand accounts. But to take advantage of such opportunities, consumers have to live in !'Jew England or certain other special locations, or belong to certain credit unions, or at least have the financial sophistication to handle alternative payments opportunities. The whole process thus has been somewhat haphazard and piecemeal. How much would consumers benefit from the nationwide adoption of !'JOWs?The !'Jew England evidence suggeststhat the combination of implicit and e)(plicit payments initially would be much larger than the implicit return consumers now earn on thei r demand deposits. Eventually, the nation's depository institutions probably would impose service charges in an effort to re2 - - - - cover at ieast part of the costs of offering NOW accounts-and meanwhile they would be under pressure to improve their productivity in order to limit such costs. But over time, consumers might well obtain a higher overall rate of return than they now do, because of the intensified competition for business by depository institutions, and also because of their own growing ability to economize on the use of checks. What would be the cost of NOWs to financial institutions themselves? Federal Reservestudies indicate that, in the competitive situation likely to arise in the early stages of the new regime, commercial bank pre-ta)( earnings in the worst transition year cou Id average 5 to 6 percent below the levels otherwise prevailing. But to minimize transition costs, the new legislation limits eligibility for NOVVs and SDAs to individuals; altogether, the volume of demand deposits convertible to such accou nts probably amounts to $80 billion or so, compared to the roughly $320 billion found in all checking accounts. The legislation would minimize transition costs in other ways too-by requiring the ma)(imum interest rate payable on NOWs be set initially below the bank savings-rate ceiling, by establishing a range of reserve requirements below that of demand deposits, and by delaying enforcement of the act until one year after enactment. Membe!l'shap dedine Minimizing the costs of NOWs is especially important for Federal Reserve member banks, many of which have begun to leave the Systemto avoid the financiai burden of membership. Withdrawals mainly reflect the high cost of noninterest earning reserves that member banks (unlike nonmembers) are required to hold. Over the past eight years, 520 banks have left the System,some because of mergers but most because of outright withdrawals. The remaining members are generally the larger banks, so that members as a group account for 73 percent of total commercialbank deposits. (Still, their share was 88 percent a quarter-century ago.) There is little reason for optimism in today's environment, because withdrawals have been especially heavy in the area offering NOW accounts (New England), with competitive pressuresforcing large as well as small banks out of the System at a rapid pace. The Fed thus argues for the necessity of combining actions to limit the burden of Fed membership with the extension of accounts. Why should the fed worry about declining membership? first, a declining proportion of bank deposits at member banks tends to loosen the links between bank reserves and the money supply. This reduces the precision of the central bank's monetary control, especially in view of the wide variations in the relative growth rates of member and nonmember demand deposits. Besides,any attempt the fed might make to raise reserve requirements as a policy measure could worsen the competitive disadvantage of member banks and prompt further erosion of membership. (That fact helps explain why the Fed is anxious to see reserve requirements imposed on NOWs at all depository 3 institutions.) Again, banks withdrawing from the System lose their direct accessto the Fed's discount window, and this could cause a structural weakening of the nation's banking system. The loss of Fed members could be slowed through the adoption of uniform reserve requirements for all banks, but Congress has consistently rejected that suggestion, despite the recommendations of many official study commissions over the years. Still, the payment of interest on required reserve balances could be a useful step in the right direction. That proposal has met with some resistance in Congress, because the Fed returns virtually all its net revenues to the Treasury, and any reduction in Fed revenues thus means a reduction in Treasury revenues. However, the Treasury might recoup about 55 percent of the amounts paid because of the higher income taxes that would be paid by banks and bank stockholders. In the Fed's view, the proposed 10percent-of-earnings limitation on interest payouts might not be sufficient to stem the membership decline. Given the present level of earnings, that Iimitatfon might yield commercial banks no more than $600 million a year. Yet Fed studies indicate that $500 million alone might be needed to offset the present costs of membership, so that little would be left over to alleviate the banks' costs of introducing NOW accounts-or to offset any costs they would incur if the Fed began to charge for its services. VVmiarn iBlUlII'!,e U Ol8u!4SB M. 4Bln • uo8aJO • BpBAaN .o4BPI !!eMeH • e!UJOWEJ EUOZ!JV 0 j)@ ·me::> lo;)spue.l:lues (;S.£ ·ON llWlI: Jd (U Vd G ·s·n 11\1 SSV1::> W lSlIH BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Seleded Assetsand Liabilities Large Commercial Banks Amount Outstanding 6/15/77 + loans (gross,adjusted) and investments* loans (gross,adjusted)-total Security loans Commercial and industrial Real estate Consumer instalment U.S.Treasury securities 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 negotiableXD's ... 98,717 75,178 2,266 23,684 23,373 13,175 10,034 13,505 97,502 28,070 985 66,926 5,590 31,600 27,585 10,836 Weekly Averages of Daily Figures Week ended 6/15/77 Member Bank ReservePosition Excess Reserves(+)/Deficiency (-) Borrowings Net free(+)/Net borrowed (.::.) Federal Funds-Seven Large Banks Interbank Federal fund transactions Net purchases(+)/Net sales (-) Transactionswith U.S. security dealers Net loans (+)/Net borrowings (-) Change from year ago Dollar Percent Change from 6/8/77 - + + + + + + + + - + + 236 517 932 122 188 90 444 309 1,191 590 782 79 96 172 143 321 + + + + + + + + + + - + - + + - + 11.15 + 12.05 + 46.95 + 7.32 + 15.77 + 18.35 + 6.00 + 10.17 + 9.20 + 13.77 - 4.28 + 8.02 11.51 + 21.80 + 0.69 - 10.44 9,900 8,085 724 1,615 3,183 2,043 568 1,247 8,212 3,397 44 4,967 727 5,656 188 '1,263 Week ended 6/8/77 - Comparable year-ago period 5 5 10 + 76 + 76 496 + 707 + + 689 + 562 *Includes items not shown separately.:j:lndividuals, partnerships and corporations. 401 52 32 84 + 733 + ° Editorial comments may be addressedto the editor (William Burke) or to the •••• Information on this and other publications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco,P.O. Box 7702, San Francisco94120. Phone (415)544-2184. E>JStqV
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