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February 10, 1984

Some Implications of Deposit Deregulation
Deposit deregulation, mandated by the
Depository Institutions Deregulation and
Monetary Control Act of 1 980 and the
Garn-St Germain Act of 1982, has resulted
in the almost complete removal of interest
rate ceilings imposed underthe Interest Rate
Adjustment Act of 1966. In December 1979,
approximately 60 percent of all time and
savings deposits were in accounts subject
to fixed rate ceilings. Now, less than 20
percent of these deposits are subject to such
ceilings. Moreover, proposals to allow the
payment of interest on demand deposits,
which have been introduced in the 98th
Congress, would virtually eliminate deposit
rate regulation for banks and thrifts. These
changes have important implications for the
way depository institutions raise funds as
well as for the way their regulators attempt to
control risk-taking. This Letterdiscusses two
aspects ofderegu lation: the growth of brokered, insured deposits and the increased
volati lity of deposit costs.
Brokered deposits
Deposit rate deregulation, combined with
an increase in deposit insurance coverage
from $40,000 to $1 00,000, has given depository institutions additional incentives
to expand their deposit draw beyond their
own geographically limited service areas.
Deposit brokerage represents one means by
which banks and thrifts can mobilize funds
from a broadening national deposit market.
The deposit btokerobtains funds from investors throughout the country and channels
them to the client depository institutions,
assigning title for the deposit (in separate
units of up to $1 00,000) to a number of
different investors. An increasing number of
banks and thrifts are finding that this is an
economical way to raise additional funds.
From an economist's perspective, it represents an efficient deposit-gathering mechanism that enables' funds to flow to uses for
wh ich the demand is greatest.

The practice of deposit brokering, however,
has been attacked by some legislators and
bank regulators for increasing the risks
insured institutions might undertake, and it
has provoked various schemes intent on
regulating it. The regulators' primary concern is that, because of deposit insurance, it
is possible for institutions in poor condition
to raise large quantitites of funds from the
national deposit market. For example, the
Chairman of the Federal Deposit Insurance
Corporation (FDIC) recently told a Congressional sub-committee that "many of the 72
commercial banks that failed between
February 1 982 and October 1983 had substantial brokered deposits. Overall,
brokered deposits constituted 16 percent of
the total deposits held by the 72 banks that
failed." In the past, the existence of deposit
rate ceilings and lower insurance coverage
(i.e., $40,000) tended to limit weak institutions' ability to tap the national deposit
market through deposit brokers. Thus, the
growth, if not the risk-taking proclivities,
of weak institutions was restricted. With
deregulation and brokered deposits, this
check on the riskier institutions has
been lost.
However, it is not the availabil ity of funds
per se, but their insured status that causes
problems. The existence of insurance on
brokered deposits enables weaker institutions to raise such deposits at a cost that is
not commensurate with the risks they are
undertaking. On the one hand, deposit
insurance lessensinvestorsl incentives to
evaluate the health of the institutions with
which they place their funds. On the other
. hand, the flat-rate deposit insurance premium structure does not require individual
institutions to pay higher rates for the higher
risks they undertake. Instead, the costs are
spread among the insuring agencies-FDI C
and FSlI C (Federal Savings and Loan Insurance Corporation) -and an other insured

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()pinions
exprL'::;sed in
newsletter do not
necessarilv reflect the views oj the managerT1Pnt
of thE' Federal Reserve Bank of San Francisco,
or of l'he Board of Covernors of the' Federal

Reserve System.
and thrift regulators. However,the direct or
brokered sale of "uninsured" deposits that
are implicitlyinsured ought to be a source of
concern as well. After all, deposit brokerage
is nota new phenomenon. Large banks have
tapped the money market for some years
both by direct and brokered placement of
negotiable large CDs. These CDs have
generally been traded in lot sizes well in
excessof the $1 00,000 deposit insurance
limit. With the notable, and probably very
special, exception of the Penn Square
failure, the holders of these uninsured
deposits have not suffered significant losses
when some of the issuers failed. In fact, it
was widely believed (at least until the Penn
Square failure) that the insuring agencies
would never payoff only the insured deposits of a failed large bank, but would, instead,
arrange a purchase that would also protect
large deposits. This view, supported by FDIC
and FSLlCpractice, has resulted in less than
full risk-pricing of large-bank CDs, leaving
the insuring agencies to share the cost of
deposits that are not fully insured by statute.

institutions in the forms of higher liquidation
expenses and lower premium rebates.
Under these circumstances, deposit brokerage may supplant the Federal Reserve's
discount window as the lender of last resort
for institutions in difficulty. Given a choice
between borrowing at the Fed, which requires that an institution put up good
collateral, and raising brokered funds,
weaker institutions may find it cheaper to
choose the latter. In effect, the federal
insurer guarantees the repayment of uncollateralized purchased funds at a rate that
does not cover the risk, while the Fed
implicitly charges a'higher rate by requiring
collateral to cover the risk.
A second concern of bank and thrift regulators is that brokered deposits may be used
to exploit the federal deposit insurance
guarantee even when the issuing institution
is in no apparent danger of default. It is
widely recognized that the current system,
which charges a uniform deposit insurance
premium, provides an Incentive for insured
institutions to engage in more risk-taking
than they otherwise would. The costs of
increased risk-taking are shared with the
federal insurer, while the rewards accrue to
the owners of the depository institution.
Deposit rate ceilings tended to constrain
depository institutions' ability to respond
to these risk-taking incentives by restricting
their ability to raise additional deposits.
However, without rate ceilings, institutions
that want to take advantage of riskier investment opportunities (such as making more
and/or risker loans) need not wait for local
deposit growth to provide the funds. They
can turn to brokers to tap the national
market. Of course, they may have to pay a
higher rate than they would for local
deposits, but they do not incur the costs
of additional branch offices and anci lIary
services to obtain these funds-and the rate
will certainly be below the rate on uninsured
deposits.

The problems with deposit brokerage
shou Id, therefore, be considered symptomatic-not of deposit deregulation, but
of a more general problem with the deposit
insurance system. The system as it is currently structured provides incentives for
greater risk-taking whether a bank uses
deposit brokers or not. Therefore, plans to
restrict insured deposit brokerage do not get
to the heart of the problem, but instead,
risk cutting off an economically efficient
mechanism. Instead of trying to restrict
deposit brokerage, it wou Id be more usefuI
and equ itable to address the thorny problem
of deposit.insurance reform.
An analogy may help make this point: When
banks began to use large computers, it was
suggested that scale economies in computing would drive small banks out of business.
This hasn't happened since a small bank
need not own a large computer to be able to
take advantage of its capabilities. Instead, a
small bank can purchase computer services

Clearly, then, the growth in insured deposit
brokerage is an important concern of bank
2

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prepared to manage this volatility. But as
was the case with deposit rate ceilings and
disintermediation, there will be problems
for undercapitalized institutions with too
many fixed rate and/or non-performing
assets.Instead of facing a liquidity crisis
caused by withdrawals, weak institutions
now will more likely face an earnings crisis
caused by a negative spread between the
yield on assetsand cost of funds. This distinction has important implications for the
way regulators monitor the condition of
banks and thrifts, particularly those that are
in danger of failing. With access to national
markets through deposit brokers, weak institutions are now less likely to encounter
liquiditv. problems and thus, may be able
to continue in operation longer than they
should.

from the owner of a large computer, who
can pool the demands of a number of banks.
Competition among such owners results in
competitively priced services. Similarly, by
pool ing the deposit offerings of a number of
banks, a deposit broker can offer smaller
banks the advantages of the large' banks'
access to national deposit markets.

Deregulation depositcosts
and
At the same time that deregu lation has
opened opportunities for deposit brokerage,
it has also changed the nature of banks' and
thrifts' costs. When deposit rate ceilings
were binding, banks and thrifts were forced
into "non-rate" competition, such as the
provision of extensive branch networks and
large staffs. As shown in the chart, bank and
thrift offices per capita increased throughout
the 1970s along with bank and thrift employees per capita. Now that the cei I ings are
gone, we are seeing an expected reversal of
the trend toward more branches and more
employees. A number of banks have announced branch closings and employee
reductions, as is clear in the chart as well.

Ironically, deposit deregulation may make
the regulators' task of enforcing capital
adequacy standards easier. The elimination
of deposit rate ceilings undermines the
argument that deposits are a cheaper source
of funds than capital and other non-deposit
liabilities. When deposit rate ceilings were
binding, deposit costs seemed, and perhaps
were, lowerthan that of other liabilities, at
least on the margin.

In the long-run, the elimination of rate ceilings will mean that depositors will receive
larger interest payments and lower payments in the form of free or underpriced
services, and depository institutions will
have to manage new marketing trade-offs
among interest payments, services, and
service fees. One of the tricky problems for
existing banks is that they must do this in
competition with new entrants that are not
weighed down with personnel and facilities
more suitable to the period of deposit rate
ceilings.

Now, however, any difference in the cost of
deposits and substitute liabilities is not an
economic cost to the issuer, but a reflection
of differences in riskiness. For example, liabilities that are subordinated to deposits
shou Id bear a higher cost because they are
riskier, just as equity's greater riskiness
carries a higher return than debt. Thus, if
deposits are truly bargains without deposit
ceilings, it is because some bank markets are
not fully competitive or because deposit
insurance premiums are insufficient, on .
the margin, to cover the insurer's deposit
guarantee liability. Regulatory policies
regarding capital adequacy standards
should not allow depository institutions to
take advantage of these sources of deposit
"cheapness;"
David Pyle

Deregulation also means that deposit costs
will become more volatile. This is the mirror
image of the volati lity in deposit quantity"disintermediation" -that occurred when
fixed rate ceilings prevented depository
institutions from paying rates comparable
to those available from non_depository institutions. More volatilitv in bank costs is not
a bad thing if depQsitory institutions are
3

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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT

Real estate
loans to Individuals
Leases
U.s. Treasury and Agency Securities2
Other Securities 2

Total Deposits
Demand Deposits
3
Oemand'Oeposits justed
Ad
4
Other Transaction
Balances

Total Non-TransactionBalances

Amount
Outstanding
1/25/84

173,881
153,598
45,069
58,897
26,650
5,039
12,139
8,144
181,947
40,852
28,138
11,700
129,395

Change

Change from
year ago

from
1/18/84

Dollar
1,018
2,342
389
865
2,073
248
682

-

471
307
55
7
54
11
- 135
29
-2,550
-2,337
-1,177
- 369
156

NA
4,249
2,520

Percent

-

0.6
1.5
0.8
1.4
8.4
4.7

6.0

NA
2.4
6.5

NA
NA
NA

NA
NA
NA

NA

NA

Money Market Deposit

Accounts-Total
Time Deposits in Amounts of
$100,000or more

Other liabilities for Borrowed
MoneyS
WeeklyAverages
of Daily
Reserve
Position,All Reporting
Banks
'Excess
Reserves l/Deficiency(..;.)
(+
Borrowings
Netfree reserves+ J/Netborrowed(
(
-)

39,688
38,456
19,133
Weekended
1/25/84

75
10
65

52

141
- 9,716 - 20.2
-1,782
- 5,699 - 23.0
Comparable
Weekended
year-ago
period
1/18184
266
22
244

393

°

393

Includeslossreserves,
unearned
income,excludes
interbankloans
Excludes
tradingaccount
securities
3 Excludes
U.s. government depository
and
institutiondeposits cashitems
and
4 ATS,
NOW,SuperNOW andsavings
accounts
with telephone
transfers
5 Includesborrowingvia FRB, T&l notes,
T
FedFunds, andothersources
RPs
6 Includesitemsnot shownseparately
,
Editorialcomments
maybeaddressed theeditor(GregoryTong) to theauthor•..• Free
to
or
copies
of
FederalReserve
publicationscan obtainedfrom the PublicInformationSection,
be
Federal
Reserve
Bankof San
San'
Francisco
94120.PhQne
(415)
1

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(Dollar amountsin millions)

loans, leasesand Investments1
2
loans and leases 5
1
Commercial Industrial
and

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SelectedAssets
and liabilities
large Commercial Ban"s

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