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February 25, 1977
Towards Unbundling
Like other businesses, banks prosper or fail depending on the spread
between the prices they obtain for
their products and the prices they
pay for their various inputs. Yet
unlike other businesses, banks are
able to obtain one major
Tnput-namely, money-at belowmarket prices becauseof regu latory
ceilings on deposit interest rates.
(For example, the explicit rate ceiling is zero on demand deposits.)
Banks in turn are able to offer many
services at below-market prices as a
means of improving their own competitive standing.
This complicated situation has gradually begun to unravel, especially
during the past decade of inflation
and high interest rates. Economically rational corporations and households have found ways of improving the return on deposits; particularly by reducing their Jtfhza'f16n
of
demand deposits. Banks have responded to these moves by taking
steps to improve their own rates of
return.
J
The situation logically would seem
to demand a movement towards
ilunbundling"-that
is, the explicit
pricing of each bank charge and
each bank service at market prices.
The securities industry has been
going through just such a process
during the past year or so, under
pressure from the Securities and
Exchange Commission. But many
banks and thrift institutions, seeing
only one side of the equation, fear
unbundling for the impact it may
have on their own earnings, and
they forcefully remind Congress of
their preference whenever legislation is proposed to change the
situation-for example, the proposal to lift the Depression-era prohibition against payment of interest
on demand deposits.
Financial innovations
o
Major changes in financial markets,
reflecting the post-Depression,
post-World War II rise in the price
of money, have served to reduce
reliance on non interest-bearing deposits for handling monetary transactions. As far back as the early
1950's, rising interest rates led some
large corporations to begin investing spare cash in Treasury bills.
Subsequently, more and more firms
developed better systems of cash
management, and then individuals
began to emulate these business
practices by shifting idle funds into
liquid market securities or savings
deposits.
In the early 1960's, the innovational
process picked up speed as large
commercial banks began to bid
aggressively for loanable funds. In
particular, they worked hard to
attract corporations' highly
interest-sensitive funds by selling
large-denomination certificates of
deposit. Later, as interest rates
soared in the early 1970's, the financial community developed an array
(continued
on page 2)
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Opinions expressed in this newsletter do not
necessarily reflect the views of the rnanagernent of the
Federal Reserve Bank of San Francisco, nor of the Board
of Covernors of the Fecierzli Reserve System.
of new financial instrumentsand
practicesto meet the public's de,..
mand for waysto minimize hold,..
ings of noninterest-bearingassets.
Today,the public's transactionsbalancesare increasing1yheld in
interest-bearingform. NOW
accounts-negotiable orders of
withdrawal-have grown steadily in
the New Englandstates,serving
effectively aschecking accountsfor
many individuals. Under newly
granted authority, smaller businessesand state-and-Iocalgovernments hold a significant part of
their cashbalancesin the form of
commercial-banksavingsaccounts.
Many individuals utilize savingsaccounts for transactionspurposesby
making paymentsthrough thirdparty transfer arrangements,or by
telephonic transfersof funds from
savingsto demand depositsto
cover newly written checks.Others
accomplishthe samepurpose
through overdraft arrangements
with banks,or through
ing onfunds kept with mQDeymarket mutual funds. Moreover,
those uHHzingnoninterest-bearing
checking accountsfrequently receive an implicit return in the form
of free or below-cost services,such
as
checksand safedeposit_boxes.
Cost of unbundling
Againstthis background,the Federal ReserveBoard of Governors this
month releaseda major staff study,
The Impact of the Payment of Inter-
2
est on Demand Deposits, which
considersthe variousconsequences
of Congress'removing or modifying its 44-year-old ban on deposit
interest. The staff arguesthat if
banks begin to pay explicit intere,st
on such deposits,they undoubtedly
would also move to price checking
and other servicesmore nearly in
line with costs.On the plus side,
this would tend to curtail uneconomic use of certain--bankservices
and would encouragean allocation
of resourcesto usesmore highly
vaiued by the public.
However,the payment of explicit
interest would temporarily reduce
bank earnings-perhaps by as
much as5 to 20 percent of 1975 pretax earningsduring the worst year
of the
The largesttransitional impact vvould be felt if interest were paid on all demand deposits and,if thrift institutions were also
empowered to offer such deposits.
The hardest hit would be those
bankswith both relatively low earnings and a relatively large amount
of deposits newly eligible for interest, especiallyhousehold demand
deposits.Roughly 370, or 2V2percent, of all commercial banksmostly very small banks-fall into
such a category.
The impact-on depository institutions could be limited jf interest
paymentswere paid only on consumers' NOW-type accountsinsteadof on all demand deposits.
The volume of demand deposits
that could be converted to NOWs
probably amounts to about $80 billion, as opposed to the roughly $320
billion found in all checking accounts.
.Thestaff study argues that if explicit interest were paid on demand
deposits, banks and other institutions would probably raise charges
for checks and other bank services
now offered free or below cost.
This would tend to equalize ratesof
return for all depositors, provided
that they all received the same interest rate and that serviceswere
priced more in line with costs.But it
would be difficult to judge who
would gain or lose the most from
payment of explicit interest and
from a probable increasein the cost
of checks and other services.Some
small depositors who write a large
number of checks might be worse
off than they are now, unless they
economized on their check writing.
The largest gainers would appear to
be those depositors with large and
relatively inactive accounts.
interest on reserves?
In th'e Fed staff's view, cost pressures resulting from demanddeposit interest payments could be
partially.offset by the payment of
interest on member-bank reserve
balancesheld at Federal Reserve
Banks. Such interest payments
would tend to promote competitive
balance between member banks
and other depository institutions,
since the latter are now permitted
to maintain the bulk of their reservesin interest-bearing form.
3
Interest on reserve balancesalso
would provide a compensating adjustment for the lossin revenue that
nonmember institutions would
.
experience if they were required to
hold reservesagainsttransactional
balancesat the Federal Reserve.As
the central bank has argued on
earlier occasions," From a monetary policy viewpoint, it would be
desirable to require all institutions
offering transactional accounts to
hold reservesagainstsuch deposits
either in vault cash or as balancesat
the Federal Reserve,and to set such
requirement on a uniform basis."
!
Summing up, the staff study said, lilf
explicit interest were paid on demand deposits, the most significant
potential problem would lie in the
transitional adjustments of banks
and other institutions to the new
competitive environment. Adjustment difficulties could be mitigated
by payment of interest on reserve
balances; by a gradual phase-in
through regulatory actions, such as
use of alow, and perhaps gradually
rising, ceiling rate; and by a delay in
the effective date for interest on
demand deposits following enabling legislation so as to permit
banks to plan effectively for the
new competitive environment." No
one knows how Congress,the financial community and the general
public will react to this study and
the Board of Governors' forthcoming recommendations, but the
long-term movement towards unbundling seemsunmistakable.
William Burke
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BANKING D ATA-TWE L F TH fE DER AL RESERVEOBSTRUCT
SelectedAssetsand liabilities
large Commercial Banks
Amount
Outstanding
2/09/77
2/02/77
-
Loans ("5ross,adjusted) and investments*
Loam (gross, adjusted)-total
Security loans
Commercial and industrial
Real estate
Consumer instalment
U.S.Treasury securities
Other securities
Deposits (less
items)-total*
Demand deposits (adjusted)
U.S. Government deposits
Time deposits-total*
Statesand political subdivisions
Savingsdeposits
Other time deposits:j:
Large negotiable CD's
92,271
70,236
1,344
22,891
21,808
12,368
8,833
13,202
91,985
26,375
251
64,137
5,846
30,939
25,370
9,040
Weekly Averages
of Daily figures
Week ended
Member Bank ReservePosition
ExcessReserves(+)/Deficiency H
Borrowings
Net free(+)/Net borrowed H
federal Funds-Seven large Banks
Interbank Federal fund transactions
Net purchases (+)/Net sales H
with U.S. security dealers
Net loans (+)/Net borrowings H
Change
from
630
- 1,276
- 189
65
+
63
9
+ 322
+ 324
+ 254
+ 415
48
+
75
- 122
+ 102
+
93
+
31
Change from
year ago
Dollar
Percent
Week ended
2/09/77
2/02/77
+
+
+
62
2
60
+
921
+
146
+
Comparable
year-ago period
1
1
0
95
+
+ 5.11
+ 7.98
+ 67.16
- 2.15
+ 11.30
+ 15.50
- 12.44
+ 4.35.
+ 5.15
+ 10.37
- 22.53
+ 3.53
- 16.14
+ 26.48
- 8.88
- 29.61
+ 4,483
+ 5,188
+ 540
- 502
+ 2,214
+ 1,660
- 1,255
+ 550
+ 4,502
+ 2,479
73
+ 2,188
- 1,125
+ 6,477
- 2,471
- 3,802
135
+
+
53
14
39
+ 1,592
+
224
*Includes items not shown separately. :j:lndividuals, partnerships and corporations.
Editorial comments may be addressedto the editor (William Burke) or to the author. . . .
Information on this and other publications tan 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) 544-2184.
@FedFRASER