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THE COMPETITION FOR TRANSACTION ACCOUNTS Walter A. Varvel and John The 1980 enactment of legislation extending authority to offer interest-bearing checking instruments to all depository institutions has brought intensified competition for consumers’ transaction balances. The rise in market interest rates over the last decade, moreover, has induced nonbank financial institutions to compete aggressively for transaction deposits once the sole domain of commercial banks. Banks have had to face the possibility that they can no longer rely on noninterest-bearing deposits as a major source of funds. Through the first threequarters of 1981, for example, U.S. commercial banks experienced a reduction of nearly $50 billion These dein traditional demand deposit accounts. velopments, which adversely affect bank costs and profitability, have forced depository institutions to devote increased attention to strategies for attracting deposits. After a brief historical review of government restrictions on interest payments on deposits and their effects on commercial bank behavior, this article describes current competitive strategies and deposit experiences of banks and thrift institutions. Special attention is devoted to the deposit pricing decision, the impact of interest-bearing checking accounts on the marginal cost of funds, and implications for competition among depository institutions. Deposit Interest Restrictions: Cause and Effect The Banking Act of 1933, passed in the midst of the nation’s most serious financial crisis, was intended to restore confidence and financial stability to the banking industry. In addition to establishing deposit insurance for participating banks, the legislation included provisions restricting the payment of interest on bank deposits-a practice that was widely blamed for the industry’s problems., In an effort to end what was termed “destructive” interest rate competition, interest on demand deposits was totally prohibited and the Federal Reserve System was given authority to set maximum rates payable on time and 2 ECONOMIC REVIEW, R. Walter savings deposits for its member banks. The Banking Act of 1935 subjected nonmember banks to similar legislation under the authority of the Federal Deposit Insurance Corporation.1 The practice of paying interest on demand deposits can be traced far back in U. S. financial history. Concern over the possibly harmful effects of such payments first arose around the middle of the nineteenth century. The original concern was not with interest on personal demand deposits so much as the large New York banks’ practice of paying interest on balances held with them by other banks throughout the country. These interbank balances were maintained as payment for correspondent banking services but also served as liquid earning reserves of smaller banks. As a consequence of these interbank ties, it was commonly believed that the health of the nation’s banking system was too dependent on the New York banks. A series of financial panics occurred over the latter half of the 1800s and early 1900s. These crises took place when many country banks drew down their demand balances with New York banks while tight credit conditions hampered the liquidation of call Since country banks deposited liquid funds loans. with the largest banks to earn interest, many believed the elimination of interest payments on such accounts to be an obvious solution to the frequent crises. After the establishment of the, Federal Reserve System in 1913, member banks could borrow at the Federal Reserve’s discount window to relieve shortterm liquidity pressures. Once the discount window was available, banks utilized it with increasing frequency.2 Meanwhile, rural banks continued to hold 1 The interest prohibition on demand deposits is still in effect. The authority to set interest ceilings on time and savings deposits, under provisions of the Depository Institutions Deregulation and Monetary Control Act of 1980, has been transferred to the Depository Institutions Deregulation Committee and is to be totally phased out by 1986. 2 The percentage of member banks using grew from 25 percent in 1915 to 76 percent p. 38] MARCH/APRIL 1982 the window in 1921. [4, interest-earning interbank deposits with city correspondents. The willingness and ability of members to borrow from the Federal Reserve weakened the “financial crises” argument for restricting interest payments on deposits. However, bankers and regulators continued to believe that there was a relationship between the payment of interest on demand deposits and unsound banking practices contributing to bank failures. The “unsound banking” argument for restricting the payment of interest on deposits was based on the belief that banks were forced to increase the riskiness of their investments in order to pay interest on deposits. This argument, together with the occurrence of mass bank failures in the 1930s, led to the enactment of interest controls on deposits. The argument has since been utilized to support the continuation of deposit interest controls in spite of mounting evidence that it is an inaccurate description of bank behavior and, moreover, that deposit interest controls have had harmful effects on individual sectors of the economy. George Benston, for example, tested the validity of the unsound banking argument and its implications for bank behavior. His results indicate that banks act to maximize profits by equalizing the marginal interest cost of a dollar of deposits with the marginal earnings from a dollar of deposits. He rejects the argument that banks are forced to increase the riskiness of investments in order to pay a market rate on deposits. Benston concludes that “the interest rate on deposits offered by a bank is a function of the investment possibilities (and their associated risks) available to the banker, rather than the reverse.” Interest restrictions had little if any impact on banks until after World War II. Until then, market interest rates were so low that banks could pay an implicit competitive return on deposits by providing banking services below cost. Moreover, following the bank failures of the 1930s, banks reduced their holdings of interbank balances and held large amounts of liquid cash reserves. In the 1950s, as market rates of interest rose, development of the Federal funds market as both a source of funds and an investment outlet for excess reserves provided a way for banks to bypass the prohibition of interest on interbank balances. In recent decades, as market rates fluctuated, banks slowly adjusted their implicit payments to customers by providing new financial services, additional conveniences (e.g., branch locations, drive-up windows, extra tellers, etc.), and even lower rates on loans to FEDERAL RESERVE their best customers. These devices have been, in the words of Friedman, a “highly effective though not perfect substitute for the explicit payment of interest Banks, however, have been on demand deposits.“3 either unable or unwilling to raise these implicit interest payments as much or as quickly as market Perhaps this is because many derates have risen. positor services are already offered “free” and it takes considerable time and expense to offer additional services and facilities. As market rates eventually rose above the implicit payments on demand accounts and interest ceilings on time and savings deposits, the opportunity cost of holding balances in these accounts increased. In an organized effort by firms-often in response, cooperation with their banks-developed to speed the collection of payments and minimize the level of funds held in accounts yielding interest in implicit forms. The increased opportunity cost of holding idle cash balances and the improvement in cash management techniques resulted in reduced demands for noninterest-bearing bank deposits. Corporate treasurers moved increasingly into liquid money market instruments bearing market interest rates. Large money center banks especially felt the loss of corporate demand deposits since they relied more heavily on this In response, source of funds than smaller banks. these banks utilized a series of new liability instruments paying market rates to retain corporate funds throughout the 1960s and 1970s (e.g., negotiable certificates of deposit, repurchase agreements, and Eurodollar deposits). Deposit alternatives for smaller customers developed more slowly. The authorization of telephone transfers in the 1960s and pre-authorized transfer accounts in the 1970s increased the liquidity of interest-bearing savings accounts at banks and thrifts to some extent. Interest-bearing transaction account substitutes for customers developed further following the introduction of Negotiable Order of Withdrawal (NOW) accounts in Massachusetts in 1972 and credit union share drafts and money market funds 3 [10, p. 24] An extensive literature has developed testing the effectiveness of deposit interest controls. Klein , for example, found that the postwar demand for money experience suggests that the interest prohibition was ineffective. Startz  concludes that banks implicitly pay approximately 50 percent of the explicit interest that would be paid in the absence. of the interest prohibition. Rush , using recent New England data, argues that Startz’s estimates of the implicit interest paid by banks is biased downwards and cites evidence supporting the “competitive rate hypothesis”-i.e., that banks (implicitly) pay competitive rates of interest. BANK OF RICHMOND 3 (with limited check-writing privileges) in 1974. The NOW experiment was subsequently extended to other northeastern states. In late 1978, commercial banks nationwide received regulatory permission to pay interest on savings accounts that could be used for making third party payments. These automatic transfer savings (ATS) accounts, as well as NOWs and share drafts are direct substitutes for demand deposits.. These deposit instruments, however, remain subject to deposit interest ceilings. The recent development of the retail repurchase agreement has facilitated the payment of market-level interest rates on portions of consumers’ liquid balances and enhanced the ability of depository institutions to retain these funds. New England NOW Competition The introduction of NOWs by savings banks in Massachusetts in 1972, followed shortly by thrifts in New Hampshire, made it possible for these institutions to pay explicit interest on what, in effect, are checking accounts. Commercial banks, on the other hand, were not initially allowed to offer interestbearing transaction accounts in these states. The commercial banks, as a result, were threatened with large losses of consumer deposits. Relief was provided in August of 1973, however, when Congress authorized all commercial and savings banks, S&Ls, and cooperative banks in New Hampshire and Massachusetts to offer NOWs. The New England evidence indicates that explicit interest payments were frequently accompanied by the pricing of transaction services that were previously provided free.4 The early pricing strategies used for these accounts were varied. Massachusetts savings banks, for example, initially paid 5¼ percent interest on NOWs with a 15 cent fee typically imposed on each draft written. New Hampshire thrifts, on the other hand, began paying 4 percent interest and charging no service fees on NOW accounts to customers. Many commercial banks also initially offered NOW accounts without fees. During 1974, however, commercial banks began imposing minimum balance requirements with associated penalty fees to discourage low balance demand deposit customers from shifting into NOW accounts. Thrifts meanwhile, typically moved in the opposite direction by offering free NOWs. As a result, average bal- 4 This section [12,13] 4 draws heavily upon the work of Kimball. ECONOMIC REVIEW, ances in NOW accounts at commercial banks were considerably larger than those at thrifts. The average balance in Massachusetts commercial banks in 1976 was $2,149, for example, compared to $826 at S&Ls, and $901 at savings banks. In March 1976, Congress permitted all depository institutions in New England to market NOWs. These accounts quickly received widespread acceptance by consumers. In Massachusetts, for example, three-quarters of the households owned NOW accounts by 1977. In 1978 and 1979, respectively, New York and New Jersey were added to the list of states where NOWs were legal. The spread of NOW accounts in New England was not uniform across states. One study used the number of NOW accounts per 100 households to It found the compare NOW growth experiences. proportion of households owning NOW accounts to be positively correlated both with the proportion of financial institutions in each state offering NOWs and with the proportion of financial institutions which offer them free, and negatively related to the average minimum balance requirement. How extensively NOW accounts spread, therefore, depends importantly upon both the pricing and availability of the For example, in Massachusetts and New accounts. Hampshire minimum balance requirements were low, a high percentage of institutions provided free NOWs, and a high proportion of institutions offered Consequently, a large percentage of the accounts. households shifted to NOWs. By contrast, fewer institutions in Maine and Vermont offered NOWs and only a small percentage were free of service As a result, fewer households acquired charges. NOWs in these states. Bank and thrift market shares depended upon the same factors that influenced the overall growth of NOWs within states, i.e., the availability of NOW accounts and pricing factors. In Massachusetts, for example, the number of banks initially offering NOWs was lower relative to thrifts than in other states. As a result, the commercial bank market share of NOW accounts was below that in other states. Also, thrifts realized larger NOW shares in states where the disparity between bank and thrift pricing was the greatest. Since NOW accounts are direct substitutes for checking accounts, demand for regular checking accounts fell when NOWs became available. The data from New England indeed show that total outstanding personal checking accounts fell while NOW balances grew an average of 8 percent per month for MARCH/APRIL 1982 the two years following the introduction of NOW accounts.5 It is difficult, however, to estimate what percentage of the-growth in NOWs came from demand deposits and what percentage was derived from Previous research suggested that other sources. between 60 and 80 percent of NOW funds were moved from regular demand deposit accounts, with the rest coming from time and savings accounts and from other sources. The success of the experience with NOWs in the northeastern United States combined with high market interest rates to increase political support for extending NOW accounts to the rest of the country. The Depository Institutions Deregulation and Monetary Control Act of 1980 authorized NOW accounts for banks and thrifts nationwide effective December 31, 1980. At the same time, ATS accounts for all depository institutions and share drafts at credit unions were authorized. Experience through the first three quarters of 1981 shows rapid growth in NOW balances both nationwide and in the Fifth Federal Reserve District. Nationwide NOW Experience Table 1 shows that NOW deposits at banks and thrifts and credit union share drafts totalled $12.3 billion nationally on December 31, 1980. Since that date, NOWs have experienced explosive growthexpanding over five-fold to $54 billion by the last week in September 1981. Seventy-eight percent of this increase occurred in the first three months of the year. While growth tapered off considerably in the second and third quarters, NOWs still grew at a relatively strong 42 percent annual rate over the period. Surveys of depository institutions conducted early in 1981 indicated that most commercial banks and savings and loan associations offer NOW accounts to their customers. A nationwide survey of all banks and S&Ls conducted by Madison Financial Corporation, for example, found that 97 percent of all banks and 86 percent of S&Ls responding to the survey offered NOWs during the first quarter of 1981. Significant differences exist between banks and S&Ls in NOW pricing and marketing strategies. Although all depository institutions uniformly tend to pay the 5¼ percent maximum allowable interest 5 [13, 22] Kimball estimates that 13 percent of demand deposits were converted to NOW accounts in the first year after the introduction of NOW accounts and nearly 40 percent were switched by the end of the fourth year. FEDERAL RESERVE on these accounts and require either minimum or average balances to avoid monthly account fees, balance requirements are generally much lower at S&Ls than at banks. The Madison survey, for example, found minimum balance requirements at commercial banks averaged $976 in the first quarter of 1981, more than twice the $434 requirement at S&Ls. Similarly, banks required customers to satisfy an average balance requirement of nearly $1,500 compared to below $700 for the S&Ls. As a result, the actual average NOW balance at banks was nearly $6,000, almost four times as large as the $1,500 average balance at S&Ls. Initial evidence suggests that, through more liberal NOW prices, thrifts have succeeded in attracting deposit customers away from banks. Watro found that differences in NOW pricing between banks and thrifts in local markets influenced the relative proportions of NOW deposits held by each type of institution. Generally, thrifts gained a larger share of NOWs in those markets where they established the greatest pricing advantages. The Madison survey indicates that the size of the minimum balance requirement influences the percentage of new funds flowing into NOW accounts. The pricing differential has helped S&Ls to report an average of 46 percent of NOW deposits as new funds. Commercial banks, on average, reported only 7 percent new money among its NOW deposits, with the rest being transferred from existing bank accounts. The proportion of new funds, moreover, varies inversely with balance requirements within Commercial each type of depository institution. banks with minimum balance requirements below $500, for example, experienced higher proportions of new money flowing into their NOWs than banks with higher requirements. On the other hand, S&Ls requiring minimum balances in excess of $1,000 realized a lower proportion of new funds in NOWs than associations with lower balance requirements. Table 1 suggests that most NOW balances come from existing accounts at depository institutions. Demand deposits held at banks by individuals, partnerships, and corporations (IPC) experienced a net reduction of nearly $50 billion through September 1981, amounting to 15 percent of these demand balances in banks at the end of 1980.6 Reductions in 6 These data are not seasonally adjusted. Demand deposits typically experience seasonal peaks during the Christmas season and seasonal troughs during the first quarter of each year. Approximately half of the demand deposit reduction in the first quarter may be attributed to seasonal trends. BANK OF RICHMOND 5 Table 1 DEPOSITS OF UNITED STATES COMMERCIAL BANKS AND THRIFT INSTITUTIONS’ ($ millions) Total Telephone I.P.C. Pre- Demand Depository A.T.S. Authorized Transfer Drafts (1) Commercial December March 19802 Personal Amount Market (5) Share (1+3+5) Share (3) Savings Accounts Drafts Amount Market Amount Market Share 13,359.1 6,722.8 8,136.7 21,495.8 79.5 359,855.5 96.5 153,038.8 8,994.7 5,490.6 38,360.3 47,355.0 83.4 344,931.0 95.5 147,664.0 47.1 293,797.0 8,455.1 5,038.8 42,157.2 50,612.0 82.4 349,448.0 95.2 143,761.8 47.2 282,813.1 8,217.1 4,496.8 45,502.1 53,719.2 81.9 341,029.1 95.0 138,700.1 47.5 1,708.8 165.3 712.1 1,493.3 1,658.6 6.1 4,079.5 1.1 51,164.8 15.9 1,563.4 1981 331,636.9 292,084.6 1981 September 134.8 696.4 1,631.2 1,766.0 3.1 4,025.0 1.1 50,108.1 16.0 47.6 Savings Banks December March 19802 1981 1,671.6 June 1981 September Savings June 1981 127.0 620.8 1,722.0 1,848.0 3.0 4,141.0 1.1 48,175.1 15.8 1,709.9 121.7 542.2 1,859.9 1,981.6 3.0 4,233.7 1.2 46,183.4 15.8 and Loans December March 1981 165.2 3,084.0 1,041.9 1,207.1 4.5 4,867.5 1.3 99,892.5 31.1 123.3 2,362.6 4,733.3 4,856.0 8.6 7,804.O 2.2 98,242.2 31.4 604.1 1981 576.4 585.2 19802 1981 September Credit Transaction Banks June 1981 Mutual Share Share Institutions Total NOW/ATS/ NOW/ 127.8 2,091.5 5,935.9 6,064.0 9.9 8,759.0 2.4 94,967.6 31.2 645.0 126.8 1,727.1 6,783.7 6,910.5 10.5 9,282.6 2.6 89,671.7 30.7 Unions December March June 46.6 1,023.8 1,335.3 1,641.1 2,665.0 9.9 4,047.0 1.1 17,194.4 5.4 42.7 983.0 1,513.3 1,839.2 2,823.0 5.0 4,379.0 1.2 17,354.3 5.5 48.2 885.8 1,585.5 2,045.7 2,932.0 4.8 4,566.0 1.2 17,516.0 5.8 59.0 830.0 1,582.5 2,122.9 2,952.9 4.5 4,594.4 1.3 17,726.1 6.1 333,968.7 14,713.4 11,854.2 12,313.0 27,026.5 100.0 372,849.5 100.0 321,290.5 100.0 294,275.9 10,235.8 10,062.9 46,564.0 56,800.0 100.0 361,139.0 100.0 313,368.6 100.0 296,120.9 9,595.7 9,336.6 51,860.8 61,456.0 100.0 366,914.0 100.0 304,420.5 100.0 285,227.0 9,295.6 8,348.6 56,268.6 65,564.2 100.0 359,139.8 100.0 292,281.3 100.0 19802 1981 1981 September 1981 Totals December March June 1981 September Source: 19802 1981 1981 Report of Transaction Accounts, 1 These data are reported weekly institutions do not report weekly, 2 NOW deposits are Other Deposits, end Vault Cash (FR 2900). to the Federal Reserve Banks by commercial these data are understated slightly. as of December 31, 1980. All other data are averages personal savings of over $14 billion at banks and $15 billion at thrifts were also experienced. While these deposit categories were major sources of NOW funds, perhaps large amounts were also withdrawn for investment in high yielding certificates of deposit and money market funds. ATS accounts at banks fell over $5 billion during the period as many banks automatically converted these funds to NOW acTelephone and pre-authorized transfer accounts. counts also lost substantial funds (presumably to NOWs) at banks, S&Ls, and mutual savings banks. Commercial banks have captured the lion’s share of NOW deposits in spite of the more liberal pricing strategy of thrifts. Banks have apparently been very successful in inducing high balance demand deposit customers (who have little difficulty meeting bank balance requirements) to crossover to the bank’s 6 ECONOMIC REVIEW, banks and for thrifts the last week with at least in each $15 million in total deposits. Since smaller month. By the end NOW account. 1981, banks controlled over NOW/share draft accounts. below 81 percent by the end as NOW growth at S&Ls expanding to $6.8 billion, or these deposits. of the first quarter of 82 percent of the total This figure dropped of September, however, was particularly rapid, over twelve percent of Commercial banks continued to dominate the market for transaction deposits, with their market share for all such accounts combined falling only Since slightly to 95 percent in September 1981. this figure includes commercial demand balances, however, it actually overstates the commercial bank The share of total consumer transaction accounts. Demand Deposit Ownership Survey conducted quarterly by the Federal Reserve System has estimated a relatively stable share of total IPC demand deposits MARCH/APRIL 1982 held by individuals of around one-third in recent years. This estimate, however, fell below 31 percent in March 1981 and below 30 percent in September following the large conversions of personal demand deposits to NOW accounts, Using these quarterly estimates to exclude nonpersonal accounts, commercial banks’ share of household transaction deposits was approximately 91 percent in December 1980, 90 percent in March 1981, and 88 percent at the end of September. In nine months time, therefore, commercial banks lost approximately three percent of total consumer transaction accounts held in depository institutions. slowdown in demand since March. at depository Conversions reduction ATS number Experience accounts accounts banks in the Fifth District accumulated in NOW accounts by September 1981. credit union share drafts in the District $229 million over this period. six commercial banks $3½ billion In addition, increased to in the Fifth District (less than one percent of total District banks) and 39 S&Ls (ten percent of the associations) reported NOW -balances as of December day these accounts were available 31, 1980, the first to the public. By since of NOW marketing ATS appear a small net December 1980. dropped accounts, their a large ATS and some offer both and telephone at credit unions, big declines at S&Ls. Transaction at banks role in the District’s in the District in favor continue transfer deposits banks deposits continued. as banks have experienced many instruments. to NOWs savings accounts minor and pre-authorized on the other hand, in the first three quarters 1981, as have telephone Since nationwide figures include the northeastern states where conversions to NOW accounts have occurred for several years, NOW growth in regions of the country where these accounts were just recently authorized might be expected to outpace the national This is true for growth in NOW accounts average. within the Fifth Federal Reserve District. Table 2 shows that commercial banks, S&Ls, and savings Only a fairly in ATS Though conversions has, however, from ATS growth experienced Fifth District NOW institutions to have played NOW deposit The erosion in personal and pre-authorized accounts at Fifth District have fallen over $400 million of transfers credit unions from the beginning of the year. Most of these funds apparently shifted to other accounts within credit unions, as several of the largest credit unions in the District imposed transaction restrictions on these funds and reclassified them as personal savings reserve requirement credit unions’ market for deposit reporting Consequently, purposes. share of total transaction and the de- posits was cut in half to only 1.4 percent. This development permitted commercial banks in the District to maintain their transaction account share over 95 percent despite a net deposit nearly $850 million. market loss of S&Ls, on the other hand, more than tripled their transaction accounts through September and increased their deposit share to almost the end of September 1981, 97 percent of the reporting commercial banks and 85 percent of the S&Ls three percent. The most dramatic offered NOWs with $3 billion and $500 million, respectively, in these accounts. As in the nationwide experience, it appears that most of the NOW growth came in the year’s first quarter and was funded by occurred in the NOW/ATS/share draft category. Savings and loan associations increased their share of these deposits to nearly ten percent in September 1981. Surprisingly, commercial banks also increased conversions from demand and personal savings deposits. IPC demand deposits fell by over $31/3 billion during the first three months of the year alone their share of these accounts through September by nearly five percent, although this percentage fell in the third quarter, These gains in market shares were while personal savings were reduced by nearly $500 million. Though total NOW growth has slowed at the expense since the first September. A detailed quarter, impressive-especially posits doubled from Commercial increased celeration bank percentage increases at S&Ls where March through NOW accounts, remain NOW deSeptember. in comparison, 26 percent over the same period. The dein bank NOW growth largely reflects the FEDERAL RESERVE less than shift in relative of credit six percent deposits of the 1981 transaction of banks and thrifts shares of banks and thrifts across states. OF RICHMOND for in de- in each Fifth District state is presented in the Appendix. 4-9 reveal significant variations in relative BANK shares which accounted of these checkable breakdown posit experiences unions market Tables market At the same 7 Table DEPOSITS OF FIFTH DISTRICT 2 COMMERCIAL BANKS AND THRIFT INSTITUTIONS’ ($ millions) Commercial Banks December March June 126.0 1,525.5 79.1 24,387.7 95.8 12,570.6 54.1 6 274 330.5 2,365.8 3,687.0 84.9 23,116.7 96.0 12,080.8 53.0 516 486 170 1,321.7 327.7 2,709.0 4,030.7 86.0 23,718.4 96.2 11,823.5 52.8 511 493 149 18,888.7 1981 401.8 1,321.2 19,360.0 1981 1,399.5 19,099.2 September Mutual 22,460.4 19802 1981 1,367.0 314.4 2,975.9 4,342.9 84.4 23,546.0 95.6 11,369.9 53.4 526 511 150 596 Savings Banks December March 60.3 September 0 0 87.7 .3 782.0 3.4 3 0 0 27.6 8.0 8.0 .2 93.0 .4 780.0 3.4 3 3 0 0 26.3 9.7 9.7 .2 95.4 .4 772.0 3.4 3 3 0 60.7 1981 27.4 0 59.5 June 1981 0 57.4 19802 1981 0 23.0 10.8 10.8 .2 94.5 .4 725.2 3.4 3 3 0 0 Savings and Loans December March 12.3 2.5 183.5 10.7 13.2 .7 209.0 .8 7,908.8 34.0 374 39 3 14.8 19802 1981 3.1 153.5 256.1 259.2 6.0 427.6 1.8 7,624.6 33.5 369 312 4 14.1 3.2 132.9 355.7 358.9 7.7 505.9 2.1 7,384.0 33.0 365 313 5 1981 12.8 3.1 119.4 496.3 499.4 9.7 631.6 2.6 6,912.6 32.4 386 326 5 19802 15.1 208.2 June 1981 September Credit Unions December March September 390.4 20.2 762.0 3.0 1,979.1 8.5 59 51 13 45.1 202.2 387.0 8.9 444.2 1.8 2,288.9 10.1 60 53 11 63.1 44.3 224.4 287.5 6.1 343.9 1.4 2,408.4 10.8 60 55 10 11.3 1981 182.2 184.8 12.1 June 1981 356.5 12.1 1981 65.5 43.8 229.1 294.6 5.7 349.7 1.4 2,303.5 10.8 69 61 11 290 Totals December March June 969.2 318.9 1,929.1 100.0 25,446.4 100.0 23,248.5 100.0 1,032 96 1,509.1 556.7 2,832.1 4,341.2 100.0 24,081.4 100.0 22,774.3 100.0 948 854 185 19,445.7 1,388.0 531.2 3,298.8 4,686.8 100.0 24,663.6 100.0 22,387.9 100.0 939 864 164 18,973.5 1981 1,610.2 19,183.5 1981 September Source: 22,540.2 19802 1981 1,435.6 500.6 3,712.1 5,147.7 100.0 24,621.8 100.0 21,311.2 100.0 984 901 166 do not report weekly, Report of Transaction Accounts, Other Deposits, and Vault Cash (FR 2900). 1 These data are reported weekly to the Federal Reserve Banks by commercial banks and thrifts with at least $15 million in total these data are understated slightly. Data exclude six West Virginia counties located in the Fourth Federal Reserve District. 2 NOW deposits are as of December 31, 1980. All other data are averages pricing affect the relative A review concluded strategies market for these deposits also shares of banks and thrifts. of the New England NOW experiment that the monopoly position that commer- cial banks previously enjoyed in the provision of third party payment accounts contributed heavily to the early success of banks in marketing NOWs. In the long run, however, the commercial bank share of NOW deposits will depend chiefly upon the ability of banks to attract new NOW deposits. In recent years, commercial banks in most of the New England states have experienced significant erosion in their NOW market shares. Kimball cites the NOW pricing differential as an important explanation for this trend. It therefore follows that in other areas of 8 Since smaller institutions for the last week in each month. time, the results closely resemble experiences observed in other regions of the country. In general, the ability of thrifts to capture significant market shares of checkable deposits is directly related to the relative strength of thrifts in deposit markets at the beginning of the period. Relative deposits. ECONOMIC REVIEW, the country where significant pricing differentials between banks and thrifts ‘persist erosion in bank shares of NOW deposits is likely. In the Fifth District, commercial banks in each state have seen reductions in their market shares of total balances held in NOW/share drafts since the first quarter of 1981. The key question is whether this trend tinue, i.e., will S&Ls continue to undercut the pricing of NOWs? Specifically, will conbanks in will lower bal- ance requirements at thrifts persist? Or will S&Ls be forced by cost considerations to price NOWs more like banks after they analyze their initial experience? Some observers have suggested that S&Ls have priced NOWs as a “loss leader” in an attempt to capture consumer business from banks and that thrifts can be expected eventually to raise their balance requirements on NOW accounts. Regardless of the validity of this particular point, the pricing decisions of banks and thrifts will certainly play a critical role in the future competition for household transaction accounts. MARCH/APRIL 1962 Despite the importance of the pricing decision, there exists surprisingly little analysis of NOW pricing.7 This is unfortunate. For before one can explain the price differential between banks and thrifts and predict the future course of those prices, one needs to specify the determinants of NOW prices. Accordingly, the remaining sections of this article will (a) employ microeconomic price theory to examine the deposit pricing decision, (b) explain the NOW pricing differential on the basis of calculations of the marginal cost of NOW deposits at banks and thrifts, and (c) theorize on what the analysis implies for future competition for interest-bearing transaction accounts. Microeconomics of Pricing Deposits Price theory provides guidance to the firm in its decision to employ variable inputs. To maximize profits, each firm should employ additional units of each factor of production until the addition to total resource cost equals the additional revenue gained from the increased output produced by the extra resources.8 If it is necessary for the firm to increase its factor payment to attract additional inputs, the firm will face a positively sloped resource supply curve, as illustrated in Exhibit A. But if the supply curve is positively sloped, the marginal resource cost (MRC) curve will also be upward sloping and will lie above the supply curve. The upward sloping MRC curve lies above the supply curve because the higher payment for additional units of the input must be paid to all (both additional and previously employed) units. The profit maximizing employment level will occur at input usage Q0, where the marginal revenue product and marginal resource cost The factor input will, in turn, curves intersect. receive compensation input unit employed, firm’s revenue than profits. equal to rO, At this rate, each up to QO, will add more to the to its costs, thus increasing its This analysis can be applied to bankers’ decisions to purchase funds to finance the acquisition of earnTo maximize profits, each institution ing assets. should acquire deposits and other liabilities until the marginal cost of each source is equal to the marginal Since the revenue derived from its employment. marginal revenue from a dollar employed in a bank is the same regardless of the dollar’s source, profits will be maximized where marginal revenue equals marginal cost and the marginal cost of each liability source used is the same. For simplicity, the marginal revenue of bank deposits can be treated as perfectly elastic or horizontal at the market-determined yield on financial assets (rm This assumes both that banks are in Exhibit A). “yield takers” and cannot influence the yield on investments (e.g., in securities markets) and that each dollar of bank deposits is equally productive in genTo attract addierating additional earning assets. tional household transaction balances (e.g., via NOW Exhibit PRICING AND A EMPLOYMENT OF DEPOSITS 7 One exception is offered by Simonson and Marks.  Their analysis, however, estimates the effect of the introduction of NOW accounts on the weighted average cost of total bank funds when all NOW balances are derived from existing demand and regular savings deposits within the bank. The present article will use survey results of the sources of bank and thrift NOW balances, respectively to estimate the net marginal cost to the institutions of new funds attracted to the firm through NOWs, taking into consideration the cost effects of internal deposit shifts. For a thorough discussion of the marginal cost of funds concept in banking, see Watson.  8 In technical language, this requires equating the marginal resource cost (MRC) to marginal revenue product (MRP). The marginal revenue product curve is the firm’s resource demand curve. it will be negatively sloped if either (a) the firm sells its product under less than perfectly competitive market conditions or (b) the firm’s production function is characterized by diminishing marginal productivity. FEDERAL RESERVE BANK OF RICHMOND 9 accounts) banks must offer higher yields on deposits. Banks, therefore, face upward sloping supply and marginal resource cost curves for transaction balances. Given these positively sloped curves, it follows that the transfer of noninterest-bearing demand deposits to NOWs results in a significant increase in interest expense for balances already employed by the bank. The marginal cost of the additional transaction deposits attracted to NOWs, therefore, is higher than the yield paid on NOW balances. Consequently, the bank will pay a deposit yield (r0) below rm, the marginal return on assets. With this framework, one can observe the bank’s behavior in response to a change in the market return on assets. If the yield on bank investments increases to rm', for example, the marginal revenue to be derived from additional deposits exceeds the marginal cost of funds at Q0. To maximize profits, therefore, the bank should bid up the yield on deposits in an attempt to increase deposits to Q1. In deposit markets where institutions are prohibited from increasing explicit interest payments, increased yields must take implicit forms. The foregoing analysis is consistent with observed bank deposit pricing behavior. For, as noted above, the prohibition of explicit interest on demand deposits led banks to increase implicit yields on balances as market interest rates rose. Conversely, the authorization of explicit interest payments on NOW and ATS accounts (together with associated balance requirements and fees) has apparently induced banks to reduce the implicit interest paid on these deposits. This response is to be expected if, as argued below, the marginal cost of NOW deposits at banks is higher than alternative sources of funds. If this is indeed the case, profit maximizing behavior requires the bank to reduce the total yield paid on NOW accounts. This reduction could be accomplished either by charging explicit fees on bank services associated with these accounts or by encouraging depositors to hold higher average balances; both methods drive down the average implicit interest paid. Marginal Cost of NOW Deposits at Banks and Thrifts The previous section argues that, given the marginal return on assets, the prime determinant of yields on NOWs is the marginal cost of these deposits to depository institutions. Several factors determine this marginal cost. Perhaps the most critical is the source of funds flowing into NOWs. 10 ECONOMIC REVIEW, The calculations shown in Table 3 demonstrate the extreme dependence of the marginal cost estimate on the composition of the source of NOW balances. In general, the marginal cost of NOW accounts (1) varies inversely with the percentage of NOW balances that represent new funds to the institution and (2) for banks, varies directly with the proportion shifted from demand deposit accounts within the same institution. It will be shown that a wide divergence in the source of NOW balances provides S&Ls with the cost advantage they presently enjoy over commercial banks in the competition for NOW accounts. Other factors influencing the marginal cost estimates include the maximum interest rates payable on transaction and savings accounts, the level of market interest rates, and the implicit yield decisions of each institution. Survey results indicate the present sources of NOW funds for banks and S&Ls. These provide a representative example of the effects of the introduction of NOW accounts on the marginal costs of funds in each type of institution. Exhibit B details the assumptions and calculations made for each institution in the marginal cost calculations. presented in Table 3. Assume each institution experiences a $1 million increase in 5¼ percent NOW deposits. If banks and thrifts pay interest on collected balances,9 the gross interest expense on the NOW balances is $48,300 and $46,200, respectively. Several adjustments are required, however, to arrive at the net cost of the additional funds attracted to the instituFirst, since savings have shifted to NOWs, tions. the commercial bank will experience a reduction of $13,125 in its savings account interest expense (using the passbook savings rate) while savings interest at the S&L will fall by $27,500. The net increase in explicit interest, therefore, is $35,175 for the bank and $18,700 for the S&L. Secondly, deposit shifts will affect the level of implicit payments at banks and thrifts in substantially different ways. Data for member banks that participate in the Federal Reserve Functional Cost Analysis program indicate that the net operating expense (total operating expense less service and handling charges) per dollar deposited in NOW accounts is lower than that incurred on demand deposits. The bank may realize operational savings, therefore, on the funds transferred from demand deposits to 9 If either or both institutions paid interest on the full $1 million, the interest expense would, of course, be $52,500. This would only slightly increase the marginal cost estimates and would not alter the results that follow. MARCH/APRIL 1982 Increased operating expenses, however, NOWs. are associated with the new funds in NOWs. Table 3 indicates that banks experience a net reduction in implicit interest expense of $11,000. S&Ls, on the other hand, incur increased net operating expenses associated with the servicing and maintenance of transaction accounts. This incremental expense is estimated at $30,000 in Table 3.10 Adjustments must also be made for changes in reserve requirements and uncollected balances resulting-from deposit shifts since these factors will alter the amount of funds actually available for investment. The calculations in Table 3 assume banks are subject to a 12 percent marginal reserve requirement on transaction accounts while a 3 percent reserve ratio is used for S&Ls.11 Under these assumptions, required reserves on funds shifted from demand deposits to bank NOW accounts will not change.12 Deposits shifted from personal savings accounts (with zero reserve requirements), as well as new funds at banks and thrifts are subject to the respective reserve ratios on NOW balances. Due from balances at each institution were assumed to represent 10 percent of transaction deposits while cash items in process of collection (CIPC) were 8 percent at banks and 12 percent at S&Ls.13 Under these 10 The magnitude of increased net operating expenses (implicit interest paid) on NOWs by S&Ls is uncertain at this point. For comparative purposes, Functional Cost Analysis data  for commercial banks were used to estimate the increased implicit payments of S&Ls. Since average NOW balances at S&Ls are closer in size to personal checking accounts at banks rather than to NOW balances, the increased expenses were estimated using net operating expenses per dollar in personal checking accounts. This assumes, therefore, that thrift NOW accounts are twice as expensive to service (4 percent per dollar) as bank NOWs (2 percent). 11 We believe this is justified for two reasons. First, S&Ls are much less likely than banks to have exceeded the $25 million base for transaction accounts subject to the 3 percent reserve ratio. In addition, even if a large S&L has exceeded the $25 million base. under the provisions of the reserve phase-in established in the Monetary Control Act, it presently holds one-fourth of the fully phased-in reserves. 12 Member and nonmember institutions, of course, are affected differently by deposit shifts during the reserve phase-in period. Specifically, required reserves for some large member banks could fall as funds move from demand deposits to NOWs. On the other hand, nonmember banks’ required reserves increase as demand deposit balances shift to NOWs. 13 Due from balances most often represent correspondent balances on which banks receive compensation (in the form of services). No opportunity cost on these funds is, therefore, incurred. Due from balances and CIPC as a proportion of bank transaction accounts vary with bank size. The proportion of due froms generally declines with bank size while CIPC increases. In addition, insti- FEDERAL RESERVE assumptions, total required reserves and uncollected balances increase by $42,440 for the bank and by $83,400 for the S&L. Since these funds are nonearning assets, the institutions incur opportunity costs of $7,215 and $14,178, respectively (assuming a 17 percent return on assets). The net marginal cost to the bank of the additional $100,000, therefore, is $31,390 or 31.4 percent per The cost figure for many new dollar employed.14 banks may even be higher. Individual banks experiencing smaller proportions of new funds flowing into NOWs, for example, will have substantially higher marginal cost estimates. Also, the implicit interest savings on funds transferred from demand deposits may be less than the two percent figure used in Table 3.15 If these savings are reduced to one percent, the marginal cost of NOWs increases by $6,500. On the other hand, if a bank experiences a larger proportion of new funds and fewer demand deposits shifting into NOWs, the marginal cost estimate drops rapidly. The Addendum to Table 3, for example, estimates 17.5 percent marginal cost when 25 percent of NOWs are new funds. Regardless of the precise figure, these initial estimates indicate that NOW deposits represent an expensive source of funds to commercial banks. Banks may be experiencing marginal NOW costs that exceed both the cost of funds from alternative money market sources and the marginal revenue from investing NOW deposits. This situation, of course, implies reduced profits for banks. tutions that are members of the Federal Reserve System have lower proportions of due from balances and higher CIPC than nonmembers. [15, p. 22] Knight’s data for member banks with total deposits between $50 million and $100 million indicate that due froms averaged approximately 10 percent of demand deposits while CIPC averaged near 8 percent. Due from balances at Virginia S&Ls were proportionally much larger than 10 percent in June 1981. This figure, however, includes S&Ls’ own commercial demand deposits at banks and cannot all be considered correspondent balances. Virginia S&Ls’ CIPC averaged slightly over 12 percent of total transaction balances in June 1981. 14 Thecalculations in Table 3 assume, for the moment, that institutions would not lose additional deposits if NOW accounts were not offered. 15 In particular, depositors with larger than average balances in their personal checking accounts have accounted for most of the funds transferred to commercial bank Banks may have previously incurred NOW accounts. less than the average 4 percent implicit expense on each dollar in these demand deposits. Longbrake , for example, found that holders of small checking accounts receive greater implicit rates of interest than holders of large checking balances. When large balance deposits shift to NOW accounts, therefore, banks’ implicit interest savings may be less than 2 percent. BANK OF RICHMOND 11 Table MARGINAL COMMERCIAL Expense Deposit ($1 COST OF NOW BANKS AND Source of NOW 2. SAVINGS Commercial Item 1. ($650,000 DDA, $250,000 Interest Expense, Collected NOW Balances (@5.25%) 3. Less: Reduced 4. Net 5. Explicit Plus: a. Net Interest, Interest Change million) Savings Net Change 7. Net Explicit 8. Adjustments Nonearning a. Increased and Reserves, 9. 10. 11. 12. Margined ADDENDUM: Marginal (@17%); Cost of [@11%] (Per Dollar (@2%) of New $20,000 $30,000 $48,700 $24,175 Accounts (@12%) $34,440 (@3%) $23,400 CIPC (@8%) $8,000 (@12%) $60,000 $83,400 $42,440 ($ 7,215) [@11%] [$ ($14,178) 4,668] [$9,174] ($62,878) [$28,843] of New (31.4%) Funds [$57,874] of NOW Deposit: ($500,000 DDA, $250,000 (12.6%) [28.8%] SA, $250,000 New) ($750,000 SA, $250,000 [11.6%] New) Accounts ($43,775) bank losses. losses would have to be replaced at market rates of interest. For example, in Table 3, the entire $650,000 in demand deposit accounts (DDAs) ECONOMIC REVIEW, [$38,9753 ($37,379) [$34,757] (17.5%) Funds) If a bank does not offer NOWs, it runs an increased risk of losing deposits to its competitors (other banks, thrifts, money market funds, etc.). 12 $10,000 (@4%) Accounts in an effort to minimize deposit (@2%) Expense Economic theory predicts that the firm in this situation will reduce its employment of the high cost factor of production in an effort to reduce costs and maximize profits. Consistent with that theory, it does appear that banks have attempted to limit their marginal expenses somewhat by discouraging demand deposit conversions with high minimum balance requirements and penalty fees. Still the question remains: Why have banks offered NOWs to their deposit customers at all if these funds are so expensive? The decision appears to be a defensive strategy These 0 $2,000 Assets: Source Cost of NOW [@11%] $27,500 $18,700 ($31,390) NOW Cost per Dollar Alternative (05.5%) -$11,000 Balances, Plus: Opportunity Cost on Nonearning Assets (@17%); Marginal (@17%); New) in in Nonearning Increase $500,000 $46,200 0 Transaction Net SA, on Funds Funds Due to Increase Assets: uncollected ($500,000 New) Loan Associations -113,000 (@-2%) Interest b. Increased SA, $100,000 and Interest Interest Implicit Savings Banks on Funds on New in Implicit ASSOCIATIONS $35,175 b. Increased Implicit Payment Shifted from Savings 6. LOAN $13,125 (@5.25%) Accounts Expense in Implicit Payment ACCOUNTS AND $48,300 Reduced Implicit Payment Shifted from DDAs c. Implicit 3 [15.6%] (15.0%) [13.9%] could be withdrawn from the bank. If this occurred, the increased interest expense of retaining these funds through purchased liabilities would be approximately $78,000.16 Freed reserves from this alternative source of funds could be invested, however, increasing revenue by $13,260,17 leaving a net expense of approximately $65,000. To the bank, this would represent a deadweight loss since no new funds are flowing into the bank. In this example, the bank is better off by offering NOW accounts even though its marginal cost may exceed money market rates. Bank profits will be higher by purchasing NOW deposits than by replacing lost deposits with purchased funds. 16 This is calculated by multiplying the lost DDA funds times 12 percent-i.e., the difference between the assumed rate on purchased funds (16 percent) and the net implicit payment on DDAs (4 percent). 17 $650,000 x .12 (reserve $13,260. MARCH/APRIL 1982 ratio) x .17 (market yield) = Exhibit ASSUMPTIONS AND Assumption B CALCULATIONS Commercial 1. Each institution experiences an increase of $1 million in NOWs. 1981 survey results used as basis for source of funds. 65% NOWs 25% NOWs 10% NOWs 2. Institutions pay interest on collected funds; 8% of bank NOWs and 12% of S&L NOWs are in process of collection (CIPC). See footnote 13 for source of ratios. $1 m. X (1-.08) 3. Interest payments reduced counts. Funds transferred accounts. $250,000 4. (2 - 5. Banks Savings from demand deposits, from swings accounts, new funds to institutions. and Loan Associations 1980 Functional Cost Analysis data for commercial banks used to estimate changer in implicit payments due to deposit shifts. a. transferred transferred represent FOR TABLE 3 X .0525 (Net operating dollar in NOWs in DDAs) times from DDAs. $1 m. X (1-.12) X .0525 X .055 = No funds $48,300 shifted from = $46,200 X .0525 = $13,125 $27,500 expense (N.O.E.) per minus N.O.E. per dollar funds shifted to NOWs (.02 - .04) x $650,000 = (.02 - .02) X $250,000 = - $13,000 Banks: N.O.E. per times new funds. dollar in + 5b + deposits. 0 (.04 - .02) x $500,000 = $10,000 NOWs .02 x $100,000 = $2,000 personal .04 x $500,000 = $20,000 ----- (5a 7. (4 + 5c) 8. a. Increased transaction accounts are subject to reserve requirements. Institutions, however, may deduct demand balances due from depository institutions and cash items in process of collection in calculating reserves. ----- 6) b. A proportion of new funds attracted to transaction accounts is uncollected and not available for investment. Funds transferred from savings maintain their savings characteristics and do not result in increased uncollected balances. + demand NOWs regular shifted 6. (8a from savings accounts, new funds to institutions. 3) S&Ls: N.O.E. per dollar in checking times new funds. 9. transferred represent $500,000 = S&L: (N.O.E. per dollar in personal checking account minus N.O.E. per dollar in regular savings) times funds shifted to NOWs from savings. 10. NOWs NOWs on rovings acfrom passbook b. Banks: (N.O.E. per dollar in minus N.O.E. per dollar in savings accounts) times funds to NOWs from savings. c. 50% 50% Reserve requirement Due from balances = CIPC [$350,000 $100,000 = = X (1 -(.10 X .08 = .08))] + 12% 10% 8% Reserve requirement Due from balances CIPC X .12 = $34,440 [$1 m. X (1 -(.10 = = = + .12))] $8,000 $500,000 X .12 X .17 = $7,215); X .11 = $4,668] ($83,400 [$83,400 3% 10% 12% X .03 = $23,400 X .17 = $14,178); X .11 = $9,174] = $60,000 8b) Increased ence an return on of (17%) cash assets not invested experiopportunity cost at the market assets. Alternative market rates and [11%] considered. 11. Marginal cost of attracting new funds to institutions. -- (7+10) 12. ($42,440 [$42,440 each dollar of Item A bank’s estimate of the proportion of deposits that would flow out of the bank in the absence of NOW accounts is the key determinant in the decision to offer NOWs. This estimate, in turn, depends upon the competitive environment in which each bank conducts its business. If a bank is in a highly competitive market with readily available deposit substitutes at higher yields, a relatively large proportion of deposits may leave the bank if NOWs are not FEDERAL RESERVE 11 ÷ $500,000 offered. This tends to influence the decision for such banks in favor of offering NOWs. On the other hand, a bank with a near-monopoly position in a market with limited deposit substitutes may believe it faces limited deposit loss and, therefore, decide against offering NOW accounts. Of course deposit losses will be cumulative over time, weighting the decision toward providing NOWs. In Table 3, the “break-even” deposit-loss ratio is roughly 22 percent BANK OF RICHMOND 13 when market rates are 17 percent.18 In other words, banks expecting total attrition of more than 22 percent of DDAs would benefit from offering NOWs. Those anticipating smaller deposit losses might decide not to offer NOW accounts.19 The net marginal cost of NOW balances at savings and loan associations is estimated in Table 3 to be approximately $63,000 or 12.6 percent for each additional dollar of deposits employed by the firm. This estimate suggests that the marginal cost of NOWs to thrifts is somewhat below the assumed marginal cost of alternative purchased liabilities (16 percent) and lower than the assumed marginal return on assets (17 percent). As demonstrated in the Addendum to Table 3, this relationship holds for thrifts experiencing only 25 percent new funds in NOWs. What does this reveal about the 1981 NOW pricing decisions of thrifts? Most importantly, it indicates that their low balance requirements and free services are consistent with profit maximizing behavior. Any thrift institution experiencing marginal NOW cost below the marginal return on assets can increase profits by increasing yields on NOWs and attracting additional deposits. Presently, the only available method to increase NOW yields is through implicit payments. Savings and loan associations’ income positions have been under severe pressure in recent years. In large degree this is because funds purchased at high market interest rates replaced low cost sources of funds in S&L liability structures. Concurrently, the dominance of long-term, fixed rate (low interest) mortgages in S&L asset portfolios has resulted in the virtual elimination of profit margins. Savings and loan associations apparently have a substantial marginal cost advantage over commercial banks in the competition for NOW accounts. This advantage has allowed S&Ls to market and price the new deposits more aggressively than commercial banks. Of course, the maximum explicit interest S&Ls can pay on NOWs is limited by regulation to Enjoying lower the same rate offered by banks. marginal costs than banks, however, thrifts have additional flexibility to “bid up” the implicit payments on NOW accounts. .12 (increased x .12 (reserve (Table 3, item (new funds)]. for d yields d = .22. At lower market rates, the break-even deposit-loss ratio in(i.e., fewer banks might find it optimal to NOWs). in July 1981, found that 20.4 percent of the responding S&Ls were contemplating a price change in the [$650,000 x d (deposit-loss ratio) x interest expense)] - [$650,000 x d ratio) x .17 (market yield)] = $31,390 11) - [.17 (market yield) x $100,000 19 An alternative decision-making technique would be possible if institutions knew the demand and savings deposit losses likely to result from a decision not to offer NOW accounts. An estimate of the deposit replacement costs that were avoided (saved) by providing NOWs could then be incorporated into the marginal cost calculations-reducing the marginal ‘cost estimates for each institution. If this analytical technique were possible, banks and S&Ls would maximize profits by providing NOW accounts to customers as long as NOW marginal costs (including the cost savings estimates) were equal to or below the marginal return on assets. 14 Implications for NOW Competition Between Banks and Thrifts What do these conclusions imply for the form and direction of future NOW competition between banks and thrifts? As long as Regulation Q interest ceilings on NOWs remain in effect, competitive strategies will likely be expressed through implicit interest payments. The analysis in the previous section indicates that S&Ls have a profit incentive to increase implicit interest payments on NOW accounts as long as their marginal cost remains below the marginal Early indications are that return on investments. many S&Ls, indeed, plan to lower their NOW balance requirements. A follow-up survey of banks and 18 The “break-even” deposit loss ratio (d) is found by setting the net marginal costs of the alternative actions equal (so that the effect on profits will be identical): Solving interest creases provide The above analysis on the impact of NOW accounts on the marginal cost of funds at S&Ls suggests NOWs have not been a contributing factor to the financial problems currently faced by the indusTo the contrary, NOWs may have reduced try. associations’ cost of funds and improved earnings. S&Ls’ profit experience, in other words, might have been worse without the authorization of NOW acFor example, without NOWs the outflow counts. of savings accounts from thrifts to money market alternatives could have been even worse than experienced, forcing S&Ls either to replace those additional funds at higher interest or to liquidate assets. ECONOMIC REVIEW, S&Ls conducted near future. by Madison A significant Financial proportion Corporation (19.4 percent) of the S&Ls stated that they would price their NOW accounts lower if they had it to do all over again while only 2.5 percent indicated they would increase Furthermore, S&Ls anticipated minitheir price. mum balance requirements averaging $317 by the end $435 during the first quarter. MARCH/APRIL 1982 for their of 1981, associations compared to Commercial banks, on the other hand, express satisfaction in their present NOW prices and foresee little change in minimum balance requirements. If the marginal cost of NOW deposits for banks is indeed above the marginal return on assets and marginal cost of other sources of funds, liberalization of bank NOW prices should not be anticipated. A continuation or widening of the pricing differential, in turn, is expected to result in a steady erosion in commercial bank shares of transaction accounts. This does not, however, preclude some individual banks from eventually reducing NOW account prices. This response is possible for banks facing especially strong thrift competition or where individual banks enjoy a significant inflow of new funds into NOW accounts. As interest ceilings on time and savings deposits and interest-bearing checking accounts are phased out, the marginal cost of NOW accounts Will increase at both commercial banks and thrift institutions. It is anticipated that banks will competitively raise their explicit interest payments on NOWs while further lowering implicit payments. Reduced implicit payments will probably be facilitated by explicit fees for If the marginal cost of NOW transaction services. accounts for thrifts, however, remains below the available return on assets, thrifts are more likely than banks to maintain implicit subsidies on services related to transaction accounts while paying competitive explicit interest. If market interest rates fall, the marginal cost of NOWs to depository institutions will also drop as the opportunity costs on nonearning cash assets (reserves and uncollected balances) fall. The marginal cost of NOWs, however, may not fall by as much as market interest rates. Table 3 provides alternative FEDERAL RESERVE estimates for banks and S&Ls when the marginal return on assets is reduced to 11 percent. Holding the source of funds constant results in reductions of nearly three percent and one percent in marginal costs of NOWs at banks and S&Ls, respectively, compared to the six percent drop in market ‘rates. Despite reduced costs, therefore, the relative attractiveness of employing NOWs (instead of other sources of funds) would deteriorate at both institutions and reduced implicit payments might result. A larger reduction in marginal NOW costs is possible, however, as market interest rates fall. The proportion of new funds flowing into NOW accounts, for example, might increase as the yield on NOWs becomes more attractive to consumers relative to rates on money market instruments. If this occurs, the marginal cost of NOWs could fall more rapidly than market rates. In Table 3, for example, the combined effects of (1) a reduction in market interest from 17 percent to 11 percent and (2) an increase in the proportion of new funds flowing into NOWs at banks from 10 percent to 25 percent will reduce the marginal cost of NOWs at banks by nearly 16 percent (from 31.4 percent to 15.6 percent). Summary The analysis in the preceding sections has offered a framework for explaining and anticipating alternative deposit pricing decisions of commercial banks and thrift institutions. Initial experience with NOW accounts confirms the theoretical conclusion that competition among depository institutions for interestbearing transaction accounts is determined by factors affecting the marginal costs of employing alternative sources of funds. The future course for financial institutions should also depend upon these factors. BANK OF RICHMOND 15 APPENDIX Tables 4-9 report deposit figures for depository institutions in the District of Columbia and each state within the Fifth District. These data reveal that commercial banks in each state experienced significant net reductions in demand deposit accounts over the course of 1981. The tables show that North Carolina banks lost $1,225 million in these accounts through the end of the third quarter, while Virginia banks lost $755 million, and those in Maryland $526 million. On a percentage basis, demand deposit outflows within the District ranged from a low of 12 percent of the December 1980 figure in Maryland to a high of 20 percent in North Carolina. ATS accounts fell in every state except Virginia, which experienced an increase of over $150 million. ATS deposits in District of Columbia credit unions and telephone and pre-authorized transfer accounts at Virginia credit unions fell precipitously in the first and second quarters as most of these funds were re-categorized as personal savings. Commercial banks and savings and loan associations in each state experienced personal accounts mutual savings savings $614 million as did in depository institutions grew the District, totalling $995 mil- Carolina, in Virginia, lina, $371 million 16 losses in the year, banks in Maryland. NOW deposits rapidly throughout lion in North through $619 million $573 million in the District in Maryland, in South Caro- of Columbia, ECONOMIC and REVIEW, $355 million in West Virginia at the end of September. Commercial banks in North Carolina, Virginia, and West Virginia (where thrift competition, as measured by 1980 market shares of personal savings accounts, was less significant than in other states) were especially successful in garnering large proportions of NOW deposits, Banks in each of these states captured over 90 percent of funds in NOW/ ATS/share draft accounts by September and continued to constitute near monopolies in total transaction accounts. Faced with stronger thrift competition, banks in South Carolina, the District of Columbia, and Maryland collected 84 percent, 71 percent, and 65 percent, respectively, of NOW/ATS/share draft deposits. Banks in these latter states continued their dominance of total transaction accounts, however, holding over 90 percent of state totals at the end of the third quarter. Savings and loan associations in Maryland and South Carolina held 23 percent and 13 percent, respectively, of NOW/ATS/share drafts by the end of the third quarter. It should be pointed out, however, that S&Ls in these states held relatively large portions of personal savings prior to 1981 while commercial banks held less than half of these deposits. S&Ls and credit unions in the District of Columbia, which combined to control 76 percent of personal savings in December 1980, held 29 percent of total NOW/ ATS/share drafts by September. MARCH/APRIL 1982 Table DEPOSITS Commercial June 1981 Savings and 69.4 24.5 2,447.2 90.0 701.4 24.1 17 0 305.8 56.8 2,322.3 89.2 720.2 24.9 14 14 20.6 .1 313.9 334.5 72.4 2,350.1 93.3 688.0 23.4 14 14 14.2 .1 328.6 342.8 70.8 2,306.6 92.8 679.0 24.6 16 16 23.5 1,963.7 0 46.1 Loans 1.9 1981 September 1981 49.6 1.3 .5 .2 52.1 1.9 1,447.8 49.7 17 3 .3 37.2 22.0 22.3 4.1 64.6 2.5 1,426.4 49.2 14 13 .4 32.8 28.3 28.7 6.2 63.2 2.5 1,381.3 46.9 13 12 .8 19802 1981 .3 5.0 1.7 December Credit INSTITUTIONS1 282.2 69.4 2,015.6 1981 June BANKS AND THRIFT .1 2,331.7 2,016.4 19802 1981 September March 4 OF COLUMBIA COMMERCIAL Banks December March OF DISTRICT .3 29.1 42.5 42.8 8.9 72.7 2.9 1,247.3 45.2 12 12 Unions March Juno 1.6 138.1 3.7 80.1 214.0 75.4 219.4 8.1 763.9 26.2 16 13 2.2 124.8 4.2 85.8 210.6 39.1 217.0 8.3 751.4 25.9 16 13 2.6 3.5 4.4 95.0 98.5 21.3 105.5 4.2 874.2 29.7 16 15 2.2 3.0 4.6 95.9 98.9 20.4 105.7 4.3 835.6 30.3 18 17 2,335.2 207.8 99.4 81.4 283.9 100.0 2,718.7 100.0 2,913.1 50 16 2,023.6 148.6 41.5 390.0 538.7 too.0 2,603.4 100.0 2,898.0 100.0 44 40 2,019.9 December 24.5 37.3 437.2 461.7 100.0 2,518.8 2,943.5 100.0 43 41 1,966.7 17.5 33.8 467.0 484.5 100.0 2,485.0 2,761.9 100.0 46 45 19802 1981 1981 September 1981 Totals December March 19802 1981 June 1981 September Source: 1981 Report of Transaction Accounts, Other Deposits, and Vault 100.0 Cash (FR 2900). Table DEPOSITS OF MARYLAND 5 COMMERCIAL BANKS AND THRIFT INSTITUTIONS ($ millions) Commercial Banks December March June Mutual 93.9 50.5 4,381.9 95.2 3,144.9 48.3 81 0 37 337.1 413.7 70.8 4,199.2 93.4 3,072.0 48.0 76 68 21 76.1 20.0 396.9 472.9 69.4 4,324.8 92.9 3,031.8 48.0 76 70 19 3,738.6 76.1 17.0 433.2 509.3 64.8 4,264.9 91.6 2,888.5 48.6 75 71 19 60.3 0 27.4 0 0 0 87.7 1.9 782.0 12.0 3 0 0 57.4 0 27.6 8.0 8.0 1.4 93.0 2.1 780.3 12.2 3 3 0 0 26.3 9.7 9.7 1.4 95.4 2.1 772.0 12.2 3 3 0 60.7 0 23.0 10.8 10.8 1.4 94.5 2.0 725.2 12.2 3 3 0 4.3 0 38.2 2.5 3.7 2.0 42.5 .9 2,159.1 33.2 73 10 0 1.8 2.7 35.7 69.2 71.9 12.3 109.4 2.4 2,124.3 33.2 71 59 1 2.1 1981 23.7 21.2 59.5 September 93.9 76.7 3,831.8 1981 4,264.3 3,764.2 19802 1981 2.8 30.2 102.3 105.1 15.4 137.4 3.0 2,091.5 33.1 69 59 1 1.8 2.6 28.4 174.6 177.2 22.5 207.4 4.5 1,933.7 32.6 73 61 1 0 Savings Banks December March June 19802 1981 1981 September 1981 Savings and Loans December 19802 March 1981 June 1981 September Credit 1981 Unions December March .1 September 38.6 88.2 47.5 90.3 2.0 424.2 6.3 15 12 5 2.1 40.7 90.6 15.5 92.8 2.1 421.1 6.6 15 13 5 48.9 2.1 44.8 93.7 13.8 95.9 2.1 425.0 6.7 15 13 5 .2 1981 2.0 49.9 .1 June 1981 49.4 .2 19802 1981 46.9 1.7 41.7 88.6 11.3 90.5 1.9 392.4 6.6 15 13 5 42 Totals December March June September Source; 1981 143.3 91.3 41.1 185.8 100.0 4,602.4 100.0 6,510.2 100.0 172 22 129.3 86.6 455.0 584.2 100.0 4,494.4 100.0 6,397.7 100.0 165 143 27 3,893.5 1981 4,329.0 3,823.6 19802 1981 127.8 165.2 553.7 681.4 100.0 4,653.5 6,320.3 100.0 163 145 25 3,801.3 125.6 70.1 660.3 785.9 100.0 4,657.3 5,939.9 100.0 166 148 25 institutions do not report Report of Transaction Accounts, Other Deposits, and Vault Reserve Banks by commercial 2 NOW All other are as of December 31, 1980. data 100.0 Cash (FR 2900). 1 Those data are reported weekly to the Federal those data are understated slightly. deposits 100.0 are overages banks and thrifts for with at least $15 million the last week in each month. in total deposits. Since smaller weekly, Table DEPOSITS OF NORTH CAROLINA 6 COMMERCIAL BANKS AND THRIFT INSTITUTIONS’ ($ millions) Number Offering A.T.S. Commercial Banks December March June 1981 289.3 117.8 2,658.4 55.2 67 3 45 421.6 271.5 696.6 1,118.2 93.8 6,289.4 98.2 2,540.0 54.7 62 60 26 91.9 6,470.9 97.9 2,500.5 55.2 61 60 23 6,448.3 97.4 2,401.2 55.0 60 59 21 95.9 563.5 403.7 271.5 776.5 1,180.1 4,888.8 406.4 261.4 891.7 1,298.1 6,966.8 98.9 and Loans 2.4 4.6 .8 43.4 .6 1,859.3 38.6 137 10 2 1.3 2.2 30.3 46.1 48.3 4.1 79.9 1.3 1,785.0 38.4 137 113 2 1.3 2.0 25.1 70.0 72.0 5.6 98.3 1.5 1,712.5 37.8 137 115 3 1981 .9 .1 22.9 102.9 103.0 7.2 126.8 1.9 1,659.2 38.0 148 121 3 19802 13.0 1.0 4.4 18.6 19.6 .3 37.0 .5 296.9 6.2 5 5 1 8.6 1.4 4.6 23.9 25.3 2.1 38.5 .6 321.7 6.9 6 6 1 8.3 1.6 4.7 29.5 31.1 2.4 44.2 .7 317.2 7.0 6 6 1 6.9 1.6 4.8 30.7 32.3 2.3 44.0 .7 302.1 6.9 8 7 1 48 December March June .9 19802 1981 1981 September Credit 445.7 5,019.4 1981 September Savings 6,114.0 4,899.6 19802 1981 2.2 37.9 Unions December March June 1981 1981 September 1981 Totals June 1981 September Source; 1981 448.9 331.6 138.8 587.7 100.0 7,047.2 100.0 4,814.6 100.0 209 18 4,909.5 19802 1981 6,127.9 425.2 306.4 766.6 1,191.8 100.0 6,407.8 100.0 4,646.7 100.0 205 179 29 5,029.0 December March 407.3 301.3 875.9 1,283.2 100.0 6,613.4 100.0 4,530.2 100.0 204 181 27 4,896.6 408.1 289.1 1,025.3 1,433.4 100.0 6,619.1 100.0 4,362.5 100.0 216 187 25 34 Report of Transaction Accounts, Other Deposits, and Vault Cash (FR 2900) Table DEPOSITS OF SOUTH CAROLINA 7 COMMERCIAL BANKS AND THRIFT INSTITUTIONS’ ($ millions) Commercial Banks December March September Savings 57 2 79.5 29.4 395.3 464.7 84.3 2,768.9 95.4 820.2 44.8 51 51 15 74.5 28.4 454.8 529.3 83.9 2,903.4 95.2 824.7 46.0 49 49 12 2,187.5 68.8 25.3 488.4 557.2 83.6 2,770.0 94.8 794.7 46.4 51 51 13 8.1 33.7 132.4 79.7 2,768.5 97.1 859.6 44.2 and Loans December March 1981 124.3 2,345.7 June 1981 2,602.4 2,264.8 19802 1981 1.6 September 2.7 2.7 1.6 21.6 .8 926.5 47.6 64 5 0 15.0 61.6 61.6 11.2 78.3 2.7 846.3 46.2 64 51 0 0 14.3 76.5 76.5 12.1 92.4 3.0 802.7 44.8 64 51 0 1.5 1981 17.3 0 1.6 June 1981 0 1.7 19802 1981 0 12.7 84.2 84.2 12.6 98.4 3.4 752.1 44.0 64 52 0 Credit Unions December March 19802 14.3 June 1981 September .1 1981 31.1 18.7 60.6 2.1 159.7 8.2 8 8 3 18.8 24.8 4.5 54.1 1.9 164.6 9.0 8 8 2 6.1 0 16.8 29.2 28.2 18.9 25.0 4.0 53.1 1.7 164.0 9.2 8 8 2 5.8 0 29.4 6.0 .1 1981 27.9 19.4 25.2 3.8 53.2 1.8 164.2 9.6 9 9 2 Totals December March September Source: 138.6 27.6 166.4 100.0 2,850.7 100.0 1,945.8 100.0 129 15 37 85.5 73.6 475.7 551.1 100.0 2,901.3 100.0 1,831.1 100.0 123 110 17 2,347.3 1981 2,604.1 2,266.5 19802 1981 June 1981 80.6 70.9 550.2 630.8 100.0 2,189.1 74.6 65.9 592.0 666.6 100.0 Report of Transaction Accounts, Other 80.4 Deposits, and Vault Reserve Banks by commercial 2 NOW All other 18 are as of December 31, 1980. data 1,791.4 100.0 121 108 14 2,921.6 100.0 1,711.0 100.0 124 112 15 institutions do not report Cash (FR 2900). 1 There data are reported weekly to the Federal these data are understated slightly. deposits 3,048.9 100.0 are averages banks and thrifts for ECONOMIC with at least $15 million the last week in each month. REVIEW, MARCH/APRIL 1982 in total deposits. Since smaller weekly, Table DEPOSITS OF VIRGINIA Commercial June 1981 5.6 634.4 94.8 6,027.7 93.9 3,462.3 67.4 197 1 108 708.6 5.3 420.5 1,129.1 93.3 5,812.6 97.9 3,297.8 62.9 160 146 70 736.2 5.3 493.7 1,229.9 92.4 5,979.5 97.7 3,214.1 63.3 158 149 59 4,633.0 791.3 5.2 539.8 1,331.1 92.0 5,969.3 97.5 3,093.9 63.5 164 157 59 0 and Loans December March June 1.8 0 0 32.7 .9 .1 39.9 .6 1,342.6 26.1 64 7 0 45.1 45.1 3.7 81.7 1.5 1,315.8 25.1 64 56 0 37.2 3.9 19802 1981 .9 6.4 27.5 62.0 62.0 4.7 95.9 1.6 1,239.1 24.4 64 57 0 0 23.9 74.0 74.0 5.1 104.1 1.7 1,174.5 24.1 70 61 0 0 5.4 316.9 28.2 33.6 5.0 350.5 5.5 334.4 6.5 15 13 2 1.1 2.6 5.0 33.0 35.6 2.9 41.7 .7 630.0 12.0 15 13 1 1.1 1981 0 6.2 1981 September Credit 634.4 4,744.2 September 5,387.7 4,678.2 19802 1981 1981 Savings INSTITUTIONS1 Banks December March 8 COMMERCIAL BANKS AND THRIFT 2.9 4.9 36.2 39.1 2.9 45.1 .7 628.0 12.4 15 13 1 41.6 2.9 48.2 .8 604.8 18 14 1 110 Unions December March 19802 1981 June 1981 September, 2.9 1.8 1981 4.8 38.7 12.4 Totals December March June September Source: 1981 639.8 359.7 29.1 668.9 6,418.1 100.0 5,139.3 100.0 276 21 4,683.2 711.2 43.0 498.6 1,209.8 100.0 5,936.0 100.0 5,243.6 100.0 239 215 4,751.7 19802 1981 1981 739.1 37.7 591.9 1,331.0 100.0 6,120.5 100.0 5,081.2 100.0 237 219 60 4,641.0 794.2 33.9 652.5 1,446.7 100.0 6,121.6 100.0 4,873.2 100.0 252 232 60 do not report weekly, 5,389.5 Report of Transaction Accounts, Other Deposits, and Vault Cash (FR 2900). 1 These data are reported weekly to the Federal these data are understated slightly. Reserve Banks by commercial 2 NOW All other deposits are as of December 31, 1980. data are averages banks and thrifts for with at least $15 million Commercial INSTITUTIONS’ 33.6 4.0 2.1 35.7 1,989.9 87.1 201 1 50 12.9 3.3 262.2 275.1 94.8 1,893.9 99.0 1,850.2 86.9 172 166 40 12.2 2.7 306.3 318.5 94.1 1,860.1 98.7 1,782.9 86.9 172 170 38 1,619.1 11.8 5.8 332.9 344.7 91.8 1,969.6 98.2 1,728.5 86.8 180 177 40 2.0 0 3.3 1.0 1.0 2.7 6.3 .3 271.7 11.9 24 5 0 1.5 1981 1,942.1 0 3.1 14.2 14.2 4.9 18.7 1.0 256.8 12.1 23 22 0 95.5 1,981.8 99.6 and Loans December June 9 COMMERCIAL BANKS AND THRIFT 1,538.9 September March Since smaller institutions 1,611.5 19802 1981 June 1981 Savings deposits. Banks December March OF WEST VIRGINIA in total the last week in each month. Table DEPOSITS 71 19802 1981 1.5 3.5 18.8 18.8 5.6 23.8 1.3 246.6 12.0 23 22 0 0 3.2 22.0 22.0 5.9 26.8 1.3 237.3 11.9 25 24 0 0 0 0 .7 .7 1.9 .7 .O 21.8 1.0 1 1 0 0 0 0 .8 .8 .3 .8 .0 21.9 1.0 1 1 0 0 0 0 1.2 1.2 .4 1.2 .1 22.5 1.1 1 1 0 0 1981 0 1.6 1981 September 5.3 0 3.9 9.2 2.4 9.2 .5 25.9 1.3 2 2 1 Credit Unions December March June 19802 1981 1981 September 1981 Totals December March September Source; 7.3 3.8 37.4 100.0 1,988.8 100.0 2,283.4 100.0 226 7 50 12.9 6.4 277.2 290.1 100.0 1,913.4 100.0 2,128.9 100.0 196 189 40 1,540.4 1981 33.6 1,617.0 19802 1981 June 1981 12.2 6.2 326.3 338.5 100.0 1,885.1 100.0 2,052.0 100.0 196 193 38 1,620.7 17.1 9.0 358.8 375.9 100.0 2,005.6 100.0 1,991.7 100.0 207 203 41 1,944.1 Report of Transaction Accounts, Other Deposits, and Vault Cash (FR 2900). 1 Those data are reported weekly to the Federal Reserve Banks by commercial banks and thrifts these data are understated slightly. Data for the entire state are included in the table. 2 NOW deposits are as of December 31, 1980. All other data are averages FEDERAL for with at least $15 million in total deposits. Since smaller institutions do not report weekly, the last week in each month. RESERVE BANK OF RICHMOND 19 References 1. Beckhart, Benjamin H., and Smith, James G. The New York Money Market: Sources and Movements of Funds. vol. 2. New York: Columbia University Press, 1932, p. 204. 15. Knight, Robert E. “Comparative Burdens of Federal Reserve Member and Nonmember Banks.” Monthly Review, Federal Reserve Bank of Kansas City (January 1977), pp. 13-28. 2. Benston, George J. “Interest Payments on Demand Deposits and Bank’s Investment Behavior.” Journal of Political Economy (October 1964), pp. 43149. 16. Linke, Charles M. “The Evolution of Interest Rate Regulation on Commercial Bank Deposits in the United States.” National Banking Review (June 1966), pp. 449-69. 3. Board of Governors of the Federal Reserve System. Federal Reserve Bulletin (February 1920), p. 157. 17. Longbrake, William A. “Commercial Bank Capacity to Pay Interest on Demand Deposits; Part I : Principal Issues.” Journal of Bank Research (Spring 1976), pp. 8-21. 18. “Commercial Bank Capacity to Pay Interest on Demand Deposits; Part II: Earnings and Cost Analysis.” Journal of Bank Research (Summer 1976), pp. 134-49. 19. Madison Financial Corporation. NOW Accounts ... The First 90 Days. Nashville, Tennessee: Madison Financial Corporation, 1981. 4. 5. 6. 7. Discount Reappraisal of Mechanism. 1971. on Demand the Federal Reserve The Impact of the Payment. of Interest Deposits. Staff Study, January 1977. Cox, Albert M. Regulation of Interest on Bank Deposits. Bureau of Business Research, Graduate School of Business Administration, The University of Michigan, 1966. Cox, William W. “NOW Pricing: Perspectives and Objectives.” Economic Review, Federal Reserve Bank of Atlanta (February 1981), pp. 22-25. 8. Crane, Dwight B., and Riley, M. J. “Strategies for a NOW Account Environment.” The Bunkers Magazine (January-February 1979), pp. 35-41. 9. Federal Reserve System. Functional Cost Analysis: 1980 Average Banks. 1981, pp. 13-19. 10. Friedman, Milton. Paid by Banks.” Banking (February 11. Goodfriend, Marvin; Parthemos, James; and summers, Bruce. “Recent Financial Innovations: Causes, Consequences for the Payments System and Implications for Monetary Control.” Economic Review, Federal Reserve Bank of Richmond (March/ April 1980), pp. 14-27. 12. 13. 14. 20 20. “Variations in the New England NOW Account Experiment.” The NOW Account Experience in New England, Federal Reserve Bank of Boston (January 1981), pp. 3-19. Klein, Benjamin J. “Competitive Interest Payments on Bank Deposits and the Long-run Demand American Economic Review (Decemfor Money.” ber 1974), pp. 931-49. ECONOMIC REVIEW, . “NOW Account Follow-up Results.” September 1981. Question- 21. “Federal Funds.” InstruMonhollon, Jimmie R. ments of the Money Market. 4th ed. Edited by Federal Reserve Timothy Q. Cook. Richmond: Bank of Richmond, 1977, pp. 38-48. 22. “Effect of NOW Accounts on Paulus, John D. Costs and Earnings of Commercial Banks in 197475." Staff Economic Studies, Board of Governors of the Federal Reserve System, Washington, D. C., Spring 1976. 23. “Comment and Further Evidence Rush, Mark. Implicit Interest on Demand Deposits.” Journal Monetary Economics (July 1980), pp. 437-51. 24. Simonson, Donald G., and Marks, Peter C. “Pricing NOW Accounts and the Cost of Bank Funds; Part Two: NOWs and the Cost of Funds.” The Magazine of Bank Administration (December 1980), pp. 21-24. 25. Startz, “Controls on Interest Rates Journal of Money, Credit and 1970), pp. 15-32. Kimball, Ralph C. “The Maturing of the NOW Account in New England.” The NOW Account Experience in New England, Federal Reserve Bank of Boston (January 1981), pp. 75-90. naire R. pp. 515-34 on of “Implicit Interest on Demand Deposits.” Journal of Monetary Economics (October 1979), 26. “The Battle Watro, Paul R. nomic Commentary, Federal Cleveland (August 1981). 27. Cost of Funds Watson, Ronald D. “The Marginal Concept in Banking.” Journal of Bank Research (Autumn 1977), pp. 136-47. MARCH/APRIL 1982 for NOWs.” EcoReserve Bank of THEFEDERAL RESERVE’S ROLEIN THE PAYMENTS MECHANISM ITS AND COMMUNICATION PLANS Statement by THEODORE Staff Director Board of Governors Before the Subcommittee E. ALLISON for Federal Reserve Bank Activities of the Federal Reserve System on Government Information and Individual Rights of the Committee U.S. on Government Operations House of Representatives October 22, 1981 Introduction I am pleased with your Subcommittee Reserve in the provision of payments to be able to discuss to role in the payments mechanism responsibilities, obsolescence has made it The necessary to replace the current network. This replacement project, incidentally, isn’t at all remarkable-the facilities System every The Federal has a number has upgraded and U.S. mechanism Payments may be helpful. Mechanism: A Brief tory Prior to 1800, exchange of currency gold) was the primary method used to transfer its communications (and funds. Paper Reserve, as the nation’s central bank, of diverse, but highly interrelated, and they have played a dominant role in the U. S. payments mechanism ever since. With over 30 billion regulation, monetary and policy, payments bank system checks per year moving superoper- through the economy and the the check system. Electronic fund transfers, which are only in their infancy, have the potential to improve greatly the security, efficiency, and reliability firmed by the Congress only last year with the passage of the Monetary Control Act of 1980. This legislation makes it clear that the Federal Reserve should participate in the payments mechanism in ways that will promote competition, contribute toward greater efficiency, and ensure an adequate level RESERVE used in the mid-1800s, cost of labor and transportation increasing, electronic payment systems are being developed to supplement ations. Our basic responsibility for the efficiency and integrity of the nation’s payments mechanism dates from the Federal Reserve Act of 1913, and was con- FEDERAL checks became widely His- 10 to 20 years since 1915. responsibilities-for vision is accom- full cost. This is a major development in the evolution of the payments mechanism, and I will discuss its implications later on in my statement. First, however, a brief history of the Federal Reserve’s In addition, I will explain why the Federal Reserve’s operation of a highly secure and flexible network is needed to carry out the System’s monetary policy and payments and why technological This nationwide. plished by requiring the System to make available its payment services to all depository institutions and over the long run to charge for such services at their the role of the Federal of payments mechanism services, particularly those that are often referred as electronic fund transfer services (EFTS). services of the money transfer system. Prior to the creation of the Federal Reserve, checks were cleared, and funds transferred, through a network of interbank correspondent balances. In order for one bank’s check to be cleared when deBANK OF RICHMOND 21 posited at another bank, the check one or more correspondent correspondent depended banks banks. involved on many factors tween the two banks. moved through The number in clearing including of a check the distance be- This process led to pyramiding from funds to another The one institution bank Treasury maintain to another, on behalf Department accounts and at Federal and to send of its customers. Federal Reserve agencies offices balances and a slow they use these accounts collection system. The establishment altered of the Federal the U. S. payments important respects. banks to maintain balances First, system in 1913 in at least two it reduced the need network of correspond- a complex to clear Reserve checks and other for and the wire transfer extensively to disburse and collect monies. 43 million of correspondent ent ances reserve volving an aggregate The settlement count ism. of funds contribute through the full force and power balance. which could result Indeed, the Federal Reserve Act directed that reserve accounts be used to clear payments actions among depository institutions. Today spondent balances primarily smaller accounting are still used to clear payments depository using but eliminated transcorre- reserve institutions, accounts, the need of Book-entry however, to ship currency banks to settle payments flows between regions of the United States. has all between geographic to provide access to these centralized reserve accounts. In 1915 the wire network was a telegraphic communication system. It has evolved into a high speed, computerized network. Besides its role in the payments mechanism, the wire network is a vital element in the conduct of monetary policy and the operation of the government securities market. Despite the changes in the carry out these responsibilities, mechanism however, central by the Federal banking role performed serve has not changed since used to the basic wire payments the Federal the risk in serious mechan- Reserve, of a central ac- transfer with bank behind of settlement disruptions it, failure in financial markets. The Wire Policy Transfer Depository to their reserve Network institutions accounts and must to adjust Monetary have access them in response to fluctuations in their reservable liabilities. One way this access is provided is by the wire transfer system. The second change in the payments system was the establishment of a national wire transfer network reduces and reserve of the to an efficient Settlement In 1980, took place, in- transfers functions Instead, Federal Reserve member banks could transfer funds by wire using a single reserve account substantially transfers of $78 trillion. maintenance system payments. balance and system This system is also used by the Federal Reserve, the Treasury, and depository institutions to transfer U. S. government and agency securities. It is also through this network that Federal Reserve open market operations are facilitated. Open market operations are the primary method used to expand or contract the money supply. The wire transfer system improves the efficiency of open market operations by promoting a large, secure, and liquid market for government securities. facilitates the marketing This arrangement not only debt but also of government results in lower cost to the Treasury. Other Uses of the Federal Re- 1913. cation System cation network Reserve’s Communi- The Federal Reserve’s communiis also used for two other principal Federal Reserve Wire Transfer and Settlement Operations The 12 Federal Reserve District purposes. Banks and ac- deposit counts and all to-day monetary policy purposes. These data include daily deposit information on 14,000 depository insti- their clear 25 branches directly depository institutions institution wishing maintain and indirectly in the nation. to transfer reserve with A depository funds from its reserve balance to another depository institution uses the Federal Reserve’s wire transfer system. Reserve balances are transferred by depository institutions to purchase interbank 22 or sell Federal funds, (that is, to make loans), to move correspondent bank balECONOMIC REVIEW, First, it is used to transmit data to the Federal Reserve timely Board bank for day- tutions. Secondly, it is used to transfer small dollar value recurring payments such as direct deposit of payroll and bill payments among automated clearing houses. The ACH was established jointly by the banking industry and the Federal Reserve as a vehicle to clear and settle certain types of electronic MARCH/APRIL 1982 payments. 160 In 1980 about 60 million million through Treasury the ACH. the social ACH significant to have their processed over 30 percent in the United benefits certain we believe, the which has the potential and greater types of payments. The Reserve on Electronic NCEFT involvement was necessary because not yet able to operate without this assistance. A Description the Federal ACH is shared Transfers concluded in the that operation the private facilities of sector was economically of the Federal Reserve’s Communi- eral data processing machines of the type used by most large multipurpose organizations, both public and private. Our need to transmit data among the Federal Reserve offices, the Board, and the Treasury is accomplished through the use of three communications networks. The networks include the Interdistrict Fedwire, the Interdistrict Bulk Data, and the Networks. On the Fedwire more than 175,000 messages containing wire transfers of funds and securities, along with administrative information, are being communicated each day among the Federal Reserve Banks through a central store-and-forward message switch in Culpeper, Virginia. This network, including its extensions from head offices to branches and offices, was installed between 1969 and 1974 and replaced an antiquated semi-automated network in 1953. A bulk data network, which Each Federal New tem Federal Reserve As it has done the District. Communications on the average Reserve placing its communications grading System network. 10 is now re- The current up- system and its are 10 years old, and more cost-effective and reliable service Sys- of every is needed because the present technology technologies system that are available. Moreover, relies in large part on an AT&T will terminate in 1983, and its central switch is maintained by a vendor that will cease its Within the maintenance responsibilities in 1985. Federal Reserve, the replacement project is known by the acronym FRCS-80 (Federal Reserve Communications System for the Eighties). Conceptual that was installed technology Reserve the passage The Control Act of 1980. will be a general-purpose that is sent over the current The functions data network. of the existing separate communi- cations networks will be consolidated into a single network providing better service at less cost. Historically, as the need for new data communications applications emerged, the most frequent solution was the implementation of independent data communications systems tailored to a single application. With FRCS-80, new communications requirements can be without additional networks or major design changes. FRCS-80 will : l RANK Improve the reliability and efficiency of the Federal Reserve’s communications operations. l the head office and its RESERVE system Treasury, and other government agencies. FRSC-80 will be used for the transmission of the same data high-speed FEDERAL of the Monetary new communications network that will satisfy the Federal Reserve’s internal communications requirement of providing services to the financial community, the Bank has also implemented between in the 1980s and that tions. These assumptions have proven correct with the development of packet switching technologies and met uses would be available the Federal Reserve System would be making its payment services available to all depository institu- switched circuits to connect the 12 Federal Reserve Banks and the Board of Governors, was implemented in 1976. This network is used to transmit bank deposit data and ACH payments. its own local network are used to move account- planning for FRCS-80 began in late 1975 on the assumption that a more efficient communications cation Network The Federal Reserve uses data processing and communications to receive, process, and deliver payments. The computers used are gen- Local District The the present and by the Fund further for government, user of the ACH, Commission (NCEFT). security This judgment industry, is the largest National to offer to the public in terms of decreased convenience, by the financial These facilities ing data and other local traffic within of States sent through branches. to 20 years, the Federal benefits cost, increased ACHs recipients were and mechanism. The ACH, Federal Incidentally, security have elected payments commercial Reduce the total cost of System communications through a more efficient use of circuits. OF RICHMOND 23 Increase l Federal security Reserve of data moving within the center correspondent reaus System. written. The conceptual distributed central design “packet-switched” switching Culpeper, network. will be required of the network. a computerized wire, FRCS-80’s among is that No site, such as the current Virginia, the operation around of FRCS-80 single switch in to coordinate Rather than Fed- power will be distributed Reserve network. The private network chosen because of security public network and the lack of control bility of the public because legislative After the Federal Reserve or monetary evaluating approach risks involved network. a over the flexiis critical respond to rapid policy changes. proposals from software, and install operations, certain based several vendors, the network of of is being priced tem- costs In the near future to encourage ACH on a in early 1983. Services of the Federal its services will volume The Mone- tary Control Act of 1980 required the pricing of These services certain Federal Reserve services. include all payments mechanism services, such as in Point-of- Sale (POS) It is our understanding parties are concerned that FRCS-80 signed to accommodate bilities. Fund The that certain is being de- point-of-sale National Transfers switching Commission in 1977 reported capa- on Electronic to Congress government in EFT. on The Commission recommended “that the Federal government not be involved operationally, at present or in the foreseeable facilities intention Reserve on long-run economies the efficiency Reserve Role expected of Federal of their The among Pricing because to enter this market. turn-key basis. Recently a factory acceptance test was completed and equipment is now being installed The network is in the Federal Reserve offices. to be fully operational are and interna- transfers. types of funds transfers, porarily SWIFT2 for domestic for improving the role of the Federal the Federal Reserve awarded a $10 million contract to Northern Telecommunications, Inc. to provide hardware, funds and bu- checks grows we expect competitors was in using Flexibility must large dollar ACH CHIPS,1 service of total be priced based on actual costs and as ACH a new communi- cations network, the Federal Reserve compared two network approaches : A public access network and a private tional and private proportion competitors development. offices. As part of the process of selecting Bankwire, private-sector scale and potential revolve hub, as does the current computer the Federal of a banks clear a substantial future, except depository FRCS-80 switching in POS switching for the provision institutions.” and clearing of net settlement The design of does not contemplate any point-of-sale activities, and the Federal Reserve has no of getting involved in such activities. Privacy Considerations Before I conclude my remarks this morning, I would like to explain briefly the Federal Reserve ure of electronic policy on retention payment records and disclos- containing data on check processing, wire and securities transfers, settlement, and ACH transactions. We are now charging individuals. I will focus on our ACH policy since data identifying an individual is rarely part of a wire for all financial services except cash transportation. Charges for cash transportation are scheduled to commence in early 1982. Over the long run, the revenues derived from the sale of financial services will cover all Federal Reserve costs in providing them, including an amount to reflect private sector transfer. While the ACHs. do not process enough information to serve as a privacy threat, the Federal Reserve costs not incurred by the Federal Reserve, such as taxes and financing costs. As a result, services will be offered competitively, allowing the private sector adequate opportunity to enter or expand their share of the market for payments mechanism services. Even before pricing began, significant competition already existed in check processing. Large money 24 ECONOMIC REVIEW, 1 The Clearing House Interbank Payments System (CHIPS) is a nongovernmental facility that clears international transactions for its 100 members. It is operated by the New York Clearing House Association, which has as its controlling members the 12 largest New York City commercial banks. 2 The Society for Worldwide Interbank Financial Transactions (SWIFT) is a cooperative company located in Belgium that operates a communications network to exchange members. MARCH/APRIL payment 1982 instructions among its over 800 has taken affirmative steps to insure data in our possession. tain individual numbers, and and identification retained business social limited time ments. Records Such needed than containing for 60 business Microfiche ual transaction end records The tains The are for requireare days following Reserve to all payments Federal Reserve data except to parties such as the originating institutions or when a grand of a court Conclusion The the Board to testify Federal Reserve munications the Federal are individ- for one year. periods services, Banks disclosure policy including proven banking Subcommittee’s jury subpoena jurisdiction is FEDERAL requested Reserve offers payments services internal all delivers, and settles indi- RESERVE ment industry and facilities, mittee’s inter-bank concern OF RICHMOND payments. and telecommunications and we appreciate that the provision occurs in a competitive RANK the its role to be in the provision of telecomAs I have explained today, services. At per- for on what it believed and uses telecommunications The Federal Reserve operations. the ACH. will not disclose invitation at this hearing to comment so, we use computer data with that are part and receiving presented. data settlement. are destroyed. Federal financial or an order appropriate not containing retention of the transfer, historical transaction respective vidual transaction the media Microfiche data are retained of their data days following records con- account only operational 30 business of individual on computer individual historical bank other transaction of the transaction, retained records Banks to fulfill maintained records the and Reserve no longer settlement ACH names, security numbers. by Federal retained Various the privacy to the for its clears, In doing equip- the Subcom- of these facilities environment. 25