Full text of Economic Quarterly (Federal Reserve Bank of Richmond) : March-April 1982, Vol. 68

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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
[14], for example, found that the postwar demand for
money experience
suggests that the interest prohibition
was ineffective.
Startz [25] concludes
that banks implicitly pay approximately
50 percent
of the explicit
interest that would be paid in the absence. of the interest
prohibition.
Rush [23], 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

(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]

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 percentwere 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

Table

DEPOSITS OF UNITED STATES COMMERCIAL

BANKS AND

THRIFT INSTITUTIONS’

($ millions)

Total

Telephone
I.P.C.

Pre-

Demand

Depository

A.T.S.

Authorized

Transfer

Drafts

Institutions
(1)

Commercial
December
March

19802

1981

September

Personal

Amount

Market

(5)

(1+3+5)

(3)

Savings

Accounts

Drafts

Amount

Market

Amount

Market
Share

1981

331,636.9

13,359.1

6,722.8

8,136.7

21,495.8

79.5

359,855.5

96.5

153,038.8

292,084.6

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

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

June 1981
September
Savings

June

1981

1,671.6

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

19802

1981
1981

September
Credit

Transaction

Banks

June 1981

Mutual

Total

NOW/ATS/

NOW/

1981

576.4

165.2

3,084.0

1,041.9

1,207.1

4.5

4,867.5

1.3

99,892.5

31.1

585.2

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

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

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

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

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.

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

transfers

credit unions

from the beginning

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

which accounted

of these checkable

breakdown

posit experiences

unions

market

Tables
market

At the same

Table

DEPOSITS

OF FIFTH DISTRICT

COMMERCIAL BANKS AND THRIFT

INSTITUTIONS’

($ millions)

Commercial

Banks

December
March
June

19802

1981
1981

September
Mutual

1981

22,460.4

1,399.5

401.8

126.0

1,525.5

79.1

24,387.7

95.8

12,570.6

54.1

274

19,099.2

1,321.2

330.5

2,365.8

3,687.0

84.9

23,116.7

96.0

12,080.8

53.0

516

486

170

19,360.0

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

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

19802

1981

June 1981
September

1981

60.3

27.4

87.7

782.0

3.4

57.4

27.6

8.0

93.0

780.0

3.4

59.5

26.3

9.7

95.4

772.0

3.4

60.7

23.0

10.8

94.5

725.2

3.4

Savings and Loans
December
March

19802

1981

12.3

2.5

183.5

10.7

13.2

209.0

7,908.8

34.0

374

14.8

3.1

153.5

256.1

259.2

6.0

427.6

1.8

7,624.6

33.5

369

312

14.1

3.2

132.9

355.7

358.9

7.7

505.9

2.1

7,384.0

33.0

365

313

1981

12.8

3.1

119.4

496.3

499.4

9.7

631.6

2.6

6,912.6

32.4

386

326

19802

15.1

208.2

June 1981
September
Credit Unions
December
March

1981

June 1981
September

1981

356.5

182.2

390.4

20.2

762.0

3.0

1,979.1

8.5

12.1

184.8

45.1

202.2

387.0

8.9

444.2

1.8

2,288.9

10.1

12.1

63.1

44.3

224.4

287.5

6.1

343.9

1.4

2,408.4

10.8

11.3

65.5

43.8

229.1

294.6

5.7

349.7

1.4

2,303.5

10.8

290

Totals
December
March
June

1981

September

Source:

19802

1981
1981

22,540.2

1,610.2

969.2

318.9

1,929.1

100.0

25,446.4

100.0

23,248.5

100.0

1,032

19,183.5

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

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

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

EMPLOYMENT

OF DEPOSITS

7 One exception is offered by Simonson

and Marks.
[24]
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. [27]
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

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.

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
$46,200,
and
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 [9] 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
[18], 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

Table

MARGINAL
COMMERCIAL
Expense

Item

Deposit

($1

Source

of NOW

Interest Expense, Collected
NOW Balances (@5.25%)

Less: Reduced

Net

Explicit

Plus:
a.

Net

Interest,

Interest
Change

Savings

Net

Change

Net

Explicit

Adjustments
Nonearning
a.

9.
10.

11.

12.

Increased

Implicit

in Nonearning

Margined

ADDENDUM:
Marginal
(@17%);

Cost of
[@11%]

(Per Dollar

of New

$10,000

(@4%)

$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

[@11%]

($ 7,215)

($31,390)

[$28,843]

(31.4%)

Funds

4,668]

($14,178)

[$9,174]

($62,878)

[$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

Funds)

bank losses.

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.).
losses would

have

to be replaced

market rates of interest.
For example, in Table 3, the
entire $650,000 in demand deposit accounts (DDAs)

(@2%)

of New

in an effort to minimize

deposit

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

$27,500
$18,700

$2,000

Assets:

Source

Cost of NOW
[@11%]

New)

Accounts

Cost per Dollar

Alternative

$500,000

(05.5%)

-$11,000

Balances,

NOW

SA,

$46,200

0
(@2%)

Funds

Plus: Opportunity
Cost on
Nonearning
Assets (@17%);
Marginal
(@17%);

($500,000

New)

Loan Associations

on Funds

Transaction

Net

SA, $100,000

and

-113,000

(@-2%)

Due to Increase
Assets:
Reserves,

Savings

Banks

Interest

uncollected

ASSOCIATIONS

$13,125

(@5.25%)

Accounts

Interest

b. Increased
Increase

$250,000

LOAN

on Funds

on New

in Implicit
and

DDA,

ACCOUNTS

AND

$35,175

b. Increased Implicit Payment
Shifted from Savings

($650,000

Expense
in Implicit

Payment

SAVINGS

$48,300

Reduced Implicit Payment
Shifted from DDAs

c. Implicit

COST OF NOW

BANKS AND

Commercial
million)

ECONOMIC

REVIEW,

($43,775)

[$38,9753

($37,379)

[$34,757]

(17.5%)

[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

CALCULATIONS

Commercial

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

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)

Interest
payments
reduced
counts.
Funds transferred
accounts.

$250,000

(2 -

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

Banks

Savings

from demand
deposits,
from swings
accounts,
new funds to institutions.

X .0525

$48,300

(Net
operating
dollar
in NOWs
in DDAs) times
from DDAs.

Associations

from
savings
accounts,
new funds to institutions.

$1 m. X (1-.12)

X .0525

$500,000

X .055

No funds

shifted

from

$46,200

X .0525

$13,125

$27,500

(.02

.04)

x $650,000

(.02

.02)

X $250,000

- $13,000

Banks: N.O.E.
per
times new funds.

dollar

deposits.

(.04

.02)

x $500,000

$10,000

NOWs
.02 x

$100,000

$2,000

personal
.04 x $500,000

$20,000

-----

(5a

5c)

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.

-----

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

(8a

Loan

expense
(N.O.E.)
per
minus N.O.E. per dollar
funds
shifted to NOWs

S&Ls:
N.O.E.
per dollar
in
checking
times new funds.

and

transferred
represent

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.

50%
50%

Reserve requirement
Due from
balances =
CIPC
[$350,000

$100,000

X (1 -(.10

X .08

12%
10%
8%

Reserve requirement
Due from
balances
CIPC

.08))]

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

X .17 = $14,178);
X .11 = $9,174]

3%
10%
12%

X .03 =

$23,400

$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.

(7+10)

12.

Marginal
cost of attracting
new funds
to institutions.

($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

RICHMOND

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.

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

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

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

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

19802

1981
1981

September

1981

Savings and

June

INSTITUTIONS1

69.4

24.5

2,447.2

90.0

701.4

24.1

282.2

305.8

56.8

2,322.3

89.2

720.2

24.9

20.6

313.9

334.5

72.4

2,350.1

93.3

688.0

23.4

14.2

328.6

342.8

70.8

2,306.6

92.8

679.0

24.6

2,331.7

69.4

2,016.4

23.5

2,015.6
1,963.7

19802

1981
1981

September
Credit

BANKS AND THRIFT

46.1

Loans

December
March

OF COLUMBIA COMMERCIAL

Banks

December
March

OF DISTRICT

1981

1.9

49.6

1.3

52.1

1.9

1,447.8

49.7

5.0

37.2

22.0

22.3

4.1

64.6

2.5

1,426.4

49.2

1.7

32.8

28.3

28.7

6.2

63.2

2.5

1,381.3

46.9

29.1

42.5

42.8

8.9

72.7

2.9

1,247.3

45.2

Unions

December
March
Juno

1.6

138.1

3.7

80.1

214.0

75.4

219.4

8.1

763.9

26.2

2.2

124.8

4.2

85.8

210.6

39.1

217.0

8.3

751.4

25.9

2.6

3.5

4.4

95.0

98.5

21.3

105.5

4.2

874.2

29.7

2.2

3.0

4.6

95.9

98.9

20.4

105.7

4.3

835.6

30.3

2,335.2

207.8

99.4

81.4

283.9

100.0

2,718.7

100.0

2,913.1

2,023.6

148.6

41.5

390.0

538.7

too.0

2,603.4

100.0

2,898.0

100.0

2,019.9

24.5

37.3

437.2

461.7

100.0

2,518.8

2,943.5

100.0

1,966.7

17.5

33.8

467.0

484.5

100.0

2,485.0

2,761.9

100.0

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

COMMERCIAL BANKS AND THRIFT

INSTITUTIONS

($ millions)

Commercial

Banks

December
March
June

19802

1981
1981

September
Mutual

1981

4,264.3

93.9

23.7

93.9

50.5

4,381.9

95.2

3,144.9

48.3

3,764.2

76.7

21.2

337.1

413.7

70.8

4,199.2

93.4

3,072.0

48.0

3,831.8

76.1

20.0

396.9

472.9

69.4

4,324.8

92.9

3,031.8

48.0

3,738.6

76.1

17.0

433.2

509.3

64.8

4,264.9

91.6

2,888.5

48.6

60.3

27.4

87.7

1.9

782.0

12.0

57.4

27.6

8.0

1.4

93.0

2.1

780.3

12.2

59.5

26.3

9.7

1.4

95.4

2.1

772.0

12.2

60.7

23.0

10.8

1.4

94.5

2.0

725.2

12.2

4.3

38.2

2.5

3.7

2.0

42.5

2,159.1

33.2

1.8

2.7

35.7

69.2

71.9

12.3

109.4

2.4

2,124.3

33.2

2.1

2.8

30.2

102.3

105.1

15.4

137.4

3.0

2,091.5

33.1

1.8

2.6

28.4

174.6

177.2

22.5

207.4

4.5

1,933.7

32.6

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

19802

1981

June 1981
September

1981

49.4

2.0

38.6

88.2

47.5

90.3

2.0

424.2

6.3

49.9

2.1

40.7

90.6

15.5

92.8

2.1

421.1

6.6

48.9

2.1

44.8

93.7

13.8

95.9

2.1

425.0

6.7

46.9

1.7

41.7

88.6

11.3

90.5

1.9

392.4

6.6

Totals
December
March
June

1981

September

Source;

19802

1981
1981

4,329.0

143.3

91.3

41.1

185.8

100.0

4,602.4

100.0

6,510.2

100.0

172

3,823.6

129.3

86.6

455.0

584.2

100.0

4,494.4

100.0

6,397.7

100.0

165

143

3,893.5

127.8

165.2

553.7

681.4

100.0

4,653.5

6,320.3

100.0

163

145

3,801.3

125.6

70.1

660.3

785.9

100.0

4,657.3

5,939.9

100.0

166

148

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

COMMERCIAL BANKS AND THRIFT

INSTITUTIONS’

($ millions)

Number
Offering
A.T.S.

Commercial

Banks

December
March
June

19802

1981
1981

September
Savings

1981

445.7

289.3

117.8

2,658.4

55.2

4,899.6

421.6

271.5

696.6

1,118.2

93.8

6,289.4

98.2

2,540.0

54.7

91.9

6,470.9

97.9

2,500.5

55.2

6,448.3

97.4

2,401.2

55.0

95.9

563.5

5,019.4

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

43.4

1,859.3

38.6

137

1.3

2.2

30.3

46.1

48.3

4.1

79.9

1.3

1,785.0

38.4

137

113

1.3

2.0

25.1

70.0

72.0

5.6

98.3

1.5

1,712.5

37.8

137

115

1981

22.9

102.9

103.0

7.2

126.8

1.9

1,659.2

38.0

148

121

19802

13.0

1.0

4.4

18.6

19.6

37.0

296.9

6.2

8.6

1.4

4.6

23.9

25.3

2.1

38.5

321.7

6.9

8.3

1.6

4.7

29.5

31.1

2.4

44.2

317.2

7.0

6.9

1.6

4.8

30.7

32.3

2.3

44.0

302.1

6.9

December
March
June

19802

1981
1981

September
Credit

6,114.0

2.2

37.9

Unions

December
March
June

1981
1981

September

1981

Totals
December
March

19802

1981

June 1981
September

Source;

1981

6,127.9

448.9

331.6

138.8

587.7

100.0

7,047.2

100.0

4,814.6

100.0

209

4,909.5

425.2

306.4

766.6

1,191.8

100.0

6,407.8

100.0

4,646.7

100.0

205

179

5,029.0

407.3

301.3

875.9

1,283.2

100.0

6,613.4

100.0

4,530.2

100.0

204

181

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

Report of Transaction

Accounts,

Other

Deposits,

and Vault

Cash

(FR 2900)

Table

DEPOSITS

OF SOUTH CAROLINA

COMMERCIAL BANKS AND THRIFT

INSTITUTIONS’

($ millions)

Commercial

Banks

December
March

19802

1981

June 1981
September
Savings

124.3

79.5

29.4

395.3

464.7

84.3

2,768.9

95.4

820.2

44.8

2,345.7

74.5

28.4

454.8

529.3

83.9

2,903.4

95.2

824.7

46.0

2,187.5

68.8

25.3

488.4

557.2

83.6

2,770.0

94.8

794.7

46.4

8.1

33.7

132.4

79.7

2,768.5

97.1

859.6

44.2

and Loans

December
March

1981

2,602.4
2,264.8

19802

1981

June 1981
September

1981

1.6

17.3

2.7

1.6

21.6

926.5

47.6

1.7

15.0

61.6

11.2

78.3

2.7

846.3

46.2

1.6

14.3

76.5

12.1

92.4

3.0

802.7

44.8

1.5

12.7

84.2

12.6

98.4

3.4

752.1

44.0

Credit Unions
December
March

19802

1981

June 1981

September

1981

14.3

29.4

16.8

31.1

18.7

60.6

2.1

159.7

8.2

6.0

29.2

18.8

24.8

4.5

54.1

1.9

164.6

9.0

6.1

28.2

18.9

25.0

4.0

53.1

1.7

164.0

9.2

5.8

27.9

19.4

25.2

3.8

53.2

1.8

164.2

9.6

Totals
December
March

19802

1981

June 1981
September

Source:

1981

2,604.1

138.6

27.6

166.4

100.0

2,850.7

100.0

1,945.8

100.0

129

2,266.5

85.5

73.6

475.7

551.1

100.0

2,901.3

100.0

1,831.1

100.0

123

110

2,347.3

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

are as

of December

31,

1980.

data

1,791.4

100.0

121

108

2,921.6

100.0

1,711.0

100.0

124

112

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

19802

1981
1981

September
Savings

1981

5,387.7

634.4

5.6

634.4

94.8

6,027.7

93.9

3,462.3

67.4

197

108

4,678.2

708.6

5.3

420.5

1,129.1

93.3

5,812.6

97.9

3,297.8

62.9

160

146

4,744.2

736.2

5.3

493.7

1,229.9

92.4

5,979.5

97.7

3,214.1

63.3

158

149

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

and Loans

December
March
June

19802

1981
1981

September
Credit

INSTITUTIONS1

Banks

December
March

COMMERCIAL BANKS AND THRIFT

1981

1.8

37.2

3.9

32.7

39.9

1,342.6

26.1

45.1

3.7

81.7

1.5

1,315.8

25.1

6.4

27.5

62.0

4.7

95.9

1.6

1,239.1

24.4

6.2

23.9

74.0

5.1

104.1

1.7

1,174.5

24.1

5.4

316.9

28.2

33.6

5.0

350.5

5.5

334.4

6.5

1.1

2.6

5.0

33.0

35.6

2.9

41.7

630.0

12.0

1.1

2.9

4.9

36.2

39.1

2.9

45.1

628.0

12.4

41.6

2.9

48.2

604.8

110

Unions

December
March

19802

1981

June 1981
September,

1.8

1981

2.9

4.8

38.7

12.4

Totals
December
March
June

19802

1981
1981

September

Source:

1981

639.8

359.7

29.1

668.9

6,418.1

100.0

5,139.3

100.0

276

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

739.1

37.7

591.9

1,331.0

100.0

6,120.5

100.0

5,081.2

100.0

237

219

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

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

19802

1981

June 1981
September
Savings

June

Since smaller institutions

COMMERCIAL BANKS AND THRIFT

INSTITUTIONS’

1981

1,942.1

33.6

4.0

2.1

35.7

1,989.9

87.1

201

1,611.5

12.9

3.3

262.2

275.1

94.8

1,893.9

99.0

1,850.2

86.9

172

166

1,538.9

12.2

2.7

306.3

318.5

94.1

1,860.1

98.7

1,782.9

86.9

172

170

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

2.0

3.3

1.0

2.7

6.3

271.7

11.9

1.5

3.1

14.2

4.9

18.7

1.0

256.8

12.1

95.5

1,981.8

99.6

and Loans

December
March

deposits.

Banks

December
March

OF WEST VIRGINIA

in total

the last week in each month.

Table

DEPOSITS

19802

1981
1981

September

1981

1.5

3.5

18.8

5.6

23.8

1.3

246.6

12.0

1.6

3.2

22.0

5.9

26.8

1.3

237.3

11.9

1.9

21.8

1.0

21.9

1.0

1.2

22.5

1.1

5.3

3.9

9.2

2.4

9.2

25.9

1.3

Credit Unions
December
March
June

19802

1981
1981

September

1981

Totals
December
March

19802

1981

June 1981
September

Source;

1981

33.6

7.3

3.8

37.4

100.0

1,988.8

100.0

2,283.4

100.0

226

1,617.0

12.9

6.4

277.2

290.1

100.0

1,913.4

100.0

2,128.9

100.0

196

189

1,540.4

12.2

6.2

326.3

338.5

100.0

1,885.1

100.0

2,052.0

100.0

196

193

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

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

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.

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.

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.

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.

Crane, Dwight
B., and Riley, M. J.
“Strategies
for a NOW Account
Environment.”
The Bunkers
Magazine
(January-February
1979), pp. 35-41.

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.

“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

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
ANDITS
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

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

posited

at another

bank,

the check

one or more correspondent
correspondent
depended

banks

banks.

involved

on many factors

tween the two banks.
of correspondent

moved

through

The number

in clearing

including

a check

the distance

be-

This process led to pyramiding

balances

and

slow

collection

system.
The establishment
altered
important

respects.

banks to maintain
ent

of the Federal

the U. S. payments

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

ances

from

funds

to another

The

bank

Treasury

maintain

Department

accounts

extensively

to disburse

and collect monies.

reserve

volving

an aggregate

The settlement
count
ism.

balance
of funds

maintenance
contribute

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

Book-entry

however,

to ship currency

banks to settle payments flows between
regions of the United States.

has all
between

geographic

through

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

reduces

and reserve

of the

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

In 1980,

took place, in-

transfers

functions

to an efficient

Settlement

substantially

transfers

and

system

of $78 trillion.

which could result

Act directed

agencies
offices

43 million

balance.

Reserve

Federal

Reserve

and the wire transfer

the full force and power

the Federal

and to send

of its customers.

and

at Federal

Instead, Federal Reserve member banks could transfer funds by wire using a single reserve account
Indeed,

to another,
on behalf

they use these accounts

system

payments.

one institution

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

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

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.

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

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

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

RANK

will :

Improve
the reliability
and efficiency of the
Federal Reserve’s communications
operations.

Reduce the total cost of System communications through a more efficient use of circuits.

OF RICHMOND

Increase

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

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.

was

in using

over the flexi-

Flexibility
must

is critical

respond

to rapid

policy changes.

proposals

from

software,

and

install

operations,

certain
porarily

based

several

vendors,

the network

on a

Reserve

Services

The Mone-

tary Control Act of 1980 required
the pricing of
These services
certain Federal
Reserve services.
include all payments
mechanism
services, such as

are

and interna-

transfers.

because

of their

for improving

on long-run

economies

the efficiency

is being priced tem-

costs

In the near future

to encourage
ACH

its

services

will

volume

The

Reserve

Role

of the Federal

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

of Federal

SWIFT2

to enter this market.

expected

in early 1983.

bu-

checks

grows we expect competitors

among

Pricing

and

for domestic

types of funds transfers,

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

funds

the role of the Federal

the Federal Reserve awarded a $10 million contract
to Northern
Telecommunications,
Inc. to provide
hardware,

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

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

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

the

require-

transaction

Reserve

to all payments
Federal

Reserve

financial

individ-

periods

or when a grand

of a court

Conclusion

The

services,
Banks

disclosure

policy

including

FEDERAL

jury subpoena
jurisdiction

the Board

to testify

Federal

Reserve

banking

invitation

at this hearing

to comment

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.

per-

for

on what it believed

and uses telecommunications
The Federal
Reserve
operations.

the ACH.

will not disclose

proven

Subcommittee’s

so, we use computer
data

with

that are part
and receiving

presented.

munications
the Federal

are

data except to parties
such as the originating

institutions

or an order

data

settlement.

are destroyed.
Federal

of the transfer,

appropriate

for one year.

retention

vidual transaction

historical

not containing

respective

are

days following

Microfiche

data are retained

of their

data

media

days following

records

con-

account

only

operational

30 business

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.

Full text of Economic Quarterly (Federal Reserve Bank of Richmond) : March-April 1982, Vol. 68

FRASER