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January 31, 1977


A Study of the Staff of
the Board of Governors of the
Federal Reserve System*

^Stephen H . Axilrod, Staff Director for Monetary Policy, was
responsible for preparation of this study in collaboration
with members of the Board's Division of Research and
Statistics, Principal contributors were John D . Paulus,
Chief, Banking Section; Edward C , Ettin, Associate Director
in the Division; David E . Lindsey, Senior Economist, Econometric and Computer Applications Section; and Thomas D .
Simpson, Economist, Banking Section. Assistance was also
received from Brian Gendreau, Sue Gibson, David Graham,
Peter Lloyd-Davies, and Naomi Salus.





Background t o t h e L e g i s l a t i v e P r o h i b i t i o n
o f I n t e r e s t on Demand D e p o s i t s
Emerging Methods o f P a y i n g
on T r a n s a c t i o n s

Economic E f f i c i e n c y








Monetary Aggregates,



on D e p o s i t o r s


and the Economy



Summary and C o n c l u s i o n s


on C o s t s and E a r n i n g s













on Reserve B a l a n c e s








This paper evaluates the probable effects of lifting the
prohibition on payment of interest on demand deposits on banks, other
depository institutions, and the public, as well as on monetary policy
and credit markets as a whole.
tentative and judgmental*

The conclusions reached are necessarily

Various assumptions have had to be made

with regard to the types of institutions that might be authorized to
pay interest on demand deposits or other transactions-type accounts,
the classes of depositors that might be permitted to receive such
interest, and the adjustments that might be made to service charges and
other policies by banks and nonbank institutions.

Effects on depositors,

institutions, and the banking structure from payment of interest on demand
deposits and associated changes in the pricing of banking services are
highly uncertain for they involve an assessment of institutional and
public responses to a new ingredient in financial m a r k e t s — p a y m e n t of
explicit interest on demand deposits—after a period of more than 40
years over which the nation's financial structure and practices have
adapted to the prohibition of such payments.
Despite the prohibition of interest on demand deposits in
1933, banks as a group have still had to bid for the demand deposit
funds of the public in competition with other highly liquid financial

Bank efforts to attract such deposits have mainly involved

the payment of implicit interest in the form of charges below cost
for services performed.

However, banks also pay explicit interest to

some customers on highly liquid funds that can be easily converted to
demand deposits or can be used directly for payments purposes; banks
borrow from other banks and certain other institutions on an overnight

basis at an interest rate called the Federal funds rate> and many also
place "surplus" funds of State and local government and corporate
customers in securities under an agreement by the bank to repurchase
the securities at a predetermined price.

Moreover, in recent years it

has become increasingly convenient for the public to place transactional
balances in savings accounts at both bank and nonbanlc institutions*
Such balances can be easily transferred, by telephone in many instances,
to demand deposits for purposes of writing a check.

In other c a s e s -

such as the negotiable order of withdrawal (NOW) accounts permitted
in New England--checks can be written directly on savings accounts c
Share drafts against credit union savings accounts and drafts drawn on money
market mutual fund

accounts are similar to NOW accounts in many respects.

Thus, competitive pressures have been leading banks and other
financial institutions more and more toward interest payments on transactional balances.

Introduction of explicit interest payment on

demand deposits would accelerate the process of evolution and alter its
nature, but it is difficult to characterize and estimate in a precise
way the institutional changes that may ensue.
It seems likely that introduction of explicit interest would
change the public's perception of the return on demand deposits
and might cause them to shift liquid funds from other assets to such
deposits; that banks would be motivated to gauge more carefully their costs
of demand deposit services; and that existing competitive relationships
among banks and between banks and other depository institutions would
be altered.

Competitive stresses would probably be greatest in the

transition period following introduction of interest on demand deposits,

as individual banks and nonbank depository institutions (if they too
are permitted to offer interest bearing demand deposits) strive to
increase or maintain market shares.

Under such circumstances, the return

to deposit holders and costs to depository institutions could, for a
time, be above longer-run equilibrium levels.

With time, the

additional interest burden for depository institutions would
tend to be offset by higher charges for checks and for other
services presently provided free or below cost to depositors.


vould be resulting gains in economic efficiency for the nation as a
vhole, as banking services were priced more in accordance with their
actual costs in terms of resource use.

But in the process, not all

depositors and institutions would be equally affected; some may be
better off than they are now and others worse off.
Given the wide variety of possible institutional and public
responses to the availability of explicit interest on demand deposits,
there is clearly a considerable area of uncertainty in assessing the
likely effects of removing the present prohibition of such interest

Thus, conclusions with respect to the incidence of interest

on demand deposits on banks, other financial institutions, depositors,
and the nation can only be judgmental and qualitative.
Quantitive estimates of probable impacts h a v e been made where
possible in the analysis, but these estimates should b e viewed, at
best, as rough approximations.

Analysis is limited both by a paucity

of data and by lack of significant experience with interest on demand
deposits under an institutional structure and economic framework such
&B now prevails in this country.

However, the experience with

-4interest-bearing negotiable order of withdrawal (NOW) accounts in
New England since 1974 does provide some general insight into possible
institutional and public behavior in response to payment of interest
on transactional deposits more generally.
Foreign experience offers little guidance on probable effects
in the United States of explicit interest payments on demand deposits.
A few countries with developed financial markets--such as Germany,
Italy, the Netherlands, Switzerland, and Canada--have interest-bearing
accounts against which checks can be drawn.

The rates paid vary over

time and across countries, but generally tend to be quite low.


the banking and financial structures of these countries are quite
different from those of the United States.

This country has a con-

siderably larger number of competing banks and nonbank depository
institutions $ and the structure of liabilities and assets of banks in
the Ue S . differ from those abroad®
The next section of this paper provider some historical
background and discusses the apparent reasons for the abolition of
interest on demand deposits in the Banking Act of 1933.

The third

section reviews the various methods developed, particularly in recent
years, that enable many depositors to earn interest on funds that
are tantamount to demand deposits.

The next four sections discuss

major issues in connection with payment of interest on demand
deposits: efficiency in resource allocation; effects on costs and
earnings of financial institutions; effects on depositors; and monetary

-5aggregates, credit markets, and the economy.

The payment of interest

on reserve balances held at Federal Reserve Banks is considered in
section VIII.

Conclusions with respect to the impact of interest

on demand deposits are summarized in the final section.


Background to the Legislative Prohibition
of Interest on Demand Deposits

Section 19(i) of the Federal Reserve Act provides in
part that "No Member Bank shall, directly or indirectly, b y any device
whatsoever, pay any interest on any deposit which is payable on demand."
This provision was added by the Banking Act of 1933 that was signed
into law by President Roosevelt on June 16, 1933.

The statutory

provision against interest payments on demand deposits was extended
to insured nonmember banks by the Banking Act of 1935•
Historical Perspective—^
Banks began to pay interest on selected accounts during the
early part of the nineteenth century.

With deposits at that time

representing only a small part of bank liabilities—most banks issued
notes in exchange for s p e c i e — s u c h payments were small in comparison to
total bank expenses.

By the mid-1800s, however, large banks in New York

City had attracted a considerable volume of bankers


balanses--that is,

deposits of other commercial b a n k s — a n d were paying interest on those

By the end of the last century, interest on deposits was being

paid to governmental units, banks, and other large depositors.


For a comprehensive review of the payment of interest on deposits
and associated criticism, see Charles M . Linke, "The Evolution of
Interest Rate Regulation on Commercial Bank Deposits in the United
States," National Banking Review, June 1966.

-7In the century before the passage of the Banking Act of
1933, the payment of interest on deposits was frequently criticized
by bankers, regulators, and legislative bodies.

Before the Federal

Reserve System was established, such criticism was usually directed
toward interest payments on bankers' balances and the role these balances
were thought to have played in the periodic banking crises that occurred
between 1857 and 1 9 0 7 . ^
Following the periods of financial crisis, repeated efforts
were made to prohibit or restrict the payment of interest on bankers


After the panic of 1857, the newly formed N e w York City

Clearinghouse--an association of 46 large New York City b a n k s — i s s u e d
a report recommending that interest payments on bankers


balances be

This recommendation was defeated by the association's six

largest members which held nearly two-thirds of all bankers balances



Bankers balances served as a highly liquid repository of funds
for many smaller rural banks which tended to experience strong
seasonal fluctuations in deposits and loans coinciding with the
spring planting season and the fall harvest. These banks would
rely upon their deposits at large banks to meet local customers'
needs for funds. During periods of normal economic activity, large
banks had little difficulty in adjusting to seasonal contractions
in bankers' balances. However, when money was tight, the money
center banks found it difficult to obtain loan repayments on
short notice.
According to critics of interest payments on
bankers balances, the resulting inability of large banks to meet
their obligations to small banks during such periods caused
severe stress on financial markets and was mainly responsible
for banking panics. These critics contended that if interest had
not been paid on bankers' balances, smaller banks would have
invested their funds locally and the crises would have been

in the city r

A similar effort b y the Clearinghouse following the panic

of 1873 was unsuccessful.

However, the panic of 1884 produced an

agreement by association members to restrict the rate of interest on


balances to 2 per centc

This restriction, however, was

apparently only partially effective as some banks lowered service
charges, to raise the effective rate above the agreed upon maximum.
After the passage of the Federal Reserve Act of 1913,
criticism of interest payments on deposits began to focus on the
implications for bank safety of excessive rates paid on time deposits<
Since reserve requirements for Federal Reserve member banks were much
lower for time than for demand deposits, such banks sought to attract
time deposits by raising interest rates on those deposits*

As the

stock of time deposits expanded, interest expenses as a fraction of
total bank costs began to rise.

This development alarmed many bankers

who felt that higher interest payments might encourage banks to acquire
higher yielding, more risky assets in order

offset higher costs c

Though somewhat reduced, the concern over interest payments
on bankers * balances also continued during the 1913 to 1933 period*
With the threat of banking panics seemingly eliminated by the establishment of this Federal Reserve System, attention turned to the uses to
which bankers* balances were put by money center banks.

It was argued

that interest payments attracted funds from rural areas to money
centers for the purpose of financing speculative investments in the
securities market.

Further, it was commonly alleged that such specula-

tively invested funds were being diverted from productive uses in rural

Perhaps reflecting these concerns > the clearinghouse associations of all twelve Federal Reserve cities agreed in 1920 to limit
the payment of interest on bankers


balances to 2% per cent.

While this

rate limitation was generally effective throughout the twenties, the
flow of funds from rural areas into the securities markets in the
money centers was hardly affected, since rural banks commissioned
money center banks to serve as their agents in placing funds in that

Thus, the interest rate restriction apparently served only to

change the channel through which such funds found their way into high
yielding investments.
Arguments Used to Support the 1933 Prohibition
The legislative history of the Banking Act of 1933 is
relatively thin; it was enacted in a crisis atmosphere without formal

Concern at that time did not center on interest on demand

deposits, but rather on other issues, such as establishing Federal
deposit insurance.
From the limited discussion of the 1933 Act and from policymakers


statements on similar bills, at least three reasons appear to

emerge for the provision prohibiting interest payments on demand

First, the popular view was advanced that the payment of

interest on bankers


balances encouraged the movement of funds from

rural areas to money center banks able to pay higher interest rates,
thus limiting credit availability to rural areas.

Senator Carter Glass,

one of the sponsors of the bill, argued that "the payment of interest on

demand deposits has resulted for years and years in stripping the country
banks of all their spare funds * which have been sent to the money
centers for stock speculative purposes.


Glass believed that this

practice resulted in credit shortages in the markets outside the
money centers, and his main objective was evidently to force these
banks to retain excess funds for use in their local communities c
Second, the prohibition of interest on demand deposits was
expected to reduce bank costs significantly and thereby to improve
bank profits and the stability of the banking industry*

Moreover, the

reduction in costs would encourage banks to place their * deposits in
less risky loans and investments* further promoting bank soundness*
This argument was often generalized to apply to interest rate competition for all bank deposits, time as well as demand.
A third reason, also relating to lower costs expected to
result from the prohibition, concerned deposit insurance for banks c
A major concern was how banks, in their weakened financial condition,
could afford to pay the necessary assessments

for such insurance.

Senator Glass observed on the floor that, "If banks are relieved of
the competitive necessity of bidding for demand deposits on interest y
they will not only have money to meet this assessment. „.but they will
have almost an equal amount left over."

-11Appraisal of the Bankers' Balance and Bank Safety Arguments
The argument that payment of interest on bankers



drained loanable funds from rural areas did not consider that loans
generally earned considerably more than bankers
the period prior to the prohibition.—^


balances over most of

Thus, the interest that could

be earned on such balances was not the sole incentive for holding them.
Among the other reasons for holding bankers


balances overlooked by

those arguing for the prohibition were:
First, bankers


balances were a convenient form in which

smaller banks could hold liquid funds against seasonal swings in
deposits and loan demand.
Second, because country banks tend to b e small and distant
from financial centers, they always maintain balances with correspondents
to facilitate check clearing and other transactions w i t h larger urban banks.
Finally, reflecting in part the lack of short-term money market
investments available in the twenties—Treasury bills were not introduced
until 1929 and the Federal funds market was relatively underdeveloped
until after World War I I — b a n k e r s


balances served as a highly attractive

short-term asset for the purpose of diversifying the portfolios of
rural banks and stabilizing the expected return on their assets.



For example, from 1927 to 1930, the average interest rate paid on
interbank deposits was less than 2 per cent. At the same time,
the average return on loans and investments for member banks ranged
from a little over 5 to 5\ per cent. Data are not available for
the return on loans in rural areas, but there is little reason
to believe that it would be well below the average return
on member bank loans and investments.

-12asset diversification was especially important for rural banks which
depended heavily on activities related to a single industry, agriculture,
for deposits and earning assets*
The bankers


balance argument appears even less applicable

to issues connected with interest on demand deposits under current
circumstances than it was in 1933*

Rural areas are no longer dependent

solely upon rural bank deposits for loanable funds, and rural banks
have several channels available for placing interest"bearing highly
liquid funds in nonlocal institutions.

For example, rural banks

presently earn interest on short~term funds placed with other commercial
banks through the Federal funds market and the certificate of deposit (CD)

As will be discussed in section III, large banks borrow

extensively from smaller banks in the overnight Federal funds rnarkete
The bankers


balance argument is also less relevant because rural

areas now have increased access to funds originating outside those

Credit provided through Federal farm credit agencies has enabled

agriculture to tap national money markets.

In addition, the Federal

Reserve discount window is a source of funds to member banks in
agricultural areas.
The other principal argument for the prohibition of interest
on demand deposits in 1933 concerned bank safety and stability.
George Benston and Albert Cox have examined the question of whether
interest rate competition for bank deposits increased the instability

-13of the banking system in the early thirties.—^

Neither found evidence

that rate competition for demand deposits led to bank failures.
Benston used two sets of data:

a New York State Bankers

Association study of commercial banks in New York State outside of
New York City for 1923 to 1934, and data for all national banks from
1928 to 1933 from the Annual Report of the Comptroller of the Currency.
If rate competition had forced banks to acquire risky assets, a
positive relationship would be expected between the interest paid on
demand deposits and measures of asset risk.—

Benston, however, found

no relationship between interest rates paid on all deposits and measures
of asset risk in the New York data and found either negative relationships or no relationships between the interest rate paid on demand
deposits and measures of asset risk in the national bank data. Similarly, if rate competition led to bank insolvencies, a positive relationship would be expected between demand deposit rates and the probability
of bank failure.

But, measuring probability of bank failure as the

ratio of failed banks in a city or state during the time period to the
total banks in that locality, Benston found either negative or
insignificant relationships between demand deposit rates paid by national
banks and the probability of their failure.


George J . Benston, "Interest
Payments on Demand Deposits and Bank
Investment Behavior,
Journal of Political Economy, October 1964,
and Albert H . Cox, Jr., Regulation of Interest on Bank Deposits
(Michigan Business Studies, Vol. XVII, # 4 , 1966).
Benston used ''Percentage of Gross Earnings Paid Out as Interest as
an indicator
of interest payments on deposits, and "Gross Earnings
on Assets and "Net Losses on Earning Assets" as indicators of asset

-14Cox's study was based on a sample of 285 national banks,
almost all the national banks in operation in 1929 in Michigan,
Mississippij Oregon, Vermont, and the District of Columbia*


samplej admittedly not random, comprised 4 per cent of the 7>500
national banks in operation in that year.

Cox divided the

banks into two groups, those that survived the 1930-33 period
intact (165 banks) and those that failed or otherwise went out of
existence daring the same period, even if only temporarily (115 banks,
or 42 per cent of the sample) c

After adjusting for bank size and

deposit composition, Cox compared banks that survived with those that
failed and found that banks that failed were paying slightly higher demand
deposit rates (*2 per cent higher on average) than surviving banks with
similar characteristicse

However, the banks that survived were generally

paying considerably higher rates on time deposits (.6 per cent higher)
than those banks that failed*

Cox thus found no support for the

argument that excessive rate competition had contributed to bank
In summary, the arguments for prohibition of interest on

demand deposits in the 1930 s appear to have had little validity at
the time the prohibition was enacted.

The desirability of permitting

interest to be paid on demand deposits under current conditions would

-15seem to depend mainly on an appraisal of its impact on economic
efficiency, the costs and profits of banking institutions, the benefits
to depositors, and monetary conditions and credit markets.—^


Over the past 15 years studies of the financial system by several
groups (private, government-sponsored, and legislative) have
included, in varying detail, analysis and recommendations
with respect to the prohibition of interest on demand deposits.
Their views are summarized in the appendix to this section.

-16Appendix to Section XI
Chronological Summary of More Recent Views on Interest on Demand
Deposits in Major Studies of the IJ*S, Financial System

Money and Credit and Their Influence on Jobs, Prices and Growth,
the Report of the Commission on Money and Credit, 1/ recommended
continuation of the prohibition against payment of interest on
demand deposits c


The Commission, in giving its recommendation, noted only
that the prohibition was imposed to reduce competition
for deposits among commercial banks and thereby relieve
pressures leading to imprudent Joans; and that by rendering
special services some banks, in effect, pay interest on
demand deposits indirectly. The recommendation was contained
in a chapter proposing extensive changes for the financial
system which, according to the Commission, balance two


preserving and increasing the safety of the financial
system, and


providing greater flexibility for portfolio investment,
increased mobility of funds, and increased alternatives
for savers and borrowers.

April 1963*



U . S . Committee on Financial Institutions, Report to the
President of the United States 2/ (Heller Committee)
recommended.continuation of the prohibition on payment of
interest on demand deposits.
The Committee concluded
(with three of the 11 members dissenting) that differential
treatment of deposits was justified, and that demand
deposits, as the fundamental medium of exchange, should
be subject to unique restrictions not necessary in the
case of deposits serving as a store of value*

Those favoring continuation of the prohibition reasoned
that present day counterparts existed to the specific
conditions that gave rise to the prohibition, and if it
were eliminated:


banks in financial centers would compete more actively and
attract funds away from banks in smaller communities, and


competitive bidding might induce banks to reach for unsound

Prentice-Hall, Inc., Englewood Cliffs, N.J., page 1 6 7 .
U.S. Government Printing Office, Washington, D . C . , pages 20-22.

-17The majority also contended that the prohibition helps
preserve the fundamental distinction between the payments
medium and liquid savings, "a distinction that underlies
the existing arrangements for monetary control."
Those favoring elimination of the prohibition argued that:

the holding of demand deposits is unnecessarily costly
to the depositor and that, in order to minimize this cost,
the public is forced into frequent financial transactions
that serve no economic purpose.


if the prohibition were eliminated and if demand deposit
rates moved cyclically with other rates, the extent
to which movements in velocity tend to offset countercyclical monetary policy would be dampened.
Both those in favor and those opposed to a change in law
recognized practices by which interest is paid implicitly.
on demand deposits, such as more liberal lending terms,
free services, etc. Most believed that the public and
banks have adjusted to this substitution of implicit for
explicit payment of interest, and that a change in the law
might prove harmful. Some felt, however, that such a change,
with a requirement that interest rates be published, would
result in more equitable and uniform treatment of depositors.

December, 1971*


Report of the P r e s i d e n t s Commission on Financial
Structure and Regulation (Hunt Commission) 1/
recommended that the prohibition against payment of
interest on demand deposits be retained.

The Commission believed that elimination of this prohibition
if imposed with the other extensive regulatory changes
recommended, would create a situation of disintermediation for thrift institutions, forcing them to shift to third
party services more rapidly than desirable. This would thwart
the "phase-in" process necessary to the success of the
Committee's other recommendations and might also adversely
affect the flow of funds into the mortgage market.
The Committee cited trends which would make review of their
recommendation necessary in the future, including: improved
cash management techniques by large business, which enables
transfer of accounts easily into short-term interest-bearing
assets, an option more difficult for small business; the


U.S. Government Printing Office, Washington, pages 27-29.

blurring of distinctions between demand and time deposits
and the use of various ingenious devices to evade the
prohibition of^ payment of interest on demand deposits;
non~price competition leading to uneconomic increases in
operating costs and misallocation of resources.
November 4 , 1975c


The "discussion principles of Financia1Institutions
and the Nation's Economy (FINE), a report issued by
the House Committee on Banking and Currency,
recommended phase-out of the prohibition of payment
of interest on demand deposits at the direction of
a new Federal Depository Institutions Commission,
according to a schedule which would avoid injury to
the affected institutions and the flow of capital
to housing. The prohibition would be lifted no later
than 5 years following authorizing legislation


Emerging Methods of Paying Interest
on Transactions Balances

While payment of explicit interest on demand deposits at
commercial banks has been prohibited since 1933, a number of alternatives
have evolved that result in the effective payment of interest on transactional balances.

Among the most important are:

interest on commercial bank demand balances

(1) implicit

through nonpecuniary

services and subsidies in the form of customer service charges below
bank costs; (2) explicit interest payments by commercial batiks on
very short-term, mainly overnight, borrowings, such as Federal funds
and repurchase agreements; and (3) explicit interest payments on
transactions-type balances at banks and nonbank institutions.
Implicit Interest Payments
The prohibition of explicit interest payments on demand
deposits has limited one of the methods by which commercial banks
can compete for lendable funds.

As a result, banks have developed

alternative competitive strategies to attract demand deposits.
In addition to convenient locations and banking hours, gifts to new
customers, more attractive loan rates for depositors, and miscellaneous
nondeposit services, banks also offer demand deposit services at
charges below costs.

This subsidization of check-related services is,

in effect, an implicit interest payment on demand balances.
One method of estimating implicit interest paid on demand
deposits is to measure the excess of bank expenses for servicing
demand accounts over the various account fees charged customers.

-20No comprehensive data exist from which such statistical estimates can
be m a d e .

But about 15 per cent of member banks voluntarily participate

in a program run by the Federal Reserve System designed to estimate
the costs and revenues associated with various bank f u n c t i o n s ^
These "Functional Cost" data provide a basis for estimating the implicit
return on demand deposits, but they are subject: to a number of problems,
even apart from the limited sample size.

There are obvious accounting

difficulties in allocating general revenues and costs to specificfunctions * Moreover, there is evidence that the participants in the
Functional Cost Analysis (FCA) program tend to be more aggressive than
the banking universe, which might result in some biases in implicit
interest estimates.—

On the one hand, banks which are aggressive

in attracting deposits can be expected to offer their depositors higher
returns, and thus estimates of average implicit interest payments on
demand deposits drawn from FCA data might be on the high side.

On the

other hand, if aggressive banks are more efficient, their costs will
tend to be lower and implicit interest estimates could be somewhat
lower than the average for all banks.

On balance, it is difficult to

infer the direction and the size of any biases that may be present
in estimates of implicit interest rates calculated from FCA data.
Table III-l shows estimates of implicit rates paid on personal
checking accounts in 1975 for the three size categories of member banks used


Only about 2 per cent of the member banks with deposits less than
$5 million participate, but the participation rate rises to over
a third in the $100-$500 million category; the participation declines
for banks with deposits over $500 million. In 1975, 870 member
banks participated, a decline of 121 since f,1971.
See John J . Mingo and Arnold A11. Heggestad, 0n the Usefulness of
Functional Cost Analysis Data, Journal of Bank Research, (Forthcoming, 1977).

-21in the Functional Cost S u r v e y s — t h o s e banks with total deposits below
$50 million, $50 to $200 million, and over $200 million.


these size categories will be referred to as small, medium, and large
banks *
On average, bank expenses (both direct and indirect) to
service the average personal checking account exceeded income from
customer charges in 1975 by about $31 at small banks, $39 at medium
banks and $48 at large banks.

By dividing this implicit interest pay-

ment by the average account balance, the net return to customers is
shown to be about 4 per cent for small and medium banks and 4.7 per cent
at large banks.

To the extent that personal account customers received

other nonpecuniary services, e.g., cheaper loans, safe deposit b o x e s ,
etc., the implicit interest payment was even higher.
It is important to note, however, that it is likely that a
discrepancy exists between the net costs to banks of administering a
checking account and the value of the checking services as perceived by

The customer's valuation of checking services is equal to

the sum of values attached to each check written.

In general, these

values will differ from the cost to the bank of processing checks, thus
making bank costs an imperfect measure of the value of checking services
to the customer.
Functional Cost data appear to indicate that the implicit
interest payment on commercial checking accounts is significantly smaller
than that for personal accounts. As shown in Table III-2, the implicit
interest cost for commercial checking accounts—calculated the same way
as for personal accounts—varied between 1.15 and 1.45 per cent in 1975.

-22Table III-l
. Balances, Income, Expenses and Implicit
Interest Cost Per Personal Checking Account, b y Size of Bank
Banks with
total deposits
up to $50K
Average balance
per account
Income from charges
(per year)
Service charges
Penalty charges

Banks with
total deposits
$50M to $2Q0M






6 c 97

Banks with
total deposits
over $200M




$ 14.80

$ 11.28

$ 14.56

$ 16,29

$ 15.70

$ 17.57




$ 46.29

$ 49.87

$ 62.59

Implicit interest
$ 31.49
(Expenses less Income)

$ 38.59

$ 48.03







Total Income
Expenses (per year)
Debits 1/
Deposits If
Transit checks 3/
Total Expenses

Implicit interest rate
(Per cent)
MEMO: Implicit interest
rate after required
reserve adjustment
(Per cent)
Debits per year




A debit is a check drawn on a depositor's account and the expense
shown is the cost to the bank of processing such checks.
2/ The cost of processing deposits other than transit items.
3/ Transit checks are those deposited into an account that must be sent
out of the bank for clearing.
Source: Functional Cost Analysis - 1975 Average Banks, p . 7.7

However, the apparent lower cost to banks of commercial accounts may
well b e illusory.

The direct and indirect expenses shown for such

accounts in Table III-2 do not include several other services that
banks offer commercial customers at no explicit cost or at a subsidized


These include such services as payroll processing, lock-boxes,—

zero balance accounts,— payable through drafts,— deposit scanning,—
and other cash management services.

In addition, banks may offer lower

loan rates, including lower fees or more attractive nonprice terms 5 on
loans to business customers with large account balances that may be used for




Lock-boxes are essentially bank depositories to which the bank
customer's accounts receivables can be paid in order to speed up
cash receipts to the customer.
Zero balance accounts have two functions. In conjunction with a
regular balance, the customer draws checks on an account with no
balance and at the end of the day the bank transfers funds to the
zero balance account to cover drafts received by the bank that day.
The transferred funds come either from the regular account (mainly
in compensating balances that must meet a certain, level on average)
or from money market assets owned by the customer and managed by the
bank. In this w a y , customers have better control over their cash
balances and can earn explicit interest on excess cash. The second
function is to delay the actual cash disbursement. A zero balance
account can be opened at a distant correspondent, with the customer's
bank wiring funds once a day to cover checks drawn against that account.
Payable through drafts are drawn on the customer himself (rather
than a bank) but are payable through a bank. Before the draft is
paid by the bank, the customer must approve the payment, giving
the customer more control over drafts drawn. More generally, however, payable through drafts — l i k e zero balance a c c o u n t s — c a n also
be used to delay payment. Such drafts cleared through distant
banks take time
to reach the "payable through bank" and, in addition,
the customer s bank does not transfer funds to cover the draft until
payment is approved by the customer.
Deposit scanning is a service some banks provide for customers with
balances in many banks throughout the country. At regular intervals
during the course of the day the principal bank monitors balances
at the firm's other banks and, when balances with an individual
bank rise above or fall below a specified level, it arranges to take
ftmds out of or to put funds into the firm's accounts at these various

-24Table III-2
Balances, Income, Expenses and Implicit Interest
Cost Per Commercial Checking Account, fry Size of Bank
Banks with
total deposits
up to $5OH
Average balance
per account


Income from charges
Service charges
Penalty charges

Banks with
total deposits
$50M to $2001-1

Banks with
total deposits
over $200M







Debits 1/
Deposits If
Transit checks 3/
Account maintenance




Total Expense


Total Income

Implicit interest payment
(Expense less Income)
Implicit interest rate
(Per cent)
MEMO: Implicit interest
rate after required
reserve adjustment'
(Per cent)
Debits per year















1/ A debit is a check drawn on a depositor's account and the expense shown
is the cost to the bank for processing such checks.
The cost of processing deposits other than transit items.
Transit checks are those deposited into an account that must b e sent
out of the bank for clearing.
Source: Functional Cost Analysis - 1975 Average Banks, p . 7.6


-25transactions purposes.

These various services suggest that the implicit

return to businesses on demand balances is considerably higher than that
sh.own in Table III-2 and may be at least as high as the implicit return
to consumers.
The implicit return to deposits generally appears to have risen
over the past ten years as may be seen from Table III-3.

This increase

probably reflects in part the general rise in market interest rates over
the period as well as increased competition among banks for deposits and
from other institutions with expanding third party payment powers.
Interest Payments on Very Short-Term Borrowing by Banks
Apart from implicit interest on demand deposits, banks,
particularly large banks, have also offered businesses and other large
depositors explicit interest-bearing outlets for transactional or highly
liquid funds.

The large negotiable time certificate of deposit (CD) was

promoted in the early 1960 s to aid banks in stemming deposit attrition of
larg2 corporations.

However, while the holder can sell a CD before

maturity if cash is desired, there are small transaction costs i n v o l v e d —
as there are for most other money market assets.

In addition, the

minimum maturity of CD's as established by regulation is 30 days.
As large depositors have become more sensitive to the costs
of holding idle demand deposits, banks have sought other ways to

The upward trend shown in Table III-3 was also found by other analysts.
See, for example, Robert J . Barro and Anthony M .11 Santomero, "Household Money Holdings and the Demand Deposit Rate, Journal of Money,
and Banking, May 1972, pp. 397-413; and William E . Becker, Jr.,
The Effectiveness of Regulation Q 11and the Implicit Rate of Return on
Demand, Savings, and Time Deposits, (Forthcoming in Papers and
Proceedings of the Midwest Finance Association).

-26Table III-3
Estimates of the Implicit Interest Rate Paid on
Personal Demand Deposit Accounts
(Per cent)

Up to $50M

Banks with Total Deposits
$50 to $200H

Oveil $20011










































Based on Functional Cost Analysis data.

-27maintain funds that might otherwise be lost to them because of the

They have increasingly offered interest-bearing non-

deposit liabilities with very short maturities, and these have taken
two principal forms:

Federal funds borrowing and securities sold

under repurchase agreements.
Under current Federal Reserve regulations, member banks can
borrow "Federal funds" from other banks (commercial banks, domestic
offices of foreign banks, and Edge Act and Agreement Corporations),
some nonbank thrift institutions (savings and loan associations and
savings banks), Federal agencies (such as the Federal Home Loan Bank
Board), and securities dealers who have received Federal funds in payment
for securities sold.—^

Such borrowing by member banks is not subject

to interest rate ceilings and is, for the most part, on an overnight

A member bank may also borrow funds from any lender free of

interest rate, maturity, and reserve requirement limitations if the
loan is arranged as a repurchase agreement (RP) secured by U . S .
Government or Federal agency securities

The market for Federal funds and R P s has grown quite rapidly.
At the large weekly reporting member banks—-which account for almost
1/ Historically, a "Federal funds transaction" referred to an interbank
loan of immediately available funds involving a direct transfer of
a deposit at the Federal Reserve between two member banks. Today,
however, a Federal funds transaction need not involve an actual
debit or credit to a Federal Reserve Bank account nor necessarily
involve two banks. Indeed, a significant share of current Federal
funds borrowing never goes through a Federal Reserve account nor
results in a shift of funds to or from a bank. For example, some
of the Federal funds borrowing is from customers who have a demand
deposit account with the borrowing bank; the bank simply reduces the
customer's demand account and increases its own liability, "Federal
funds borrowed."
2/ The FDIC has similar regulations affecting insured nonmember banks.

-2890 per cent of all banks borrowing in the Federal funds m a r k e t — t h e
gross amount of Federal funds purchased rose from $37 billion in 1969
to $50 billion in 1974 and to about $68 billion currently.
Generally, only qualitative information exists on the
institutions or groups that hold assets in the form of Federal funds

or RP s«

However, in the spring of 1974 the Board surveyed 45 large

banks~~which account for about two-thirds of all Federal funds b o r r o w i n g "
to determine the sources of their funds.

The results are shown in

Table IX1-4.
Of the over $35 billion of dally average gross borrowing of
immediately available funds by these 45 banks during the 1974 survey
week (column 3), about $22 b i l l i o n — o r a little over 60 per cent of the
t o t a l — w a s loaned by commercial banks and nearly all of this was on an
"overnight basis.

Thus, the Federal funds market has t:o some extent

replaced the market for interest-bearing bankers


balances of the 1920*8.—'

Institutions other than commercial banks also earn interest by making
short-term funds available to banks.

Of the $13% billion loaned by this

group, about 40 per cent was made available by depository institutions
and another two-fifths by business corporations and State and local
Such very short-term borrowing from nonbanks represents
payment of interest on funds that are thought of by the lenders as
being nearly equivalent to demand deposits.

Banks engage in these trans-

actions as an alternative to losing funds to the money market in a
framework under which explicit interest cannot be paid on demand balances.

There are, of course, interbank balances at present which bear no
interest. They totalled about $35 billion at the end of October 1976.

Table III-4
(Amounts in Billions of Dollars)
45 Large Banks



Member commercial banks
Nonmember commercial banks
Domestic offices of foreign bank3
Edge Act and Agreement Corp.
Commercial Bank Subtotal


Savings and loan associations
and cooperative banks
Savings banks
Federal Home Loan Banks and Board
All other agencies of the U.S.
Securities Dealers

Funds 1/

R P s on
U . S . Gov't
and Agency

__0 1 1_














_20 1 3_



Maturing ^/
in One Day —


Business corporations
State and iocal governments
Foreign banks and foreign, official
4 . All other


tm m

- -


MEMO: Noncommercial Bank Subtotal
\J May be secured or unsecured.
2/ Includes continuing contracts which have no maturity but can be terminated without advance notice
by the lender or the borrower.
Less than $500 million.
NOTE: Totals may not add due to rounding.

-30Explicit Interest Payments on Transactions~Type Balances
Over the past decade there has been an increasing number of
innovations and regulatory changes which have resulted in the explicit
payment of interest on balances used directly or indirectly to transfer
funds to third parties*

Both banks and thrift institutions are currently

authorized to offer NOW accounts in the six New England states.

On a

nationwide basis, banks have been permitted to transfer funds from a
savings to a demand account on the telephone order of a customer, making
it more convenient for the customers to hold a portion of transactions
balances in savings accounts.

A n d , businesses and .State and local govern-

ments have been permitted to hold savings accounts at commercial banks,
which have enabled them to transfer precautionary and to some degree
transactions balances out of demand deposits t
Most of these developments benefited households and small
businesses, and many were associated with efforts of thrift institutions
to enter third-party payment deposit markets that have been dominated
b y commercial banks.

The following list provides a chronology of the

innovations, and regulatory and legislative changes that have produced-directly or indirectly--transactions accounts bearing explicit interest.



September 1970

Savings and loan associations were permitted
to make preauthorized nonnegotiable transfers
from savings accounts for household-related
expenditures. 1/


June 1972

State-chartered mutual savings banks in
Massachusetts began offering NOW accounts.


September 1972

State-chartered mutual savings banks in New
Hampshire began offering NOW accounts.

Authority contained in the Housing Act of 1970.




January 1, 1974

All depository institutions in Massachusetts
and New Hampshire (except credit unions)
were authorized by Congress to offer NOW
accounts. If Accounts similar to NOWs, but
noninterest-bearing, began to be offered b y
state-chartered thrifts in other states in
the course of the year.


January 1974

First Federal Savings and L o a n , Lincoln,
Nebraska installed customer bank communication terminals (CBCTs) in two supermarkets,
allowing its customers to make deposits
to or withdrawals from savings accounts.
Such withdrawals can be used to pay for
merchandise purchased from the stores. The
First Federal system, known as Transmatic
Money System, is now being franchised to
other S&Ls.


Early 1974

Money Market Mutual Funds came into existence
on a large scale basis. These funds which
invest in money market instruments, allow
their shareholders to redeem shares either
by checks drawn on accounts established at
designated banks, by wire transfer, by
telephone or by m a i l .


August 1974

Federal credit unions were permitted to issue
credit union share drafts which are checklike instruments payable through a commercial
bank. If


November 1974

Commercial banks were authorized to accept sav
ings deposits from state and local governments


April 7 , 1975

Member banks were authorized b y the Federal
Reserve to make transfers from a customer's
savings account to his checking account upon
telephone order from the customer. This
authority permitted banks to match the
competition of thrift institutions offering
the service of immediate transfer of funds
from savings accounts to a commercial bank
demand account on telephone order of the
customer. Such plans permit the payment of
interest on an account that can be converted
quickly to a transaction balance.

Public Law 93-100 signed August 16, 1973.
Section 721.3, Rules and Regulations of the National Credit Union
Administration (NCUA), established rules for experimental pilot EFT
programs which include share draft plans.


April 1 6 , 1975

The Federal Home Loan Bank Board broadened
its 1970 action to allow S&Ls to make pre«*
authorized third party nonnegotiable
transfers for any purpose.

September 2, 1975

Commercial banks were authorized by Federal
regulatory authorities to make preauthorized
third party
nonnegotiable transfers from a
customer s savings account for any purpose«

November 10,

Commercial banks were authorized by Federal
regulatory authorities to offer savings
accounts to partnerships and corporations
operated for profit, limited to $150,000 per
customer per bank* In conjunction with telephone transfers, this authority permitted the
payment of interest on funds that can be
readily used for transactions.

Fefcru&rY 27*

Federal legislation authorizing NOW accounts
in the States of Connecticut, Maine, Rhode
Island, and Vermont became effective c

It is difficult to estimate the portion of funds held for
transactions purposes on deposit in the various interest-bearing accounts
listed above*

The largest part of NOW account balances are probably held

for transactions purposes.

As of the end of August 1976, there was a

total of $1.6 billion in NOW accounts in the six New England states,—^ and
the number of drafts drawn on active NOW accounts currently averages
about 11 per month, not very different from the average number of checks
written against personal checking accounts at commercial banks throughout the country (14 per month).

Balances against which credit union

share drafts can be written thus far remain small.

Such balances

averaged only about $70 million in the summer of 1976; the average
number of drafts drawn per account was almost 10 per m o n t h .


Of which almost $1 billion was at commercial banks, $0.5 billion
at mutual savings banks, and $155 million at savings and loan

-33deposits of businesses and state and local governments at all commercial
banks totalled an estimated $15 billion by the end of 1 9 7 6 , but probably
a smaller proportion of such deposits, as compared with NOW accounts and
credit union share drafts, represent funds used for transactions purposes.
No statistics exist for telephone transfers from business, state and
local government, and individual savings accounts to demand deposits, for
telephone and automatic billpaying services from savings deposits, or
for transfers by draft from money market mutual funds.
It seems clear that new third party payment accounts and
the availability of more convenient means of transferring funds out
of savings deposits have reduced the effectiveness of the prohibition
of explicit interest payment on demand balances.

These developments

have eroded old distinctions, have altered competitive relationships,
more so in some regions of the country than others, and appear to be
gaining momentum.


Economic Efficiency

Commercial banks, like all depository financial institutions,
borrow from and lend to the public.
form of deposits *

Their borrowing mainly takes the

In order to attract deposits, banks must offer

depositors something of value, which under current law can take the
form of explicit interest only on time and savings deposits; no such
interest payment is permitted for demand deposits.

As a result, banks

must offer nonpecuxiiary returns to attract demand depositee

As indicated

in the previous section, these nonpecuniary returns to d e p o s i t o r s — o r
implicit interest—include check services offered below cost, a wide
variety of other free or below cost services, and, particularly in
the case of businesses, more assured access to credit.
Such methods of attracting demand deposits are likely to lead
to an inefficient use of resources by-the banking system.

Free or

below cost checking tends to encourage the public to over-utilize that
service, as is true for any good or service provided below cost.


the circumstances the public has little, or n o , economic incentive to
economize on check writing, even though check clearance costs for
banks are significant.
If banks and other institutions were permitted to pay
explicit interest on demand deposits, they would be likely over the

Estimates for the cost of clearing checks vary widely. Cost estimates
for clearing a check through the banking system range between 16 cents
and 26 cents. For an individual bank, according to FCA data, it
appears to cost about 10 cents to clear a check written by its own
deposit customer. The larger figures reflect the fact that a number
of banks are often involved in clearing a single check.

-35long run to raise service charges on checking accounts and other services
presently offered below cost in order to offset the explicit interest
payment. —

Higher service charges on checks would encourage the public

to reduce the number of checks w r i t t e n — b y increasing the use of
currency for small transactions and by combining payments into a
single check where possible.

Higher charges on other services would

similarly restrain their use.

In exchange for the more careful manage-

ment of check writing and other services, the public could receive
explicit interest payments about equal to the increase in charges
collected by banks plus the cost saving to the bank of the foregone
checking and other services.
The public could, of course, use the explicit.interest
income earned for any desired purpose, including purchase of the same
quantity of checking services.

It is likely, though, that the public

would divert some of this new interest income to the acquisition of consumer goods or services which are valued more highly than checking services
at the margin.

In contrast, under the current prohibition of interest pay-

ments, the public's "earnings" on demand deposits can be used only for check
writing or other bank-related services.

The wider range of choice in

employing the pecuniary earnings from demand deposits that would be
made available by payment of explicit interest would make the public

Any payment of explicit interest, other things unchanged, increases
the return to depositors and the costs to banks. Assuming that banks
and depositors were roughly in competitive
equilibrium prior to the
payment of explicit interest, banks service charges would have to
rise (i.e., implicit return to depositors would have to fall) so that
the total yield to the depositors (explicit plus implicit return)
would move back toward the original yield (which was entirely an
implicit return).

-36as a whole better off.

As the public reduces its u s e of checks, for

example, resources that would otherwise be employed in check clearing
will be released for the production of goods and services valued more
highly by the public.
Some observers have argued that explicit payment of interest
on demand balances is more likely to lead to higher loan rates than to
increased charges for checking and other bank services*
come appears doubtful.

This out-

Virtually ail interest: rates charged by banks

are determined in highly competitive markets where banks and
other lenders are offering similar services.

While there may be some

minor changes in the structure of rates, it is unlikely that the
average level of interest rates would rise in the long run as a result
of interest payments on demand deposits


Moreover, it should be far

easier for banks to pass on this cost increase by raising checking account
service charges since such charges would be coupled with additional payments to depositors.

The relation of interest on demand deposits to

market interest rates is discussed in more detail in section VII.
As noted in the previous section, demand deposit substitutes
paying explicit interest have been developed.

Each of these appear to

be less efficient than paying interest explicitly on demand deposits.—
1/ Similar arguments were made in the past when Regulation Q ceilings
were raised, but there is little or no evidence of their validity.
2/ NOW accounts are an exception since they are in effect interestbearing demand deposits, with NOW drafts cleared in virtually the
same way as checks.

They involve added inconvenience or the use of additional resources
to shift funds back and forth between interest-bearing assets and deposits
from which payments can be made.

For example, telephone calls are

necessary to transfer funds from savings to demand accounts; additional
bookkeeping is required for transfers among deposit categories; and
personnel must be diverted to make transfers from corporate demand
accounts to security RP's or "Federal funds



Besides being less efficient, interest-bearing third party
transactions vehicles and demand deposit substitutes are not accessible
to all members of the public.

Only certain depositors are permitted

to lend "Federal funds" and only large account customers appear to be
able to place surplus funds in repurchase agreements with banks.


interest-bearing transaction accounts are more accessible in those areas
where thrift institutions have sought entry into the market for third
party payment vehicles.

Explicit interest on demand deposits would tend

to widen the availability of such services to the public at large.
On balance, it would seem that authorizing payment of
explicit interest on demand deposits would be a step in the direction
of greater economic efficiency and would rationalize the current system

that has become needlessly more complex with the passage of time.

The net

gains to society from interest on demand deposits cannot be readily
quantified, however.

Such gains will be limited in part by the extent

to which the public can, or will, readjust check-writing habits, and
by the extent to which direct interest on demand deposits replaces less
efficient methods currently used to pay interest on transactions balances.

Moreover, any assessment of overall gains to the nation in terms of
resources released to more productive uses should be balanced
against an evaluation of potential gains and losses to particular
depositors and depository institutions.


Effects on Costs and Earnings of Depository Institutions
In this section, an effort is made to estimate the potential

for upward cost pressures and the associated impact on earnings of financial
institutions—mainly b a n k s — f r o m removal of the prohibition of interest
on demand deposits.

Such pressures are likely to develop during the

transition period to a new equilibrium, and their intensity will depend
in part on whether the authority to pay interest on demand deposits is
extended to thrift institutions as well as to banks.

Over the longer run,

as indicated in the previous section, banks can be expected to offset
higher interest costs by raising charges to depositors for services
that are now offered free or below cost.
Given the uncertainties in predicting the reaction of the
many thousands of banks and thrift institutions and the multitude
of depositors to the availability of explicit interest on demand
deposits, it is difficult to forecast how long earnings pressures
would last; it could be a relatively short period of a year or less,
or a longer period of perhaps two to four years.

It is equally

difficult to estimate the intensity of competition for market shares
in such a period.

Therefore, the estimates in this section are best

thought of as rough indicators of potential transition problems for
depository institutions.
These estimates should also be viewed as upper limits since
they do not allow for certain influences that may in practice work to
limit transitional pressures.

For instance, they do not allow for

a phase-in of interest on demand deposits through regulatory actions,

-40such as use of a low, though perhaps gradually rising, ceiling interest

Nor do they allow for the possibility that a substantial delay

in the effective date for interest on demand deposits following
enabling legislation would permit banks to plan more effecitvely for
the new competitive environment*

Finally, these estimates do not take

account of the substantial offsets to cost pressures that could result
if interest were paid on reserve balances held at Federal Reserve
Banks, as discussed in section VIII.
Competition for Market Shares During the Transition Period:
Estimates of Cost Increases
In the most general sense, checking accounts are among
the products and services sold to the public b y commercial banks and
thrift institutions.

Any regulatory change creating a new account

that has the potential to contribute to future profits may cause intense
competitive pressures for a time, as institutions seek to capture a
share of the new market.

Basically, depository institutions would tend

to compare the higher costs of acquiring new deposits with the expected
long-run profits to be derived from those deposits after market shares
stabilize and costs decline.

In a competitive market, during the period

before market shares stabilize, costs would rise to a level where the

-41temporary reduction in profits is just equal to the discounted value
of the expected addition to future profits.
The NOW account experiment in Massachusetts and New Hampshire,
where thrifts and commercial banks have competed for interest bearing
NOW balances since 1974, provides an example of higher costs resulting
from competition between depository

institutions for shares of a new

NOW balances in the two states have cost banks and thrifts

about 8% per cent per year, or about 4 percentage points more than
demand deposits.—^ As a result, earnings of depository institutions
in those states have declined somewhat since 1974.—

However, after

NOW market shares stabilize in Massachusetts and New Hampshire, the
cost of NOW accounts to banks and thrifts can be expected to decline
until it is about equal to the cost of other funds of comparable
maturity and stability.

Those institutions that acquired sizable

NOW balances during the transition period will then be in a position
to earn additional profits as long as the NOW balances are retained.
The removal of the prohibition against the payment of interest
on demand deposits would extend the devices by which banks can compete
with each other for demand deposits, but competitive pressures in the
transition would be much less if the removal were not coupled with
extension o f demand deposit powers to thrift institutions.


banks might view the payment of interest on demand deposits as a means
of enlarging market shares, thus driving up costs in local markets,
but it seems unlikely that banks would pursue such costly policies

The 8^ per cent is the sum of 5 per cent explicit interest plus
3% per cent implicit interest reflecting the institutions' servicing costs in excess of service charges and other fees.
For details of the NOW
experiment in Massachusetts and New Hampshire,
see John D. Paulus, Effects of NOW Accounts on Costs and Earnings of
Commercial Banks in Massachusetts and New Hampshire in 1974-75,"
Federal Reserve Board Staff Economic Study, August 1976.

-42on a large scale $ or for long*

Banks currently can attempt to increase

market shares through other devices:

for example, by offering very

high rates of return, or favorable services, on specific types of

Such behavior is uncommon, though, because the expected

gains in deposits are not only expensive, but are likely to be reversed
as competitors react to protect their own positions.

T h u s , without

competition from thrifts, payment of interest on demand deposits at
commercial banks may be accompanied by fairly prompt adjustments in
checking account service charges as banks seek to recover higher interest

In this case the period of transition may be relatively short

and involve only modest upward cost pressures*
By contrast, the extension of interest bearing demand deposits
to thrifts would effectively increase the supply of demand deposit
services in banking markets, which could intensify cost pressures on
commercial banks considerably.

Thrifts> many of whom

have seemed

anxious to acquire checking account powers, may be expected to compete
aggressively in order to acquire a share of this market.

In order to

protect their own market shares s commercial banks will be required to
offer depositors at least equivalent terms.

Thus, bank earnings could

come under pressure, both from the loss of demand deposit balances to
thrifts and from the higher average cost of retained deposits.
The increase in bank costs associated with extending interestbearing demand deposits to thrifts is difficult to estimate.


evidence on these effects is available, however, from the NOW experiment
in New England.

As noted earlier, costs of NOW accounts in Massachusetts

and New Hampshire appear to exceed average costs of demand deposits by
about 4 percentage points.

In March 1976, the NOW experiment was extended


Table V-l
Characteristics of NOW Accounts in New England
August 31, 1976
(In Per Cent)
Proportion of Institutions:
Paying Interest
from Day of
Paying 5 Per
Deposit to Day
Free Drafts
Cent Interest
of Withdrawal
All Institutions
M a s s . and N.H.
Conn., M e . , R.I., V t .
All New England










Commercial Banks
Mass. and N . H .
Conn., M e . , R.I., V t .
All New England





Mutual Savings Banks
Mass. and N . H .
Conn., M e . , R.I., V t .
All New England


Savings and Loan
Associations &
M a s s . and N . H .
Conn., M e . , R.I., Vt.
All New England




to include the four other New England s t a t e s — M a i n e , Vermont, Rhode
Island, and Connecticut.

Table V~1 shows that terms offered on NOW

accounts have been less generous in these four states than in
Massachusetts and New Hampshire.

The proportion of institutions

offering free NOW drafts, for example, is significantly lower for
all three types of institutions.

In addition, the proportion of

institutions paying interest on a day~of~deposit to day-of-withdrawal
basis is lower.

Thus, while they exceed the average cost of

personal demand deposits, NOW accounts in the four states joining
the experiment in 1976 are less costly than in Massachusetts and
New Hampshire.
The more modest increase in NOW costs in these four states
probably reflects, in part, the lower interest rates in 1976 compared
to 1974, when large credit demands and high rates encouraged banks and
thrifts to compete vigorously for deposits«

Thus if NOWs or interest

on demand deposits were extended nationwide to all depository institutions under current, or moderately tighter, money market conditions,
it seems plausible that offering terms might initially be similar to
those on NOWs in Maine, Vermont, Rhode Island, and Connecticut.

As a

rough estimate, bank costs of NOWs might rise by about 2 to 3 percentage
points, from 4^ to between 6% and 1\ per cent during the transition
period r
Explicit interest payments on business demand deposits, however, should cause bank costs to rise by a smaller amount.

As discussed

This could take the form of either a 2 to 3 per cent explicit
interest rate and no increase in service charges, or a higher
explicit rate accompanied by increased service charges*

-45in section III, businesses already receive interest in several w a y s ,
either directly or indirectly, on demand deposit balances.

In addition,

most business funds are highly mobile and can be readily shifted among
banks, whenever more favorable rates are found.

This suggests that

business demand balances probably already receive a competitive rate
of return in implicit form. Moreover, the effect on offering rates
to businesses of extending interest-bearing demand deposits to thrifts
would likely be small; the inability of thrifts to provide businesses
with loans and other services would greatly limit the size of business
balances that could be a t t r a c t e d . ^ Given that business demand balances
now earn a competitive rate at commercial banks, and that competition
from thrifts would be severely restricted, it seems unlikely that the
average cost to banks of business demand deposit balances would rise
by as much as one percentage point.

As a rQugh estimate, the average

cost of business demand balances may increase by about one-half
percentage point during the transition period.
Transitional Impacts on Earnings of Banks
There are several possible ways of authorizing interest on
demand deposits.

The authority may be extended to commercial banks only,

Thrifts are severely restricted, by statute and regulation, from
entering the business loan market. Most of the asset portfolios
of savings and loan associations consists of mortgages and construction loans as well as Treasury and agency securities. In
recent years there has been some increase in consumer lending
powers for these institutions. Mutual savings banks, having broader
asset powers, are somewhat more diversified than S&Ls. However,
these institutions are smaller in the aggregate than commercial
banks and S&Ls and they have generally not maintained close relationships with medium and large businesses.

-46or to both banks and thrift institutions c

I t can b e authorized for house-

hold demand deposits only or for all demand deposits.

Or the authoriza-

tion may take the form of permitting nationwide NOW accounts.
If both banks and thrift institutions were permitted
to pay interest on transactions balances, the transitional effects on
banks' earnings could be smaller if NOW accounts were authorized than
if interest were permitted on ail demand deposits.

NOWs can be offered

only to Individuals and not-for-profit organizations, and the volume
of demand deposits that could be converted to NOWs is limited to about $80
billion* or about one^third of total demand deposits at commercial

Moreover, based on the NOW account experience in New England,

it seems unlikely that more than about one-third of eligible demand
deposits* or $25 to $30 billion,, would be converted to N0#s within a
- a 1.r-!
two-year period
Commercial banks in Massaphusetts and New Hampshire were
able to retain about one-half of the funds converted from demand deposits
to NOW accounts after two years, but it seems plausible that on a
nationwide basis banks would retain a much higher proportion of new
NOW balances, perhaps about 75 percent.

This estimate mainly reflects the

stronger competitive positions of banks relative to thrifts outside of
New England.

As shown in Table V - 2 , commercial banks in Massachusetts

and New Hampshire held only about 20 per cent of small time and savings
deposits in those states*

However, on a national basis * banks have about

45 per cent of the market for small time and savings deposits.
1/ See John D . Paulus, ojk cit.

-47Table V-2
Deposits at Major Depository Institutions 1/
(December 1975)
Mass. and N.H.
Bank Share
($ billions) (per cent)
Household Demand
Savings Deposits
(excluding NOWs)
Time DepositsTotal:

and Small

NOW Accounts
Total Household
Demand (including
NOWs) and Small
Time and Savings

Bank Share
($ billions) (per cent)

























Includes commercial banks, M S B s , and S&Ls. Excludes credit unions.
MSB data are partially estimated based on June 1975 Report of
Estimated from Demand Deposit Ownership Survey, Federal Reserve Board.
Excludes time deposits greater than $100,000.
The estimated peak transitional effect on commercial banks*

before tax earnings from competition with thrifts for NOW accounts is
shown in Table V - 3 .

This estimate assumes conversions from demand

deposits to NOW accounts at commercial banks of about $21 billion in a
transition period (line 1 of the table) and to NOW accounts at thrift
institutions of about $7 billion (line 4 ) — w i t h the amounts based on
the analysis of the preceding two paragraphs.

The estimated earnings

reduction shown in line (7) ignores such factors as flows of time and

savings deposits to NOWs and inflows to banks from substitutions out
of currency and securities, because it is thought that their effect
on bank earnings will be relatively small
Table V-3
Estimated Transitional Effect on Commercial Bank
Before Tax Earnings of Nationwide NOWs
($ billions)


Demand deposits Converted
x Average Cost Increase
« Higher Costs
Demand Deposit Outflow to Thrifts
x Net Earnings on Demand Deposits
Earnings Lost Due to (4)
Before Tax Reduction in Earnings (3) -i (6)
1975 Commercial Bank Before Tax Income
(7> 7 (8)

$ 7.0
$ 9,0

The factor thought to have the largest depressing effect on
bank profits is the higher cost associated with converting demand
deposits to NOW accounts.
shown in line (2)


The 2 percentage point increase in costs,

reflects the estimated 2 to 3 percentage point

increase in offering rates (explicit interest plus implicit return")

For funds transferred from savings accounts to a NOW account within
a single bank there might tend to be a small cost: saving resulting
from the reduction in transfers (telephone calls, etc.) from savings
to demand accounts which are priced below bank costs and, perhaps, by
a lower interest rate. Conversion from currency and from securities
to NOW accounts should also have only modest effects on such earnings
since the net cost to the bank of these funds is likely to be on the
order of 6% to 7% per cent, which leaves little margin for profit.

-49offset partially by lower average reserve requirements against NOW
accounts relative to demand deposits, given the current reserve requirement structure. — ^ The smaller earnings reduction due to deposit
outflows, shown in line (6), is based on an assumed n e t return on demand
deposits of 1% per cent. —
Bank earnings are estimated to decline by about one-half
billion dollars in the worst year of the adjustment period to nationwide
NOWs, as shown in line 7 .
cent of banks


This represents a reduction of about 6 per

before tax earnings in 1975,

After the adjustment period,

bank earnings should recover as market shares begin to stabilize and
competitive pressures on bank costs gradually diminish.
Should interest payments be authorized on all demand deposits,
and if authority is given to both banks and thrifts to offer such deposits,
a more substantial reduction in bank earnings would likely result during
the transition period than was estimated for nationwide N O W s .

The compe-

titive effect of permitting thrift institutions to offer interest-bearing
demand deposits would fall mainly on consunEr-type demand deposits.



As noted

Because NOW accounts are classified as savings deposits for Federal
Reserve member banks, the reserve requirement against such accounts
is 3 per cent. Reserve requirements against demand deposits for
member banks range from 7 per cent for small banks to 16V per cent
for the largest banks, and average a little under 13 per cent. Thus,
the transfer of funds from a demand deposit to a NOW account reduces
reserve requirements. Earnings from bank investment of the released
reserves (assuming a 5 percent return) tend to lower net costs of NOW
accounts by about one-half percentage point.
According to the 1975 Functional Cost Statistics, the average return
on demand deposits was about 1 per cent. This has been adjusted slightly
upward; reflecting the belief that the incremental cost of a demand
deposit may be slightly-lower than average costs. Thus, while earnings
on demand deposits may average 1 per cent, the return on an additional
account may be slightly higher for the range of deposit shifts considered

-50above, thrifts are limited in their ability to serve the financial needs
of business customers; banks


demand deposit costs for businesses would

therefore probably rise only marginally, mainly reflecting efforts by
some banks to improve market shares.
The estimates of higher costs and reduced earnings from interest
payment on all demand deposits are shown in Table V - 4 ,

T h e increase in

the cost of household demand deposits of 1% percentage points (line 2)
is slightly lower than that assumed for nationwide N O W s ,


Table V-4
Estimated Transitional Effect on Commercial Bank
Before Tax Earnings of Interest Payments on Demand Deposits
($ billions)
$ 50
(1) Household Deposits Converted
(2) x Average Cost Increase
(3) = Higher Cost for Households
(4) All Other Deposits Converted
(6) = Higher Cost for Other Depositors
(7) Demand Deposit Outflow to Thrifts
$ 15
<8> x Marginal Earnings
(9) = Earnings Lost Due to (7)
(10> Before Tax Reduction in Earnings (3)4(6)-f (9)
(11) 1975 Before Tax Earnings of Banks
(12) Relative reduction in earnings (10)

$ .75
$ .75
$ .225

1/ The assumption of a somewhat lower explicit offering rate on demand
deposits, relative to NOWs, reflects the likely profit calculation of
commercial banks. In determining any explicit offering rate on transactions accounts, banks must balance the higher cost of offering explicit
interest on their present stock of deposits against the potential future
profit reductions from the loss of deposits to competing institutions.
For NOWs, the customer must explicitly notify the bank to set up such an
account, and only at that time do bank costs rise. B u t , when interest is
paid on all "demand deposits of a certain class, it is more likely that
the entire stock of such deposits would earn interest and, consequently,
the short-run cost increases to the bank would be much larger. The
balancing of short-run costs from paying interest on an existing class
of demand deposits against expected future revenue losses from deposits
shifted to competing institutions is thus likely to lead to lower offering rates on demand deposits (where the existing stock of deposits is
more likely to bear interest) than on NOWs (where only those accounts
opened bear interest).

-51the expected volume of household demand deposits "converted


to interest-

bearing form, shown in line (1) of Table V - 4 , should be considerably
larger than for NOW accounts.
nature of most conversions.

This, of course, reflects the automatic
In addition, the projected outflow of

demand balances to thrift institutions shown in line (7) is somewhat

Included in the estimated $15 billion outflow, it should

be noted, is a modest amount, probably less than $2 billion, of business
demand deposits.
The total estimated earnings reduction of $1,725 billion from
interest payments on all demand deposits for the worst transitional
year represents one-fifth of 1975 before tax income of commercial

This reduction is a little more than three times larger than

that expected to occur if only NOW accounts are authorized.


larger estimated earnings reduction results mainly from the more
rapid conversion of non-interest-bearing demand deposits to interestbearing form, and from a modest net increase in the cost of interestbearing demand deposits for businesses and other non-household accounts.
As with NOW accounts, this reduction in earnings is mainly a transitional phenomenon, and earnings should recover in the longer-run as
check service charges and charges for other bank services are adjusted
over time more fully to reflect costs, or as the explicit interest rate
is lowered.

This may occur in part because bank offering rates during the transition in this case might be a little lower than rates offered on
demand deposits by thrift institutions, who would not face the same
potential cost burden as banks (as explained in the footnote on
p . 50).

-52In view of the potentially large increase in costs from
interest on demand deposits, banks may choose to offer interest-bearing
demand deposits in the same way that most institutions have offered NOW

Instead of notifying depositors that existing demand deposit

accounts will automatically begin to earn interest, banks might simply
offer new interest-earxiing demand accounts to those depositors who
request them.

Under such a procedure, if interest on demand deposits

were limited to individuals and nonprofit organizations, conversion to
interest-earning demand deposits might be closer to the slower pace
assumed for nationwide NOW accounts in Table V - 3 .

The impact on bank

earnings from interest on converted demand deposits would be about the
same as in Table V«3 C

If interest were extended to all classes of

depositors^ the reduction in earnings might be over §1 billion, or a
little more than 10 per cent of 1975 earnings.
As a final alternative, cost impacts from authorization of
banks to pay interest on demand deposits without an associated extension
of such powers to thrift institutions may be considered c

Pressures on

bank costs of household demand deposits would be considerably reduced
by the absence of competition from thrifts, and such an alternative
would probably result in more rapid adjustment of service charges by

The after tax earnings reduction would thus be smaller during

the transition period than that shown in Table V - 4 , even though, as noted
earlier, some banks would probably attempt to improve competitive positions.
As a very rough estimate, the transitional reduction might be as low as
5 per cent of 1975 after tax earnings and this loss would be incurred
over a shorter period of time.

-53The estimated earnings reductions from the various possibilities considered ranged from about 5 to 20 per c e n t — d e p e n d i n g on the
types of deposits and institutions eligible for interest payments, and
on institutional responses.—^

It should be stressed once again that these

earnings reductions represent estimates of temporary effects while banks
are in the process of making longer-run adjustments (to b e discussed later
in this section) • Moreover, as noted earlier, the estimates do not assume
use of relatively low ceiling interest rates to moderate transitional pressures, or the possibility of offsetting increases in bank revenues from
the payment of interest on reserve balances held at the Federal Reserve.
Differential Impacts by Bank Size
The preceding estimates of impacts on costs and earnings apply
to the banking system as a whole.

However, effects on particular

institutions may vary widely depending upon the type of market and
customer served, with some institutions being less able to withstand
transition costs than others.

In particular, those institutions with

adequate earnings but with relatively large amounts of deposits eligible
for conversion to interest-bearing accounts (such as household accounts)


Over the period 1960 through 1975 banks net income after taxes as
a percentage of equity ranged between 8.7 per cent and 11.3 per cent.
In the period from 1962 through 1966, the measure was consistently
between 8.7 and 8.9 per cent. From 1971 through 1975, this measure
was between 10.3 and 11.3 per cent, with the lower figure in 1975.
If the highest estimate for a temporary earnings reduction because
of interest on demand deposits is realized, and assuming a marginal
tax rate for banks of about 25 per cent, the average after-tax return
on equity in 1975 would be temporarily reduced to around 8% per. cent-or only a little less than the 1962-66 average. The smallest estimate
for the temporary reduction in earnings would reduce the 1975 return
on equity to around 9-3/4 per cent.

-54may tend to experience sharp reductions in earnings c

The most vulnerable

institutions would thus appear to be those that have low earnings ana
a high proportion of deposits in accounts eligible for conversion to
interest-bearing form^-as well as those facing intense deposit competition in local markets, including competition from thrift institutions should
they be given authority to offer interest-bearing transactions accounts.
Table V~5 shows the number of commercial banks by size class
that had both low earnings in 1975—defined as before tax income equal to


less than one-half per cent of total deposits—

ncl a high ratic>"-50 per

cent or more~«of demand deposits to total deposits.—

A total of 371

banks ? or about 2\ per cent of all banks in the U r S c , satisfied both

Many of these banks could experience severe difficulties

in adjusting to the removal of the prohibition.
Table V~5
Vulnerable Banks b^ Size Class:
Payment of Interest on Demand Deposits














Banks 1/
















($ millions)
Number of






1/ Banks with both before tax income less than .5 per cent of total deposits and
demand deposits representing more than 50 per cent of total deposits.

In 1975, the average ratio of before tax income to deposits was
1.15 per cent.
Based on the 1975 Call Report, demand deposits represented 4 1 per
cent of total deposits for all U,S. banks.


-55Very small banks appear to face the most difficult adjustment
problems, but a few large banks, particularly those with.extensive
branch systems, could also experience transitional difficulties.


shown in the table, more than 6 per cent of the 2300 banks with deposits
less than $5 million had both low earnings in 1975 and a high ratio of
demand to total deposits.

And 80 per cent of all vulnerable banks had

deposits of less than $25 million. However, some of these banks may
be located in markets with limited competition from other depository
institutions, and may remain essentially unaffected by interest on
demand deposits.

Others serving small communities may face stiff

competition from aggressive thrift institutions or other banks.
Further evidence suggesting that smaller banks might suffer
the largest relative earnings reductions concerns their commitment
to the market for consumer, or household, demand deposits.

As shown in

Table V-6, a little over 10 per cent of bank deposits are held by
consumers in checking accounts.

However, a larger proportion of the

deposits of small banks are held by households in demand accounts.
Since, as noted, cost increases will probably be greatest for household
Table V-6
Ratio of Household Demand Deposits to Total Deposits

($ millions')
Ratio Household Demand
to Total Deposits 1/








1/ Estimated from Demand Deposit Ownership Survey•





-56accounts, the smaller batiks, on average, can be expected to experience
relatively larger earnings reductions than very large b a n k s c
Impact on Thrift Institutions
Earnings of thrift institutions will also be affected during
the transition period by the various proposals, but probably only

Thrifts need only pay interest on new demand deposits or N O W s s

while banks are more likely, for competitive reasons* to pay intereston most, if not all, eligible demand deposits.

With extension of trans-

actions balances on a nationwide basis to thrifts, either in the form
of NOW accounts or interest-bearing demand deposits, such funds may
be estimated to cost the institutions an average of about 7 per cent
in a transition period (explicit interest plus net cost of services) 5
assuming rates of interest at around today's levels.
The impact on earnings would depend on the return obtained
from investment of newly acquired funds.

It seems likely that thrifts

will place less of newly acquired transactions balances, in mortgages
than has been the ease for time and savings deposits* because of the
short-run volatility of demand deposits.

Instead, a substantial proportion

of these funds would probably be invested in more liquid Treasury and
agency securities, which generally yield less than mortgages.


ing this lower marginal yield on assets, thrift earnings as a percentage
of deposits would probably decline slightly during the transition

-57If interest-bearing demand deposits were authorized for
commercial banks only, the potential loss of funds by thrifts would
depend largely on the explicit rate of interest offered by banks on
transactions balances.

A significant erosion of thrifts



deposits would be unlikely to occur unless the explicit rate on
demand deposits approached the savings deposit rate.
Longer-run Adjustments
The potential temporary pressures on costs and profits
discussed earlier were the product of initial efforts b y banks and
other institutions

to increase, or maintain, market shares after

being given the authority to pay explicit interest on demand

Transition pressures were thought to be most intense

if both banks and thrift institutions were permitted to pay interest
on demand deposits, and less intense if the authority were limited
to banks.

However, the reduction in earnings that would develop

during a transition period would itself tend to limit the duration
of such a period and hasten the longer-run adjustments that would be
made in an effort to restore profits.
Such adjustments would include further increases in service
charges by banks, to make them commensurate with the costs of particular

Downward adjustments in the explicit interest rate paid

might also occur.

Costs might also be reduced if banks were able to

reduce or eliminate services that had been developed as a substitute
for explicit interest on demand deposits.

Many of these activities,

such as repurchase agreements and telephone transfers from savings
accounts, involve a more extensive use of resources in shifting funds


and in paperwork than would be necessary if the funds w e r e held in
demand deposits.

Another long-run saving to banks would appear

through the reduction in resources used to clear checks.
In. the long run, banks could find that the net cost per dollar
of transactional balances will decline*

This could occur primarily

because services that are expensive to the bank, but not valued highly
by the customer, would be replaced by explicit interest, whose value
to the bank and customer would be equal.
For example, under current conditions, the customer with
free check-writing generally would value the last check h e writes by
much less than it costs the bank to handle it.

He might.value this

check a t , say s 2 cents, while it costs the bank about

10 cents *


the customer were offered explicit interest, coupled with service
charges on his checks at least greater than 2 cents, h e would no longer
write that last c h e c k — s a v i n g the bank 10 cents.

The bank need pay the

depositor only 2 cents in interest to make him as well off as before.
T h u s , the bank would be saved 8 cents * A similar argument is applicable
to those banks that currently charge customers for services so long

as the charge is below the bank s cost of handling checks.
These considerations suggest that banks' earnings would tend
to be restored to levels prevailing prior to the payment of interest
on demand deposits, or perhaps even improve a little.

H o w e v e r , if

third party payment powers are extended to thrifts when the prohibition
is lifted, the increased competition, particularly for household
deposits, may work to keep the rate of return (explicit plus implicit)
to depositors above the current implicit return.

This would act

-59to offset, at least in part, the cost savings from increased efficiency.
In addition, competition from thrifts may result in a permanent shift
in some demand deposits from commercial banks to thrifts, which would
also tend to reduce bank profits compared with what they otherwise
might b e .
Longer-run adjustments by banks to the payment of explicit
interest on demand deposits may also entail adaptations in the banking

Competition among large and small b a n k s — o r among local,

regional, and national b a n k s — h a s become more intense in recent years
as a result of the wider availability of deposit and credit services
through such devices as bank-by-mail, bank credit cards, and direct
deposit of payroll checks.

Payment of explicit: interest would provide

a clear measure for depositors of the return on their funds available from
a number of competing banking institutions.

In an environment in which

deposit mobility has been increasing, smaller banks may find it more
difficult to restore profit margins than larger banks, which--because of
their more highly developed managerial and technological skills-~may be
in a better position to adjust marketing strategies and costs to the
new circumstances.
In addition, the incentive for banks to establish branch
systems may be reduced if the prohibition on demand deposit interest
payments is removed.

In the absence of such explicit interest payments,

the establishment of branch systems has enabled banks to offer depositors
an implicit return through the convenience of branch locations.


tion for deposits directly through payment of explicit interest would
reduce the need for such expensive, fixed cost methods of attracting


Effects on Depositors

Adjustments to interest on demand deposits may have
differential impacts, not only on depository institutions, but also
on depositorsr

Depositors are likely to derive the most benefit

from removal of the prohibition during the transition period*


noted in the preceding section, competitive efforts by institutions
to maintain or increase market shares in the initial adjustment period
would probably cause the total of explicit and implicit returns to
nearly all depositors to rise above the current implicit return,
perhaps substantially*

After market shares stabilize, the temporary

transition benefits to depositors would tend to d i s a p p e a r ^


longer-run equilibrium return to depositors as a w h o l e — v i e w e d as
the sum of explicit and implicit rates—should more nearly approximate
the current implicit return.

This section assesses possible gains

and losses to particular depositor groups—differentiated mainly by
size of deposits--over the longer-run, after banks have* adjusted
service and other charges to offset higher interest expenses «
Analysis of the effects over the longer-run on particular
groups of depositors is seriously constrained by the limited data,
not to mention the uncertainties in appraising the reactions of both
banks and the public to removal of the current prohibition of demand
deposit interest.

An evaluation of differential impacts requires

As noted in section V, banks in the most recent states where NOV
powers have been authorized—-Connecticut, Rhode Island, Maine, and
V e r m o n t — h a v e imposed higher service charges than in Massachusetts
and New Hampshire, and in many cases they are imposing substantial
minimum balance requirements.

-61data for bank costs of servicing checking accounts, bank charges to
customers for account servicing, and the value of other services provided
to customers free or below cost.

However, virtually no such data exist

on a comprehensive basis by size of account or by any other breakdown
of depositor characteristics.
As discussed in section III of this report, there are functional
cost data that can be used to compare the cost to banks of personal and
commercial checking accounts.

But these data appear to significantly

underestimate the cost per dollar of commercial accounts (and thus
the implicit return to business demand deposit holders) since they do
not take account of the many services that banks offer commercial
customers below c o s t — s u c h as cash management a d v i c e — o r other related
aspects of the customer relationship—-such as attractive loan terms to
businesses with large cash balances.
There are fragmentary data on coasts to banks of personal
deposits by limited size breakdowns implicit irt the functional cost

They are subject to the same limitations as the commercial

account data in that they do not measure the value of other services
rendered by the bank to the depositor.

Nevertheless, the data may

be used as a basis for tentative judgments about possible impacts
on small as compared with larger personal depositors of explicit
interest on demand d e p o s i t s — o n the assumption that the value of
non-checking services does not differ substantially across depositors
within a relatively broad size range and that, in any event, the value
of such services is much less for personal than for business depositors.

-62Current Implicit Returns for Personal Deposits by Deposit Size
Relatively small average balances are maintained in the
great majority of demand deposit accounts.

The average demand balance

in 1975 at banks participating in the functional cost program of
the Federal Reserve was about $2,500 for all customers—personal,
business, etc«-~but nearly two-thirds of all accounts had balances
of less than $500, as may be seen from the first column of
Table VI-1.

The average balance of such accounts was only $166, as

shown in the last column of this table®

The distribution of accounts

by size was roughly the same for each of the three bank size classes
reported in the FCA data.
The average balance in personal demand accounts was $990.
No further information on the distribution of personal accounts is
available from the functional cost data.

However, it seems reasonable

to assume from the data on all accounts that most personal accounts
are probably significantly smaller than $990.
The cost to banks of servicing accounts depends
importantly on account activity-number of checks written and number
of checks deposited—although related services provided to account
holders may also be a significant cost, particularly for business

Unfortunately, data on account activity by size of account

are extremely sketchy.

Nevertheless, there is some evidence to suggest

that the number of checks written per account does not increase in
proportion to the increase in account size.


Table VI-1
The Distribution of Demand Deposits for
all Functional Cost Banks by Number and Volume, 1975

Deposit Size

(In per cent)

Average Balance
Per Account 1/
($ Amount)

Under $200




$200 to $500




$500 to $1,000




$1,000 to $5,000




$5,000 to $10,000




$10,000 to $25,000




$25,000 to $100,000




$100,000 and over





Functional Cost Analysis - 1975 Average B a n k s , p . 7.2

Average balance for all accounts under the upper limit of the
class interval s h o w .

-64Functional cost statistics are maintained for three types
of personal checking accounts:

special accounts (specified service

charges per check and sometimes a maintenance fee), no service charge
accounts (generally requiring a minimum-balance or the use of another
bank service such as holding

a savings deposit), and regular accounts

(remission of service charges varying with average balance) f


all banks participating in the functional cost survey, the average
balances in the first two account types in 1975 were about $365 and
$880, respectively, and the monthly average number of checks written
were 11 and 16 * respectively.

While such data do not exist for so-called

regular accounts, the statistics available for the first two types of
personal accounts suggest that the number of checks written does not
on average rise anywhere in proportion to the size of account b a l a n c e s ^
Thusj the dollar costs to banks of checking account activity
in personal accounts do not appear to vary proportionally with size of

In addition, banks incur fixed costs for statement prepara-

tion, building occupancy, and other items that are similar for large
and small accounts alike.


As a result, banks


gross costs of servicing

This judgment is reinforced by a formal study of account activity
by size of account prepared by the staff of Security Pacific National
Bank (Los Angeles, California) entitled
"Restructuring of Financial
Institutions 'Interest on Deposits,
Discussion Paper, 1976. Their
results indicate that 53 per cent of all personal accounts at that
bank had minimum balances below $100 during the survey month and the
average number of checks written on these accounts was 17 per month.
By contrast, 11 per cent of all that bank's personal accounts had
minimum balances of $1,000 or more and the average number of checks
written on these accounts was 19 per month.

-65a checking account per dollar of account balance appear to be
higher for small than for large accounts.
Banks, of course, levy service and other charges to offset
some of the costs of checking account activity.

The FCA data suggest

that banks do not completely recover the costs of account activity, and
thus personal depositors as a group received an implicit return on
demand deposits of from 4 to 4% per cent in 1975, as shown in Table

The breakdown of functional cost statistics between special

accounts (with service charges) and no service charge accounts (with
minimum balance requirements) can be employed to obtain a rough
approximation of the implicit return to small as compared to larger
depositors, since small depositors are predominantly in the former
Table VI-2 shows the costs and income derived from these
two types of accounts at medium-size banks in 1975.

Balances in

special checking accounts with per check service charges averaged
$359; administration of the accounts cost

banks an average of $37 per

year; and banks recovered $16 through fees and other charges.


no service charge accounts, the average balance was larger, checking
activity was slightly higher, and a much smaller proportion of costs
was recovered by the bank through service charges.

-66Table VI-2
Income v Cost, and Return to Demand Deposit Accounts, 1975
(medium-size banks)




Average balance


Checks written per month


No Service
Charge Accounts





Cost of administration

$ 37



Cۥ Charges and fees




Net cost to bank (B-C)




Out-of-pocket cost to depositor (~C)




Implicit return to depositor in
p e r c e n t (B f A )



The implicit return to depositors (line F) with the smaller
account was higher (5,8 per cent) than for those with the larger account
(4,2 per cent)®

On the other hand, out-of-pocket costs to the depositor

(line. E) were higher for the small account holders because of higher
service charges e

The advantage to the small account holder derived

chiefly from the fact that such depositors wrote almost as many checks
as large depositors, but with a smaller average balance.
Data limitations—such as the relatively small number of FCA
reporters and problems of cost allocation—make any conclusion with
respect to relative rates of return to small and larger depositors
highly uncertain.

More importantly, however, banks may act to equalize

returns across deposit size groups by offering large depositors free,
or below-cost, non-checking services—such as travelers


checks at

-67no charge, safe-deposit boxes at reduced rates, and preferential
treatment for loans and other financial services.

Although it is

impossible to quantify the extent to which these services benefit
larger account customers, it is likely that they tend to raise bank
costs of larger accounts relative to small accounts, though they
may be most important for very large accounts and may not have
significant differential effects on accounts within a fairly broad
size range.
Differences in returns to depositors may reflect the costliness to banks of adapting service charges and nonprice benefits to
a highly diverse set of depositors with disparate average balances and
account activity.

As a consequence, in the absence of'authority to

pay explicit interest on demand balances * banks offer a package
of deposit and related services, aimed mainly at the typical depositor,
and this leads to some depositors benefitting more than others.


addition, it is possible that banks may be willing to incur higher costs
for small accounts in anticipation that small depositors will come to
use other bank services (such as savings accounts and loans) over
their lifetime and may also increase the size of average demand balances.
Impact of explicit interest
If explicit interest were paid on demand deposits, the adjustments made by banks to service charges and related fees may have
differential effects on the over-all return—explicit plus implicit
interest—realized b y different types of depositors and b y depositors
of the same type with checking accounts of different size.


-68general, banks can be expected to unbundle packages of services
available to depositors and to price each of these services more in
accordance with its cost®
With regard to businesses, it seems reasonable to assume
that they now receive a highly competitive return on demand deposits,
after taking account of the value of other services offered by banks*
The demand deposit account is only one element in a complex variety of

offered to business by customer banks* some of which> such as

loans, can be obtained elsewhere*

A n d , as part of ordinary business

practice, it can be expected that every effort has already been made
by corporate treasurers to minimize costs of banking services 5
including deposit, loan, and other related services.
If businesses are now receiving close to an optimum return
on their demand deposits, it seems likely that after payment of explicit
interest on such deposits banks would adjust charges on checking
account activity and terms on other services in order to re-establish
the pre-existing equilibrium.

They may introduce, or raise, fees

for cash management or lock-box services c

It is possible that the

stated loan rate (including fees) on a deposit customer s business
loan may rise somewhat to offset the payment of explicit interest on
what were formerly interest-free compensating balances.
With regard to personal account holders, banks would also
be expected to take measures over time that would bring the total
cost per dollar of demand deposit accounts to a level close to that
which prevailed prior to payment of explicit interest.

However, It

-69is possible that the ultimate return to consumers as a g r o u p — m e a s u r e d
as explicit plus implicit i n t e r e s t — m a y be higher than the current
implicit return.

It is probable that most consumers are currently

not as aware as businesses of the return from banking services now
being provided to them at less than cost.

The information conveyed by

payment of explicit interest is likely to make individuals more aware
of the return on demand deposits and the costs of checking and other
related services.

This greater awareness—together with any increased

long-run competition for transactions deposits if thrift institutions
are permitted to offer such interest-bearing accounts--could lead to
establishment of a somewhat higher equilibrium return for consumers
after explicit interest is permitted.
Impacts may differ, however, b y deposit size, depending on
how banks and consumers adjust to the new conditions.

Banks could

adapt, for example, by establishing either a relatively high or low
explicit interest rate.

If banks set a high explicit rate, they would

be likely over time to raise charges and fees to the point where they
recover a very high proportion (or all) of the costs of administering
checking accounts.

In that case, the apparent relative advantage of

small depositors over larger depositors shown in Table VI-2 would
be reduced (and would be eliminated if charges and fees were set to
fully recover the costs of administering checking accounts).


would occur because the increased explicit interest earned on deposit
balances would serve as a greater offset to increased service charges

-70for large accounts than it would for small accounts, since both the
small and larger account holders on average appear to write nearly
the same number of checks.

On the other hand, if banks pay a relatively

low explicit interest rate on demand deposits, they would have less
incentive to adjust service charges as fully as if a higher explicit
rate were paid.

In consequence, the relative advantage of small

depositors might tend to be maintained.
The impact of explicit interest on depositors would also
be affected by adaptations in their check-writing habits.

As banks

raise the price of check services, depositors would have an incentive
to economize on check writing.

To the extent that depositors write

fewer checks, their potential out-of-pocket costs would be reduced
as charges and fees decline relative to interest income received.
A personal depositor would have a particularly strong incentive to
economize on check-writing since service charges are not tax deductible
(as they would be for business) whereas explicit interest income is,
of course, taxable«>
In sum, because of the variety of responses available to
banks and depositors, and because of limitations on what can be
determined about the current distribution of implicit returns by
type of depositor or b y size group, it is virtually impossible to
assess with any certainty the distribution of gains and losses across
depositor groups that would result from payment of explicit interest.
It is possible that consumers as a group may benefit a little more,
than businesses, who may already be managing their deposit funds


Depositors with small balances who write a large number of

checks could be worse off than they are now.

The clearest gainers

would appear to be depositors with large and relatively inactive

Tax considerations could erode consumer gains generally,

however, since, as noted above, explicit interest is taxable whereas
the added service charges are not tax deductible; this will tend to
increase potential out-of-pocket costs.


Monetary Aggregates, Credit Markets, and the Economy
This section considers the effects that payment of interest

on demand deposits may have on monetary aggregates, economic activity,
and credit markets.
Monetary aggregates and monetary control
Payment of explicit interest on demand deposits will affect
the significance and interpretation of the monetary aggregates s including
money supply narrowly defined as currency and demand deposits in the
hands of the public (M^) , as well as broader measures of money including
time and savings deposits at banks and thrift institutions (M2 and M^) *
Thus, it will influence formulation of longer-run growth ranges for
the monetary aggregates consistent with over-all economic objectivesc
Given particular monetary growth ranges, payment of explicit interest
is unlikely to have a significant effect on the ability of the Federal
Reserve to control monetary aggregates through open market operations
or other measures affecting the member bank reserve base*
Implications for longer-run money supply growth rates«


present, financial markets are in a transition period involving the
accelerated development of a variety of substitutes for demand deposits
bearing an explicit interest rate, as discussed in section III,


developments, which have blurred the distinguishing characteristics
of the various monetary aggregates, have complicated the formulation
of monetary policy.

-73M ^ was formerly viewed as the sole repository of transactions

Recent institutional developments—including NOW accounts,

telephone transfers, and business saving accounts--have increased the
transactions character of savings deposits at banks and thrift institutions and thus of

and M ^ .

Money market mutual funds also offer

individuals a highly liquid investment, virtually available on demand.
Over the past year alone, it appears as if these and other developments
may have reduced the demand for M ^ by as much as 1% percentage p o i n t s . ^
As demand deposit substitutes evolve, public preferences for
various types of assets in which transactions and liquidity balances can
be held will remain in a state of flux, and it will be more difficult to
choose one-year growth ranges for the monetary aggregates that are consistent with over-all economic objectives.

If interest is paid directly

on demand deposits, this evolutionary process will be altered.


institutional arrangements and behavior patterns w i l l be changed.
It is difficult to predict how quickly, and by how m u c h , banks may
adjust explicit rates paid and make offsetting adjustments in service

Moreover, if demand deposit powers were extended to thrift

institutions, there would be yet another unknown in appraising
institutional responses.

Thus, uncertainties, as compared with the

present situation, would be heightened for a time.


However, the

See John Paulus and Stephen H . Axilrod, "Recent Regulatory Changes
and Financial
Innovations Affecting the Growth Rate of the Monetary
Aggregates, a Board staff memorandum of November 2 , 1976.

-74adjustments may be more expeditious and the institutional structure
that finally evolves easier to interpret if explicit interest is
authorized on demand deposits than if events continue on their present
As time passes, a fairly stable pattern of explicit interest
rates, institutional arrangements, and deposit holdings would be
expected to emerge e

However, even if permitted to move freely, an

explicit rate on demand deposits would probably b e adjusted sluggishly,
as banks and other institutions seek to maintain costs of such deposits
more in line with longer run interest rate expectations than with shortrun, transitory market rate variations.

In any event, the Federal

Reserve would be able to observe such rates, and would begin to learn
how rapidly institutions adjust them in response to changes in market
interest rates.

Also, the Federal Reserve might eventually be able

to estimate more precisely the demand sensitivity of various types of
deposits to changes in the return on demand deposits if explicit
interest were permitted.

Under current conditions, the Federal Reserve

has little direct evidence on implicit rates, the value of related
financial services and arrangements, and on demand sensitivities to
these rates.

Payment of explicit interest on demand deposits might also

contribute to stabilizing the institutional environment by tending
to curtail the development of financial instruments designed to

-75substitute for demand deposits in the payments mechanism.


in turn, would simplify analysis of the economic significance of
various monetary aggregates.
The extent to which monetary policy will need to permit
adjustments in growth of the various monetary aggregates in order to

accommodate shifts in the public s desire to hold demand deposits will
depend in part on the particular types of depositors w h o are permitted
to earn explicit interest.

Payment of an explicit interest rate would

tend to increase the public's desire to hold demand deposits.


appears to be more clearly the case for consumers than for businesses.
At present, households receive an implicit return largely
through either free checking services or service charges below cost.
With free services, for example, households may be said to have a
marginal return to deposits that is zero since there is no additional
gain from holding added balances, though there is an incentive to
open an account.

Payment of an explicit interest rate would permit

incremental deposits to earn additional interest and thereby would
provide an incentive to increase demand deposit holdings.

The increased

incentive would be less clear for those household accounts where
service charges are presently scaled inversely to demand deposit
levels since these accounts presently receive an implicit marginal

-76return; in these cases banks may lower the implicit marginal return to
help offset the payment of an explicit rate«~^
With regard to the behavior of corporate depositors, it is
uncertain whether their demand deposits would tend to rise if an
explicit rate were paid.

The scope for adjustments in other related

services and terms on loans is broader than for consumers, as noted in
earlier sections 5 and it is more likely that the current marginal
return to corporate depositors (which is now implicit) might change
little if explicit interest were paid.
If explicit interest were paid to state and local governments, there may be some increase in willingness on their part to
hold more demand deposits, particularly the smaller units.


the magnitude would be highly uncertain, because there would surely
be adjustments in the relationship between services provided by banks
to local governments-^including the availability of repurchase
agreements on U,S, Government securities and support on issuance
of securities, particularly those of smaller governmental u n i t s — a n d
the terras offered on deposits,

If an explicit interest rate were permitted nationwide only on
NOW accounts, the principal difference—as compared with interest
on all demand deposits—may be in the nature of the transition
It may be slower for NOW accounts, as discussed in section V,
Moreover, during the transition NOW accounts might include more of a
mixture of savings and transactions balances than would an interestearning demand deposit since some institutions may offer to convert
savings deposits automatically to NOW accounts. Over the longer-run,
the ability of institutions to pay a higher rate on NOW accounts as
compared with interest-bearing demand deposits, and thereby to attract
more savings-type funds into NOW accounts than into demand accounts,
would seem to depend on the continuation of the present large
difference in reserve requirements on the two accounts.

-77As deposit holders adjust to payment of interest on demand
deposits, the money supply growth consistent with attainment of
economic objectives would be affected, as noted earlier.

If the

exact pattern of institutional and public adjustments could be foreseen, the Federal Reserve could simply adjust the projected ranges
for the various monetary aggregates accordingly.

However, it may be

difficult to forecast such adjustments with any precision, particularly
early in the transition period.
Interest on demand deposits in the short run, therefore,
introduces some uncertainty with regard to the interpretation
of the degree of economic stimulation, or restraint, implied by various
monetary growth rates.

But these problems do not differ in kind from

those that have developed recently as transactions substitutes for demand
deposits have become more widespread.

Thus, it does not appear that pay-

ment of interest on demand deposits would complicate significantly the
formulation of monetary policy in the short run.

In any event, with


interest on demand deposits, the public s preferences for the various
depository claims would probably become more predictable sooner than
under present circumstances, and the formulation of growth ranges of
the aggregates would be simplified.
Interest on Treasury demand deposits.

Payment of interest

on U . S . Treasury demand deposits held at commercial banks would not
affect the monetary aggregates directly, since such deposits are not
included in measures of money supply.

It might, however, lead to

-78some minor improvement in the ability of the Federal Reserve to
implement monetary policy on a day-to-day basis.
If interest on demand deposits were paid to the Federal
Government, there might be some incentive for the Treasury to hold more
of its deposits at commercial banks instead of at Federal Reserve Banks.
This incentive would be minimal, however, unless the interest rate
on its demand deposits approached the return on the System's portfolio e
At present, the bulk of Treasury deposits are held at the Federal
Reserve, where they in effect earn interest equivalent to the average

yield on the System s security portfolio (since the System turns over
to the Treasury the earnings on the Government securities that
Reserve Banks acquire in consequence of a rise in Treasury deposits).
To the extent that the Treasury -did reduce its average
balance with Reserve Banks and raise it with commercial banks


monetary control in the short run would be simplified. A t present }


If sufficiently high interest on demand deposits could not be
paid the Treasury to induce a significant shift: in deposits
to commercial b a n k s — o r if no interest could be p a i d — t h e
same practical effect could be accomplished by permitting
the Treasury to lend Federal funds to banks. Such authorit}^
was granted the Treasury in legislation passed b y the House
of Representatives in 1976 (H.R. 3035).


the Treasury s balance at Federal Reserve Banks fluctuates from
week to w e e k .

These fluctuations necessitate large offsetting open

market operations in order to keep bank reserves from being unduly

On occasion, the Federal Reserve has found that such

operations are so large that they cannot be accomplished in as
timely a fashion as would be desired and therefore that short-term
disturbances develop in bank reserves and in money market rates.
If the Treasury balance were maintained mainly at commercial banks,
the effect on bank reserves of variations in Treasury receipts and
expenditures would be considerably lessened.
Effects on monetary control.

Whether payment of explicit

interest Ttfill in practice weaken, or strengthen, monetary control
depends on the predictability of the response of banks and the public
to changes in reserve availability under the new circumstances, on
whether or not explicit interest is subject to a ceiling, on whether
demand deposit or similar powers are simultaneously extended to
other depository institutions, and on the reserve requirement structure
behind such deposits.
Any heightened uncertainties about demands for various
deposits after banks begin to pay explicit interest on demand deposits
would tend to reduce the predictability of the multiplier relationship
between bank reserves and the money supply.

Unpredicted shifts among

deposit categories subject to different reserve requirement ratios


the multiplier relationships between reserve and monetary


Unpredicated movements in deposit demands also give rise

to unpredicted movements in money market rates, given reserve
aggregates; hence, the excess and borrowed reserve positions of
banks would be affected, which also would alter the multiplier
relationships between reserve and monetary aggregates.


uncertainties about money demand would also reduce the precision
of monetary control if the Federal funds rate is used as the main
day-to-day operating guide for control of the monetary aggregates,
since control, in that case, depends more heavily on knowing the

relationship between interest rates and the p u b l i c s money demand.
Over the longer-run, though, it seems likely that
uncertainties about shifts in public holdings of deposits will
be reduced with explicit interest paid on demand deposits as
compared with the current environment in which a wide variety of
evolving demand deposit substitutues are greatly complicating
interpretation of monetary aggregates.

But controllability of the

aggregates will also be affected in part by the regulatory environment following removal of the prohibition of explicit interest.
Monetary control will be influenced to a certain extent
by whether or not interest-bearing demand deposits are subject to
a regulatory ceiling.

With a relatively low fixed rate ceiling that

prevents explicit offering rates from adjusting to market rates, changes

-81in the public's demand for money in response to changes in market
interest rates may not be significantly different from what they are

The availability of an explicit rate would probably increase the

demand for money for any given level of market rates.

But as market

rates change, the public may respond no differently to the changing
spread between a fixed explicit return and market rates than it now
A more flexible demand deposit rate offered by institutions
in the absence of a ceiling could introduce additional uncertainty
in evaluating the demand for money because faster bank responses to
changing market rates would in turn influence the public's willingness
to hold demand deposits.

However, changes in the terms on which banks

offer demand deposits are likely to be clearer than they are now--when
they take the form of service charge adjustments, changes in compensating balance requirements, or other such d e v i c e s — a n d the System
therefore would be in a better position to adjust its short-run
money market and bank reserve operating guides.

In any event,

even if permitted to move freely, adjustments in an explicit rate
on demand deposits by banks and other institutions would probably
be sluggish, as noted earlier, so that short-run control problems
would not in practice be significantly different from what they are
Still, a reporting system on explicit interest on demand
deposits, as well as related service charges, would, under the

-82circumstances, be helpful in appraising both the public's willingness
to hold demand deposits and the adjustments in the reserve base that
the Federal Reserve may be required to make to affect the volume of
such deposits.
The effectiveness of monetary control would also depend
on whether institutions offering third-party payment accounts are
required to maintain reserves on such deposits at the Federal Reserve,
Member banks, of course 5 do hold such reserves.

Monetary control

would be enhanced if nonmember institutions were also required
to hold reserves against demand or other transactional deposits on
a uniform basis and if they were maintained in vault cash or as
balances at Federal Reserve Banks.

To the extent that NOW accounts

are used as transactions balances and are considex-ed similar
to demand deposits for purposes of monetary policy, it would also
be desirable from a control point of view for reserve requirements

on N O W s to be identical with those on demand deposits.
Monetary policy and the economy
The extent to which payment of interest on demand deposits
will alter the responsiveness of the economy to monetary policy or
other forces will depend in part on how flexibly banks adapt the
interest rate paid on demand deposits to changing market rates.


as seems probable, the deposit rate is adjusted sluggishly in response
to changing market interest rates, the process and speed of economic

-83adjustraent to an easing of monetary policy, for example, will be little
different than under current circumstances.

The quantity of money

demanded will increase about as it does now in reflection of a
decline in short-term market rates.

And subsequent adjustments in

economic activity will occur with about the same speed and magnitude
as they do now in response to the resulting lower interest rates,
enhanced capital values, greater credit availability and any improvement in liquidity positions of key economic sectors.
If, on the .other hand, banks were able to adjust explicit
interest rates on demand deposits significantly more rapidly than they
presently adjust implicit rates, the speed and magnitude of the economy's
response to any given change in bank reserves and money would be

Suppose that money is encouraged to grow more rapidly in a

noninflationary period and money market rates drop in the short run.
Banks would, as a result, have some incentive to lower demand deposit
rates *

To the extent deposit rates decline, the public would have

less of an interest rate incentive to hold the added m o n e y .


interest rates would then tend to drop further, so long as the quantity
of money demanded remains below that supplied.

The greater decline

in market rates generated by a more flexible deposit rate would
more promptly set in motion forces that will act to generate additional
economic activity and, as a result, additional demand for money.
Thus, if offering rates are varied more rapidly, payment of interest
on demand deposits would lead to a somewhat more rapid and pronounced

response of the economy to changes in money growth rates.


another way* this analysis suggests that changes in the velocity of
money would be less of a potential offset to changes in money supply
the more flexible is the interest rate paid on demand deposits.
Such a speed-up in responsiveness of the economy to money
supply growth has both stabilizing and destabilizing aspects.

It is

stabilizing to the extent that monetary policy actions may more rapidly
offset other factors causing undesired economic disturbances t It is
destabilizing, on the other hand, to the extent that the Federal
Reserve is unable to maintain an appropriate money supply growth,
either because interest on demand deposits increases the difficulty
of setting long-run growth ranges for the aggregates or because
adequate tools are not available to control money growth under the new
circumstances *

Such difficulties would tend to be minimal after a

transition period, however, assuming that the demand for money would
become more predictable and that the Federal Reserve would have
authority to set reserves behind transactional deposits.
The effects on the economy of more flexibility in the
interest rate on demand deposits can also be considered in relation
to exogenous shifts in the demand for money or in the demand for goods
and services, assuming no change in money supply growth.

If the demand

for money changed relative to economic activity while money supply
growth was being kept unchanged, a more flexible rate on demand
deposits might cause the economy to be somewhat less stable.


example, if money demand were increasing relative to G N P , interest
rates would tend to rise more rapidly than otherwise for given money

-85supply growth.

Following a rise in market rates generated by the

increase in money demand relative to supply, banks would raise
demand deposit rates.

This would further increase the public's willing

ness to hold money; the public would sell additional assets in order
to acquire the limited supply of deposits, raising interest rates
still higher.

This consequent heightening of interest rate p r e s s u r e s —

accompanied by greater declines in the velocity of money than would
otherwise o c c u r — w o u l d thus tend to reinforce any downward effects on
economic activity resulting from the initial rise of interest rates.
On the other hand, more flexibility in demand deposit rates
will work in a stabilizing direction to moderate changes in economic
activity generated by exogenous changes in demands for goods and

For example, with money supply growth unchanged, a drop

in the demand for goods and services would drive market interest
rates down, and this decline would be accentuated b y a fall in deposit

Lower market rates would provide an incentive to increase

spending, velocity would fall less than it would otherwise, and
economic activity would tend to be maintained at a higher level
than otherwise.
The analysis in this section,suggests that interest on
demand deposits may have no clear net advantage or disadvantage in
terms of impacts on aggregate economic activity.

On balance, its

effect is likely to be quite minor, mainly because it appears probable
that institutions able to pay such interest will probably adjust the
rate rather sluggishly in response to longer-run changes in market

-86conditions—much as is done now with the implicit r a t e — r a t h e r than
rapidly in line with short-run fluctuations in rates.
Credit markets
The effect of beginning to pay interest on demand deposits on
the average level and the structure of interest rates will depend on the
response of the Federal Reserve to changes in money demand occasioned
by payment of interest, on how banks or other institutions pass on the
added cost of demand deposits, and on shifts in flows of savings among
banks, other institutions, and the markets.

As the public s desire to hold demand deposits rose as a
result of the payment of interest on such accounts, the Federal Reserve
would presumably provide the reserves necessary to permit the increase
to occurc

If reserves were not provided, economic activity might

well b e adversely affected as interest rates rose reflecting sales
of securities b y the public or transfers out of time and savings
deposits (which have relatively low reserve requirments) to the
new demand deposits bearing explicit interest (and which have relatively
high reserve requirements).

But if additional reserves were provided,

over-all interest rate pressures would be averted.

Thus, the average

level of interest rates would not be affected b y the introduction of
interest on demand deposits.
The costs to banks would, at least temporarily, be higher
on those deposits which bear explicit interest.

However, banks would

-87probably not be able to pass on these costs to any significant
extent in the form of higher interest rates on particular loans or
investments they make.

Most of these interest rates are determined

in highly competitive markets characterized by a very large number of
borrowers and lenders.

Even in regional and local markets, competi-

tion among banks and other lenders limits the ability of any single
lender to raise lending rates.
To the extent that payment of interest on demand deposits
has any impact on interest rates in national markets, it would be
reflected in the structure of interest rates.

If payment of interest

on demand deposits enabled banks to capture a larger share of total
financing, yields might decline a little in those areas where banks
are important suppliers of f u n d s — s u c h as loans to businesses
Interest rates could rise somewhat in other areas, such as in the
mortgage market, if the funds diverted to banks came from thrift

These increases would probably be quite small, how-

Permitting thrift institutions to pay interest on demand
deposits would reduce the likelihood of any such shift in relative

In the process of adjustment to an explicit return on demand
deposits, stated loan rates to corporate customers could rise
if these customers also received explicit interest on demand
deposits. But this would not imply an increase in the true cost
of borrowed money to these firms. At present, non-interest
earning compensating balances generally raise the cost of loans
to corporate borrowers above the stated rate. If interest could
be paid on demand deposits, adjustments might be made to compensating balances—either by paying interest or reducing the
non-interest bearing a m o u n t — w i t h a higher contract loan rate
providing an offset.

-88credit availability.

But, it is difficult to gauge the precise

effects on credit flows of permitting all depository institutions
to offer interest bearing demand deposits.

Much would depend on the

exact form of those new powers—whether they included only NOW or demand
deposit accounts limited to households, whether they encompassed all
demand deposits, and whether they were subject to rate ceilings.


would also depend on any accompanying changes in the investment powers
of nonbank depository institutions.

The degree to which these institu-

tions compete for costly and volatile demand balances may well depend
on whether they are given greater access to shorter-term investments
and loans.
If all depository institutions were permitted to pay interest
on demand deposits, it is possible that thrift institutions would
increase their share of the total of all forms of deposits e


availability of demand deposit powers to thrifts might also tend to
stabilize their total deposit flows over the economic cycle.


market interest rates rose, growth of time and savings deposits would
still tend to decelerate, but thrifts might continue to attract their
share of expanding transaction-type deposits.

This might, at the margin,

help to reduce the sensitivity of mortgage flows to cyclical swings
in credit availability and interest rates.
The ability of thrift institutions to compete with banks for
interest-bearing demand deposits over the course of an economic cycle
is open to some question, however.

Banks have more diverse assets,

and they may be better able than thrifts to adjust demand deposit rates

-89upward in a period of rising market rates.

On the other h a n d , in a period

of easing credit conditions thrift institutions would appear to be in
a better position to maintain high deposit rates relative to banks.
Maintenance of a relatively low ceiling rate on demand deposits at all
depository institutions over an economic cycle might tend to minimize
the likelihood of shifts in institutional shares of transaction-type
deposit accounts as market interest rates change.

Nevertheless, even

without ceiling rates, thrift institutions would probably have a
larger availability of funds in periods of high interest rates if
they had demand deposit powers than if they did not.


Interest on Reserve Balances

If banks and other depository institutions were given
permission to pay explicit interest on demand deposits, consideration
might also be given to paying interest on balances held b y such
institutions as reserves at Federal Reserve Banks *

The added return

would help facilitate institutional adjustments to cost increases
associated with payment of interest on demand deposits.

In addition*

over the longer run, interest on reserve balances would serve to
increase the effective return to demand deposit holders to the
extent that banks and other institutions pass on part of the interest
At present only member banks of the Federal Reserve System
would be affected by interest on reserve balances.

But it would

also aid other institutions if, as has been proposed, their transactions balances are subject to reserve requirements set b y the Federal
Member banks of the Federal Reserve System now earn no
interest on the reserves that they are required to hold either in

A number of proposals have been made to Congress that would
require depository institutions to hold reserves against
transactional-type deposits at the Federal Reserve. The
Financial Institutions Act passed by the Senate in 1975, for
example, authorized the Board to set reserve requirements on
demand deposits and NOW accounts for members of the Federal
Home Loan Bank System and the National Credit Union Association Discount Funds. The Federal Reserve has also proposed
legislation that would make all deposits of such institutions
subject to reserve requirements set by the Board of Governors.
Under both proposals such reserves were to be held in vault
cash and deposits at the Federal Reserve.

-91the form of demand balances at Federal Reserve Banks o r vault cash.
Other depository institutions—nonmember banks, savings and loan
associations, and credit unions--can earn interest on a l l , or at least
a sizable portion, of their required reserves.

Member banks are thus

placed at a competitive disadvantage in relation to other depository
ins t i tut i on s . ^
The implications for the effectiveness of monetary policy of
any proposal to pay interest on reserve balances must b e considered,
along with the expected effects of such a proposal on bank costs,
competitive balance among institutions, and on Treasury revenues.


of these issues is examined below.
Monetary Control
A major issue with respect to the payment of interest on
reserve balances is its implications for the ability of the Federal
Reserve to control the monetary aggregates and to influence overall
liquidity and credit conditions.

Effects on monetary control will

depend in part on whether interest is paid on total reserves, excess
reserves, or required reserves.

Payment of interest on reserve balances may therefore help stem
the considerable attrition in membership in the Federal Reserve
System. This attrition, as it continues, could raise problems for
che soundness of the banking system in that fewer banks would come
to have ready access to the discount window
and for monetary policy
in that an increasing share of the nation s money supply would not
be subject to reserve requirements set by the Federal Reserve.

-92If interest were paid on all of banks' reserves, including
excess reserves, the linkage between bank reserves and money and
credit could become looser.

In implementing monetary policy, the

Federal Reserve must take account of the quantity of excess reserves that banks are likely to hold, since such reserves do not
add to the supply of bank credit and money made available to the

With interest paid on excess reserves, the System would

have to guard against an undesirable accumulation of such reserves
by banks as market rates moved close to or below the rate on excess
reserves *

Thus, the interest rate on excess reserves would have to

be adjusted from time to time.

In view of the need to adjust

the rate and because the behavior of member banks with respect to
excess reserves under the new circumstances might b e less predictable, monetary control could become somewhat more complicated.
These problems could be avoided, however, by confining the payment of interest to required reserves, which would have no significant
effect on the ability of the Federal Reserve to control monetary aggregates through control of the reserve base.

Payment of interest might

b e confined, in addition, to those required reserves held on deposit
at Federal Reserve Banks; vault c a s h — t h e other form in which
member banks may currently maintain reserves—serves for banks a
transaction purpose similar to that of currency in circulation in
the hands of the public (which does not of course earn interest) .

-93If a fixed interest rate were paid on that portion of required
reserves held at the Federal Reserve, banks would not b e
likely to alter significantly their response to changing market
conditions,and thus the predictability of the relationship
between reserves supplied by the Federal Reserve and money and
bank credit would probably not deteriorate.
Nor would occasional variations in the rate paid on
required reserves held at Federal Reserve Banks be likely to present problems for monetary control.

To be sure, changes in that

rate might influence the rates banks in turn pay on deposits, and
hence the demand for bank deposits.

But such effects would pro-

bably be quite small and would not significantly complicate
the determination of longer-run ranges for the monetary aggregates
or t e Federal Reserve's ability to influence growth in these
aggregates or overall credit conditions.
It has been advocated that banks be permitted to earn
interest on reserve balances by allowing their holdings of certain
securities—usually those of the U.S. Government—to be counted
as reserves.- This, however, would seriously erode System control
over bank reserves, and hence over money and credit.


would be able to obtain added reserves merely by purchasing
securities in the market.

Such an action, initiated solely

by commercial banks, would in itself increase the lending and
and money-creating capacity of the banking system.

-94I f , however, banks continued to b e subject to a fixed
reserve requirement limited to balances at Federal Reserve Banks or
vault cash, and interest-earning securities were held solely as
an additional supplementary reserve, monetary control would not
be significantly weakened.

But such a supplementary reserve would

not reduce the burden on banks of reserve requirements unless
the reserve ratios for those reserves held in balances at the Federal
Reserve and in vault cash were reduced.

Cutting reserve requirements

would, of course y reduce the reserve burden on b a n k s .

A supple-

mentary reserve would then serve little purpose arid would raise all
of the problems and economic inefficiencies that are associated with
credit allocation, since a decision would have to be reached regarding what securities are acceptable for reserve requirements.


ment of interest on required reserves held at the Federal Reserve
has the advantage of keeping monetary control problems to a minimum
and of avoiding issues of credit allocation.
Competitive balance among financial institutions
Maintenance of non-earning reserve balances b y member banks
at Federal Reserve Banks represents a tax or added cost of doing
business that is borne by member banks and possibly their customers,
but not by nonmember commercial banks and other depository institutions.
Such institutions are generally required to hold a smaller proportion

-95of deposits as reserves.

They are also typically permitted to

hold their reserves, at least in part, in earning a s s e t s — s u c h as
Treasury and State and local securities, and time d e p o s i t s — a n d
in assets that they would hold in their portfolios in any event
such as interbank balances.
Thus, competitive balance among member banks and other
institutions would be promoted in the long run if member banks
were not subject to cost burdens that were not shared by other
competing institutions.

If nonmember institutions were required

to hold reserves against transactional balances at Federal Reserve
Banks (or in vault c a s h ) — a s is desirable from a monetary policy
viewpoint—interest payments on reserve balances would provide a
compensating adjustment for the loss in revenue

that nonmember

banks would experience on reserves against demand deposits currently
held in the form of earning assets.
Effects on bank costs
Payment of interest on reserve balances held at the
Federal Reserve would in effect reduce bank costs•

It would, there-

fore, help ease adjustments by banks during the transition period
as banks and possibly other institutions adapt to interest on demand

Over the longer-run, it should also serve to increase

the effective return to demand deposit holders as banks and other
institutions pass on part or all of the interest return.

-96Each 1 per cent paid on reserve balances of member banks
at Federal Reserve Banks would currently produce about $300 million
of additional before-tax income for member b a n k s . -i/

This effect

might be somewhat smaller, however, if institutions other than
banks are also permitted to compete for demand deposits and in
consequence demand deposits are attracted away from member banks* ~~
Based on the estimates of Scction V , pre-tax profits of
the member commercial banks could decline by about $500 million to

billion in the adjustment period to interest on demand deposits.

If only NOW accounts for individuals and non-profit institutions
were authorized, the reduction in earnings could be on the order of
$500 million.

A 2 per cent interest rate on reserve balances would

therefore more than offset the aggregate earnings reduction from

nationwide N 0 W s


the lowest estimate of the transitional impact

from interest on demand deposits.
The value to individual banks of such an offset to
interest on demand deposits will vary considerably depending on
their own market strategies and competitive environments.

In any

event, the principal beneficiary would b e member b a n k s of the
Federal Reserve, even if by legislation all depository institutions
were required to maintain reserves on all transactions balances at
1/ This assumes that member banks shift 30 per cent of their
vault cash to such deposits.
2J If nationwide NOW accounts were permitted rather than interest
on demand deposits, tne interest payment on member bank balances
would be further reduced as NOW accounts with currently lower
reserve requirements replaced demand d e p o s i t s — a l t h o u g h banks,
of course, would receive interest on securities or loans made
as a result of the reduction in reserve requirements.

-97Federal Reserve Banks (or as vault cash) . Member banks would
receive interest on reserves held for time and savings* deposits
as well as those held for transactions balances.

Other institu-

tions, however, are able to hold such reserves in interest-earning form at present.
Impact on Treasury revenues
If interest were paid on reserves held at Reserve Banks
(to the extent that they reflected required reserves), one result,
of course, would be a reduction in the earnings of the Federal
Reserve and therefore in the amount of funds returned by the
Federal Reserve to the Treasury each year.

The amount of revenue

loss would depend in part on the interest rate paid on reserves
and in part on the regulatory environment surrounding the payment
of explicit interest on demand deposits and the extension of
demand deposit powers.
As noted above, for ea^h 1 per cent paid on reserve
balances at present, Treasury revenues would b e directly reduced
by about $300 million per year.

This figure represents about

5 per cent of the funds returned to the Treasury by the Federal
Reserve in 1976.
The net revenue loss to the Treasury stemming solely from
interest payments on reserve balances would be lower, of course,
because of several offsets.

First, interest paid to member banks

will partly be returned to the Treasury in the form of income tax
payments from the ultimate recipients.

To the extent that interest

-98on reserve balances ends up as bank profits > banks may pay about
35 cents of each dollar in taxes to the Treasury; taxes on dividends
and capital gains of bank stockholders would generate an additional
20 cents in revenue for a total of 55 cents.
interest on reserve

To the extent that

balances is passed on as interest to depositors

ih proportion to their current holdings of demand deposits, about
40 cents per dollar will be repaid to the Treasury.

T h u s , between

40 and 55 cents of each dollar paid as interest on reserves would
ultimately be returned to the Treasury in tax revenue.
Second, to the extent that payment of interest on reserve
balances stems attrition in Federal Reserve membership ? potential future
revenue losses to the Treasury would be reduced.

T h i r d , the reduction

in Treasury revenues might be further offset if banks using System
facilities were charged for various s e r v i c e s ™ s u c h as check collection,
wire transfer, and custody of securities—long provided without
charge partly as an offset to the requirement that member banks
hold non-interest earning balances.

And finally, if all institutions

were required to maintain reserves against transactional deposits
at the Federal Reserve, the System would augment its Government
security holdings by an equivalent amount, which would Increase
net earnings to the degree that the interest rate on securities
acquired exceeds the rate paid on reserve balances.


Summary and Conclusions

The arguments advanced in 1933 for prohibiting interest

on demand d e p o s i t s — t h a t interest rate competition undermined bank
safety and drew funds from rural areas in the form of bankers


balances—appear to have had little validity.

The prohibition of interest on demand deposits has

been eroded by developments in financial markets.

Despite the pro«

hibition, interest is available in one form or another on transactions

Banks can pay interest on overnight funds loaned b.y banks

and others.

Explicit interest is also available at banks and other

financial institutions on funds that can be conveniently used either
directly or indirectly to make payments to third parties.

Such accounts

have become increasingly available to the public in recent years.
Moreover, demand deposit holders have been receiving an implicit return
on their accounts in the form of services provided b y banks free or
below cost.

Payment of explicit interest on demand deposits is likely

to be accompanied by pricing of banks
nearly in line with costs.


checking and other services more

This would tend to curtail uneconomic use

of certain bank services and would encourage an allocation of resources
to uses more highly valued by the public.

The methods that have been

developed over the past 40 years to pay i n t e r e s t — b o t h explicit and
i m p l i c i t — o n transactions-type balances have already tended to reduce
some of the economic inefficiencies produced by the interest rate

However, these methods are generally less efficient than

-100payment of explicit interest on demand balances, since they usually
involve use of additional resources to shift funds between demand and
other accounts, to clear checks that otherwise would not be written if
service charges more fully reflected costs, and so o n .

The payment of explicit interest on demand deposits

would temporarily reduce bank earnings.

A reduction of between 5

and 20 per cent of banks * total before-tax earnings is estimated during
the worst year of the transition, depending on the types of deposits
eligible for interest and on institutional responses.

The largest

transitional impact would be felt if interest w e r e paid on all demand
deposits and thrift institutions were also empowered to offer such

Impacts would probably be considerably smaller'if interest-

bearing demand deposit powers were limited to commercial banks, or if
both banks and thrift institutions were authorized on a nationwide
basis to offer only NOW accounts restricted to individuals and nonprofit organizations (as is the case in the current experiment with
such accounts in New England) e

Transitional adjustments to interest on demand deposits

would be most difficult for those banks with both relatively low
earnings and a relatively large amount of deposits eligible for interest,
especially household demand deposits.

About 3 7 0 , or

per cent, of

all commercial banks in the United States fall into such a category;
they have both more than 50 per cent of total deposits in demand form
and before-tax earnings of less than one-half p e r cent of total deposits.

-101Most of these are very small banks.

(For all b a n k s , demand deposits

are about 40 per cent of total deposits and before-tax earnings average
a little over one per cent of deposits).

Whatever reduction in earnings develops during a transi-

tion period would itself tend to limit the duration of such a period
and hasten the longer-run adjustments that would be made in an effort to
restore profits.

Such adjustments would include further increases in

service charges by banks to make them more commensurate with costs.
If demand deposit or NOW powers are also extended to thrifts, the
increased competition, particularly for household deposits, may tend to
increase the cost somewhat to banks of demand deposits over the longer

Earnings of thrift institutions will also be affected

during the transition period by various proposals for interest on
demand deposits, but probably only modestly.

If thrifts were permitted

to pay interest on demand deposits, they would need to pay interest
only on new funds attracted.

Banks would be more likely, for competi-

tive reasons, to pay interest on all, or most, eligible deposits.
Over the longer-run, earnings of thrift institutions may be a little
more stable if they are permitted to acquire transactional balances,
since such deposits tend to be less sensitive to interest fluctuations
than time and savings deposits.

The temporary cost pressures on banks resulting from

payment of interest on demand deposits could b e partially offset by the

-102interest payments on reserve balances maintained at Federal Reserve

At present, this would affect only member banks of the Federal

Reserve System.

It is estimated that a 2 per cent interest rate on

reserve balances would more than offset the aggregate earnings reduction
from nationwide NOW accounts in the worst transition year^ "or the
lowest estimate of earnings reduction from interest on all demand

Payment of interest on reserve balances held at Federal

Reserve Banks would have no adverse impact on monetary policy.

It would

also tend to promote competitive balance between member banks and other
depository institutions, since the latter are now permitted to maintain
the bulk of their reserves in interest-bearing form.

Moreover, payment

of interest on reserve balances would provide a compensating adjustment
for the loss in revenue that nonmember institutions would experience
if they were required to hold reserves against transactional balances
at the Federal Reserve.

From a monetary policy viewpoint, it would be desirable

to require all institutions offering transactional accounts to hold
reserves against such deposits either in vault cash or as balances
at the Federal Reserve, and to set such requirement on a uniform

Moreover, since NOW accounts and demand deposits serve similar

purposes, monetary control would be enhanced if reserve requirements
on NOW accounts were equal to those on demand deposits.

Payment of interest on demand deposits would mean that

depositors would receive a total return on their deposits made up of

-103an explicit interest payment and an implicit return (to the extent that
banks continue to offer checking services below cost).

At present,

depositors receive only an implicit, or nonpecuniary return on demand

A.pecuniary return provides more options to the depositor,

and in this sense the depositor is better off if a given implicit
return is replaced by an explicit return of the same size, or perhaps
even smaller*

Explicit interest on demand deposits will extend the

possibility of obtaining a pecuniary return on transactional balances
to a wider range of d e p o s i t o r s — i n particular c o n s u m e r s — t h a n now
receive such a return through one form or another.

With explicit

interest, banks and other institutions would probably raise charges
for checks and other bank services now offered free or below cost.
This would tend to equalize rates of return for all depositors, to
the extent that they receive the same interest and services are priced
more in line with costs.

It is virtually impossible, however, to make a definitive

judgment with respect to the distribution of gains and losses across
depositor groups from payment of explicit interest on demand deposits.
It is-possible that some small depositors who write a large..number
of checks may be worse off than they are now (if they cannot
economize on check writing).

The largest gainers would appear to

be those depositors with large and relatively inactive accounts.

-104When tax considerations are taken into account, h o w e v e r , part or all of
the benefits to individuals may be eroded, since explicit interest
is taxable and service charges are not now tax deductible.

Interest on demand deposits may temporarily introduce

some uncertainty about interpretation of the rates of growth of monetary

But this is essentially no different from the interpretation

problems that have developed recently as transactions substitutes for
demand deposits have become more widespread.

In. any event, »?ith

interest on demand deposits, demands for the various monetary aggregates
should ultimately become more predictable in comparison with the
continuation of the prohibition which will be accompanied by the
continued evolution of a variety of new third-party payment accounts.

Payment of interest on demand deposits may somewhat

increase the speed with which the economy responds to monetary j>olicy
to the extent that explicit rates are adjusted more promptly than
implicit returns have been to changing market interest rates.

A more

flexible adjustment of explicit rates would reduce the extent to
which changes in the velocity of money would offset changes in the
money supply r -The effects on the economy of more flexibility in the
interest rates on demand deposits can also be considered in relation
to exogenous shifts in the demand for goods and services or in the
demand for money, assuming no change in money supply growth.

If there

is an exogenous shift in demands for goods and services and an accompanying change in market interest rates, more flexible interest rates on

-105demand deposits would work in a stabilizing direction by inducing an
offsetting change in velocity.

On the other, h a n d , explicit interest

payments on demand deposits would tend to be destabilizing if there
were unanticipated shifts in the demand for money relative to G N P ,
as the more flexible deposit rate would lead to more perverse movements
in market interest rates in the process of balancing the demand for
and supply of money,

Payment of interest on demand deposits is not

likely to have a significant effect on interest rates in credit

The average level of rates will not be affected so long as

the Federal Reserve accommodates reserve provision to. shifts in the

public s demand for deposits caused by the authorization of interest
on demand deposits.

To the extent that payment of interest on demand

deposits has any impact on interest rates in national markets, it would
be reflected in the structure of rates and would depend on relative
shares in funds flows obtained by banks and other institutions.


local and regional markets, competition among banks and other lenders
would severely limit the ability of any single lender to raise lending

If explicit interest were paid on demand deposits,

this study suggests that the most significant potential problem
lies in the transitional adjustments of banks and other institutions
to the new competitive environment.

Adjustment difficulties could

be mitigated by payment of interest on reserve balances; by

-106a gradual pliase-in through regulatory actions, such as use of a low,
and perhaps gradually rising, ceiling rate; and by a delay in the
effective date for interest on demand deposits following enabling
legislation so as to permit banks to plan effectively for the new
competitive environment*