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Testimony of Governor Laurence H. Meyer
Comments on H.R. 1585 and regulatory streamlining
Before the Subcommittee on Financial Institutions and Consumer Credit, Committee
on Banking and Financial Services, U.S. House of Representatives
May 12, 1999
The Board of Governors appreciates this opportunity to comment on H.R. 1585, the
"Depository Institution Regulatory Streamlining Act of 1999," introduced by Representative
Roukema. The Board welcomes this legislation and supports its purpose of revising outdated
banking statutes that are imposing costs without providing commensurate benefits to the
safety and soundness of depository institutions, enhancing consumer protection, or
expanding credit availability. As the members of this subcommittee are aware, unnecessary
regulatory burdens hinder the ability of banking organizations to compete effectively in the
broader financial services marketplace and, ultimately, adversely affect the availability and
prices of banking services and credit products to consumers.
Measures the Board Supports
In my testimony today, I would like to highlight those provisions of this legislation that the
Board supports and believes are particularly significant in reducing burden and promoting
efficient regulation. The Board strongly supports allowing the Federal Reserve System to
pay interest on required and excess reserve balances held by depository institutions at the
Federal Reserve Banks, and it supports allowing banks to pay interest on demand deposits.
(Attached to this statement is an appendix containing an expanded discussion of these
topics.) The Board also strongly supports the protections embodied in Title V of this bill, the
"Bank Examination Report Privilege Act", which promote effective bank supervision by
enhancing the cooperative exchange of information between supervised financial institutions
and their regulators.
While the Board also applauds many of the other measures contained in this bill, which
eliminate restrictions that no longer serve a useful purpose and thereby enhance the ability
of U.S. banking institutions to operate efficiently and effectively in increasingly competitive
financial markets, there are a few provisions with which the Board has concerns. While I
will discuss them, I do not wish these objections to detract from my central message--that
the nation's banking system would benefit from the type of reform embodied in this
legislation.
Interest on Reserves and Interest on Demand Deposits
The Board strongly supports provisions in section 101 of H.R. 1585, which would permit
the Federal Reserve to pay interest on both required and excess reserve balances that
depository institutions maintain at Federal Reserve Banks. Because required reserve
balances do not currently earn interest, banks and other depository institutions employ costly
procedures to reduce such balances to a minimum. The cost of designing and maintaining
the systems that facilitate these reserve avoidance techniques represent a significant waste of
resources for the economy. In addition, because some small banks do not have a sufficient
volume of deposits to justify these costs, current reserve avoidance techniques tend to place
smaller institutions at a competitive disadvantage.
The reserve avoidance measures utilized by depository institutions also could eventually
complicate the implementation of monetary policy. Declines in required reserve balances
through avoidance schemes could lead to increased volatility in the federal funds rate. Since
last July, when I spoke to this subcommittee on the same topic, required reserve balances
have fallen further and some episodes of heightened volatility in federal funds rates have
occurred, although they were associated in part with stresses on global financial markets.
Allowing the payment of interest on required reserve balances would reduce current
incentives for reserve avoidance and would likely induce a rebuilding of reserve balances
over time. If volatility in the federal funds rate nevertheless did become a persistent concern,
the Federal Reserve at present has a limited set of tools to address such a situation;
authorizing interest payments on excess reserve balances would be a useful addition to the
Federal Reserve's monetary policy tools for this purpose. Several other major central banks,
including the European Central Bank and the Bank of Canada, already have the power to
pay interest on excess reserve balances.
If increased volatility in the federal funds rate did become a persistent feature of the money
market, it would affect other overnight interest rates, raising funding risks for large banks,
securities dealers, and other money market participants. Suppliers of funds to the overnight
markets, including many small banks and thrifts, also would face greater uncertainty about
the returns they would earn. Accordingly, allowing the Board to pay interest on required
reserve balances would not only eliminate economic inefficiencies, but also alleviate risks
that could affect monetary policy and the smooth functioning of the money markets.
Because the level of required reserve balances has fallen substantially in recent years, owing
to the implementation of additional reserve avoidance measures by depository institutions,
estimates of the revenue losses to the Treasury associated with paying interest on required
reserve balances have dropped to a relatively low level. After taking account of the increases
in revenue from a related measure, the payment of interest on demand deposits, the
Congressional Budget Office recently estimated that the net federal budget costs of similar
legislation pending in the Senate would be about $130 million per year over the next five
years.
The Board strongly supports allowing the immediate payment of interest on demand
deposits held by businesses. The current prohibition against paying interest on such deposits
is an anachronism that no longer serves any public policy purpose. This prohibition was
enacted in the 1930s, at a time when Congress was concerned that large money center banks
had earlier bid deposits away from country banks to make loans to stock market speculators.
This rationale for the prohibition is certainly not applicable today: Funds flow freely around
the country and among banks of all sizes. The absence of interest on demand deposits is no
bar to the movement of money from depositories with surpluses--whatever their size or
location--to the markets where funds can be profitably employed.
Moreover, although the prohibition has no current policy purpose, it imposes a significant
burden both on banks and on those holding demand deposits, especially small banks and
small businesses. Smaller banks complain that they are unable to compete for the deposits of
businesses precisely because of their inability to offer interest on demand deposit accounts.
Small banks, unlike their larger counterparts, lack the systems to offer compensating
balance schemes and sweep accounts that allow these banks to offer businesses credit for or
interest on excess demand balances. Small businesses, which often earn no interest on their
demand deposits because they do not have account balances large enough to justify the fees
charged for sweep programs, stand to gain the most from eliminating the prohibition of
interest on demand deposits.
For these reasons, the Board strongly supports immediate repeal of the prohibition of
interest on demand deposits. In contrast, Section 102 of H.R. 1585 would allow payment of
interest on demand deposits to begin on October 1, 2004. During a transition period lasting
until that time, the bill would authorize a 24-transaction-per-month money market deposit
account (MMDA). Demand deposits could be swept into this new MMDA account in order
to earn interest. The 24-transaction MMDA would be fully reservable, and therefore would
not contribute to further declines in required reserve balances and the complications that
might entail for the implementation of monetary policy.
While a relatively short transition period prior to the implementation of direct payments on
demand deposits would not be objectionable, delaying direct interest payments on demand
deposits for any extended period, such as the five years or so proposed in the bill, is not
advisable. Such a long delay would be associated with further wasteful sweep activities and
would disadvantage small banks and their business customers relative to the larger
organizations already using sweep programs that can be modified to incorporate a new
MMDA product.
Finally, the Committee has asked the Board to comment specifically on the impact on the
banking industry of repealing the prohibition on paying interest on business checking
accounts. For banks, interest on demand deposits will increase costs, at least in the short run.
Larger banks (and securities firms) may also lose some of the fees they currently earn on
sweeps of business demand deposits. The higher costs to banks will be partially offset by
interest on reserve balances, and over time, these measures should help the banking sector
attract liquid funds in competition with nonbank institutions and direct market investments
by businesses. Small banks, in particular, should be able to bid for business demand deposits
on a more level playing field vis-a-vis both nonbank competition and large bank sweep
programs. Moreover, large and small banks will be strengthened by fairer prices on the
services they offer and by the elimination of unnecessary costs associated with sweeps and
other procedures currently used to try to minimize the level of reserves.
Bank Examination Report Privilege
The Board endorses Title V of the bill, the "Bank Examination Report Privilege
Act" ("BERPA"). BERPA would take three steps to promote effective supervision of
depository institutions by helping to preserve candor in communications between such
institutions and their examiners. First, BERPA would clarify that a supervised institution
may voluntarily disclose information that is protected by the institution's own privileges,
such as the attorney-client privilege, to a federal banking agency without waiving those
privileges as to third parties. Some courts have ruled that disclosure of information to
examiners waives an institution's privileges in private civil litigation and, as a result, some
institutions have attempted to withhold information from their supervisors. By ensuring that
privileges are not waived when data is given to examiners, BERPA would overcome the
present reluctance of many institutions to disclose information for fear of losing commonlaw privileges.
Second, BERPA would establish uniform procedures that govern how a third party may
seek to obtain confidential supervisory information from a banking agency. BERPA would
require third parties to request such information directly from the federal banking agencies,
under regulations and procedures adopted by the agencies. Third parties may turn to the
courts only after exhausting their administrative remedies. Finally, BERPA would define
what constitutes confidential supervisory information and would strengthen the protection
afforded to such information. In this regard, the measure would also require Federal courts
to afford to confidential supervisory information of state and foreign bank supervisory
authorities the same status with regard to privilege as is afforded to the confidential
supervisory information of the Federal banking agencies.
By protecting disclosures by depository institutions to their examiners and by safeguarding
supervisory information based on such disclosures, BERPA would prevent unwarranted
disclosures that would have a chilling effect on the examinations process. Taken together,
these measures would enhance the ability of the federal banking agencies to assess and to
protect the safety and soundness of depository institutions.
The banking agencies may have some further suggestions for refining the language of
sections 501 and 502, and we would be pleased to work with the Subcommittee on those
suggestions.
Other Burden Reduction Provisions
There are other parts of this bill, as well, that would relieve regulatory burden without
giving rise to safety and soundness, supervisory, consumer protection, or other policy
concerns. For example, section 311 would eliminate the outdated and largely redundant
requirement in section 11(m) of the Federal Reserve Act, which currently sets a rigid ceiling
on the percentage of bank capital and surplus that may be represented by loans collateralized
by securities. Current supervisory policy, as well as national and state bank lending limits,
address concerns regarding concentrations of credit more comprehensively than section 11
(m), but do so without the unnecessary constraining effects of this section of the Federal
Reserve Act.
Section 312 would eliminate section 3(f) of the Bank Holding Company Act, which applies
certain restrictions that govern the nonbanking activities of bank holding companies to the
activities conducted directly by savings banks under state law. Since the enactment of
section 3(f), the courts have found that the insurance and other nonbanking prohibitions of
the Bank Holding Company Act do not apply to the direct activities of banks. Eliminating
section 3(f) would put savings banks that are subsidiaries of bank holding companies on
equal competitive footing with their state bank counterparts, allowing savings banks and
their subsidiaries to engage in those activities that are permissible for state banks under state
law.
Section 303 of the bill authorizes the banking agencies to act jointly to allow up to 100
percent of the fair market value of an institution's purchased mortgage servicing rights to be
included in its Tier 1 capital. Currently, only 90 percent of the value of such assets can be
included. Developments since Congress enacted current law in 1991 have greatly reduced
the concerns that prompted the existing capital "haircut." Accordingly, the Board believes
the change envisioned in Section 303 would reduce regulatory burden without
compromising safety and soundness. The Board also suggests changing all the section's
references concerning "purchased mortgage servicing rights" to "mortgage servicing assets"
to reflect current accounting terminology.
In another area, the alternative consumer credit disclosure mechanism permitted by section
401 will be less burdensome to creditors, and just as helpful to consumers, as the disclosure
requirement embodied in current law. Congress has already eliminated the requirement that
creditors disclose a historical table for closed-end variable rate loans. Taking similar action
with respect to open-end variable rate home-secured loans would reduce regulatory burdens
without sacrificing consumer protections.
Areas of Concern
Although the Board supports most of the provisions in the bill, there are a few sections of
the legislation that cause us concern. These provisions may give certain entities unfair
competitive advantages, may harm the safety and soundness of depository institutions, or
are unnecessary.
Nonbank Banks
Two sections of the bill would eliminate limitations that have been applied to nonbank
banks. Section 223 would allow nonbank banks, and FDIC-insured credit card banks, to
offer business credit cards, even where these business loans are funded by insured demand
deposits. Section 222 would remove the activity limitations and cross-marketing restrictions
that currently apply to nonbank banks. It would also liberalize the divestiture requirements
that apply when companies violate the nonbank bank operating limitations and allow
nonbank banks to acquire assets from credit card banks. Eliminating these restrictions on
nonbank banks, at first glance, may have intuitive appeal. However, there are important
reasons for the Board's concern about these provisions.
Nonbank banks--which, despite their popular name, are federally insured, national or statechartered banks--came into existence by exploiting a loophole in the law. By means of this
loophole, industrial, commercial, and other companies were able to acquire insured banks
and to mix banking and commerce in a manner that was then, and remains today, statutorily
prohibited for banking organizations. In 1987, in the Competitive Equality Banking Act
("CEBA"), Congress closed the nonbank-bank loophole. At that time, Congress chose not to
require the 57 companies operating nonbank banks to divest these institutions. Instead,
Congress permitted the companies owning these banks to retain their ownership so long as
they complied with a carefully crafted set of limitations on the activities of nonbank banks
and their parents. In a unique statutory explanation of legislative purpose, Congress stated in
CEBA that these limitations were necessary to prevent the owners of nonbank banks from
competing unfairly with bank holding companies and independent banks.
Fewer than 15 nonbank banks currently claim the grandfather rights accorded in CEBA. The
Board is concerned that removal of the limitations and restrictions that apply to nonbank
banks would enhance advantages that this relative handful of organizations already possess
over other owners of banks and would give rise to the potential adverse effects about which
Congress has in the past expressed concern. In addition, removal of limitations would permit
the increased combination of banking and commerce for a select group of commercial
companies, a mixture that the House Banking Committee recently considered and decided
not to permit in the context of a broader effort to modernize our financial laws.
The Board continues to believe that the questions of whether and to what extent it is
appropriate to enhance the position of nonbank banks are questions most fairly determined
in connection with broad financial modernization legislation. In that broader context, it may
be possible to relieve some of the restraints placed on the handful of existing nonbank banks
without seriously disadvantaging the majority of banking organizations that do not have the
privileges enjoyed by nonbank banks.
Call Report Simplification
Section 302 of the bill largely restates section 307 of the Riegle Community Development
and Regulatory Improvement Act ("Riegle Act"). The Board and the other Banking
agencies, working through the Federal Financial Institutions Examination Council (FFIEC),
have made substantial progress in implementing the mandate of section 307 of the Riegle
Act and the Board believes that this section of the bill is unnecessary.
Thus far, in response to Section 307, the federal banking agencies have eliminated
approximately 100 Call Report data items; placed revised instructions and forms on the
Internet for the Call Report, the Bank Holding Company (BHC) Reports, and the Thrift
Financial Report (TFR); adopted Generally Accepted Accounting Principles ("GAAP") as
the reporting basis for all Call Reports (and consistent with the reporting basis for the BHC
reports and the TFR); produced a draft core report that is consistent with the TFR report and
resolves most of the definitional differences between the reports; condensed four sets of Call
Report instructions into one; provided an index for Call Report instructions; implemented an
electronic filing requirement for all institutions submitting Call Reports (consistent with
existing mandatory electronic filing for the TFR and optional electronic filing for the BHC
reports); placed much of the Call Report data and some of the BHC data on the Internet; and
reported to Congress on recommendations to enhance efficiency for filers and users.
The agencies surveyed users of the information to identify additional Call Report items that
could be eliminated, while retaining items that are essential for safety and soundness and
other public policy purposes. The FFIEC's Reports Task force is analyzing the results of the
survey of Call Report users throughout each of the agencies to identify all of the current
purposes served by the information. After the surveys are analyzed, the Task Force will
recommend ways to further streamline the reporting requirements and continue to refine a
set of common, or "core", reporting items. The agencies have not determined an
implementation date, given year 2000 concerns for the banking industry and the regulatory
agencies, and given that banking institutions have requested a minimum lead time of one
year to implement a "core" report. However, we believe significant progress that has been
made by the agencies to date and the agencies' on-going efforts suggest that this section of
the draft bill is not necessary.
Closing Thoughts
The legislation being considered by the Subcommittee today builds on two prior reform
measures, the Community Development and Regulatory Improvement Act of 1994 and the
Economic Growth and Regulatory Paperwork Reduction Act of 1996, that the Board
supported. Those were useful measures that achieved meaningful reductions in regulatory
burden. Those bills--coupled with the Board's independent initiatives to make our
regulations simpler, less burdensome, and more transparent--have had a practical, bottomline, effect: fewer applications need to be filed with the Board, and banking organizations
have saved substantial regulatory, legal, compliance, and other costs. Those statutory and
regulatory changes have enhanced the competitiveness of banking organizations and have
benefitted the customers of these financial institutions. Nonetheless, more can and should be
done.
The Board applauds the efforts of the Subcommittee to continue to eliminate unnecessary
government-imposed burdens. The Subcommittee has fashioned legislation that, in the main,
builds upon past successes in regulatory reform and relieves regulatory burdens on banking
organizations. In a few areas, however, the bill may not achieve meaningful reform but
instead would lead to competitive inequities or raise safety and soundness and other
concerns.
The Board has long endorsed regulatory relief and financial modernization strategies that
promote regulatory equity for all participants in the financial services industry, minimize the
chances that federal safety net subsidies will be expanded into new activities and beyond the
confines of insured depository institutions, guarantee adequate federal supervision of
financial organizations, and ensure the continued safety and soundness of financial
organizations. The Board would be pleased to work with the Subcommittee and its able staff
to reach these goals through legislation.
Appendix
Additional Views of the Federal Reserve Board on Interest on Reserves and Demand
Deposits
The Board strongly supports proposals to allow payment of interest on demand deposits and
on the required and excess reserve balances that depository institutions maintain at Federal
Reserve Banks. We have commented favorably on such proposals on a number of previous
occasions over the years, and the reasons for those positions still hold today.
These legislative proposals are important for economic efficiency: Unnecessary restrictions
on the payment of interest on demand deposits and reserve balances distort market prices
and lead to economically wasteful efforts to circumvent them.
Because of recent financial market innovations, the proposals are also important for
monetary policy. Balances that depository institutions must hold at Federal Reserve Banks
to meet reserve requirements pay no interest. Reserve requirements are now 10 percent of all
transaction deposits above a threshold level. Requirements may be satisfied either with vault
cash or with balances held in accounts at Federal Reserve Banks. Depository institutions
have naturally always attempted to reduce such non-interest bearing balances to a minimum.
For over two decades, some commercial banks have done so in part by sweeping the
reservable transaction deposits of businesses into nonreservable instruments. These business
sweeps not only avoid reserve requirements, but also allow firms to earn interest on
instruments that are, effectively, equivalent to demand deposits.
In recent years, developments in computer technology have allowed depository institutions
to begin sweeping consumer transaction deposits into nonreservable accounts. As a
consequence, the balances that depository institutions hold at Reserve Banks to meet reserve
requirements have fallen to quite low levels. These consumer sweep programs are expected
to spread further, threatening to lower required reserve balances to levels that may begin to
impair the implementation of monetary policy. Should this occur, the Federal Reserve
would need to adapt its monetary policy instruments, which could involve disruptions and
costs to private parties as well as to the Federal Reserve. However, if interest were allowed
to be paid on required reserve balances and on demand deposits, changes in the procedures
used for implementing monetary policy might not be needed.
The prohibition of the payment of interest on demand deposits was enacted in the mid1930s. At that time, Congress was concerned that large money center banks might have
earlier been bidding deposits away from country banks to make loans to stock market
speculators, in the process depriving rural areas of financing. It is unclear whether the
rationale for this prohibition was ever valid, but it is clear that this rationale is no longer
applicable today. Funds flow freely around the country, and among banks of all sizes, to
find the most profitable lending opportunities, using a wide variety of market mechanisms,
including the federal funds market. The absence of interest on demand deposits is no bar to
the movement of funds from depository institutions with surpluses--whatever their size or
location--to the markets where the funding can be profitably employed. In fact, small firms
in rural areas are able to bypass their local banks and invest in money market mutual funds
with transaction capabilities. Indeed, smaller banks complain that they are unable to
compete for the deposits of businesses precisely because of their inability to offer interest on
demand deposits.
The prohibition of interest on demand deposits distorts the pricing of transaction deposits
and associated bank services. To compete for the liquid assets of businesses, banks set up
complicated procedures to pay implicit interest on what are called compensating balance
accounts. These accounts, which represent a sizable fraction of demand deposits, earn
credits that can be used to pay for a firm's use of other bank services. Banks also spend
resources--and charge fees--for sweeping the excess demand deposits of businesses into
money market investments on a nightly basis. To be sure, the progress of computer
technology has reduced the cost of such systems over time. However, the expenses are not
trivial, particularly when substantial efforts are needed to upgrade such automation systems
or to integrate the diverse systems of merging banks. Such expenses waste the economy's
resources, and they would be unnecessary if interest were paid on both demand deposits and
the reserve balances that must be held against them.
The prohibition of interest on demand deposits also distorts the pricing of other bank
products. Because banks cannot attract demand deposits through the payment of explicit
interest, they often try to attract these deposits, aside from compensating balances, through
the provision of services at little or no cost. When services are offered below cost, they tend
to be overused--an additional waste of resources attributable partly to the prohibition of
interest on demand deposits.
However, the potential gains in economic efficiency cannot be fully realized by paying
interest on demand deposits alone. As has been demonstrated in the case of the consumer
checking accounts, on which interest is paid, the absence of interest on the reserve balances
that must be held against such transaction deposits has in itself provided strong enough
incentive for banks to start sweep programs. The costs that banks incur to design and
maintain the automation systems needed to implement such sweep programs are another
instance of economic waste. The payment of interest on required reserve balances could
remove the incentives to engage in such reserve avoidance practices.
In light of the resources used by depository institutions to try to circumvent reserve
requirements, the reason for having such requirements might be questioned. Indeed, reserve
requirements have been eliminated in a number of other industrialized countries. It may be
helpful, therefore, to review the historical and current purposes served by reserve
requirements.
Although the word "reserves" might imply an emergency store of liquidity, required
reserves cannot actually be used for this purpose, since they represent a small and fixed
fraction of a bank's transaction deposits. Reserve requirements have at times been employed
as a means of controlling the growth of money. In the early 1980s, for example, the Federal
Reserve used a reserve quantity procedure to control the growth of M1. For the most part,
however, the Federal Reserve has looked to the price of reserves--the federal funds rate-rather than the quantity of reserves, as its key focus in implementing monetary policy.
While reserve requirements no longer serve the primary purpose of monetary control, they
continue to play an important role in the implementation of monetary policy in the United
States. They do so by helping to keep the federal funds rate close to the target rate set by the
Federal Open Market Committee. They perform this function in two ways: First, they
provide a predictable demand for the total reserves that the Federal Reserve needs to supply
through open market operations in order to achieve a given federal funds rate target. Second,
because required reserve balances must be maintained only on an average basis over a twoweek period, depositories have some scope to adjust the daily balances they hold in a
manner that helps stabilize the federal funds rate. For instance, if the funds rate were higher
than usual on a particular day, depository institutions could choose to hold lower reserve
balances, and their reduced demand would help to damp the upward pressure on the funds
rate. Later in the two-week period, they could make up the shortfall in their average
holdings of reserve balances.
Depository institutions hold balances in their accounts at Federal Reserve Banks for reasons
other than satisfying their two-week average requirements. Some balances are needed as a
precaution against the chance that payment orders late in the day might leave a depository
with an overdraft on its account, and the Federal Reserve strongly discourages overdrafts.
On days when payment flows are particularly heavy and uncertain, or when the distribution
of reserves is substantially displaced from normal, depository institutions tend to hold
balances for precautionary purposes well above required levels.
Unlike the two-week average demands, these daily precautionary demands cannot help
smooth the funds rate from one day to the next. They are also difficult to predict, making it
harder for the Federal Reserve to determine the appropriate daily quantity of reserves to
supply to the market. In the absence of reserve requirements, or if reserve requirements were
very low, the daily demand for balances at Reserve Banks would be dominated by these
precautionary demands, and as a result, the federal funds rate could often diverge markedly
from its intended level.
An example of the volatility that can arise in the federal funds market because of a low level
of required reserve balances occurred in early 1991. The Federal Reserve had reduced
certain reserve requirements in late 1990 as a means of easing funding costs to banks during
the credit crunch period. The cut in requirements reduced required balances at Reserve
Banks for many depository institutions to below the balances needed for precautionary
purposes, and the federal funds rate consequently became very volatile. On a typical day in
that period, the funds rate strayed over a range of about 8 percentage points and missed the
target for the average of daily rates by 1/2 percentage point. After a couple of months,
stability returned to the federal funds market because depository institutions made
improvements in their reserve management and because strong growth in deposits again
boosted the level of required reserve balances above precautionary demands for many
institutions.
Since that time, depository institutions have become much more adept at managing their
reserve positions, and their need for precautionary balances on a typical day has declined
considerably. In fact, they are now managing to operate with lower aggregate required
balances at Reserve Banks than they had in early 1991, and the federal funds rate is
nevertheless much more stable. A number of measures taken by the Federal Reserve have
helped to foster stability, including improvements in the timeliness of account information
provided to depository institutions, more frequent open market operations geared to daily
payment needs, and improved procedures for estimating reserve demand. In addition, the
Federal Reserve Board recently decided to shift to lagged reserve requirements, which has
also contributed to some reduction in uncertainty about reserve demand.
The additional improvements in reserve management in recent years have been needed
because required reserve balances have dropped substantially-- from about $28 billion in
late 1993 to about $7 or $8 billion today. This decline has not occurred because of further
cuts in required reserve ratios by the Federal Reserve, but because of the new retail sweep
programs implemented by depository institutions. These programs use computerized
systems to sweep consumer transaction deposits, which are subject to reserve requirements,
into personal savings accounts, which are not. The spread of such retail sweep programs has
not yet fully run its course, and considerable uncertainty shrouds its eventual outcome. We
expect that the effects of future declines in required reserve balances on the volatility of the
federal funds rate will not necessarily proceed gradually; the rather modest effects on
volatility seen so far may not preclude a more outsized reaction as reserve balances fall even
lower.
Heightened volatility in the federal funds rate is of concern for a number of reasons. To be
sure, the transmission of volatility in the funds rate to volatility in longer-term rates is likely
to be muted because of the averaging out of upticks and downticks in the overnight rate.
However, even in the absence of much transmission to longer-term rates, increased volatility
in the federal funds rate would affect other overnight interest rates, raising funding risks for
most large banks, securities dealers, and other money market participants. Suppliers of funds
to the overnight markets, including many small banks and thrifts, would face greater
uncertainty about the returns they would earn. Market participants concerned about
unexpected losses would incur additional costs in managing their funding to limit the
heightened risks.
Countries that have eliminated reserve requirements do not generally experience a great deal
of volatility in overnight interest rates because they are able to use alternative procedures for
the implementation of monetary policy. One type of procedure, for instance, establishes a
ceiling and a floor to contain movements of the overnight interest rate. The ceiling is set by
a penalty interest rate on loans provided freely by the central bank through what is called a
Lombard facility. The floor is established in effect by the payment of interest on excess
reserves because banks would not generally lend to private parties at an interest rate below
the rate they could earn on a risk-free deposit at the central bank. For the Federal Reserve to
be able to set a similar interest rate floor, it would need authority to pay interest on excess
reserves. The legislation before the Subcommittee would provide such an authorization. As
regards a ceiling on the funds rate, a change in the Federal Reserve's approach to the
discount window would be necessary, as we have no penalty interest rate and instead subject
borrowing applications to an administrative review. Alternative means of establishing a
ceiling could be considered.
If interest were allowed to be paid on both demand deposits and required reserve balances,
as the legislation also provides, adjustments in the procedures for implementing monetary
policy might not be needed. Such interest payments would likely boost the level of
transaction deposits substantially, as some business and household sweep programs were
unwound, and as banks became more able to compete for the liquid funds of businesses. The
increased transaction deposits could ensure that required reserve balances would remain
above the level of daily precautionary needs for many institutions, thus helping to stabilize
the federal funds rate, while also improving economic efficiency as previously noted.
The magnitude of the prospective responses to these measures is uncertain, however. Some
corporations may not find the interest paid on demand deposits high enough to induce them
to shift out of other liquid instruments. Also, some banks may retain consumer sweep
programs in order to seek higher investment returns than the Federal Reserve would pay on
reserve balances. If interest were allowed on required reserve balances, the Federal Reserve
would likely pay a rate close to the rate available on an overnight repurchase agreement.
Higher yields are of course available on investments of greater risk and longer maturities.
Because of the uncertainties involved, the Federal Reserve needs to be able to pay interest
on excess reserves as well as on required reserve balances, and at differential rates to be set
by the Federal Reserve. The ability to pay interest on excess reserves would provide an
additional tool that could be used for monetary policy implementation, but one that might
not need to be used, if interest on required reserve balances and demand deposits resulted in
a sufficient boost to the level of those balances. Even if not used immediately, it is important
that the Federal Reserve have the full range of tools available to other central banks, given
the inventiveness of our financial markets and the need for the Federal Reserve to be
prepared for potential developments that may not be immediately visible.
The bill includes a long delay before the direct payment of interest on demand deposits
would be authorized, during which time a reservable 24-transaction money market deposit
account (MMDA) would be allowed. This new type of account would be fully reservable
and therefore would not raise concerns about further declines in reserve balances that could
potentially complicate the implementation of monetary policy. Each month, twenty-four
transfers out of this MMDA could be made. Because there are not more than twenty-four
business days in a month, banks would be able to sweep balances from demand deposits into
these 24-transaction MMDAs each night, pay interest on them, and then sweep them back
into demand deposits the next day. Thus, this type of account would permit banks in effect
to pay interest on demand deposits, but perhaps more selectively than would be the case
with direct interest payments. Some transition period leading up to the direct payment of
interest on demand deposits would be appropriate, as many banks would likely take some
time in any case to develop competitive interest-bearing demand deposit products. However,
the delay should be relatively short. The 24-transaction MMDA, which would be useful only
during the transition period before direct interest payments became effective, would entail
extra expenses associated with new sweep arrangements and would be able to be
implemented at lower cost by banks already having sweep programs. Other banks would
face a competitive disadvantage during the transition period; moreover, some businesses
would not benefit from this MMDA.
The payment of interest on reserve balances would tend to reduce the revenues received by
the Treasury from the Federal Reserve, while the payment of interest on demand deposits
would increase those revenues. Treasury revenues would be directly reduced by the payment
of interest on existing reserve balances. However, there would be some offset to this direct
revenue loss. The level of reserve balances would rise because of the interest payments, and
the Federal Reserve would therefore be able to increase its holdings of government
securities. The Federal Reserve on average would earn a higher yield on those securities
than the rate it would pay on required reserve balances. On net, Treasury revenues are still
likely to fall with the payment of interest on required reserve balances, but the recent
declines in such balances have reduced that revenue loss considerably. Similarly, interest
payments on demand deposits would increase the level of demand deposits, as well as the
reserve balances held against them on which the Federal Reserve would also earn a positive
interest rate spread. The size of this further offset to the Treasury's revenue loss on required
reserve balances is subject to considerable uncertainty.
In the long run, the benefits of the proposed legislation will likely be distributed rather
widely among bank customers. The biggest winners should be small businesses that
currently earn no interest on their checking accounts. They will gain from the interest earned
and from being able to relax procedures used to hold to a minimum the size of their
checking account deposits. Larger firms will benefit as well, in part by saving on some
sweep fees.
For banks, interest on demand deposits will increase costs, at least in the short run. Larger
banks and securities firms may also lose some of the fees they currently earn on sweeps of
business demand deposits. The higher costs to banks will be partially offset by interest on
reserve balances, and over time, these measures should help the banking sector attract liquid
funds in competition with nonbank institutions and direct market investments by businesses.
Small banks in particular should be able to bid for business demand deposits on a more level
playing field vis-a-vis both nonbank competition and large bank sweep programs. Moreover,
large and small banks will be strengthened by fairer prices on the services they offer and by
the elimination of unnecessary costs associated with sweeps and other procedures currently
used to try to minimize the level of reserves.
In the early 1980s, the Congress decided to deregulate interest rates on all household
deposits and to allow money market deposit accounts for businesses. It is now time to
extend the benefits of deposit interest rate deregulation to the ordinary checking accounts of
businesses. Eliminating price distortions on demand deposits and on required and excess
reserve balances would spare the economy wasteful expenditure, increase the efficiency of
our financial markets, and facilitate the conduct of monetary policy.
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1999 Testimony
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