TMA represents almost 12,000 treasury professionals who, on behalf of over 4,000 corporations and other organizations, are significant participants in the nation's payments systems and capital markets. Many of our members are responsible for their organizations' banking relationships, payments activities, short-term investments, and general cash management functions. Organizations represented by our members are drawn generally from both the Fortune 1000 and middle market companies -- with fifty percent of our members employed by organizations with annual sales under $1 billion. They are significant users of financial services generally, and specifically sweeps services offered by banks, and they have an active interest and sizable stake in any changes affecting the prohibition of interest on demand deposit account balances.

The TMA is pleased to offer comments today on proposed Sections 101 and 102 of the "Financial Institution Regulatory Streamlining Act of 1998." We strongly support provisions which would both end promptly the prohibition against payment of interest on business checking accounts, and allow the Federal Reserve to pay interest on depository institution balances required to be held on reserve at the Federal Reserve. The alternative proposal -- delaying the removal of the prohibition for six years while immediately raising the number of allowed transactions from the current level of 6 to 24 -- is an unsatisfactory bandaid approach which merely constitutes stalling the march toward modernization of our financial services system through the elimination of protective regulatory devices like Regulation Q.

Congressional legislation passed in 1933 prohibited banks from paying interest on demand deposits and was implemented by the Federal Reserve as Regulation Q. Most of these restrictions were removed early in the 1980s, but some vestige remains in the prohibition of interest on demand deposits held by businesses.

For most of TMA's membership, Regulation Q has become an annoying anachronism. Earnings on balances can for the most part be managed through other types of accounts and transfers made possible by current technology and willing competitors to commercial banks. The practical effect of Regulation Q today is that it has spawned a myriad of demand deposit substitutes which obviate the long obsoleted intention of the Banking Act of 1933. Many smaller businesses however still suffer the effects of Regulation Q because of lack of sophistication, access to technology and/or insufficient deposit balances. Even large businesses which use innovative procedures to employ balances profitably would benefit from the flexibility and simplicity in funds management which would follow from payment of interest on demand deposits.

Cash management would be simplified for all businesses and banks through abolition of the ban on paying interest on business checking.

Allied with the Regulation Q problem is the rapid decline of required reserves held at the Federal Reserve. Just as commercial customers have incentives to move balances from demand deposit accounts to interest-bearing accounts outside the banking structure, so do banks have incentives to move demand deposits subject to reserve requirements to "sweeps" or other accounts not subject to sterile reserve requirements. As a result, required reserve balances at the Federal Reserve have declined from $27.4 billion in 1994 to below $10 billion. The Federal Reserve reports that reserve balances are critical to management of monetary policy. The Fed uses the markets for overnight loans of reserve balances to influence other interest rates. The smaller this market, the greater difficulty the Central Bank has in stabilizing or managing rates. The cure for this problem would be to allow interest to be paid on required reserves.

Before the Banking Act of 1933 was passed, banks regularly paid interest on demand deposit accounts. Then, in the wake of more than 9,000 bank failures between 1930 and 1933, Congress passed the Banking Act to limit banks' service options and to protect them from competition. Among other measures included in the Act, a provision (implemented as Regulation Q) prohibited payment of interest to corporations on their demand deposit account (DDA) balances to keep banks, in the heat of competition, from offering interest levels on deposit balances that might be sustained through risky investments.

Today, of course, banking is much different. Interest-bearing checking accounts for individuals have been allowed since 1980, and many of the services traditionally controlled by banks -- checking account services among them -- are now being provided by non-banks, which are not subject to restrictive banking regulations. Meanwhile, faced with a prohibition against earning interest on DDA balances, savvy treasury professionals utilize innovative procedures to sweep those funds into money market and other instruments often held outside the banking system.

So it follows that Regulation Q is an outdated regulation. But it has had the effect of freeing banks from incurring interest expense, and not surprisingly, some banks have come out against the repeal.

Regulation Q should be abolished on the basis of its obsolescence alone. But there are other reasons as well. For one thing, reliance on the "work-arounds" that Regulation Q has spawned puts smaller banks and bank customers at a competitive disadvantage because they lack the sophistication, access to technology, or required balances to utilize sweep accounts. And even those businesses that have already made the investment would benefit from the flexibility and simplicity in funds management that payment of interest on demand deposits would afford.

For decades, treasury managers at major corporations have sought ways to put the "idle balances" in bank demand deposit accounts to profitable use. The banking industry has responded, first by developing interest-earning substitutes, and then by providing businesses with increasingly accessible options for moving funds out of demand deposit accounts and into income-generating instruments. With continual advances in computer technology and treasury automation, such services have become cost-effective for even middle market companies.

The earliest and most widely available method that banks developed to add value to the collected balances maintained by businesses in demand deposit accounts was the earnings credit. Banks use an earnings credit rate -- most often tied to the 90-day Treasury bill rate -- to calculate how much the collected balances in demand deposit accounts would have earned if interest could have been paid. This amount is then subtracted from the fees owed by the company for the services that the bank provides. By means of the earnings credit, bank deposits are put to work as compensating balances for services.

Companies became increasingly dissatisfied, however, with keeping funds on deposit to compensate the banks for services...for three good reasons. First: if a company maintains collected balances in excess of the amount required to compensate the bank, the excess earnings on those balances cannot be returned to the company as cash or used productively. Some banks allow the excess to be carried forward to future periods; other do not.

Second, the earnings credit rate is reduced by the reserve requirement. The reserve requirement is the percent of balances that must, by law, be maintained by financial institutions in a non-interest earning account at the Federal Reserve. It is currently 10%. That 10% is subtracted from the earnings credit rate. As a result, companies can earn higher rates of interest on their excess cash by investing it themselves than by keeping the money at the bank.

Finally, even without the reserve requirement, the Treasury bill rate most often used as the earnings credit rate is lower than other types of short-term investments, such as commercial paper and repurchase agreements.

As a consequence, large corporations looked to their banks for ways to minimize the cash in their accounts so that they could invest the money themselves. The response from the banks, as early as the 1970s, was controlled disbursement. Controlled disbursement is a bank service that notifies a company by early or mid-morning of the dollar amount of checks that will clear against its account that day. It enables a company to invest all of its available funds each day without having to guess the amount that will be deducted from its account at night, when checks are routinely processed and posted to demand deposit accounts. And the company can make that investment in the morning, when rates are higher. Net borrowers also benefit from controlled disbursement services in that borrowing decisions for funding requirements often need to be made by 11:00 am.

The overwhelming majority of companies with annual sales above $250 million now use controlled disbursement services.

The automation of check processing procedures combined with faster, less expensive methods of delivering check clearing information electronically have resulted in the widespread availability and use of controlled disbursement services. The automation of the treasury function has also given the treasury professional faster and better information each morning about deposits of funds into the company's accounts, wherever they are located, and faster means of concentrating those funds into one central account for investment purposes.

Faced with the challenge of generating income from the excess cash that their automated reports confirmed was available in the company's bank accounts each day, aggressive managers of corporate cash looked to non-bank competitors for investment opportunities. They moved funds out of banks and into brokerage and investment banking firms, which faced no restraints on the interest-bearing investment vehicles they could offer. These firms soon linked checking services to their investments, further eroding banking's share of corporate deposits.

Banks fought back, developing other services to circumvent the prohibition on paying interest on corporate funds. The primary weapon in their competitive battle: the sweep account.

Let's examine sweep accounts -- what they are, how they work, their recent growth, and high value to the banking industry in terms of fee income and reduced sterile reserve requirements. Sweep accounts transfer funds automatically, in excess of a pre-determined balance, from a customer's demand deposit account (DDA) into an interest earning account or short-term investment. Funds are "swept" into any of several investment options.  In effect a sweep is a service which automatically links a commercial deposit account with an investment account. The most common investment accounts are:

• Depository accounts such as Money Market Deposit Accounts (MMDA)
   
• Money market mutual funds -- both bank proprietary and third party funds
   
• Offshore instruments such as deposits in affiliates of U.S. banks
   
• Overnight instruments such as repurchase agreements of U.S. Treasuries, commercial paper, and Fed funds
   
• Trust accounts

Sweep account asset growth during the 1994-1996 period was 143% for all instruments, with Money Market Funds (156%) and Offshore (155%) accounts reflecting the largest increases.

Preliminary reports are that the growth outlined in sweep account activity and fees are even more dramatic for 1997.

Historically, banks offered commercial sweep investment programs as a defensive tactic against money market mutual funds and other devices which were disintermediating bank deposits. Now, many banks are becoming aggressive in the marketing of sweeps since the apparent benefits to banks from offering sweep accounts appear to be compelling:

• Income -- Sweep account fees range from $50 to $250 per month per account.  Fee and spread income net banks an average of 119 basis points.
   
• No Interest -- In lieu of interest expense for demand deposits, banks provide artificial mechanisms for their customers to avoid sterile reserves.
   
• Reduced reserves -- Sweeps move customer funds off balance sheets, and reserves on those deposits are eliminated.
   
• Recapture of lost assets -- Many companies invest directly in money market mutual funds. A sweep product provides an opportunity for customers to consolidate investments and accounts at the bank.

The benefits are misleading, and the advantages to large banks' rising sweeps revenues may be short-lived.  Demand deposits are still declining and now constitute only 20% of total deposits, and 15% of total bank liabilities -- down from 33% and 30%, respectively, only 20 years ago. This translates into demand deposits seeking value outside banks, and the increasing need for banks to fund through borrowing.

The bottom line is that federal regulation drawn from depression-era protective legislation creates an artificial market environment which provides benefits which may be short-term to some large bank participants. Large and middle market companies are generally able to escape sterile balances resulting from the ban on interest for demand deposits. Smaller companies often miss opportunities provided by sweeps because "most competitive overnight instruments require minimum denominations that are out of reach for most small companies."¹  Also, many smaller financial institutions lack the scale and resources to provide sweeps products.

Often overlooked as a casualty of the interest ban are the "residue" balances remaining in demand deposit accounts which utilize sweep services. These cumulative balances are substantial and fail to earn value. So in fact bank customers of all sizes are disadvantaged by Regulation Q. A free market scenario should present sweep and interest-on-deposit options to all bank customers and banks. Ending this archaic regulatory device will not terminate aggressive cash management tools like sweeps. But the end of Regulation Q will terminate the artificial environment which created the sweeps market. Products should not owe their existence to government protection through price regulation (i.e., no interest on business checking accounts). Rather, they need to demonstrate their worth in a free market as another option a customer may choose.

Finally, it is because of the interest expense that banks would incur following elimination of Regulation Q that some are supporting an alternative measure, which keeps Regulation Q intact but creates yet another loophole. This plan offered by the American Bankers Association (ABA) would expand to 24 (from six) the number of times a company can withdraw funds from money market deposit accounts each month. Through daily transfers from interest-bearing accounts to cover checks drawn against DDAs, a bank gives its corporate clients, in effect, checking account interest. The plan does not address a common problem for many corporate customers: they cannot anticipate all funding needs, and frequently would require multiple daily transfers from the money market deposit account -- not permitted under this juryrigged approach.

This plan does provide more flexibility in enabling customers to utilize idle funds but neither simplifies the customer's cash management procedures nor addresses the falling Fed reserves issue and outflow of funds from banks. In fact, this approach maintains and extends the need for controlled disbursement, the basic building block used to invest funds more profitably. And it ties the banks' hands as well. Without Regulation Q, banks have the freedom to develop products, with or without an interest component.

In a letter released on February 20, 1998, Federal Reserve Board Chairman Greenspan criticized the ABA plan: "The Board supports the elimination of unnecessary or anti-competitive regulatory requirements. A 24-transaction account might aid banks in meeting competition but the Board believes that a more straightforward and more economically efficient way to address this issue would be simply to repeal the prohibition against the payment of interest on demand deposits."

A May 1998 Senior Financial Officer Survey conducted by the Federal Reserve makes a telling point concerning the impact on banks of paying interest on business checking. This survey reflects the opinions of senior financial officers of 44 large commercial banks:

"In summary, it seems that banks would incur a short-term increase in costs if they were allowed to pay interest on demand deposits. The extent of this increase, however, would probably be muted considerably by a tiered-deposit rate schedule and by the fact that a substantial proportion of demand deposits already earn implicit interest. In the long run, the effects of allowing banks to pay interest on demand deposits would almost certainly be salutary by removing a significant regulatory distortion and by encouraging increased competition and efficiency in the banking industry."

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We support the proposed Sections 101 and 102 of the "Financial Institution Regulatory Streamlining Act of 1998" because its provisions solve some fundamental problems for bank customers, banks, and the Federal Reserve. The inability of depository institutions to pay interest on business accounts hurts all sectors of the economy but especially small businesses. Some banks have convoluted arrangements to sweep sterile checking account funds on a daily basis to money market deposit accounts or other earnings instruments. These "sweep" systems in connection with controlled disbursement services are cumbersome and costly for smaller banks and savings institutions to operate. This impedes the ability of smaller depository institutions to compete for business checking accounts and for small businesses to obtain the benefits of productive use of funds often available to larger and more sophisticated businesses. However, even large businesses which have developed means to employ balances profitably would welcome the flexibility and simplicity in funds management which would follow the elimination of Regulation Q.

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¹1997 Commercial Banking Sweep Account Survey Results, Treasury Strategies, Inc., Chicago, Ill., Summary, pg. 2.