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Reg Q Reactions: What Every Corporate Should Know

  • By Mohamed Siraj
  • Published: 2011-05-18

One change in the Dodd-Frank Act is the repeal of the Federal Reserve’s Regulation Q, which prohibited banks from offering interest on business transaction accounts. The repeal of Regulation Q, which takes effect in July, will have long-term implications on corporates as well as banks.

Reg Q background 

Prior to the passage of Reg Q in the early 1930s, the vast majority of corporate bank funds in the U.S. were kept in demand deposit accounts (DDAs), which included nearly all corporate checking accounts. In response to the chaotic business environment fostered by the Great Depression, Congress restricted banks in an attempt to reduce competition for deposits. It was thought that excessive competition for corporate accounts encouraged unprofitable lending by banks, ultimately contributing to a wave of financial institution failures in the early part of the decade.

Reg Q gradually caused corporate liquidity to flow out of banks and into the secondary markets. In response, banks created a suite of cash management products, such as the “soft” earning credits on business demand deposit accounts which could be used to offset services provided by the banks. Offered in lieu of “hard” interest payments on account balances, soft credits provided a valuable return for corporates. To further entice corporate deposits, banks began offering services that enabled clients to maximize yields and maintain access to funds—sweep products, zero balance accounts, and controlled disbursement accounts, to name a few.

Reg Q was modified in the 1980s to discourage corporates from moving funds between a checking account and one that pays interest. Banks responded by developing the Negotiated Order of Withdrawal (NOW) account which earns interest. However, NOW accounts could only be held by individuals, sole proprietors or non-profit organizations.

Ramifications of repeal 

Through the repeal of Regulation Q, corporates will have the opportunity to earn interest on DDA funds. Corporates may choose to receive hard interest on their entire account balances, or they may elect to continue to receive soft earning credits on their deposit balances, and earn hard dollar interest on excess balances.

In reviewing their deposits options, corporates should consider the trade-offs necessary between soft earning credits and hard dollar interest income. A shift to interest income deposit products could lead to fierce competition amongst banks and erode their net interest income margins, forcing them to charge higher fees on fee-based products.

Also, if banks begin offering a relatively high interest on demand deposit accounts, corporates could invest their excess cash in high-yield DDAs rather than buying institutional money market mutual funds or commercial paper which may lead to an increase in demand for credit and place a greater reliance on banks to fund working capital.

Corporates should take into consideration the temporary unlimited FDIC insurance on non-interest bearing deposits, which became effective on December 31, 2010 and will end on December 31, 2012, when considering hard dollar interest versus soft earning credits.

Pressing cash flow requirements may place a greater importance on securing hard interest on corporate account balances, but such interest will be subject to taxes. For that reason, some corporates may choose to continue with soft earning credits that help to offset bank fees on services, while avoiding any changes to their tax liability.

Corporates will face the challenge of determining the most effective strategy that best meets their working capital and liquidity needs. This will require examining the structure of their accounts, services, and associated fees. These complex choices will, in all likelihood, significantly impact how banks structure their solutions, influencing account analysis calculations, sweep products, and commercial deposit product mixes.

Uncertain future 

Despite the July 2011 effective date for the repeal of Reg Q, there is still great uncertainty about its final implementation. The repeal of Reg Q may present a new revenue opportunity for the U.S. government through tax payments on interest generated by corporate accounts. However, with the recent change in the makeup of Congress, it is possible these regulations will be altered or suspended before full implementation.

Mohamed Siraj is Product Manager for Liquidity Solutions, Fifth Third Bank. 

Read AFP’s comments on Reg Q.  

This article originally appeared in the May issue of Payments. 

Copyright © 2015 Association for Financial Professionals, Inc.
All rights reserved.

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