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.
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.
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
originally appeared in the May issue of Payments.