When we wrote last week "FDIC Says DDAs w/Interest Ineligible for Unlimited Deposit Insurance," we hadn't been aware of a May 13, 2011, letter written by the Investment Company Institute and its Chief Economist Brian Reid. The "ICI Comment Letter on Federal Reserve Board Proposal to Repeal Regulation Q," says, "The Investment Company Institute appreciates the opportunity to comment on the Federal Reserve Board's proposed rule that would repeal Regulation Q, which prohibits member banks of the Federal Reserve System from paying interest on demand deposits. The proposed rule, which implements Section 627 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), repeals Section 19(i) of the Federal Reserve Act, the statutory authority under which the Board established Regulation Q. In its rule proposal, the Board asked a series of questions about the repeal of Regulation Q, including whether it would have implications for money market funds."
Reid's letter comments, "It is unclear how significant the competitive effect of allowing banks to pay interest on demand deposits will be on investor demand for money market funds, in part because banks already pay implicit interest on certain business demand deposit accounts (DDAs) through 'earnings credits.' We have deep concerns, however, that the elimination of Regulation Q, coupled with the unlimited deposit insurance on noninterest-bearing transaction accounts as required under Section 343 of the Dodd-Frank Act,3 will effectively extend unlimited insurance to interest-bearing accounts. [Note: see Crane Data's prior New story "FDIC Says DDAs w/Interest Ineligible for Unlimited Deposit Insurance" for the latest.] These changes could dramatically alter the competitive landscape between banks and money market funds and potentially create large outflows from money market funds and into banks either immediately or during a future financial crisis, putting severe pressure on the money markets. Furthermore, the combination of these two changes will significantly increase moral hazard for the banking system, and potentially increase the costs of operating the deposit insurance program for the FDIC and ultimately the U.S. taxpayer. Indeed, the adoption of these two provisions likely will create systemic risks that did not previously exist. It is important, therefore, that the unlimited insurance, authorized for two years in Section 343, be allowed to expire as contemplated by the Dodd-Frank Act."
ICI explains, "Regulation Q was put in place by the Glass-Steagall Act of 1933 as part of a Congressional response to banking practices and problems encountered during the Depression. It authorized the Board to set the rates of interest that banks would be allowed to pay their customers, including a rate of zero on DDAs. From the mid-1960s to the mid-1980s, yields on money market instruments generally were significantly higher than the imposed zero rate that banks were allowed to pay on DDAs and also were often higher than the ceiling imposed on passbook savings accounts. Among other things, these developments discriminated against investors with modest balances. When market interest rates were above deposit ceiling rates, wealthy investors, including institutions, were able to shift from deposits to direct investments in money market securities such as repurchase agreements or commercial paper. Smaller investors were forced to continue to hold their liquid balances in deposit accounts paying submarket yields. Money market funds provided a conduit through which smaller investors could, for the first time, gain access to the higher yields available on open market instruments. For institutional investors, through asset pooling, money market funds often provided more efficient cash management and better diversification than direct investments in money market instruments. These funds also provided investors with larger balances with a cash-management tool that reduced their exposure to a single bank."
They says, "With the notable exception of prohibiting the payment of interest on DDAs, Regulation Q restrictions on deposit rates were gradually phased out in the 1980s, allowing depositories to compete more effectively by creating new products. In the retail space, these products included negotiable order of withdrawal accounts and money market deposit accounts, which are not considered DDAs. Banks have used sweep accounts to provide interest to business customers. Under such arrangements, banks allow customers to keep zero balances overnight in DDAs and sweep customer funds into repurchase agreements, money market funds, and offshore deposits daily. Banks also have been able to compete for business deposits by providing 'earnings credits' on DDAs that can be used to offset service charges generated by the business account owner. These earnings credits amount to the implicit payment of interest on DDAs. The earnings credit rate, however, is reportedly sometimes less than that offered by a 'hard' interest-earning account and any unused earnings credits typically do not carry forward from month to month. The repeal of Regulation Q, therefore, may make DDAs a more appealing alternative for business cash management, thereby potentially reducing demand for money market funds, sweeps, or other arrangements."
Reid continues, "The effect of repealing Regulation Q on investor demand for money market funds, however, likely will be tempered by the tremendous benefits and protections money market funds provide to investors. Institutional investors historically have been attracted to money market funds not only for their market-based yields, but also for the unique protections offered by Rule 2a-7 under the Investment Company Act of 1940. Rule 2a-7, which was further strengthened in 2010, contains several conditions designed to limit a money market fund's exposure to certain market risks by specifying strict limits on portfolio credit quality and maturity of portfolio securities, and requiring readily available liquidity for redemptions. In addition, the rule requires that money market funds maintain a diversified portfolio designed to limit a fund's exposure to the credit risk of any single issuer. Indeed, money market funds often invest in hundreds of different underlying securities, providing investors with diversification across a large number of nonfinancial and financial institutions. In contrast, banks depositors are protected against losses by bank capital and through insurance by the FDIC up to $250,000 per account. Institutional investors, however, often manage cash balances totaling millions to hundreds of millions of dollars or more. For such investors, the repeal of Regulation Q may be an insufficient incentive to offset the risks of an undiversified exposure of deposits in a single bank compared to the more diversified investment available through a money market fund."
He adds, "Thus, it is difficult to predict with any degree of precision what effect the repeal of Regulation Q, in and of itself, will have on investor demand for money market funds. As discussed below, however, the balance between the different approaches of money market funds and banks could be dramatically altered, as the risks associated with the lack of diversification in DDAs are mitigated by the availability of unlimited insurance on noninterest-bearing transaction accounts.
ICI's comment letter also says, "The economic role of a carefully designed deposit insurance program is to help promote stability across the entire economy. Deposit insurance reduces the probability of bank runs by guaranteeing that retail depositors are made whole when a bank defaults. Despite its demonstrated benefits, deposit insurance also carries risks for the financial system. For example, deposit insurance reduces the incentives for insured depositors to monitor the creditworthiness of banks, which in turn creates moral hazard that encourages banks to take additional risks, knowing that depositors will not withdraw their deposits if the bank's financial condition deteriorates. In addition, deposit insurance can cause other systemic risks for financial markets by increasing the propensity for investors to sell off assets -- such as stocks, bonds, mutual fund shares, and other securities -- and move the proceeds into insured deposits. As the FDIC itself has previously observed, this behavior can produce or exacerbate broader market dislocations during periods of financial stress."
Finally, Reid writes, "Historically, the risks posed by deposit insurance programs have been mitigated by capping the amount of a depositor's account that is insured (currently $250,000). In the case of the temporary unlimited insurance authorized by Section 343 of the Dodd-Frank Act, even with the statutory limits on the types of accounts covered (noninterest bearing), the moral hazard and systemic risks created by the banking system have increased, particularly with the removal of Regulation Q. For example, we are not aware of any limitation placed on interest-bearing DDA holders that would prohibit them from moving their cash balances to a noninterest-bearing, fully insured transaction account during a period of financial stress at an individual bank or in the financial markets in general. Nor are we aware of any prohibition on banks creating such a linkage that could be executed automatically. Taken together, the removal of Regulation Q and the unlimited insurance on noninterest-bearing transaction accounts required under Section 343 of the Dodd-Frank Act will effectively allow the FDIC to provide unlimited insurance on interest-bearing accounts and will no doubt draw money away from money market funds, other cash pools, and direct investments in the money market, perhaps even to a degree that could raise systemic concerns. It is critical, therefore, that the unlimited insurance on noninterest-bearing transaction accounts, authorized for two years in Section 343, be allowed to expire as contemplated by the Dodd-Frank Act. Indeed, this point is sufficiently important that we recommend the Board express this view to Congress and the FDIC to ensure that the unlimited insurance is not extended by statute or regulation." [Note: This letter was posted before last Thursday's Crane Data News story, "FDIC Says DDAs w/Interest Ineligible for Unlimited Deposit Insurance".)
