The overriding purpose of the Dodd-Frank Act is to curb systemic risk in the financial system. But one provision of the act about to take effect will dramatically increase systemic risk.
Effective July 21, 2011, the law repeals Regulation Q, which has long prohibited banks from paying interest on business checking accounts. This abrupt policy reversal will increase funding costs for banks, heighten interest rate and liquidity risk, stress bank profit margins, increase credit costs for businesses and consumers, and potentially destabilize the banking system as well as short-term money markets and the economy as a whole.
In 1980, Congress eliminated Regulation Q prohibitions on payment of interest on personal checking accounts. But it did so in a measured way, creating an interagency regulatory committee to study the issue and phase out the prohibition over a multiyear period.
Even so, the phaseout resulted in deleterious interest rate competition among depository institutions, particularly thrifts, some of which advertised rate offerings in excess of 20%. This competition resulted in excessive asset growth and a ruinous mismatch of assets and liabilities, leading to the thrift industry's ultimate collapse. The abrupt repeal of Regulation Q for business checking accounts is likely to unleash similar forces with potentially unpredictable and devastating results.
Interest rate risk is a major supervisory concern even apart from Regulation Q repeal, as Federal Deposit Insurance Corp. Chairman Sheila Bair recently testified to Congress. Regulation Q repeal will significantly exacerbate this risk and present even greater challenges in maintaining banking stability.
Some banks may suffer a net loss of deposits because of aggressive price competition. Competition for deposits will be especially challenging for small community banks that excel at competition based on services and customer relationships but lack the ability of larger banks to engage in sustained rate competition. Regulation Q repeal will threaten these relationship-based deposits that provide community banks a stable source of funding. Banks need to reprice their loans and services upward at all levels.
The total deposit base of the nation's banking system will increase unevenly as business customers shift funds from money market funds to insured, interest-bearing deposits in banks that can pay a competitive rate. Yet most banks do not have the capacity to deploy excess deposits in creditworthy loans sufficient to earn a return that will offset the anticipated increase in the cost of funds.
MMFs historically have served as an alternative to non-interest-bearing bank deposits. They will remain an attractive cash equivalent for amounts in excess of the FDIC insurance limit of $250,000. Yet, Regulation Q repeal will result in potentially significant outflows from MMFs, with broader economic consequences.
The liquidity of the commercial paper market is tied to the flow of funds in MMFs, which hold nearly 40% of the high-quality commercial paper that businesses issue to finance payrolls, inventories and other short-term operating needs. MMFs also hold two-thirds of short-term debt financing for state and local governments and public projects such as roads, bridges and hospitals.
Banks cannot purchase equivalent amounts of commercial paper and municipal debt because of applicable capital requirements. (MMFs are not subject to capital requirements because, among other things, they are not leveraged like banks, are not federally insured and don't have access to the discount window.) Municipalities and commercial paper issuers will find fewer purchasers for their debt as a result of Regulation Q repeal, and their funding costs will increase.
Bank loans are an expensive substitute for direct issuance of commercial paper and municipal securities in the market.
The Federal Reserve Board recently requested public comment on the implications of Regulation Q repeal, inviting comment on alternatives it could adopt to minimize its impact. The board has a number of alternatives:
- A policy statement establishing supervisory requirements before banks can pay interest on business checking accounts (e.g., review of interest rate risk management, review of plans to deploy increased deposits).
- Stress tests before banks are allowed to pay interest.
- Restrictions on payment of interest substantially in excess of market rates in geographic regions.
- Reporting requirements for monitoring purposes.
- An explicit measure of interest rate risk and the corresponding capital charge — currently, interest rate risk assessment is qualitatively but not quantitatively assessed and there is no explicit charge to bank capital.
- Increased reserve requirements on demand deposits to facilitate monetary policy, which the board has said includes maintaining financial stability.
The idea of eliminating a Depression-era regulatory restriction may have sounded appealing to members of Congress who sponsored Regulation Q repeal. But the reason for enactment of the prohibition on the payment of interest on demand deposits in 1933 remains relevant in today's still-weakened banking system — to avoid ruinous competition for interests rates that banks can ill afford to pay, and the related systemic effects.
It is ironic that Congress, in its efforts to promote banking stability following the worst crisis since the Great Depression, chose to repeal a law enacted for the very purpose of addressing banking instability following the Great Depression.
Abrupt repeal of Regulation Q is fraught with unintended consequences that will harm the banking system and the economy as a whole without any significant offsetting benefits to the small-business interests that lobbied for it. The Fed should address this systemic threat and prevent another financial crisis from arising.
