The potential repeal of Regulation Q, now before Congress, represents a major opportunity for banks to reposition themselves as liquidity managers for their commercial clients.
Just as some opportunistic banks used the Monetary Control Act of 1980 to transform cash management operations into significant lines of business, banks can use the potential repeal of Regulation Q as a catalyst to re-intermediate substantial customer assets.
There is no doubt that interest on commercial demand deposit accounts threatens bank profitability in the short run. However, a carefully crafted deposit profit management program, in conjunction with an aggressive deposit re-intermediation strategy, has huge long-term strategic and profit potential. Together, these programs can lock in existing profits, produce new profits, and secure customer relationships by pre-empting competitors.
On the other hand, a nonresponse could put significant profitability at risk. We estimate that the Regulation Q repeal would increase the weighted cost of all corporate demand deposits - not just "free" deposits - by 100 to 125 basis points at an annual industry rate of $5 billion.
Interest rate deregulation is a double-edged sword for major banks such as Bank of America, Citibank, Chase Manhattan, Bank One, First Union, and Wells Fargo. While each of these organizations has several hundred million dollars of annual profits at risk, well-crafted strategies could mitigate that risk and create significant new opportunities.
The most vulnerable organizations are corporate short-term asset management and investment firms such as Goldman Sachs, Merrill Lynch, Fidelity Investments, and Lehman Brothers. On the other hand, opportunities abound for thrifts like Washington Mutual, Great Western Financial, and Dime Savings.
These risks must be managed carefully. The real opportunity for banks is to use a repeal of Regulation Q to re-intermediate funds that have left the banking system and to do so profitably.
According to our research, for every $1 that the average company keeps in either demand or sweep accounts, $5 is invested elsewhere. For large corporations, that ratio jumps to $30 for every $1 in a demand or sweep. This means that bank demand and sweep accounts hold only $600 billion of the potential $3.6 trillion of liquid assets of U.S. businesses.
A two-pronged approach is essential to profitable re-intermediation.
First, the bank must defend its commercial account profitability. This requires a careful balance of five critical variables: market segmentation; interest rate levels and structure; earnings credit rates; individual strategies for key accounts; and service repricing.
Market research, data mining, and customer modeling tools can be used to set the first four variables in a way that locks in more than half of the profits at risk. Judicious service repricing can protect the rest.
Second, the bank needs to establish an aggressive customer asset re-intermediation program. This involves several components:
- Creating liquidity management accounts with skillfully priced balance tranches and interest rate tiers to replace corporate demand deposit accounts.
- Coordinating earnings credit rates, deposit interest rates, and sweep account options.
- Implementing products that give the bank a better view of their customers' off-balance-sheet liquidity.
- Incorporating Boolean decision rules so that banks can automatically implement customer investment policies and optimize them along the yield curve.
- Data mining to pinpoint customer cash outflows.
- Transforming the sales process - from offering service and credit to optimizing the firm's liquidity management strategy.
By expanding and repricing liquidity offerings and by coordinating earnings credit rates with sweep accounts options, banks can motivate their customers to profitably bring back new money from outside investments.Among our clients, it's not surprising to see a $50 billion-asset bank identify $1 billion to $2 billion of monthly outflows to investment intermediaries. By pinpointing these cash outflows, a bank can transform its sales process in ways that stop this hemorrhage.
Finally, corporate treasurers make their investment decisions by considering convenience, relationship, and risk minimization. These factors are the key attributes of commercial banks.
Changing events represent threats to the traditional commercial deposit function of banks. Indeed, $5 billion of industry profit is at risk. The solution should not stop with building strong defenses. Major profits accrue in those banks that are aggressively (and systematically) reinventing their organizations to re-intermediate customer assets.
With nearly $3 trillion of corporate liquid assets held outside of bank demand and sweep accounts, the potential is significant.
Capturing the most assets requires putting into place timely defensive strategies that lock in profitability and offensive strategies that systematically capture assets.
Mr. Carfang is a partner and co-founder of Treasury Strategies Inc., a treasury activity consulting firm with offices in Chicago and New York.