FRB Governor Laurence Meyer testifying to the House Committee on Financial Institutions and Consumer Credit suggesting that banks be allowed to pay interest on demand deposits and that the Federal Reserve be allowed to pay interest on reserves held at Reserve Banks.
>>Moderate levels of volatility are not a concern for monetary policy, in part because the Federal
Reserve now announces the target federal funds rate, eliminating the possibility that fluctuations in
the actual funds rate in the market would give misleading signals about monetary policy. A
significant increase in volatility in the federal funds rate, however, would be of concern because it
would affect other overnight interest rates, raising funding risks for most large banks, securities
dealers, and other money market participants. Suppliers of funds to the overnight markets,
including many small banks and thrifts, would face greater uncertainty about the returns they would
earn and market participants would incur additional costs in managing their funding to limit their
exposure to the heightened risks.
As we have previously testified, the issue of potential volatility in the funds rate has arisen in recent
years because of substantial declines in required reserve balances owing to the reserve-avoidance
activities of depository institutions. Depositories have always attempted to reduce required reserve
balances to a minimum, in large part because those balances earn no interest. For more than two
decades, some commercial banks have done so by sweeping the reservable transaction deposits
of businesses into instruments that are not subject to reserve requirements. These wholesale
business sweeps not only have avoided reserve requirements, but also have allowed businesses to
earn interest on instruments that are effectively equivalent to demand deposits. In recent years,
developments in information systems have allowed depository institutions to sweep transaction
deposits of retail customers into nonreservable accounts. These retail sweep programs use
computerized systems to transfer consumer and some small business transaction deposits, which
are subject to reserve requirements, into savings accounts, which are not. Largely because of such
programs, required reserve balances have dropped from about $28 billion in late 1993 to around
$5 billion or $6 billion today, and the spread of such programs probably has not yet fully run its
course.
Despite the unusually low level of required reserve balances, no trend increase in the volatility of
the funds rate has been observed to date. In part, this stability reflects the increasingly important
role of contractual clearing balances, which have risen over the last decade to the point where they
now exceed the level of required reserve balances. In addition, improvements in information
technology have evidently allowed depository institutions to become much more adept at
managing their reserve positions, and as a result, their needs for day-to-day precautionary
balances have declined considerably. A number of measures taken by the Federal Reserve also
have helped to foster stability in the funds market. These include improvements in the timeliness of
account information provided to depository institutions; more frequent open market operations
geared increasingly to daily payment needs rather than two-week-average requirements; a shift to
lagged reserve requirements, which gives depositories and the Federal Reserve advance
information on the demand for reserves; and improved procedures for estimating reserve demand.
To prevent the sum of required reserve and contractual clearing balances from falling even lower
and to diminish the incentives for depositories to engage in wasteful reserve-avoidance activities,
the Federal Reserve has sought authorization to pay interest on required reserve balances and to
pay explicit interest on contractual clearing balances. With interest on required reserve balances,
some of the retail sweep programs that have been implemented in recent years might be unwound,
and new programs would be less likely to be implemented, thereby helping to boost the level of
such balances. Eliminating such wasteful reserve-avoidance activities would also tend to improve
the efficiency of the financial sector.<<
>>The payment of interest on required reserve balances would reduce the revenues received by the
Treasury from the Federal Reserve. The extent of the revenue loss, however, has fallen in recent
years as banks have increasingly implemented reserve-avoidance techniques. Paying interest on
contractual clearing balances would primarily involve a switch to explicit interest from the implicit
interest currently paid in the form of credits, and therefore would have essentially no net cost to the
Treasury. In the past, bills approved by the Committee, such as H.R. 4209 from the last
Congress, have provided for a general authorization for the payment of interest on any balances
held by depository institutions at Reserve Banks. This would be a desirable outcome. However, if
budgetary issues continue to inhibit the passage of legislation to authorize payment of interest on
required reserve balances, the Federal Reserve would support a separate authorization of the
payment of interest on contractual clearing balances, which would have essentially no budgetary
cost. The payment of interest on excess reserves could also be authorized without immediate
effect on the budget because the Federal Reserve would use that authority only in circumstances
that do not seem likely to arise in the years immediately ahead.
Another legislative proposal that would improve the long-run efficiency of our financial sector is
elimination of the prohibition of interest on demand deposits. This prohibition was enacted during
the Great Depression, a time when Congress was concerned that large money center banks might
have earlier bid deposits away from country banks to make loans to stock market speculators,
depriving rural areas of financing. It is unclear whether the rationale for this prohibition was ever
valid, and it is certainly no longer applicable today. Funds flow freely around the country, and
among banks of all sizes, to find the most profitable lending opportunities, using a wide variety of
market mechanisms, including the federal funds market. Moreover, Congress authorized interest
payments on household checking accounts with the approval of nationwide NOW accounts in the
early 1980s. The absence of interest on demand deposits, which are held predominantly by
businesses, is no bar to the movement of funds from depositories with surpluses--whatever their
size or location--to the markets where the funding can be profitably employed. In fact, small firms
in rural areas are able to bypass their local banks and invest in money market mutual funds with
transaction capabilities. Indeed, smaller banks complain that they are unable to compete for the
deposits of businesses precisely because of their inability to offer interest on demand deposits.
The prohibition of interest on demand deposits distorts the pricing of transaction deposits and
associated bank services. In order to compete for the liquid assets of businesses, banks set up
complicated procedures to pay implicit interest on compensating balance accounts. Banks also
spend resources--and charge fees--for sweeping the excess demand deposits of businesses into
money market investments on a nightly basis. To be sure, the progress of computer technology has
reduced the cost of such systems over time. However, the expenses are not trivial, particularly
when substantial efforts are needed to upgrade such automation systems or to integrate the diverse
systems of merging banks. Such expenses waste the economy's resources, and would be
unnecessary if interest were allowed to be paid on both demand deposits and the reserve balances
that must be held against them.
The prohibition of interest on demand deposits also distorts the pricing of other bank products.
Because banks cannot attract demand deposits through the payment of explicit interest, they often
try to attract these deposits, aside from compensating balances, through the provision of services
at little or no cost. When services are offered below cost, they tend to be overused to the extent
that the benefits of consuming them are less than the costs to society of producing them.<<
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