Effects of Interest on Demand Deposits: Implications of Compensating Balances R. ALTON GILBERT EGISLATION is being considered which would This article is concerned with the same sort of allow depository financial institutions throughout the analysis of interest-hearing demand deposits, only as 1 nation to offer to households interest-paying checking it applies to business accounts. Although business accounts, more popularly known as NOW (Negotiable accounts have not been given serious consideration in Order of Withdrawal) accounts. Bankers, in general, the discussion of permitting interest-bearing demand are concerned about the effects on earnings of such a deposits, it seems likely that a favorable experience regulatory change. Several studies of NOW accounts, with interest-bearing household accounts could lead to however, suggest that this concern may be unjustified, the lifting of the interest-paying prohibition on all as only small earnings effects have been detected in demand deposits.~The analysis involves an examina- areas where NOW accounts are currently permitted? tion of compensating balances, or the demand deposit balances banks require from firms in compensation for One of the reasons for the expectation of small preferential loan terms or low-priced services. effects on bank earnings due to nationwide NOW accounts can he traced to the ways by which banks are currently circumventing the prohibition of interest THE ROLE OF COMPENSATING on demand deposits by offering services to depositors BALANCE REQUIREMENTS IN THE at no charge or at low rates. The primary service COMPETITION AMONG BANKS FOR offered to households is the processing of checks writ- THE DEPOSITS OF BUSINESS FIRMS ten and deposited by these customers. In effect, this amounts to implicit interest payments.2 Thus, permis- Bank policies of requiring compensating balances sion for nationwide NOW accounts would have the from business finns are considered since, as revealed most pronounced effect on the form in which banks NOW .Accounts in New England,” Studies on the Payment pay demand deposit interest, with direct interest of interest on Checking Accounts, pp. 23—38; William A. payments replacing indirect, or implicit, interest Longbrake, “Comninercial Bank Capacity to Pay Interest on Demand Deposits, Part 11; Earnings and Cost Analysis,” payments. Journal of Bank Research (Summner 1976), pp. 134-49; Carl C. Nielsen, Bottom Line Study for Kansas Banks, pre- mThose studies also suggest that future earnings effects of pared for the Kansas Bankers Association, May 1977; Staff NOW accounts are likely to be rednced as more banks re- Study, Board of Governors of the Federal Reserve System, The Impact of the Paymne;mt of Interest on Demand Deposits, quire minimoum balances and/or charge for previously free services. See Ralph C. Kimball, “Recent Developments in January 31, 1977. The NOW Account Experiment in New England,” New ~ recent regmmlatory change has mnade the prohibition of England Economic Review, Federal Reserve Bank of Boston interest payments on the demnand deposits of business firms (November/December 1976), pp. 3-19; Kimball, “Impacts of less effective. Banks am’e now pennitted to offer savings ac— NOW .kccounts and Thrift Institution Competition on Se- cosmnts to btmsincss firms up to $150,000 per firmn. The firms lected SmnaIl Commercial Banks in Massachusetts antI New that take advarmtage of another regtmlatomy change which hampshire, 1974-75,” New England Economic Review allows l,anks to transfer funds between their checking and (January/February 1977), pp. 22-38; and john D. Paulus, savings accounts based upon telephone instruction are able to “Effects of ‘NOW’ Accounts on Costs and Earnings of Com- keep part of their working balances in interest earning mercial Banks in 1974—75,” Staff Economic Studies, Board of acc’ommnts. However, these changes in regulations significantly Governors of the Federal Reserve System, 1976. affect the cash management of only relatively small firms. 2David C. Cates and Samnm,el B. Chase, Jr., Time Payment of Tsvi, recent studies consider vemy briefly the effects on banks Interest on Checking Accountt.s, a report to the South Caro- of imiterest on demnand deposits of business firmns. Both studies lina Bankers Association, Fehruam’y 1976; Charles F. flay— conclmmde that smmch interest payments Wum mId have minimal wood, “Possible Effects of Payment of Imsterest on Dcmnanrl effects on bank earnings. See Cates and Chase, The Payment Deposits,” in Studies on the Payment of Interest on Checking of Interest on Checking Accounts, p. viii, and Staff Study, Accounts (Washington, D.C. ‘. Anmerican Bankers Association, Board of Governors, The Impact of the Payment of Interest 1976), pp. 1—11; Charles lloffmnam, and Earlene Herman, on Demand Deposits, pp. 44-45. Page 8 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1977 in several studies cited below, most bank lending A third view of compensating balances is that banks arrangements with business firms involve compensat- require them as part of agreenients that involve pay- ing balance requiremnents. Therefore, if banks are cur- ment of implicit interest on the demand deposits that rently paying implicit interest on demand deposit business firms use as their working balances. Business balances of business firms, such hank policies would finns hold working balances to finance their transac- tend to be reflected in the nature of compensating tions, hut banks are not allowed to compete for those balance requirements. deposits with offers of direct interest payments. Oper- ating under this constraint on bank competition, firms Differing views are held as to why banks require shop to find banks which, in return for deposit of their compensating balances. One viexv is that banks re- working balances, will offer loans at lowest interest quire compensating balances simply to increase the rates and lowest fees for services. To insure that the)’ return on loans. Another view is that compensating are compensated for preferential loan tenus and low balances serve as partial collateral for loans, fees on services, banks require that firms keep certain average demand deposit balances. Thus, finns can use Of these two explanations, the argument that banks their deposits that sen-c as compensating balances for attempt to increase their returns on loans by requiring their working balances, drawing them down when hom’rowers to hold demand balances is discussed more 5 making expenditures and letting them accumulate frequently in the banking literature. According to when receiving payments. this view, a hank requires a borrower to leave some proportion of its loan with the hank as an idle demand If this third intem-pretation of compensating bal- deposit balance. Under this arrangement the effective ance requirements is correct, banks xvould tend to yield on lending to the customer is higher than the offer better loan terms and lower fees on services to stated rate on its loan, since the customer has use of their depositors than to nondepositors, but also, banks only a portion of the total loan on which it is paying would set compensating balance requirements in interest. While only a few economists explicitly state terms of average balances, rather than minim urn. this view of compensating balances, many apparently Therefore, at any point in time, demand deposit bal- support it when they claim that the true costs of bor- ances of customers holding comnpcnsating balances rowing at commercial banks must he adjusted upward would not necessardç, be some minimumn proportion from stated loan rates to reflect the additional cost of of their loans outstanding. holding idle compensating balances. Several reasons can lie given for accepting the view The accuracy of this explanation of compensating that compensating balance requirements reflect pay- balances can he tested, since it Imas several implica- ment of implicit interest on the working balances of tions for behavior. For example, the stated interest business finns, and thus, for rejecting the view that rates on loans to horrowem’s that hold compensating banks require compensating balances just to raise the balances would tend to be lower than the interest effective interest rates on loans. If banks require firms rates on loans to borrowers that do not hold compen- to hold idle compensatisig balances to increase their sating balances. Also, banks would set compensating effective yields on loans. both banks and their custo- balance requirements in termns of minimum balances, misers could benefit from elimninating such comnpensat- since compensating balances would represent simply ing balance requirements, except when usury ceilings the borrowed funds which customers are not allowed are effective. The same reasoning can be used to to use, and not their working balances. Consequently, indicate why reqsmiring mninimnm compensating bal- demand deposit balances of borrowers holding com- ances wouldl be an unprofitable way of charging for pensating balances would tend to be at least some use of bank services or of requiring borrowers to pro- minimum fraction of their outstanding loans at all vidle collateral for loans. However, as indicated in the points in time. These inferences would also follow Appendix, both banks and their borrowers can benefit from the explanation that compensating balances from average conipensating balance requirements serve as a form of partial collateral for loans. satisfied by the customers’ workmg balances. 5 Also, evidence