Senate Banking, Housing and Urban Affairs Committee

Hearing on S.1405
"The Financial Regulatory Relief and Economic Efficiency Act of 1997"

My name is Edward E. Furash. I am Chairman of Furash & Company, management and strategic consultants to the financial services industry, with a particular emphasis on banking.

SUMMARY

I urge that you take favorable action on Sections 101 and 102 of S. 1405, the "Financial Regulatory Relief and Economic Efficiency Act of l997." I have four reasons for making this recommendation.

1. It will significantly improve the ability of the Federal Reserve to conduct effective monetary policy through the use of reserve requirements, influence on interest rates and greater capacity to restore control of the money supply.
   
   
2. It will significantly improve the ability of the banking system to restore its competitiveness with the capital markets through pricing clarity and product simplification, while at the same time reduce bank risk by reducing the need to engage in sweep accounts and complex balance sheet manipulations to match capital markets interest rates.
   
   
3. The banking industry is sounder and more profitable than ever, making it possible to absorb the costs of the inevitable transition to paying interest on business demand deposits.
   
   
4. The improved outlook for Federal Government revenues and the prospect of balanced budgets in the future make this an opportune time to absorb the possible decline in revenue from paying interest on reserve balances. This is a small price to pay for enabling the Federal Reserve to conduct monetary policy more effectively. Besides, the overall impact of passing Sections 101 and 102 will undoubtedly help maintain the sound currency and improved prosperity that will increase government revenues.

TESTIMONY

The need to pay interest on business demand deposits and bank reserves stems from banking's seriously weakened role in intermediating money between investors and borrowers. Thirty, twenty, even ten or fifteen years ago banks dominated the process of converting liquid funds into loans. In those days, bank deposits were the main source of lendable funds. This is no longer the case. New financial technology has enabled capital markets players to substitute for banks by drawing deposits off into mutual funds and making loans possible through securitization or creative debt issuance. Bank deposits have dwindled as households and businesses have moved their assets elsewhere (Exhibits A and B), and commercial paper and corporate bonds now exceed commercial bank commercial and industrial loans as the dominant business financing method (Exhibit C). Similarly, consumer credit is now financed mainly by the capital markets (Exhibit D).

There are numerous other examples of how the capital markets now dominate intermediation in such areas as mortgages, auto finance, and credit cards, and securitization is an increasing factor in small business finance. Bank loan rates are set by securitization competition and deposit rates by money market mutual fund alternatives.

Banks have been able to partially counter the disintermediation of consumer deposits through paying interest on NOW accounts. But even this cumbersome device has not been available to businesses. To meet business customer demand that they be paid a competitive interest rate for their funds, banks have resorted complex arrangements called "sweep accounts." In a sweeps program, a bank automatically transfers surplus funds from non-interest bearing accounts with reserve requirements to interest-bearing accounts without reserve requirements. As a result, sweep accounts have risen to $170 billion and reserve balances have fallen to $10 billion in November 1997 from $24 billion in December 1994 (Exhibit E). This is an eerie confirmation of Federal Reserve Chairman Paul Volcker's prediction in 1983 that "the payment of interest on reserves would keep banks from creating transaction type accounts outside the depository system." In other words, the Federal Reserve would loose one of its mainstays--reserve requirements--in controlling money supply as an instrument of monetary policy.

This is just what has happened. The question before you, in my opinion, is not whether to pass Sections 101 and 102 of S. 1405, but whether these moves go far enough to restore the Federal Reserve's ability to execute monetary policy other than through the discount rate. Let us hope that these actions are at least a start in the right direction. Certainly it will encourage banks to hold money in demand deposits. It is my opinion that the Federal Reserve has not been able to control the money supply for a number of years and must eventually have greater powers over near money and other capital markets substitutes if it is to do so.

Allowing interest to be paid on business deposits and bank reserves will enable banks to compete more effectively with their "non-bank" competitors based in the capital markets. While it is not likely that the trend to capital markets instruments can be reversed, given that the capital markets are currently the cheapest place to borrow and the best place to earn interest, it is highly possible to stem the tide and reverse it slowly. Banks will be able to pay a competitive market rate for deposits and charge clear, visible prices for payments services. This unbundling will per se make banks more competitive because of such clarity. Moreover, the products will be simpler and easier to understand, producing more effective sales efforts. (See Article--"Make it Interesting") There appears to be an opportunity to draw business deposits back into the banks, thereby increasing reserves. A recent study by Treasure Strategies, a treasury management consulting firm, found that for ever $1 businesses were holding in demand deposits, another $49 were invested in mutual funds and the like. A side benefit of paying interest on business demand deposits is that it should make banks sounder by reducing the need to engage in investment manipulation solely to produce higher yields to cover both the costs of sweep accounts and to meet capital market rates.

Many concerns have been raised regarding the earnings "hit" which banks will take if they begin to pay interest on demand deposits. I have my doubts that this will be the case if only because the increased deposits that are sure to come can be invested in loans. It will also lessen the need for banks of all sizes to resort to even more expensive wholesale market funding to substitute for scarce deposits. However, there has never been a better time for banks of all sizes to "bite the bullet" because bank earnings and soundness are at an all time high (Exhibit F). Deferring tough decisions like this which are in the customer's interest--for example, resisting NOW accounts--has rarely turned out well for banks in the past. The decision will be no less painful when bank earnings are under pressure because of a weak economy.

Similarly, given currently strong Federal Government revenues and an optimistic balanced budget outlook, the government can absorb any revenues losses. Again, such potential revenue losses may be a phantom, given the help that Sections 101 and 102 can bring to the economy.

By moving ahead with Sections 101 and 102, Congress can help the Federal Reserve to implement monetary policy better, increase safety and soundness in the banking industry by enabling banks to provide market returns simply and clearly to their commercial customers, and make our banking system more competitive domestically and internationally against capital market alternative. As I read the Constitution, study the Federalist papers, and explore the debate between Thomas Jefferson and Alexander Hamilton on the kind of banking system this country ought have, I have come increasingly convinced that the role of Congress in bank regulation is to ensure a sound currency and foster prosperity for all our citizens. Sections 101 and 102 meet that test.

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