Preparing Your Bank for the Repeal of Regulation Q

With the Dodd-Frank Act going into effect in just a few short weeks, Taylor Advisors would like to touch on one aspect of the law that could have meaningful implications on the way banks do business: the repeal of Regulation Q.  As of the time of this writing, there is no consensus on how repealing this law, which prevents banks from paying interest on business checking accounts, will affect banks, or when its impact will be felt.  However, in this article, we will discuss the likely effects of the repeal of Regulation Q, as well as plans that your bank can take to be prepared when Dodd-Frank goes into effect July 21, 2011.

What to Expect: Short and Long Term

On July 21, 2011, when the Dodd-Frank Act is put into action, there will most likely not be an immediate meaningful impact relating to Regulation Q (or Reg. Q).  With historically low interest rates and an abundance of deposits in most markets, banks are unlikely to drastically change rate strategies.  Additionally, over the years banks and their business customers have side-stepped Reg. Q by using sweep and money market accounts, both of which allow businesses to earn interest while maintaining liquidity.  Taken together, these should lessen the initial impact of the new law.

Longer term, there is reason to believe that the repeal of Reg. Q will affect banks’ strategies regarding business deposits.  For one, there is the potential for rates to rise several hundred basis points, which could increase interest expense for banks.  Furthermore, changes regarding FDIC insurance on various types of accounts need to be considered.  The FDIC currently provides unlimited insurance on non-interest bearing accounts.  However, once Dodd-Frank goes into effect, all business checking accounts that begin paying interest would lose the unlimited coverage and would be subject to just $250,000.  Community banks also need to be aware that large banks have an opportunity to use their name recognition and broad financial networks in marketing campaigns in an attempt to gain deposit share in business checking accounts.

Pros and Cons of Repealing Regulation Q

When Reg. Q was first implemented during the Great Depression, one of its goals was to reduce the hyperactive competition in the banking industry, which all too often led to risky behavior in an attempt to gain deposits.  The reason for disallowing the payment of interest on business accounts was to motivate banks to focus on more sound banking practices, and thus promote stability within the industry.  In a change of course, one of the arguments in favor of repealing Reg. Q now is that it will promote competition among banks for deposits and loans, which could help stimulate the economy.

Among the arguments opposing the repeal of Reg. Q are that interest expense/funding costs will increase, which will lower net interest margin and impair profitability.  Another point is that interest rate risk may increase.  For example, paying interest on business DDAs normally would cause the balance sheet to become more liability sensitive.  A challenge then becomes managing the interest rate risk of making fixed rate loans funded by rate sensitive liabilities.  Finally, there is concern that business checking accounts may begin to show characteristics of “hot money” and chase after the highest rate available.

How to Prepare Your Bank

The strategy that your bank takes in reaction to the repeal of Reg. Q of course depends on the local marketplace and characteristics of its deposit base.  However, there are a few things that all banks can and should do to prepare themselves.  The first is to review all of the business deposit accounts at the bank.  How large are they?  How long has each account been active?  How much would it cost to begin paying interest?  How much in fee income are these accounts generating?  What is the profitability of each meaningful business DDA customer?  These are all questions relating to the internal state of the bank that need to be answered.  Externally, anticipate and monitor what other banks in your market are doing.  It is always a good practice to be proactive and have a plan in place rather than scramble at the last minute to create a deposit product if one of the competitors makes and aggressive move.

Depending on the circumstances of each individual institution, there are also several specific actions that your bank may investigate.  For example, if your financial institution needs to grow organically and/or loan demand is strong, it would be beneficial to create a marketing campaign using the repeal of Reg. Q as a tactic to gain market share.  This would also include approaching current loan customers that do not currently have any funds on deposit.  Careful market analysis would help ensure that only rate-sensitive accounts receive a higher rate, while less rate-sensitive ones receive a lower rate.

When marketing for new accounts, it is often useful to segment the businesses in your area to find companies that will yield the most profitable relationships for your bank.  For example, when segmenting by industry, professional services such as accountants, lawyers, and physicians have generally been valuable.  Other possible ways to segment the market include dividing it by company size and lifecycle.  In addition to these funds being low cost, you will often find that small business owners move their individual and family accounts to the bank as well.

Depending on the profitability analysis of the bank’s current customers and the target market analysis, the bank can then design deposit products that are tailored to their customers’ needs.  Equally as important, account fee structures could be developed that would more than offset any increases in interest expense, at least in the near term.

If deposits are abundant and there are no immediate competitive threats in the market, your bank may chose to employ a wait-and-see approach, and not pay any interest at first.  This would allow your bank to continue enjoying interest expense savings while giving the flexibility to monitor the competition and any new developments.  Many industry experts think that this option is what most banks will choose for now.

Conclusion:  The repeal of Regulation Q is one of the many significant changes brought about by the Dodd-Frank Act.  Allowing banks to pay interest on commercial checking accounts could have long-term ramifications on banks’ competitive strategies, especially in a higher rate environment.  Higher future interest expense and competitive threats are just two worries that bankers will be facing.  However, examining your market and deposit base and planning for these changes in advance will help to make sure that your bank is not caught flat-footed.

You have already subscribed to distributions. Thank you for your interest in our publications!