When the Dodd-Frank financial reform bill was signed into law it was hailed as a victory for the "little guy" and a blow to the big interests that played a role in the nation's economic meltdown.
In reality, however, a mysterious eleventh-hour amendment to the legislation — inserted without debate or open hearings — could benefit the biggest offenders and punish community banks that serve as the lifeblood for small businesses across the country. If this is not corrected quickly, the unintended consequences eventually could threaten the community bank business model with resulting negative impacts on small businesses, municipalities and the U.S. economy.
The little-known, last-minute amendment to Dodd-Frank repealed Regulation Q, which has prohibited paying interest on commercial checking accounts for nearly 75 years. While most provisions of Reg Q disappeared over time, the business demand-deposit interest rate prohibition remained. Banks compete not on interest rates but on the strength of customer relationships, customer service, credit support, credit pricing and lower costs for bank services.
This created the foundational relationship-based product in most banks' balance sheets, provided community banks with their largest source of long-term fixed-rate funding, and delivered value to business depositors through services. Recognizing this, regulators have encouraged banks to increase their relative level of core deposits, such as business demand deposits, at the expense of some other rate-sensitive deposits. They know this reduces risk in the banking system.
The elimination of Reg Q will radically change this system to the detriment of the nation's community banks. Today's competitive model for demand deposits is a level playing field based on service and relationships, two things community banks excel at compared to "too big to fail" banks. Once interest is paid on these deposits, the deposits are at risk of moving to the competitor with the biggest funding need, including TBTFs, which will be eager to offset community banks' service advantages through aggressive pricing, supported by costly ad campaigns smaller banks cannot match.
More critically, the elimination of Reg Q will likely move most community banks to a liability-sensitive position, exposing their net interest margins to losses from higher interest rates just as rates are poised to rise significantly from their historical lows. It does this by eliminating community banks' largest single source of long-term fixed-rate funding.
The S&L crisis of the 1980s, one of the most expensive bailouts in our nation's history, was precipitated by a pervasive interest rate mismatch where individual institutions took on long-term, fixed-rate exposure in the form of fixed-rate mortgage lending and funded it with interest-sensitive deposits during a protracted period of rising interest rates. The impact of funding changes means that community banks will have to have fewer fixed-rate loans, mortgages and municipal securities on their balance sheets.
Unlike community banks, the TBTFs have multiple sources of long-term funding available, which will give them an advantage in lending and investing for longer maturities. Notwithstanding their flexibility in funding, recent changes to the Federal Deposit Insurance Corp. assessment base could lead TBTFs to be more aggressive in accumulating demand-deposit funding even with an interest rate component.
With banks facing so many regulatory changes, it's understandable they have not focused on Reg Q, particularly since historically low rates will understate the initial impact of this change in 2011. However, given that rates traditionally rise 400 basis points coming out of a recession, it's easy to see how the Reg Q repeal could quickly have a multimillion-dollar impact on the typical community bank.
Consider a community bank with $600 million in assets, 25% of which are in non-interest-bearing deposits, or $150 million. If $100 million of this is business deposits and subject to interest under the repeal of Reg Q, and interest paid is 1%, the interest expense hit will be $1 million; at 2%, it's 2 million, and so on. As interest rates rise, that impact could be dramatic on a community bank. A well-run bank with a 1% ROA could see its profitability and market value decline by 10% for every 1% it pays in demand-deposit interest.
Finally, significant and costly changes will have to be made to core deposit processing software. Surely, these draconian shifts are not what Congress intended for our community banking system.
While the outlook for community banks appears to be ominous, there's still time to alter our future course. First, we need to stop the repeal of Reg Q. There's a better way to pay businesses interest on deposits. By amending Regulation D to increase the limit on the number of allowable money market account transactions, lawmakers/regulators could retain the industry's core relational DDA. Banks could then more easily sweep excess customer funds to an interest bearing MMA while still meeting the customer's funding needs. This option leaves the core relational DDA in place without having to sweep funds into an alternative off-balance-sheet product that is typically only available to larger business accounts.
The Reg Q repeal is scheduled to go into effect this summer, so the time to act is now. Contact your congressional representatives and encourage them to take immediate action to help preserve the future of community banking and its historical foundation based on relationships, service and credit support.
