From the September 2010 issue of Treasury & Risk magazine

Reg Q Wipeout

Treasurers who thought the ambitious Dodd-Frank financial reform bill would not disrupt routine cash management operations are getting a wake-up call. While over-the-counter derivatives rules and rating agency regulation attracted the most attention from treasury pros in the run-up to the bill's passage, they're now discovering that the repeal of Regulation Q could change how they deal with overnight account balances. And alterations in the coverage for bank accounts provided by the Federal Deposit Insurance Corp. could mean new banking fees and changes in how account analysis statements are handled.

Now that Reg Q is completely defunct, banks are free to pay interest on corporate checking account balances for the first time since the Depression. Just how much that will affect where cash managers keep corporate funds remains to be seen.

Some expect it to be a nonevent. What banks decide to do about paying interest on demand deposit account (DDA) balances "will not affect the way we manage cash," says George Zinn, treasurer at cash-rich Microsoft. "We already use [zero-balance accounts] to keep balances minimal and will continue to do so."

But James Haddad, vice president of finance at Cadence Design Systems in San Jose, Calif., also a big cash investor, does expect to make changes. "I think we will see more corporates keep funds at the bank," Haddad says. "The cost of transferring funds offsets much of the modest return bonus you get from using money market funds, which makes keeping higher balances at the bank a more appealing alternative."

More typical is the reaction of Jim Colby, Honeywell's assistant treasurer: "It's too soon to say. We're waiting for more information from the banks."

Some savvy observers are speculating that cash investment strategies could be in for a big change. The initial impact of erasing Reg Q will be slight, but don't let that fool you, cautions Anthony Carfang, founding partner of Treasury Strategies, a Chicago-based consultancy.

"Today, with interest-bearing accounts paying 25 basis points or less, permitting banks to pay interest on checking account balances doesn't look too important," Carfang says. "But when interest rates move up, the elimination of Reg Q, combined with FDIC transaction account guarantee programs, will cause a major competitive dislocation. It could profoundly affect the flow of capital and the risk profile of banks."

More money will accumulate in corporate DDAs, predicts Dan Geller, executive vice president at Market Rates Insight, a San Anselmo, Calif., firm that monitors and analyzes bank rates. "The Reg Q ban didn't stop corporations from earning interest on their surplus cash," Geller says. "It created workarounds to circumvent the restrictions, like using sweep accounts. To the extent that workarounds are cumbersome and operationally inefficient, it will be simpler and cheaper for banks to just pay interest on balances."

The money-moving mechanisms will gradually be phased out, he predicts. Since banks already pay interest under the workarounds, their interest costs won't go up much from paying for DDA balances, Geller adds.

Carfang seems to agree. "It won't be necessary any more to go through the sweep gyrations," he says. "The only surviving sweep product might be the money market fund."

But Carfang's not ready yet to write the obituary for sweep accounts. Sweeps and other automated workarounds to pay corporations for their cash have become so embedded in treasury practices and systems that it could be disruptive to eliminate them, even when it is legally possible to pay interest directly, Carfang points out. "An infrastructure has grown up, and banks and treasury staffs will have to decide whether they want to replace that infrastructure or not."

Of course, there's a cost involved in that infrastructure. "Rationalizing account structures could eliminate a lot of the maintenance fees and transaction fees required to optimize balances under today's practices," notes Peter Weiland, business development coordinator at Weiland Financial Group in Bannockburn, Ill., which was recently acquired by Open Solutions.

Banker Jim Graves, senior vice president for liquidity management products at KeyBank, doesn't expect the end of Reg Q to make much difference in where corporations keep their surplus cash. Sweep accounts at most cash management banks already provide an array of investment options so that cash can earn higher rates than banks are likely to offer on corporate checking account balances, Graves reasons.

"Normally, investors will see a continuum of investment options, with a euro sweep earning more than a repo sweep, which would earn more than interest on a checking account balance," he says.

Graves also expects that many treasuries will want to continue to get the earnings credit rate to cover their banking fees, which means they will keep funds in accounts that do not pay interest.

Under the new law, corporations can get full FDIC coverage on balances in checking accounts that pay no interest, or they can get insurance on $250,000 in interest-bearing accounts. A few companies may want the full coverage, at least until they are sure the economic crisis has passed, but most will want to get some return on their cash, Graves predicts.

The elimination of Reg Q could create more differences among banks and introduce new forms of competition that could reshape the marketplace. Banks now have a new tool to compete for corporate business, notes Eric Lansky, president of USA Mutuals in Dallas, Texas, which packages bank depository products for corporate investors.

"Banks will use the interest they pay on business checking accounts to compete for commercial clients," Lansky says. "This will be good for businesses, particularly small businesses. It will be bad for banks not able to pay competitive rates." And it will be bad for money funds, he adds.

But others note that banks may have limited interest in paying interest. If banks are pinched for liquidity, they could pay more on checking account balances to attract funds, but in normal times they will not want to see large balances accumulate in interest-paying demand deposit accounts and will not pay high interest rates to attract them, Graves suggests.

When banks are in a rising rate environ-ment or expect one, Geller says, they prefer to lock in lower funding rates with instruments like certificates of deposit, rather than collect deposits with floating rates that will increase their cost of funds quickly when rates go up. That means that currently banks, which have plenty of liquidity and are enjoying historically low rates, are not likely to compete aggressively to build up business DDA balances, he says.

"Banks love stable deposits," agrees Ben Campbell, president and CEO of Capital Advisors Group in Newton, Mass. Money market deposit accounts, which permit only six redemptions per monthly cycle, are more stable than regular checking accounts, so banks are likely to prefer MMDA balances to DDA balances, Campbell reasons. "Overnight DDA balances that earn interest are the least attractive form of funding for most banks," he says.

The next major movement of funds will be triggered not by the end of Reg Q, Campbell says, but by an economic recovery that gives corporate investors confidence to leave the safe harbor of bank accounts and pursue the higher returns offered by nonbank investments.

Banks appear to have three choices, says Weiland: They can maintain the status quo, since paying interest on DDA balances is not required. They can apply the soft earnings credit rate (ECR) to balances until bank charges are covered and then pay hard interest on the rest. Or they can eliminate the ECR and pay hard interest on all balances.

Carfang says that while the earnings credit rate could disappear, it probably won't. "Some companies like to pay for banking services without having to budget for them, so banks will probably offer it to keep customers happy," he says.

Whatever changes occur will take time. "The regulatory agencies still have to write the rules banks will need to follow," says Geller. "We'll have to sit tight for a while and see what the regulations say."

Sit tight, but prepare to squirm, because the changes mean more work for already stretched treasuries. "Treasury staffs will have to watch developments closely," Carfang says. "Break-even points may shift from time to time."

Companies will have to revisit the case for funds concentration, he notes. "Why would a retail chain go to the expense of concentrating cash daily when it can earn interest on funds sitting in local banks? It might make more sense to concentrate weekly." Interest on DDA balances will mean more options for corporations, which could reward those treasury staffs that continually pay close attention and act opportunistically, Carfang says, but could cost those that are less attentive and slower to act.

Cash managers may be able to diversify their banking relationships and leave more money in more banks without paying a high penalty, Carfang notes. "We may see companies redesign their bank account structures. This could affect liquidity practices significantly."

The banks' own treasurers may play a greater role in dictating deposit pricing, Carfang suggests. "They will talk to the cash management business heads about what rates are offered for which deposits or investments. Together, they'll figure out how to optimize the bank's profitability based on funds transfer pricing."

While treasury staffs need to be alert to change, they should hold off on taking action until "the market gets a new equilibrium," Carfang says.

"No one knows how the flow of funds will be altered by not just the end of Reg Q but by other, bigger changes that are going on," he says. "We're seeing the Fed charge for daylight overdrafts. We're seeing same-day settlement on the ACH, which could impact wire transfer usage. There's a lot happening now, and we're trying to figure out which are the key levers for treasury pros to watch as we all wait for the outcome to become clear."

That may take a while. Dodd-Frank mandates more than 500 new rules to cover things that are not resolved by the legislation, Carfang note. The responsibility for writing those rules is divided among 11 agencies, which means there could be inconsistencies and jurisdictional overlaps. "It will be some time before this all gets sorted out," he says.

Another change brought by Dodd-Frank is the separation of the cost of FDIC insurance from the deposit balances that are insured; instead, the cost is now linked to the assets that create risk. So increasing deposits by holding onto DDA balances will not directly increase the banks' cost for FDIC coverage, Geller points out. If they are not passing along FDIC insurance costs to depositors, they may effectively pay higher rates for those deposits, he says.

While FDIC fees are no longer calculated on deposits, they are going up dramatically, and banks will have to find new mechanisms, perhaps less transparent ones, for passing these costs on to corporate customers, Weiland notes.

"It will be harder to see a linkage between what you are paying and what you are getting and what constitutes a corporation's 'fair share,'" he says.

Treasurers should start tracking their FDIC fees immediately to establish a baseline for measuring change when it comes, he advises. "Being able to make bank-to-bank comparisons of FDIC fees will become more important to treasury staffs," he says.

The cost of FDIC coverage will go up more for the largest banks than for smaller regional banks, which could bring more disparity in price changes, Weiland notes. "Only informed cash managers will be able to see the full impact of changes to FDIC insurance," he insists.

The certain result of repealing Reg Q is uncertainty, Carfang concludes. "The bottom line is that banks will have a higher cost of funds, which will have to be recouped with higher transaction fees and adjustments to the rate structures."

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