Frederick T. Furlong

Gary C. Zimmerman

English

Research Papers in Economics

December9_1983
Deregulation and Withdrawal Penalties
For the most part, minimum early with-
drawal penalties appear to have been, or
at least were perceived to have been, suffi-
ciently harsh to discourage massive early
withdrawals by depositors merely to take
advantage ofsharp rises in interest rates.
Data available on penalty income associ-
ated with premature withdrawals suggest
that, while early withdrawals responded to
increases in interest rates, the volume of
withdrawals in the aggregate never repre-
sented a largefraction oftotal small-
denomination time deposits. Minimum
early withdrawal penalties also may have
Minimum early withdrawal penalties,
however, had another function that made
them an importantadjunct to interest-rate
ceilings on deposits. For many years small-
denomination deposits (less than $100,000)
were subjectto fixed interest rate ceilings.
These ceilings were structured so that
maximum rates payablewere loweron
short-term accounts than on longer-term
accounts. In this context, early withdrawal
penalties were needed to enforce the rate-
ceiling differentials on the various time
and savings accounts. For example, in the
absence of regulatory minimum penalties,
an institution would have been able to cir-
cumvent the lowerceiIing On passbook
savings accounts by issuing a higher-ceiling
long-term time deposit that allowed imme-
diate access to the funds without penalty.
In the late 1970s and early 1980s, as fixed
ceilings on some time deposits were re-
placed by indexed ceilings Or were removed
completely, early withdrawal penalties also
were required to prevent de facto deregula-
tion ofall time and savings deposits.
establishing withdrawal penalties, regu-
latory minimums may never have been
needed since depository institutions could
be expected to set theirown penalties or
make other arrangements to be compen-
sated for allowing premature withdrawals.
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Depositderegulation often is thoughtof as
synonymous with removing interest-rate
ceilings. While deposit interest-rate ceilings
certainly have attracted most ofthe atten-
tion, many other aspects ofdeposit account
contracts alsohavebeen affected byderegu-
lation. Oneofthese is the early withdrawal
penalty. Following the removal ofrate ceil-
ings and the reduction in the regulatory
minimum withdrawal penalties on October
1, 1983, some institutions established their
own more stringent withdrawal provisions,
when, before deregulation, they more-
or-less routinely adopted the minimum
penalties specified by regulations as
maximum penalties.
To provide some perspectiveon the changes
in withdrawal penalties, we will examine
the role early withdrawal penalties have
played in deposit regulation and howthe
easing of the regulatory minimumsfits into
the overall scheme ofdeposit deregulation.
We also will review the recent changes in
the regulatory minimums and illustrate why
the new minimum penalties do much less
than theold ones todiscouragewithdrawals
from time deposits during periods ofrapidly
rising interest rates. Finally, we will lookat
what commercial banks and thrift institu-
tions are doingwith regard to early with-
drawal penalties.
Role of minimum penalties
Minimum early withdrawal penalties have
been an integral partofdeposit regulation.
. One of the arguments usually raised in sup-
portofsetting regulatory minimum penalties
is that they are necessary to protectdeposi-
tory institutions from liquidityand earnings
pressures stemming from withdrawals of
time deposits when interest rates increase
substantially. Such protection often has
been thoughtto be particularly importantfor
thriftinstitutions and some smallercommer-
cial banks that tend to invest in longer-term
assets. But, ifthis were the only basis forIF0<:'Cdl(§!;;W icl\ll IR< ~~:g)c~ WW(~
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of lhv r(-"c!prai !\('s(:rve Bank of )JIl Fl'iHli.\·;CO.
or 01 the Hoard of COV('IT10rs of tlH' f'cdcral
!<:<';;,crv(' Sv:'>ten1.
been successful to a certain extent in en-
forcing the interest-rate ceiling differentials.
However, evaluating the impactofwith-
drawal penalties in this regard is difficult
because incentives to circumvent ceilings
were dampened by regulatory changes that
permitted depository institutions to pay
"marketrates" on short-term deposits.
Howeverwell regulatory minimum with-
drawal penalties performed in the past, they
are not likelyto be particularly useful in the
future. On October 1, 1983, the deregula-
tion of interest rates on deposits neared
completion when the Depository Institu-
tions Deregulation Committee lifted rate
ceilings on time deposits with maturities of
32 days to 2% years. The only remaining
"rate ceilings for non-transaction accounts
are those on passbook savings and time
deposits in denominationsofless than
$2,500 and with maturitiesof7 to 32 days.
Obviously, once these ceilings are gone,
regulatory early withdrawal penalties will
not be needed to enforce the ceiling-rate
structure.
In addition, since the move to deregulate
deposits reflects in part the desireofthe
Congress to reduce government involve-
ment in private markets, it would be incon-
sistent to continue to regulate early with-
drawal penalties as a means of "protecting"
depository institutions. Finally, as will be
shown below, the regulatory minimumearly
withdrawal penalties may have been re-
duced to the point where they already have
little practical importance in the current
deregulated environment.
New minimum penalties
EffectiveOctober 1,1983, the minimum
regulatory early-withdrawal penalty on
deposits with maturitiesof32 days to 1 year
was reduced tothe loss of1monthofsimple
interest from the previous 3 months of
simple interest. The penaltyfortimedeposits
with maturities of 1 year or more was low-
ered from the loss of6 months ofsimple
interest to the loss of3 months. The new
2
minimum penalties apply only totime
deposits issued on orafter October 1, 1983.
For time deposits with maturities of7to 32
days, the regulations concerning early with-
drawal were notchanged.
The effects of lowering the minimum early-
withdrawal penalties are illustrated in the
charts. They show "break-even" yields for
timedepositswith original nominal yieldsof
10 percent under the newand old penalty
rules. A "break-even" yield represents the
annualized nominal interest rate necessary
on an alternative instrumentwith amaturity
equal to that remaining on the deposit with-
drawn to compensate the depositorfor the
penalty incurred. These figures do not take
into account that the tax-laws allow the
penalties to be deducted from taxable
income. This tax advantage would reduce
the break-even yields under both sets of
withdrawal penalties in relation to an
individual's marginal tax rate.
The charts show that the new minimum
penalties do much less to deterearlywith-
drawalsthan did the old ones. As can be
seen in Panel A, for alO percent, 11-month
timedepositthatalreadyhas been held for 3
months, the interest rate on a time deposit
account (or other interest-bearing instru-
ment with the appropriate 8-month matur-
ity) would have to be only about 11.2 per-
cent, or 1.2 percentage points higher, for a
depositorto be compensated forterminating
the existing account and establishing a new
oneunder the current minimum penalty.
Given the same set ofcircumstances, the
minimum withdrawal penalty effective
before October 1 would have required the
interest rate differential on the new and old
deposit accounts to have been three times
larger, or 3.7 percentage points higher,
before adepositor could have taken advan-
tage ofthe higher yields.
For the longer-term deposit (3%-year
account) shown in Panel B, the differences
in the break-even yields under the old and
new rules are particularly noticeable as anBREAK·EVEN YIELDS FOR DEPOSIT ACCOUNTS
WITH NOMINAL RATES OF 10 PERCENT
S",ak.aven yield A. OrIgInal maturtly: 11 months
(percent}
30
«<fA
~=J
m
30 36
Old reguletory
withdrawal penaltx.
8. Original maturity: 3\1, years
15
i
/1
10.9% 11.9% ,,_....... Naw regulatory __________ ... wlthdr/lwal panalty
10
06121824
30
20
25
Sroak·evan yield
(parcenl)
35
With other withdrawal penalties which do
not vary with interest rates, commercial
banks and thrift institutions continue to bear
some ofthe risk ofa rise in interest rates.
However, depository institutions still could
be compensated for providing withdrawal
options and bearing risk ildepositors were
willing to accept a lowerexplicit interest
rate. The rate concession required byan
institution would depend in part on the
stringency ofthe withdrawal penalty and
expectations concerning the volatility and
the direction ofchanges in interest rates.
Conclusion
Regulatory minimums on early withdrawal
penalties were logical companions to
interest-rate ceilings on deposits. As deposit
rate ceiIings were removed, relaxing
minimum penalties was equally logical.
Although further reduction and the eventual
elimination ofregulatory minimum pen-
alties can be expected, they already may
have shrunk to the pointwhere they are no
longer binding.
The fading importanceofregulations on
withdrawal penalties does not mean the
disappearance ofsuch penalties, however.
Commercial banks and thrifts have an
incentive to provide compensation to them-
selves for offering withdrawa.1 options. With
policies decided on an individual basis,
withdrawal penalties are not likely to be
as uniform as they have been in the past.
As deposit deregulation approaches com-
pletion, depositors may find that there are
tradeoffs between the interest rates offered
on depositsand the stringency01early with-
drawal penalties.
Frederick T. Furlong
andGary C. Zimmerman
Months held
"Lul obsal'lallon la lor a deposIt account hatd lor 40 months
3
Old regulatory
withdrawal panalty ,.
New regulatory
wllhdrawal penalty
-----_##-,,">-
15 13.7%
1t2% ------------ 10L.r.==::..L.~~_'~~~~~
012345678910
Months held
"Lut obsal'lellon Is lor a depoelt account hald los 9 months
20
2'
account approaches maturity. Underthe
new rules, rates would not have to rise by
very much forearlywithdrawalsto be profit-
able even for long-term deposits that have
been held for some time. For example, ap-
plying the current minimum penalty, even a
year after opening a 3V,-year account, a
depositor could earn a higher return by
investingthe funds in a newaccount ifrates
were to increase by a little more than one
percentage point. Such an increase is small
compared tothemovements in interest rates
over the past few years.
Underthe last arrangement, depositors have
access tofunds held in time accounts when
interestrates rise, but they must incur an
explicitpenaltyequal to the value ofthe
withdrawal option, much like the discount
on a bond traded in the secondary market.
Reaction ofinstitutions
The combination ofreducing regulatory
earlywithdrawal penalties and lifting inter-
est rate ceilings has given depository institu-
tions greater flexibility in setting their own
provisions on withdrawals. Among institu-
tions in the West, many apparently have
incorporated the new regulatory minimum
penalties in their depositaccount agree-
ments, buta numberofinstitutions have
selected more stringent measures. Among
the institutions adopting more forceful
stances, some have set the penalties equal
to the regulatory minimum in effect before
October 1, 1983. Otherdepository institu-
tions have established withdrawal penalties
that are between the newand the old regu la-
tory minimums. At least one institution has
instituted withdrawal penalties that virtually
wipeoutanygains related to arise in interest
rates when funds are withdrawn from a time
deposit prior to maturity. It accomplishes
this by applying the greaterofeither the
regulatory minimum penalty or a penalty
based on the diffe'rence between the interest
rates on the deposits to be withdrawn and
the interest being paid on newdeposits, the
amount withdrawn, and the time remaining
to maturity on the deposits withdrawn.SS'ltl::l .lSI:lI::l
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BANKING DATA..,-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
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Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
11/23/83
Change·
from '
11/16/83
Change from
year ago
Dollar Percent
Loans'(gross, adjusted) and investments'" 163,112 135 851 0.5
loans(gross, adjusted) - total# 142,976 - 114 1,197 0.8
Commercial and industrial 43,588 - 44 - 1,399 - 3.1
Real estate 57,500 8 250 0.4
loans to individuals 25,096 83 1,538 6.5
Securities loans 2,830 30 401 16.5
U.S. Treasury securities* 7,701 9 1,111 16.9
Othersecurities· 12,434 - 30 - 1,457 - 10.5
Demand deposits - total# 41,550 -1,919 847 2.1
Demand deposits - adjusted 28,300 -1,480 684 2.5
Savings deposits - totalt 66,032 - 43 33,646 103.9
Timedeposits - total# 70,290 869 - 28,853 - 29.1
Individuals, part. & corp. 64,596 749 - 24,448 - 27.5
(large negotiable CD's) 17A84 525 - 17,860 - 50.5
Weekly Averages
ofDaily Figures
Member Bank Reserve Position
Excess Reserves (+)/Defidency(-)
Borrowings
Net free reserves (+l/Net borrowed{-)
Weekended
11/23/83
38
5
33
Weekended
11/16/83
135
13
122
Comparable
year-ago period
118
o
118
* Excludes trading account securities.
# lnc;!udes items not shown separately.
t Includes Money Market Deposit Accounts; Super-NOW accounts, and NOW accounts.
Editorial commentsmay beaddressedtotheeditor(Gregory Tong) Ortotheauthor....Freecopiesof
this and other Federal Reserve publications can be obtained by callingorwriting the Public Informa-
tionSection,Federal ReserveBankofSan Francisco, P.O. Box 7702,San Francisco 94120. Phone (415)
974·2246. .

Deregulation and withdrawal penalties

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Deregulation and withdrawal penalties

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Research Papers in Economics