The Early-withdrawal Penalties

Regulatory minimum penalties

Federal Reserve Board Regulation D (12 CFR 204.1 et seq.) is the only regulation which specifies early-withdrawal penalties for time deposits. Formerly, early-withdrawal penalties were specified by the regulations of the Federal Deposit Insurance Corporation (FDIC), the Federal Home Loan Bank Board (FHLBB), and the Federal Reserve Board. In the next subtopic, we will discuss why only Regulation D currently requires minimum early-withdrawal penalties. For right now, you only need to know what the Regulation D penalties are.

Regulation D has two minimum early-withdrawal penalties. They are:
  1. For all time deposits, a penalty of at least seven-days’ simple interest on amounts withdrawn within the first six days after deposit; and
  2. For time deposits from which you permit partial withdrawals, a penalty of at least seven-days’ simple interest on amounts withdrawn within six days after each partial withdrawal.

[12 CFR 204.2(c)(1)(i)]

The first penalty clearly must be imposed if a withdrawal occurs within six days after the time deposit is opened. Does it also apply to withdrawals made within six days after an additional deposit is made to an established time deposit? The only guidance we have found comes from Supplementary Information accompanying some Regulation D changes issued on December 31, 1996. At that time, the Board stated:
The Board believes that a bank may account for deposits and withdrawals either in order of deposit (FIFO) or in inverse order of deposit (LIFO). Therefore, the regulation does not prescribe an accounting policy to be applied to such withdrawals. However, the Board does expect that a depository institution will be consistent in its choice of policy in this regard. (See the Federal Register for December 31, 1996, at page 69023.)
The second penalty is a little confusing, as well, and the Board had this to say about it:
In the case of a time deposit account deposited in one lump sum, the Board regards a partial withdrawal from the time deposit as a withdrawal of the entire deposit followed by a new deposit of the balance retained. (See the Federal Register for December 31, 1996, at page 69023.)

So the second penalty is really just a restatement of the first, intended to clarify that the penalty must be imposed during the six-day time period following the “redeposit” of the balance remaining after the partial withdrawal.

What is the consequence of offering a time deposit and not imposing these early-withdrawal penalties? The answer is that the deposit changes its character. The deposit becomes a savings deposit if it meets the Regulation D requirements for being a savings deposit. If not, it becomes a transaction account and is subject to reserve requirements. [12 CFR 204.2(c)(1)(i)] The change in character would also mean the institution would have to report the deposit differently in its call report.

Although these are the required-minimum early-withdrawal penalties for time deposits, not many institutions actually impose penalties exactly matching these. Most impose greater early-withdrawal penalties. Our next topic explains why.

Common early-withdrawal penalties and the historical reasons for them

Most institutions with which we are familiar impose one of the following two sets of early-withdrawal penalties:
  1. One month’s interest on the amount withdrawn for time deposits with original maturities of one year or less, and three month’s interest on the amount withdrawn for time deposits with original maturities longer than one year; or
  2. Three month’s interest on the amount withdrawn for time deposits with original maturities of one year or less, and six month’s interest on the amount withdrawn for time deposits with original maturities longer than one year.

These two sets of early-withdrawal penalties are common because they are carryovers from what were the required minimum early-withdrawal penalties at different times during deposit account deregulation. In 1980, Congress created the Depository Institutions Deregulation Committee (DIDC) and charged it with the responsibility of gradually deregulating deposit account interest rates and early-withdrawal penalties. [See the Depository Institution Deregulatory and Monetary Control Act of 1980.] In the course of doing so in the early to mid-1980s, the DIDC first required the three- and six-month penalties, and later the one- and three-month penalties. Many institutions decided not to change their penalties when the DIDC lowered the minimum requirements. This was permissible since the DIDC requirements were minimums and institutions were free to impose penalties greater than the minimums. The one- and three-month penalties are especially popular since they were the minimum penalties in effect when the DIDC went out of existence in 1986, which is also when the Regulation D minimum penalties went into effect.

So, in short, the three- and six-month penalties and the one- and three-month penalties are common simply because many institutions were used to imposing them, had CD forms and disclosure forms with these penalties printed on them, and were under no legal obligation to reduce their penalties when new required minimums were imposed, since the minimums were always being reduced and the old penalties were safely in excess of the new minimums.

Calculating the penalty on variable-rate time deposits

All the early-withdrawal penalties we’ve looked at, both the required minimum penalties and the more commonly imposed penalties, equal the interest the amount withdrawn would earn over a given time period. However, it is hard to say how much interest a deposit would earn over a given time period if the interest rate on the deposit is variable, or changes over time. Suppose the penalty for early withdrawal on a particular variable-rate time deposit is one month’s interest on the amount withdrawn. In order to determine how much interest the amount withdrawn could have earned in a month, you have to decide which of a number of possible interest rates to apply. Should it be the rate that is in effect at the time the early withdrawal takes place? Or should it be the rate that was in effect at the time the account was opened? Or should it be some sort of average of the interest rates that were in effect up to the time of the early withdrawal?

There are currently no regulatory requirements as to which rate you should use in this calculation. However, the DIDC had requirements for this calculation. Although the DIDC requirements are no longer binding on financial institutions, it’s interesting to know what they were, since many institutions still abide by them. These rules appeared in the Supplementary Information included with regulatory changes the DIDC issued in March of 1982. See Docket No. D-0022.

The DIDC rules varied depending on whether the interest rate on the deposit was tied to an index outside the institution’s control. If it was, then the institution had three options in calculating the early-withdrawal penalty. It could: (1) use the rate in effect on the date the account was opened, (2) use the rate in effect on the date of the withdrawal, or (3) use the average of the rates in effect during the term of the deposit. The institution could use any one of these methods, but was required to specify in the deposit contract which method would be used.

If the interest rate on the account was not tied to an index outside the institution’s control, then the institution was required to use an average of the simple interest rates on the deposit during the time period that the deposit was outstanding.

Let’s look at an example to illustrate these methods. Suppose you have a one-year time deposit that carries an early-withdrawal penalty of one month’s interest on the amount withdrawn. The interest rate is variable and changes monthly. The depositor opens the account on June 1. The depositor makes the early withdrawal on September 1. The annual interest rate in June was 8%; in July, 9%; and in August, 10%. If the interest rate is tied to an index which is outside the control of the institution, the institution has the authority to compute the early-withdrawal penalty as one month’s interest at 8% per year (the starting rate), or 10% per year (the rate at the time of withdrawal), or 9% (the average of rates in effect during the term of the deposit—8% plus 9% plus 10%, all divided by three). The institution would have to specify in its deposit agreement the method it intended to use.

If the interest rate were not tied to an index outside the control of the institution, then the rate used to calculate the early-withdrawal penalty would have to be 9%, the average of the rates in effect during the term of the deposit.

Again, none of these methods of calculating the early-withdrawal penalty on variable- rate time deposits is binding on financial institutions anymore. You are free to use any of these methods in any circumstances, or use a completely different one. However, we do recommend that you specify in your account agreement or your penalty disclosure the method you will use.