Prohibition Against Paying Interest on Demand Deposits
The prohibition against paying interest on demand deposits, which has been in force since 1933, expires on July 21, 2011 as a result of Section 627 of the Dodd-Frank Act. The rest of this section is presented only for your historical knowledge.
Definition of “Demand Deposit”
Generally speaking, a demand deposit is a deposit that the institution is obligated to pay to the depositor “on demand,” which means whenever the depositor asks for the money. Regulation D is a little more specific, however. A demand deposit, according to Regulation D, is either of two things: first, if a deposit is one that matures, the deposit is payable on demand if the maturity period is less than seven days; second, if the account is not one that matures, then it is a demand deposit if the institution does not reserve the right to require at least seven days’ written notice prior to a withdrawal. [12 CFR 204.2(b)(1)]
- The deposit has a maturity period of seven days or more.
- The institution has reserved the right to require seven days’ written notice prior to a withdrawal against the deposit. (Again, this does not mean the institution must require seven days’ notice prior to withdrawals. It only means the institution must reserve the right to require the notice. Institutions generally do this by including a provision to that effect in their account agreements. The resulting account is, for all practical purposes, payable on demand in that the depositor can generally obtain the funds whenever he or she asks for them. But reserving the right to require notice prior to withdrawal is enough to make the account something other than a true demand deposit.)
Remember, though, that a deposit which is not a demand deposit can become one. As we saw in the previous section, an MMDA can become a demand deposit if the depositor is authorized to exceed or does exceed more than occasionally the transfer restrictions on the MMDA. Normally, the MMDA would become a NOW account, but if the depositor is not eligible to hold a NOW account, the account would become a demand deposit and the institution would be prohibited from paying interest on the account. This is true even though the institution had reserved the right to require seven days’ written notice prior to withdrawals.
We mentioned in the previous section that the most common example of a demand deposit is the ordinary noninterest-bearing checking account. Another example is a mature time deposit. Since the time deposit is mature, the institution is obligated to pay it to the depositor whenever the depositor asks for it—i.e., “on demand.”
Definition of “Interest” (and a word about premiums)
- The term interest means any payment to or for the account of any depositor as compensation for the use of funds constituting a deposit. A bank’s absorption of expenses incident to providing a normal banking function or its forbearance from charging a fee in connection with such a service is not considered a payment of interest. [12 CFR 329.1(c)]
The definition encompasses what you normally think of as interest, but also note that it excludes the absorption of the cost of normal banking functions and services by the institution. So, an institution need not be concerned that the providing of free banking functions and services in connection with a demand deposit will violate the prohibition against paying interest on the deposit. What sort of services are we talking about? The Federal Reserve Board has come up with the following list of services that are not considered the indirect payment of interest:
- Loans at preferential interest rates
- Armored car service
- Short-term overdraft privileges
- Full endorsement stamps
- Rubber stamps
- Printed checks
- Bonded safekeeping of securities
- Safe-deposit box and night depository facilities
- Maintenance of a permanent record of all checks and deposits
[STAFF OP of Jan. 3, 1974, in Federal Reserve Regulatory Service, Regulation Q, ¶2-540]
A word about “premiums” (free toasters, TVs, etc., for opening an account). Premiums were an issue of great concern when interest rates were limited. The issue was whether giving a premium constituted the payment of interest. If it did, an institution that was paying interest at the maximum rate would be violating the rate limits if it also gave a premium to the depositor. To deal with this issue, the federal regulators came up with some rules that said, in essence, that a premium would not be considered interest as long as it did not exceed a certain value and as long as it was given only at certain times.
Since deregulation, institutions no longer need to worry about exceeding maximum interest rates. Whether a premium is interest, however, is still an issue with respect to demand deposits. If giving a premium constitutes the payment of interest, then an institution that gives a premium to a customer holding a demand deposit is violating the prohibition against paying interest on demand deposits. For this reason, it is worthwhile looking at the rules.
- The premium is only given when the depositor opens an account or adds to or renews an existing account.
- The institution does not give more than two premiums per account within a 12-month period. (Institutions may not solicit accounts on the premise that an account will be divided into more than one account in order to provide more than two premiums within a 12-month period.)
- The “value” of the premiums does not exceed $10 for deposits of less than $5,000 or $20 for deposits of $5,000 or more. (If the premium is merchandise, the “value” equals its total cost, including taxes, shipping, warehousing, packaging, and handling costs. Institutions must document costs and may not average the costs of different premiums.)
A premium is also not considered interest if it is not in any way related to the balance of an account or the duration over which a balance is maintained. For example, a premium offered to a customer for accepting or using an ATM card would not be interest since it is not related to the account balance or the duration of the balance. The restrictions above relating to timing, frequency, and amount would not, therefore, apply to the premium. [12 CFR 217.101 and 12 CFR 329.103]
The premium rules we have cited are from the Federal Reserve Board and the Federal Deposit Insurance Corporation. Remember also that the prohibition against paying interest on demand deposits does not apply to credit unions.
Finally, the Federal Reserve Board is authorized to make exceptions to the prohibition against interest on demand deposits. The exceptions we described above for certain premiums are examples. The Federal Deposit Insurance Corporation is obligated to make the same exceptions for state nonmember banks. [12 USC 1828(g)] In order to eliminate the lag time between a new FRB exception and the FDIC response, the FDIC amended its regulation to automatically adopt any exceptions issued by the FRB. [12 CFR 329.3] Consequently, state nonmember banks will need to pay attention to exceptions adopted by the FRB.
Grace Period for Paying Interest on Mature Time Deposits
The prohibition against paying interest on demand deposits would seem to prevent institutions from paying any interest on time deposits once they mature. However, the federal regulations provide for a grace period to give depositors some time in which to transfer their funds or renew the time deposit after maturity without losing interest. The grace period exists primarily for the convenience of depositors.
The grace period lasts ten days. The institution may continue to pay interest (at the rate payable during the maturity period) for up to ten days on a mature time deposit until the depositor either renews or withdraws the deposit. [12 CFR 217.3, fn1; 12 CFR 329.104] So, for example, if you have a time deposit which matures on the 15th of the month, you could continue to pay interest on the deposit (at the rate payable during the maturity period) until the depositor withdraws or renews the deposit, but not beyond the 25th of the month.
An institution is not required to allow its depositors this grace period; the institution has the option of allowing or not allowing it. Furthermore, the regulations require that the institution have language in its deposit contract specifying the grace period in order to pay interest during it if the depositor withdraws. [12 CFR 217.3, fn1; 12 CFR 329.104] (No contract language is required by these regulations if the depositor renews within ten days.)