Financial Institution Services 
Solutions for Community Banks and Credit Unions

Deposit Reclassification: Benefits and Strategies
By Joe Moss

Deposit reclassification offers financial institutions a way to dramatically lower their reserve requirements. This opportunity was approved by the Federal Reserve Board (Fed) in 1994 and has been implemented by most large banks. Now, as transactional deposits are increasing in small and medium-sized financial institutions, community banks are also able to reap the benefits of deposit reclassification. We examine the benefits and the way reclassification works in this article.

What Is Deposit Reclassification

Deposit reclassification represents a significant change in the method by which transaction accounts (both interest and non-interest) are reported for reserve requirement calculations under the Fed’s Regulation D. As a result of deposit reclassification, interest and non-interest checking accounts are segmented into separate subaccounts unique to each account. The savings subaccount of the combined account balance is not subject to the 10 percent reserve requirement. The net impact is that your bank’s reserve requirements fall to insignificant levels. Other than an initial, non-adverse notice to the customer, this process of transferring funds to the savings subaccount is invisible to your customer.

The checking and savings sub-accounts are evaluated daily. Funds are automatically transferred from the savings sub-account to the checking subaccount if required to cover activity in the account. Concurrent with the sixth such transfer during a calendar month, the entire balance is transferred to the checking subaccount to remain in compliance with restrictions on savings accounts imposed by Regulation D.

Sample Account Example

Deposit reclassification maximizes the balance of the savings subaccount each day. This process is best described by showing the impact on a sample checking account. The chart in Exhibit 1 tracks a checking account with a starting balance of $10,000 through each day of the month. Initially, the savings subaccount would be $8,000, leaving $2,000 in the checking subaccount.

On a daily basis, deposit reclassification compares the ending balance of the customer’s checking account to the balance of the savings subaccount from yesterday and the status of the transfer counter. If the account balance is lower than the savings subaccount, a transfer is made from the savings subaccount to the checking subaccount. In that event, the transfer counter is incremented by one. In the event that the account balance multiplied by the threshold percentage exceeds the savings subaccount, a transfer is made from the checking subaccount to the savings subaccount. Since only debit transfers are counted, no increment is made to the transfer counter.

This process continues until the transfer counter reaches six. In the event of a sixth transfer, the entire account balance resides in the checking subaccount until the end of the month when the savings subaccount and transfer counters are reset.

Establishing Thresholds

Threshold percentages are established by checking product type and by balance range to identify relative volatility of checking accounts. A high balance and low volatility account (e.g., a high balance senior NOW account) would use a high threshold percentage. A low balance, high volatility account (e.g., a small business account) would use a low threshold percentage. On a macro level, the threshold percentage matrix should allow no more than 5 percent of total checking accounts to achieve the maximum of six transfers.

The impact on reserve requirements is dramatic. Before deposit reclassification, the entire checking account balance would be reserved at 10 percent. After deposit reclassification, only the checking subaccount is subject to reserve requirements.

On a macro level, 80 percent of the transaction accounts of a financial institution can be reported as savings deposits, and all the calculations and transfers are invisible to the customer!

Customer Disclosure

The Fed allows the use of deposit reclassification only if it is properly disclosed to the customer, which means proper disclosure is critical to the process. In the Fed’s opinion, the savings subaccount must be interpreted as a legally separate savings account to qualify as a savings account for purposes of Reg D. Since this process is invisible to the customer, the disclosure is the process by which the savings subaccount becomes legally separate.

There has been considerable debate about this issue among the Reg D purists. Since the customer is unaffected and no adverse change is being made to the customer’s account, the need for disclosure has been questioned. However, the Fed has been quite adamant on this issue. This process is a contractual change in the way the customer’s account is processed. To effect this change to the contract, the customer must be notified. Continued use of the account after disclosure constitutes acceptance.

We know of financial institutions that have chosen not to disclose deposit reclassification to their customers. But after their regulatory compliance examination, some have had to suspend deposit reclassification and restate reserve requirements with penalties as a result of not disclosing.

Financial institutions have also tried to disclose to the customer without truly informing the customer of the entire process. Disclosures referring to deposit reclassification as "an internal bookkeeping process only" or "an internal reclassification of deposit accounts" have also been denied by the Fed. The customer must be told that checking and savings subaccounts will be created and maintained and that transfers may occur between these subaccounts. However, the customer may be told that it will not negatively affect their account.

Many financial institutions have been concerned that the disclosure may create substantial dissension among their customers. The empirical evidence from actual disclosures suggests that negative customer reaction has been minimal, probably because they can be assured that the change is a non-adverse change to their account.

The Current Legislative Environment

The Fed has long been an advocate of paying interest on the reserve balances maintained by financial institutions. However, it would literally take an act of Congress for interest to be paid on reserves because the charter of the Federal Reserve Bank System currently does not allow for payment of interest on reserves. The current law against this practice would have to be modified by Congress.

It’s interesting to note that in every Congress since 1996, this issue has been debated and discussed in both the House and the Senate. Legislation has been passed by the House that would allow the Federal Reserve System to pay interest on reserves. But the legislation has always been acted on in conjunction with legislation allowing financial institutions to pay interest on commercial and personal checking accounts. Despite being approved in the House, this legislation has died in Senate sub-committee each time. Apparently, there continues to be disagreement in the Senate as to whether the Federal Reserve System should be allowed to pay interest on reserves, thereby reducing their Treasury Fund contribution.

Because of apparent disagreements in the Senate on this matter and other very significant legislative priorities, we believe that benefits of deposit reclassification will be available for the foreseeable future.

Systems Platform Should Be a Database Environment

Deposit reclassification can be managed internally with the help of a fairly basic database software package. The database approach has many benefits:

• Your internal accounting group can manage the process. If deposit reclassification is implemented in a mainframe environment, the specific information for each customer is not readily available for review by the finance accounting group or for regulatory inquiries. In addition, the finance accounting group is not well informed as to the specifics of the process and therefore is not ready to field regulatory inquiries either on the FR2900 Report or the call report.

• Management information is readily available to review efficiency of the algorithm. The algorithm, or system of choosing what transfers are needed, must be managed to allow the savings subaccount to be maximized. The database approach allows the finance accounting group to review the impact of the algorithm monthly, and adjust threshold percentages so that the process is maximized while still providing a uniform level of savings subaccounts over the entire month.

• The database environment can be very cost effective. Deposit reclassification can be implemented under an existing Microsoft ACCESS license using the existing PC and server platform of the finance accounting group. The financial overhead to set up the system will be far smaller than that of setting up a mainframe computer.

Implementation Action Steps

Implementation of deposit reclassification is much more than a data processing change because it involves a contractual change in the way a customer’s account is processed, using a unique interpretation of Reg D. It also represents a dramatic change in the way transaction accounts are reported to the Fed. As a result, the steps required for implementation go beyond the installation of a new piece of software. Use of this action plan ensures the proper implementation of deposit reclassification, consistent with Fed directives.

1. Obtain Federal Reserve Bank "No Objection." We recommend highly that a letter be delivered to your Federal Reserve bank outlining in detail how the program will work in your institution. You will receive a verbal confirmation if your program is consistent with programs previously approved. Included in this letter should be the actual customer disclosure developed in the next work step.

2. Develop disclosure strategy and complete the disclosure. Disclosure language must be developed and included in your letter to the Fed. It is critical that your disclosure be consistent with Federal Reserve bank directives. A statement stuffer can be used as the disclosure for existing accounts. You need to modify your Terms and Conditions sheet for new accounts.

3. Develop algorithm to maximize the balance of the savings subaccount. The algorithm used to maximize the savings subaccount should contain threshold percentages allowing only 5 percent to 10 percent of accounts to reach six transfers by the end of month. These threshold percentages should be established by balance range and account type to carefully match the volatility of specific account types. This provides a smooth reserve reduction across the entire month. A three-month sampling of actual account activity is required to develop the threshold percentage matrix.

4. Develop systems solution and implement the process. The database approach using existing download extract language from DDA systems allows the most efficient implementation. Implementation can typically begin immediately upon completion of the disclosure, since it is a nonadverse change.

Deposit reclassification represents a major opportunity for your bank to improve its net interest margins. You would be remiss not to consider it.

What's Your Profit Opportunity?

Interested in knowing what your institution's Profit Opportunity might be? Fax us two recent FR2900s and we'll run your numbers using our computer simulation to accurately quantify your profit opportunity. There is no cost or obligation for our computer simulation and your results will be ready in two to three working days, just fax two recent FR2900s to Romney & Associates at 509-455-5442.

Have questions? Call us at Toll Free at 877-604-6528

Exhibit 1. Account Example

Contact Information

For more information about any of our services, please contact:

Robert K. Romney
Microsoft Certified Systems Engineer #24406

 

Call Toll Free: 1-877-604-6528

Email: bobromney@msn.com