Federal Reserve Board chairman Arthur F. Burns warned Congress yesterday that permitting banks and other financial institutions to pay interest on checking accounts could threaten the "safety and soundness of our banking system."
Burnes testified that certain safeguards are needed if Congress authorizes these accounts (called NOW, or negotiated order of withdrawal, accounts) to keep banks from dropping out of the Federal Reserve system because of the high cost of paying interest on deposits that by law now must be interest-free.
Burns supported an administration bill that would permit the Fed. to pay interest on the reserves that member banks must keep on deposit with the central bank. Non-member banks can keep their state-required reserves in interest-bearing securities such as Treasury bills.
If Congress does not pass the administration bill -- or approve some other safeguards -- many weak banks will drop out of the Fed. system when faced with the need to pay interest on NOW accounts.
"For such institutions, cost cutting is understandably a pressing matter. But it is precisely those banks that can least afford to forfeit the insurance policy of ready access both to Federal Reserve counsel and to the discount window" which provides funds to banks strapped for cash.
But Sen. William Proxmire (D-Wis.) and chairman of the banking committee was critical of the idea of paying interest to Fed. member banks.
He said that the administration proposal represents a $600 million bonanza for big banks. The administration bill sets a limit on the total amount of interest the Fed could pay on member bank deposits at 10 per cent of the Fed's earnings. Last year the central bank earned avout $6 billion in interest on the Treasury securities it manages as part of its open market operations.
Treasury Secretary W. Michael Blumenthal told Proxmire that the cost to the government would be much less than $600-million. The Fed normally returns to the Treasury whatever portion of its interest income it does not need to finance the operations of the system.
Blumenthal said that Fed studies estimate that if the present rate of withdrawals from the system continue, the loss to the Treasury would be between $200 million and $300 million a year in a few years, so the net loss of paying interest would be much less than the $600 million limit set in the bill.
Both the Nixon and Ford administrations proposed legislation that would have sharply restructured the entire financial system. In 1975 the Senate approved an omnibus financial reform that failed to go anywhere in the House.
Blumenthal said the Carter administration's financial reform package is much smaller. Essentially, it provides for an extension of NOW accounts from a six-state New England experiment to a nationwide program and permits the Fed to pay interest on member bank reserves.
Burns, who testified after Blumenthal, said that he would prefer that the Fed be permitted to pay as much as 15 per cent of its earnings as interest on member bank reserves to give the agency more flexibility in dealing with dropouts from the system.
Over the last eight years, 430 banks have withdrawn from the Fed system. Another 90 left as a result of mergers with non-member banks. About 5,700 banks are members of the Fed system.
In 1950, Burns said, member banks had 88 per cent of the total deposits in the nation. On May 30 that had fallen to 73 per cent. In New England, because of the increased costs of NOW accounts, Burns said member-bank deposit shares fell from 75 per cent at the end of 1974 to 70 per cent at the end of 1976.
"The erosion accelerated sharply in the first five months of 1977, so that at the end of May, the New England member banks held only about 63 per cent of that region's commercial bank deposits."
The Federal Deposit Insurance Corp., which provides deposit insurance at most banks in the country, said that while some decline in New England bank earnings could be attributed to NOW account costs, it found no banks whose earnings were seriously eroded or whose soundness was affected by NOW accounts.