Earnings Credit Rate: A New Look at a Classic

A classic is something with enduring value and appeal. Classics not only stand the test of time; they inspire new generations to refresh or reinterpret them. This definition certainly applies to the Earnings Credit Rate (ECR), used to offset bank service fees.

For nearly 50 years, US corporations have derived value from this efficient and effective deposit solution. In today’s highly-regulated, low interest rate environment, where the pressure to reduce costs is universal, ECR is better positioned than ever to help treasurers both in the US and elsewhere in the world meet their objectives.

ECR:  A Brief History 

ECR is a daily calculation of the return that banking customers earn on funds held overnight in a demand deposit or current account. Rather than receiving hard interest, depositors receive this return in the form of an ‘earnings credit allowance’ and apply it to offset bank service charges.

This practice traces its roots to banking regulations passed in the US during the 1930s. Specifically, Regulation Q, a Federal Reserve Board (FRB) regulation enacted in accordance with the Glass Steagall Act of 1933, prohibited commercial banks from paying interest on transaction deposit accounts, and established interest rate ceilings on savings and time deposits. The ECR of today took shape in the 1960s, when the US banking industry began to provide soft dollar ‘credits’ on certain non-interest bearing deposits that were used to offset banking fees. In this way banks not only generated value for depositors, they encouraged the accumulation of banking services by lowering service expense and reinforcing the overall client relationship.

From 2008 through year-end 2012 balances in demand deposit accounts (DDAs) with ECR grew in the US, due to the Federal Deposit Insurance Corporation’s (FDIC) Transaction Account Guarantee (TAG) programme. This provided unlimited FDIC deposit insurance for balances held in non-interest bearing accounts – a valuable financial system support under the Dodd-Frank Act. During this period, treasurers viewed guaranteed bank deposits as a safe alternative to higher-risk investments and appreciated the liquidity offered, as well as the earnings credits that reduced their banking fees.

More recently, Basel III capital adequacy regulations have caused banks around the world to place much greater focus on operating balances as a source of funding. Specifically, the Liquidity Coverage Ratio (LCR) assigns lower capital requirements to operating balances (which includes balances in transaction deposit accounts) relative to other wholesale funding alternatives. As a result, banks are looking to attract operating deposit balances and pass the resulting value on to depositors in the form of higher returns. Treasurers, in turn, are using deposit accounts with ECR more aggressively to maximise operating margins and gross profit. Today, ECR continues to be industry practice in the US and is gaining traction globally.

A Classic Strategy with Benefits for Today

ECR retains its classic appeal because it satisfies many of the objectives that treasurers face, including the need for expense reduction, ready access to liquidity, improved efficiency and counterparty risk mitigation. In short, it delivers a unique combination of benefits not typically found in a single solution.

Efficiency and Cost Control:  Expense control and efficiency demands persist for treasurers. Continued weak global economic growth in recent years has brought relentless pressure to reduce expenses to sustain profits. At the same time,  global expansion and the demand to add shareholder value has meant taking on broader and more complex mandates, while coping with staff reductions and shrinking budgets.

ECR helps to address these concerns. Reducing bank fees through the use of ECR helps to raise the company’s profit and operating margin and, ultimately, its shareholder value. This type of cost impact is unique to ECR and sets it apart from interest-bearing DDAs. On the efficiency side, because ECR is automatically applied to bank service fees it requires no active intervention by treasury staff to execute, thus saving time and resources. Finally, DDAs with an ECR give treasurers the transparency they need to manage cash because balance and transaction information, along with fee details, are available on demand and included in monthly account analysis statements. 

Managing Liquidity:  Among the biggest challenges treasurers face is accurate forecasting of short-term cash. Many companies struggle to forecast out more than a few days, which makes immediate access to liquidity so critical. A recent event that put access to liquidity in the spotlight was superstorm Sandy in the US, which created its own liquidity scare when both money market funds (MMFs) and the New York Stock Exchange (NYSE) closed, limiting access to cash from securities redemptions. By contrast, funds held in DDAs were liquid because banks remained open. The incident served to prove the strategic importance of bank deposits as a critical source of liquidity.

With ECR, clients have immediate access to funds throughout the day, which simplifies forecasting. Also, a DDA with ECR does not have the constraints of notification requirements or the breakage fees associated with time deposits.

Heightened Risk: Ever since the financial crisis of 2008, treasurers have been understandably sensitive to counterparty risk. In the US, the expiration of unlimited FDIC deposit insurance on non-interest bearing deposits at the end of 2012 has led to additional counterparty screening. Even without this protection, accounts with ECR provide a safe alternative for treasury strategies that lack liquidity and transparency to underlying risk. The daily liquidity feature provides the built-in flexibility to manage counterparty risk with banking partners that have the credit rating, balance sheet strength and overall financial soundness required by the company’s internal investment guidelines.

Is ECR Right For You?

The following considerations may help to determine ECR’s suitability – or otherwise – for your organisation:

  • Is your treasury a cost centre or a profit centre?  Treasuries designated as profit centres typically prefer earning hard interest on their operating cash, since this type of return is consistent with other portfolio investments and more easily identifiable as income. Conversely, cost centre treasuries are typically tasked with reducing expenses, so they generally prefer to receive ECR rather than hard interest on DDA balances because ECR is an efficient vehicle for reducing costs.
  • Do you have bank service fees to offset? It is an obvious question, but it is important to calculate the balances required to offset fees at current earnings credit rates. Also, verify that banking fees are sufficient to absorb potential investment amounts so there are no ‘excess’ balances that are not mapped to a return.
  • Would offsetting fees be in line with your investment and accounting policies? When considering any new use of funds, it’s always prudent to consult your internal policies. You will want to ensure that the vehicle is allowable and that any economic benefit accrued – in this case, the earnings credit allowance – can be captured within your existing accounting framework.

Doing the Analysis

Once you have decided whether offsetting fees is a viable strategy, you may wish to consider the following:

  •  Determine the amount of operating cash balances that must be accessible and readily available at any given time.
  •  Review counterparty risk metrics to ensure that you allocate your ECR commitment in a way that supports your overall risk objectives. 
  •  Establish a periodic review of deposit exposures so that the deposit portfolio continues to reflect the current market environment. 
  •  When allocating deposits, consider qualitative factors such wallet share or a provider’s commitment to cash management in a particular geography. An often underappreciated counterparty risk is operating risk, or the risk that a provider will either discontinue or interrupt the service it provides. You will want to review this exposure during your analysis.
  •  Finally, work with your bank to properly integrate DDA with ECR into your account structure; for example ensuring that billing systems capture all internal groups and legal entities in scope and that required balance levels are reconciled at a frequency that facilitates optimal ECR usage.

An Expansive Future

Currently, earnings credit is undergoing a transformation as banks innovate to keep pace with market pressures and growing client demands. Some are expanding the definition of service fees to include those outside the realm of cash management, such as credit card merchant service fees and interchange. 

While ECR is now an accepted practice in numerous jurisdictions outside the US, the next generation of ECR will likely expand the concept to create borderless benefits where earnings credits can be shared across geographies, enabling clients to get greater value from global balances. These new features will make ECR programmes attractive to a broad range of companies and ensure that ECR remains a classic.

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