Citigroup can limit demand deposit withdrawals and money funds can too


Apparently, some of the ‘best reforms’ now being instituted in the U.S. to prevent a liquidity crisis in the future include limitations on demand deposits (hat tip Karl Denninger). What financial institutions are trying to prevent is a bank run in whatever form it can take – via depositors in the case of IndyMac and Washington Mutual and via interbank loans in the case of Bear Stearns.

Citibank has come up with an innovative solution – turn demand deposits into 7-day deposits:

Seen on a recent Citibank (C) statement: "Effective April 1, 2010, we reserve the right to require (7) days advance notice before permitting a withdrawal from all checking accounts. While we do not currently exercise this right and have not exercised it in the past, we are required by law to notify you of this change."…

I called Citi about it and they said the warning applies only to customers in Texas and that the notification had been mistakenly included on statements nationwide. Whatever the explanation, it doesn’t exactly inspire confidence in Citi. I’ve got nothing against Citi as a general matter — I have friends who work there, and know some account holders who are generally satisfied customers. But it’s hard to believe a bank would be sending out a notice like that on its statements.

This may be good for Citi but I wonder how it is legal. After all, the point of a demand deposit is to provide safekeeping for one’s money. Otherwise, with interest rates at zero percent, why not just keep your money under a mattress?  I find it hard to believe that Citi can simply decide to require seven days notice. I am sure that Citi uses the standard credit card tactic of issuing all affected account holders a notice in full legalese of the changes that are being instituted, giving them an option of closing their account.

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Nevertheless, this strikes me as a gross breach of trust – and a good reason we do need a consumer financial protection agency. Consumers simply do not have the financial acumen or alertness to spot this kind of move down the slippery slope to making all demand deposits into time deposits.  How many customers would get a legalese notice informing them of their rights and options and simply disregard it because it is too hard to understand or sent in the same manner as less important junk mail from Citi? And what’s to stop Citi from changing this to 14 days or 21 days?

An interested commenter on the cited article above pointed to this particular passage in a recent SEC proclamation which effectively does the same thing for money fund deposits – turning them from demand deposits into time deposits.

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Suspension of Redemptions: The new rules permit a money market fund’s board of directors to suspend redemptions if the fund is about to break the buck and decides to liquidate the fund (currently the board must request an order from the SEC to suspend redemptions). In the event of a threatened run on the fund, this allows for an orderly liquidation of the portfolio. The fund is now required to notify the Commission prior to relying on this rule.

This innovation was buried near the end of a press release from 27 Jan 2010 entitled “SEC Approves Money Market Fund Reforms to Better Protect Investors.” Again, the logic is the same; to prevent a money fund from experiencing a ‘bank run’ as some did after Lehman failed, the fund may suspend redemptions for an undetermined period. Translation: just when the economy is in a panic, you could have all access to your funds blocked indefinitely. 

While these demand deposit restrictions may safeguard individual institutions, they are unlikely to safeguard the system. You have to understand the psychology of a bank run. A demand deposit like a savings or checking account is a bank liability because the money is owned by the depositor. She is merely storing it at the bank for safekeeping and ease of use. Bank runs happen because of fractional reserve banking – in which the bank does not have all of the deposits on hand because it has lent out these funds to earn a profit. Thus, if everyone simultaneously appears and demands deposit funds, the bank would be wiped out.

Depositors understand this; and, thus, when a bank’s solvency is in question, the psychology of a run becomes self-fulfilling. In a bygone era before insured deposits, bank runs were about actually losing one’s hard earned cash. During the Great Depression, it was imperative that one got one’s money out first. Those who get their money out last were wiped out.

But today it is not about fear of losing one’s money as much as about fear of losing access to one’s money. Bank deposits are insured up to $250,000 for individuals and $500,000 for married couples.  Moreover, customers at insolvent banks now being seized regularly by the FDIC have largely seen no problem in accessing their money when their institution fails. So, right now, most people believe they will eventually receive all of their deposited funds. The key word here is eventually. If a bank run occurs in a world of insured deposits, it occurs much more because people fear they will temporarily lose access to their funds for an undefined period of time. Most people understand they will eventually receive their money, as the FDIC seizures demonstrate.

Restricting demand deposits in a way that makes it unclear when people will have access to their funds – especially since they need daily access to their checking account or money fund – makes them more likely to withdraw funds before everyone else does. Where would you rather have your funds: at an institution with withdrawal restrictions or at one without limitations on access to your funds? In essence, the Citi and SEC proclamations make the affected institutions more vulnerable, not less. This also makes the whole system more brittle and subject to the panic that uncertainty generates. If we do see another panic and liquidity crisis, watch what happens.


Citi Warns of Withdrawal Gate – Seeking Alpha

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