Sweep Accounts

“Sweep accounts” refer to accounts for which a computer program “sweeps” excess funds overnight from checking accounts, which must meet mandated reserve requirements, to money market deposit accounts (MMDA), which are exempt from reserve requirements. Since reserves earn no interest, depository institutions feel an incentive to minimize reserve holdings. The Federal Reserve System gets its name from one of its principle assignments, which is to insure that depository institutions (commercial banks, thrifts, and credit unions) maintain adequate reserves. Only two assets can serve as reserves, cash in the bank vault, or an account at a Federal Reserve Bank.

The Federal Reserve System requires depository institutions to hold a percentage of checking account deposits in the form of reserves. Depository institutions may hold a balance directly with a Federal Reserve Bank, or indirectly through a correspondent institution, which holds deposits in a Federal Reserve Account for other depository institutions on a “pass through” basis. Checking accounts are subject to reserve requirements because these accounts undergo a high rate of daily turnover in the form of new deposits and new withdrawals. Banks must hold reserves to cover the days of heavy cash withdrawals relative to new deposits. MMDA accounts experience less activity in terms of daily deposits and withdrawals and are therefore exempt from mandated reserve requirements. To be exempt from reserve requirements, an MMDA cannot allow more than six withdrawals per month. The withdrawals can be in the form of either writing a check or a pre-authorized transfer. MMDA’s attract depositors by paying interest.

Banking industry data suggest that without mandatory reserve requirements, a typical bank would elect to hold vault cash equal to roughly 5 percent of transactions accounts, and deposits at the Federal Reserve equal to roughly 1 percent of its transaction accounts. Since the mandated reserve requirement for transaction deposits usually ranges between 10 and 20 percent, banks regard themselves as paying a “reserve tax.” Reserves are assets that earn no interest, and banks must hold more reserves than they think necessary do conduct day-to-day banking operations. Therefore, banks stand eager to embrace any procedure that enables them to reduce reserve holdings within the constraints of the legal reserve requirements.

In January 1994, the Federal Reserve Board, the governing body of the Federal Reserve System, gave commercial banks the go ahead to use a new type of computer software that dynamically reclassifies balances in customer accounts from transactions deposits (demand and other checkable deposits) to money market deposit accounts. At first, the new practice caught on slowly, but after April 1995, it spread quickly.

Key to sweep accounts is the MMDA, which did not come into being until 1982. In the 1970s, when paying interest in checking accounts was illegal, banks began “sweeping” customer deposits into overnight repurchase agreements. An overnight repurchase agreement refers to a situation in which a bank sells a treasury bill to a customer overnight and “repurchases” it the next day at a higher price. Repurchase agreements were a way of indirectly paying interest on a checking account that could not legally pay interest. Only the bank’s largest customers benefited from “sweeping” into repurchase agreements. The development of MMDAs in the 1980s allowed depository institutions to apply the procedure of “sweeping” to a much larger range of depositor accounts. It also relieved commercial banks of the need to keep an inventory of treasury bills on balance sheets for overnight repurchase agreements.

Sweep accounts appear to have removed the statutory reserve requirements that depository institutions face. That is, with intelligently designed software, banks can reduce required reserves to below the levels banks would voluntarily choose to hold to cover day-to-day banking operations. At first some observers feared that the spreading use of sweep accounts might force banks to turn to the federal funds market more often for overnight loans, causing more volatility in the federal funds interest rate. The federal funds rate is the key target interest rate the Federal Reserve regulates in the conduct of monetary policy. Greater volatility in the federal funds market might hamper the Federal Reserve’s ability achieve its goals. Problems in this area, however, never materialized.