Mind Your P's And Reg Q's

MAR 16, 2012 8:43pm ET

Last year's repeal of the final remaining vestige of Regulation Q, the prohibition of payment of interest on business demand deposits, at long last completed a pro-competitive process which began with the Monetary Control Act of 1980.  The repeal was and is a good idea.  We can easily see this by asking and answering half a dozen simple questions, to make the matter clear.  These are:

1.       Should Congress engage in price fixing to benefit banks?

Obviously not.

2.       Should Congress prevent depositors from getting interest income that banks would be willing to pay?

Obviously not.

3.       Is it the business of Congress to try to prop up banking profits?

Obviously not.

4.       Should Congress force depositors to subsidize borrowers?

 Obviously not.

5.       Does Congress know the right price for a business checking account?

 Obviously not.

6.       Should Congress promote competition to benefit the customers of banks?

Obviously, yes.

I am tempted to say "Q.E.D." at this point and stop.  But perhaps we do need to consider how Regulation Q, a rule so obviously opposed to competitive economic principles, managed to get enacted and survive, albeit subject to frequent fiddling, for nearly eighty years.  The history of Regulation Q displays the folly of such schemes.

What did the Congress of 1933 think it was doing when it created interest rate ceilings on deposits, including a prohibition on paying interest on demand deposits, which became the rules of Regulation Q?

Well, they were trying to reduce competition and thus increase banking profits, goals now rightly out of fashion.  As stated by Alton Gilbert, a scholar at the Federal Reserve Bank of St. Louis, one objective was "to increase bank profits by limiting the competition for deposits."  In this respect, in other words, they wanted to make bank deposits a government-sponsored cartel, with the Federal Reserve as the cartel manager.  So they put the government into the role of price fixing and preventing depositors from getting the interest income they might otherwise have earned.

In the findings of the Monetary Control Act, the Congress of 1980 accurately observed the results of this program, which had by then been clear for a long time: "The Congress hereby finds that limitations on interest rates which are payable on deposits and accounts discourage persons from saving money, create inequities for depositors, impede the ability of depository institutions to compete for funds...."  

Another original reason for the ceilings, according to Gilbert, was to address "bank protests about the cost of federal deposit insurance premiums."   Federal deposit insurance was also being established in the Banking Act of 1933.  "Some members of Congress believed that the savings in interest expense resulting from interest rate ceilings on deposits would exceed the deposit insurance premiums"-an interesting political trade at the time.

Later, in the 1960s, Regulation Q rules tried to direct savings into financing housing, rather than industry and commerce, by giving savings and loans a slightly higher interest rate ceiling than commercial banks had.  This was the then well-known and now forgotten "quarter point differential."  In spite of this intention, the far bigger effect of the ceiling was to cause housing credit crunches.  These happened when market interest rates went over the ceilings and deposits were withdrawn from thrifts, thus cutting off funds from mortgage lending, of which they at the time were the principal providers.  This was a severe problem in the credit crunches of 1966 and 1969 and on into the 1970s-a problem caused by Regulation Q.

One regulatory response to this problem was to favor large depositors at the expense of small ones.  In 1970, deposits of over $100,000 were made exempt from Regulation Q, while the ceilings remained for the smaller deposits.  Thus huge amounts of money were effectively transferred from small depositors to bank profits-a result following logically from the goals of 1933, but clearly a perverse result, and equally perverse, this included transfers from small businesses with checking accounts to bank profits.

Also in 1970, in the Emergency Home Finance Act, Congress chartered Freddie Mac, to provide funding to mortgages unhindered by deposit rate ceilings.  There is no need to go into the unhappy history of Freddie Mac and Fannie Mae, but note that Freddie Mac was the son of Regulation Q: one government intervention set up to address the effects of a previous government intervention.

During the 1970s, when I criticized theory and effects of Regulation Q, a banking lobbyist memorably told me, "You have to understand that Regulation Q is so imbedded in the American banking system that it is permanent."  A poor prediction, as it turned out, although it took until 2011 for it to be completely falsified.

Because banks were prevented by the government from paying interest on business demand deposits for so long, cumbersome methods were developed to compensate for this regulatory rigidity.  The banks would provide "free" payments and operating services because the business customers were providing "free" funding to the bank.  This meant each bank had to set a theoretical (and debatable) "earnings credit" for the funds, instead of the interest it might have paid, and the theoretical fees for operating services (or "penny prices") were measured to see how much of the earnings credit they consumed.

In other words, the Regulation Q effect on business demand deposits was to encourage complex implicit pricing arrangements, instead of clear explicit pricing, and large companies employed treasury personnel to track, measure and negotiate these arrangements.  This was more difficult for small companies without internal bureaucracies, of course.

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