Evelyn F. Carroll
E. Gerald Corrigan - Managing Director, Goldman Sachs & Co. and Past President, Federal Reserve Banks of Minneapolis and New York
Published January 1, 1982
The rapid changes occurring in the United States financial sector are by now familiar, forming part of a pattern that has been evolving since the early 1970s. Unregulated financial institutions (and even some nonfinancial institutions) have moved into some traditional banking activities, operating without the restrictions imposed by regulation on banks. Simultaneously, depository institutions have broadened their focus to offer a fuller range of financial services. Many of these developments have gone so far, so fast, that they are now almost taken for granted even though, on the spectrum of even "recent" financial history, they are all "new."
Securities firms, insurance companies, and other nondepository institutions have moved aggressively to provide a range of liquid financial instruments. Money market mutual funds, which were inconsequential until 1979, now number more than 160, with some $190 billion in assets. Many of these funds pay a market rate of return and offer check-writing services. The total volume of fund assets has expanded enormously over the past three years, with growth rates far surpassing those at traditional depository institutions.
Large manufacturing and retail firms have moved into the commercial and retail lending businesses. Sears, Roebuck and Co., for example, owns a savings and loan association, and in 1981 acquired a major securities brokerage house and the nation's largest independent broker and real estate dealer. General Electric operates a broad range of financial services, including commercial and retail lending and insurance. Recently, it also purchased an industrial loan company, which takes savings deposits.
|The Prudential Insurance Company of America||acquired||Bache Group, Inc.|
The world's largest insurance company with assets of $59.8 billion at 12/31/80 and 1,700 offices.
One of the nation's largest brokerage houses with assets of $3 billion at 7/31/80 and 200 offices.
|American Express Company||acquired||Shearson Loeb Rhoades|
A major services and travel company with assets of $19.7 billion at 12/31/80 and 1,500 offices.
The nation's second largest brokerage firm on the basis of total capital with assets of $2.9 billion at 12/31/80 and 270 offices.
|Citizen's Federal Savings and Loan Association||merged||West Side Federal Savings and Loan of New York|
A San Francisco-based savings and loan association with assets of $3 billion at 9.4.81 and owned by National Steel Corporation.
A savings and loan association with assets of
$2.5 billion at at 9/4/81.
|Washington Savings and Loan Association in Miami Beach|
A savings and loan association with assets of $1.3 billion at 9/4/81.
|Phibro Corporation||acquired||Salomon Brothers|
Reputed to be the world's largest publicly held commodity trader with assets of $5.4 billion at 12/31/80.
One of the world's largest private investment banks and among the largest bond trading firms.
|Sears, Roebuck and Co.||acquired||Dean Witter Reynolds Organization Inc.|
The nation's largest retailer with assets of $28 billion at 1/31/81 and over 3,600 stores and sales outlets.
One of the nation's largest brokerage companies with assets of
$2.3 billion at 8/31/81 and 295 offices.
|Coldwell Bank & Co.|
The nation's largest independent broker and real estate dealer with assets of $241 million at 9/30/81 and 430 offices.
Manufacturing firms have also moved directly into the consumer banking business. Gulf and Western acquired a federally chartered commercial bank in 1980. The bank is not covered by the Bank Holding Company Act because it does not make commercial loans.
In 1981, a steel manufacturing company became the owner of one of the largest federal savings and loan associations in the country. Citizens Federal Savings and Loan Association, San Francisco, merged West Side Federal Savings and Loan of New York and Washington Savings and Loan Association in Miami Beach, forming a nationwide $7 billion financial institution. Citizens is owned by National Steel Corporation.
Depository institutions have developed new services, including NOW accounts, automatic transfer services, a variety of money market certificates, retail repurchase agreements, and account sweeping arrangements to attract funds.
And generally, there has been a proliferation of new financial markets and instrumentsfutures, forwards, options, IRAs and so on.
These developments have appreciably altered the financial environment. To some degree, regulatory constraints in the face of changing economic conditions have contributed to the changes in the financial industry that are in evidence today. Be that as it may, a formerly stableor even staidindustry has been thrown into turmoil, as competitive pressures have mounted and institutions have scrambled to preserve or to expand their "turf". Most in the financial industry see even greater change in the decade ahead. In all of this, legitimate public policy considerations must remain an integral part of our thinking about financial evolution.
The U.S. regulatory posture toward depository institutions has changed remarkably little since the 1930s, when major reforms were adopted in the wake of financial dislocations associated with the stock market crash and the Depression. The details of much of our current approach were implemented at that time to help restore and ensure an orderly financial sector and to promote a "safe and sound" banking system. In some fundamental ways, however, the underpinnings of the approach to financial regulation that emerged in the 1930s and remain in place today stem from attitudes and philosophies with origins that can be traced to the earliest days of this republic.
Major premises of our regulatory stance, for example, include a separation of banking and commerce (as well as separation of commercial and investment banking), limitations on geographic expansion by banks, and careful oversight of bank risk-taking. The separation of banking and commerce is based on a long history of concern in this country over potential concentration of financial power and the possible abuse of such power. Similar concerns underlie to an extent the limitations imposed on the geographic expansion of banks. These traditions, coupled with a legislative and regulatory framework including federal deposit insurance, Regulation Q interest rate ceilings, prohibition of interest payment on demand deposits, reserve requirements, and risk evaluation guidelines are more than a manifestation of an evolving national psyche. Indeed, in an immediate and practical sense they were designed to promote stability in the financial system and, in a more indirect way, have also come to contribute to a framework in which monetary policy can function with effectiveness.
This regulatory structure seemed to perform well, at least through the 1960s. To some extent, however, its longevity is attributable to the fact that many of its provisions were not severely binding in those earlier years. The overall structure was reasonably well-balanced. It inhibited bankers from taking unduly risky positions, but did not severely affect "traditional" bank operations.
Regulation Q ceilings, for example, were comfortably above short-term market rates and market rates were so low that the prohibition of interest payment on demand depositsor for that matter, on required reserveswas not a critical issue. Few banking organizations had ever been heavily involved in nonbanking activities, and only a handful of large ones were significantly affected by the separation of commercial and investment banking required by the Glass-Steagall Act. The locational restrictions inherent in the McFadden Act and, later, the Douglas Amendment to the Bank Holding Company Act were a real limitation on the activities of only a few of the largest banking organizations. On the other side, deposit insurance and access to the Federal Reserve Systems discount window conferred substantial benefits on the banking industry. In those circumstances and until the early 1970s, these and other benefits largely neutralized the costs that regulation imposed on banks.
All of this changed dramatically during the 1970s as several interrelated developments disturbed the regulatory balance. Short-term market interest rates rose and stayed above Regulation Q ceilings, applying real constraints to banks' abilities to gather funds. Ceilings were adjusted but have remained significantly binding. At the same time, geographic restrictions became more important. Increased economic interdependence of regions both within the U.S. and internationally, stemming from quantum improvements in communications and transportation, increased the demand for nationwide and international banking services. Simultaneously, technological innovation in the payments mechanism made new financial services important and helped overcome geographic boundaries. These developments strained the regulatory structure.
In short, the environment of the 1970s called for services and products which traditional banking organizations were hard-pressed to provide. The regulatory structure had become truly constraining. Recognizing the opportunities, and the limitations on banks, unregulated institutions moved to expand into banks traditional markets, offering market interest rates and a broad mix of services. Simultaneously, banks sought (and found) loopholes in the regulatory structure in order to compete in the new arena. The result was a proliferation of activities and institutions that lie on the fringes of or outside the scope of regulatory oversight.
Policymakers have, to some extent, reacted by revising regulations to take new developments into account. Several of the innovative instruments, including NOW accounts, money market certificates, and retail repurchase agreements have been ratified and brought under the purview of regulation. But the tendency has been to handle each new situation on a piecemeal basis. To a very considerable extent, this tendency toward a piecemeal approach has not reflected so much the intent and desire of the legislators and the regulators as it has reflected the inability or unwillingness of market participants and various constituents to reach any sense of mutual understanding and agreement as to what should be done to create a more contemporary regulatory framework.
Two major laws adopted in the past several years are, however, exceptions to this statement. The International Banking Act of 1978 extended restrictions on U.S. banks to U.S. operations of foreign banks, thereby making U.S. operations of foreign banks subject to the nonbanking prohibitions of the Bank Holding Company Act and to restrictions on interstate banking. As such, the International Banking Act was an attempt to 'level the playing field"to reduce artificial competitive differences among financial institutions.
Federal regulatory agencies authorized commercial banks and thrift institutions to issue Money Market Certificates, effective June 1. These certificates have a 26-week maturity, a minimum denomination of $10,000 and interest ceilings indexed to the 26-week Treasury bill rate, with a differential between commercial banks and thrift institutions.
The International Banking Act of 1978 was enacted. This legislation aimed at leveling the playing field between U.S. banks and branches and agencies of foreign banks.
Federal regulatory agencies authorized commercial banks and thrift institutions to issue Small Saver Certificates, effective January 1,1980.
These certificates have a 30 to 48-month maturity, no minimum denomination and interest ceilings indexed to the average 2 1/2-year yield for U.S. Treasury securities. Thrift institutions enjoy a ceiling differential.
The Depository Institutions Deregulation and Monetary Control Act was enacted.
This legislation authorized NOW accounts nationwide, extended reserve requirements to nonmember banks and other depository institutions, expanded the powers of thrift institutions, and created the Depository Institutions Deregulation Committee (DIDC). The DIDC was charged with gradual elimination of Regulation Q ceilings.
The DIDC authorized a new category of 14 to 90-day time deposit.
It established the ceiling on that account and NOW accounts at 5 1/4% with no differential between commercial banks and thrift institutions. At the same meeting, the DIDC issued final rules governing premiums, finders fees and prepayment of interest on regulated deposits.
The DIDC adopted a schedule for gradual phase-out of interest ceilings, beginning with longer term accounts.
The U.S. District Court of the District of Columbia invalidated the phase-out schedule which the DIDC had adopted.
The Economic Recovery Tax Act of 1981 was passed.
This act authorized depository institutions to issue All Savers Certificates, effective October 1, with interest paid exempt from Federal Income Taxes and broadened eligibility for IRA and Keogh Accounts, effective January 1, 1982.
The DIDC increased interest ceilings on passbook and statement savings accounts by 50 basis points, effective November 1.
At the same meeting, it authorized a ceilingless instrument for IRA and Keogh Accounts.
The DIDC postponed indefinitely the scheduled increase in passbook and statement savings account interest ceilings.
The DIDC adopted a new schedule for gradual phase-out of interest ceilings, beginning with accounts with maturity of 3 1/2 years or longer.
At the same meeting, it authorized a new 91-day savings certificate with a $7,500 minimum denomination and interest ceilings tied to the 13-week Treasury bill rate. The ceilings give thrift institutions a one-quarter point differential.
Even more significantly, the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) promised to usher in an era of deregulation and more complete leveling. DIDMCA provided for expanded competitive powers for thrift institutions, gradual elimination of Regulation Q ceilings, and restructuring and simplification of reserve requirements. In addition, it made NOW accounts permissible for depository institutions nationwide. It also included provisions dealing with pricing of Federal Reserve services and elimination of float, provisions that will work in the direction of increasing the efficiency of the payments mechanism. All of these steps promised to clear the way for further private market developments that, indeed, were already underway.
Today, however, the promise of DIDMCA is yet to be fulfilled. Substantial progress has been made in implementing the reserve requirement and pricing policy provisions of DIDMCA. But deregulatory progress has been slow. The Depository Institutions Deregulation Committee, charged by DIDMCA with the responsibility to phase out Regulation Q ceilings on deposit interest rates by 1986, has, to an extent, been stymied. A phase-out schedule adopted in June 1981 was overturned in the courts the following month. An increase in the ceiling rate on passbook accounts, adopted in September, was withdrawn following a flurry of protest.* While there can be no doubt that the severe liquidity and earnings problems in the thrift industry have constrainedand should constrainthe pace at which deregulation may reasonably proceed, it is also apparent that the problem of phasing out Regulation Q is, in the minds of many, intertwined with other issues such as the expansion of asset and liability powers for thrifts and for banks.
Other legal and regulatory changes seem stalled as well. Progress has been slow in reevaluating the role of commercial banking in the nation's economy. Major questions regarding geographic and activity expansion by banking organizations remain unanswered, and many banks have been clamoring for expanded powers.
The issues on the table remain largely the same as those raised before passage of DIDMCA. Pressures continue for further leveling of the playing field. A few of the favorite targets are:
Some argue that these funds should be subject to regulations such as reserve requirements. Others push for mutual fund powers for banks. The emergence of sweep accounts at banks threatens to make much of the debate academic.
Relaxation of the McFadden Act or Douglas Amendment restrictions would put banks on more equal footing with nationwide financial institutions. This step, however, is strongly opposed by many regional and community banks.
Banks clamor for the right to underwrite municipal revenue bonds. And bank holding companies are pushing this boundary by seeking permission for various brokerage-type activities.
Changes in our approach to financial regulation obviously are necessary indeed, they are being thrust upon us by developments in the marketplace. But what changes are warranted? Should the Federal Reserve, as one of the major regulatory agencies, simply accommodate private market developments that come down the pike, or should we try to influence the direction and pace of the evolutionary process? Some might argue that we should simply deregulate across the board and then let the market exclusively determine the results. While this may be an appealing suggestion at a highly abstract level, we at this Bank are not persuaded. In fact, we are firmly convinced that there are critical issues of public policy at stake in this process of financial innovation and evolution that require the attention and involvement of those charged with the responsibility for financial regulation and monetary policy.
Some of the problems, to be sure, are transitional in nature. To cite one example, the sudden removal or relaxation of remaining Regulation Q interest rate ceilings could create severe adjustment problems, particularly for thrift institutions and some smaller banks. Given prevailing pressures on earnings and capital, an additional rise in costs emanating from higher passbook and other rates could seriously complicate the ability of bank regulators to manage effectively the current situation in the thrift industry. By way of another example of transitory problems, the increased competition that interstate banking would permit could alter traditional competitive relationships and other characteristics of some banking markets. Similarly, explicit pricing rather than "bricks and mortar" might increasingly come to form the basis of competition in banking, thereby substantially reducing the value of the physical offices that many institutions have established. But these examples mainly suggest the need to proceed cautiously in shaping and instituting certain aspects of deregulation; they do not in and of themselves constitute permanent barriers to a more coherent approach to financial regulation and structure.
In light of all of these considerationsand the sometimes conflicting objectives they implyit is not difficult to see why industry representatives, regulators, and legislators find it so difficult to sketch out a blueprint for the financial and regulatory structure of the future. Nor is it difficult to see why those efforts seem to get mired in the details of narrow, specific questions such as those relating to McFadden, Douglas, or Glass-Steagall. There is, however, it seems to us, an opportunity and a need to step back a bit from those legitimate but specific questions and to try to identify the broad parameters within which the effort should go forward.
Several of those parameters are implicit in what has been said earlier. For example, there are a host of reasonsincluding, but not limited to, problems in the thrift industrywhich unambiguously point to the need for "deliberate" speed in phasing out existing rules and granting new powers to institutions which may not have at hand the technical and managerial expertise to effectively use such power in the short run. Similarly, in our haste to "bring in the news" we must not lose sight of those characteristics of the "old" which continue to serve the public interest well. Deposit insurance is a classic case in point. Finally, in our quest for a financial framework for the future, we must be sensitive to the historical and valuable role that community banks and other more specialized institutions have played in meeting the credit needs of small business, farmers, and others. There are, in addition, several other parameters which we believe should serve as guides to our thinking.
First, we believe that the financial and regulatory structure of the future must take into account the legitimate needs of monetary policy. Indeed, it seems to us that in the highly fluid financial environment of the 1980s, it will be impossible to segregate regulatory and monetary policyif indeed this separation were ever possible. The difficulties inherent in merely attempting to definemuch less measure and controlthe money supply illustrate this point rather clearly. But there is more to this issue than seemingly abstract definitional issues. Fundamentally, what is at issue is leveragethe ability of the monetary authority to be able to exercise discipline and restraint on the financial system in a reasonable, efficient, and effective manner.
We have already seen examples of ways in which financial innovation and/or financial deregulation have influenced, at least, the manner in which monetary policy works. For example, with the partial removal of Regulation Q, higher interest rates seem to be required to achieve any given degree of monetary restraint than formerly was the case. Monetary policy leverage has, in some sense, been altered if not reduced, and this is because the burden of restraint falls increasingly on pricethe interest rateas less falls on quantity in the form of the credit-rationing that used to occur when Regulation Q was binding. Money market mutual funds and other close substitutes for traditional transactions accounts seem to provide an instance of reduced leverage that is already at hand. The advent and growth of these instruments have added to the difficulty both of specifying appropriate targets for money supply growth and then in achieving those targets, once specified. Finally, there is at least a question as to whether developments such as the proliferation of floating rate instruments and the widespread use of financial futures may also alter the portfolio adjustments that underlie much of our conventional thinking about the manner in which monetary restraint works its way through the financial system and the economy.
These examples suggest to us that the Federal Reserve has an essential stake maintaining an efficient structure for achieving monetary policy leveragein the course of financial evolution. The continued effectiveness of monetary policy depends crucially on the existence of a handle for restraint. In the past, leverage has been provided in part by reserve requirements, especially those requirements covering transactions-type accounts. As the system becomes more fluid and transactions accounts become more difficult to isolate, the traditional concept of reserve requirements levied against selected liabilities of "banking" organizations may need to be reconsidered.
Aside from these considerations relating to monetary policy, there are at least two other major factors which we believe should play an important role in shaping the parameters around which our future financial evolution should take place. They are, first, achieving a higher degree of competitive equity among different classes of market participants and, second, preserving a distinction between "banking" and "commerce."
Taking the latter first, we believe that it is important to maintain the historical separation of banking and commerce, even if the dictates of the contemporary marketplace require that the line of demarcation be drawn in a different place and in a different way than it was previously. There is little question that the banking system remains the core of our financial structure, even in today's rapidly changing environment. The burgeoning commercial paper market, for example, functions smoothly in part because of backup letters of credit provided by commercial banks. Indeed, almost all of our financial markets and institutions depend on the banking system as their underlying source of liquidityparticularly in periods of stress. This central role has been nurtured by aspects of our regulatory structure, including federal deposit insurance and access to the Federal Reserve discount window. In an environment in which banking and commercial interests are tightly interwoven these tested and valuable characteristics of our current financial landscape might be compromised to the point that isolated financial problems or strains would be more difficult to contain.
Moreover, it seems to us that our historic concerns about the potential for conflicts of interest, concentration, and abuse of financial power inherent in the marriage of banking and commerce remain valid even today. This argues, too, for the separation principle, but it does not answer the questions as to how and where the distinction should be drawn. And, as suggested below, there is both the need and the opportunity to redraw that line of distinction in a manner compatible with the current marketplace, but also consistent with our historic concerns and with the recognition that there is, in fact, something specialsomething differentabout banking.
The final element mentioned above is competitive equity. To as great an extent as possible, similar restrictions should apply to all institutions offering services that are the functional equivalent of those deemed appropriate for regulation in the first place. It would appear reasonable that any activity deemed important enough to require regulation would merit regulation of all sources. In the financial arena, however, that principle has broken down. If a commercial bank issues a transactions account to a consumer, it is prohibited from paying more than 5 1/4 percent interest, required to hold reserves against the account, and effectively required to insure the deposit through the FDIC. If a money market fund desires to provide an account on which transactions are permitted, it may offer virtually any terms as long as it complies with SEC disclosure requirements. There is no rationale for such a difference. And importantly, regulatory inequity tends to drive customers away from regulated institutions or instruments because these institutions cannot compete on equally attractive terms, thereby in fact adding to the difficulty of achieving the original regulatory goal.
There is little question that current regulations are inequitable in that financial institutions are not playing on the proverbial level field. Rules differ both among types of depository institutions and between depository institutions and other financial institutions. We are not advocating a complete literal leveling of the field. However, to the extent that some restrictions place institutions at a competitive disadvantage and no longer serve a public policy purpose, those restrictions should be eased. On these grounds, some gradual expansion of thrift asset powers and relaxation of Glass-Steagall restrictions seem appropriate. So, too, does some tempered reduction of barriers to geographic expansion and ultimate removal of Regulation Q. However, there are, as noted earlier, constraints as to how quickly these changes can be achieved for both practical and political reasons.
Rolling all these considerations together yields, it seems to us, several principal conclusions. First, the transition period in and of itself will entail some risks as well as an opportunity to establish a more efficient and equitable financial structure. Second, the inexorable momentum of market forces is going to bring about change in any event, change that in the near term is likely to exacerbate both the transitional and underlying strains and problems in the financial arena. Third, the future effectiveness of monetary policy is inescapably intertwined with both the new landscape fostered by the market and the steps taken by legislators and regulators to shape the emerging environment.
In view of these factors, the challenges before us are clear. All partiesindustry representatives, regulators, and legislatorshave to agree on how far to go in applying the principles of competitive equity and separation of banking and commerce to managing the transition and designing and constructing the financial system of the future. With banks as the key source of liquidity in both the prevailing and prospective environment, we have to agree on those things we expect and want banks to do. We have to answer the seemingly simple but very perplexing questionWhat is a bank?
We have no illusions about the nature and difficulty of these challenges. Furthermore, in light of the experience of the 1970s, we are convinced that no matter how internally consistent and how farsighted plans for the financial and regulatory structure of the future may be, they will prove inadequate unless we succeed in reducing inflation on a permanent basis. Indeed, one of the more insidious results of the inflation of the past 15 years is the disturbances and distortions it has introduced and promulgated in the financial system. An appreciably lower rate of inflation, and the lower levels of interest rates that would ultimately accompany it, would materially ease the transition problems for thrifts and other institutions and would temper the urgency associated with broader monetary policy concerns as well. Hence, we view further sustained progress against inflation as a very essential ingredient in the future development of a sound financial structure.