In recent years, a combination of factors, including technological
change, inflation, high and variable interest rates, the increased financial
sophistication of economic agents, large and small, and our regulatory
structure have interacted to promote vigorous and rapid changes in the
financial environment. For example, new markets, new institutions, and
new financial instruments have sprung up, and the asset and liability
management practices of households, businesses, and financial institutions
have changed appreciably. Because of these changes, there was a growing
realization as the 1970's drew to a close that our existing laws and regulations
no longer served the purposes for which they were originally designed.
This pattern of change was a major factor which prompted Congress to
develop a series of changes in our national banking laws that were forged
together into The Depository Institutions Deregulation and Monetary Control
Act of 1980, which the President signed into law in March of that year.
It had two main goals: one, to enhance the Federal Reserve's ability to
implement effective monetary policy and, two, to promote greater competition,
less regulation, and greater efficiency in the provision of banking-related
financial services. There can be no guarantee that these goals will be
wholly achieved, but there can be no doubt that the new legislation brought
our laws into much better alignment with the current realities of our
ever-changing financial environment.
Enhancing Monetary Control
Key provisions of the new financial legislation will work to enhance
the ability of the Fed to implement its monetary policies. This potential
improvement in monetary control will result in large part from the broader
and more uniform reserve requirements mandated in the legislation. This
reverses a trend in the financial industry which had led to a dramatic
deterioration in the number of institutions and the percentage of deposits
that were subject to Fed reserve requirements. The shrinkage in Fed
membership thus threatened to seriously undermine the already loose
and fragile relationship between Fed policy actions and the behavior
of money and credit—possibly even over long periods of time.
The decline in the share of the nation's deposit balances held by banks
that were members of the Federal Reserve System and hence subject to Fed
reserve requirements reached alarming proportions in the late 1970s. Ironically,
the decline in the amount of reserves controlled by the Fed was aggravated
by the existence of the Fed's reserve requirements. Since member banks
could not earn interest on their required reserves. they were subjected
to a cost that was often substantial. Their cost was the amount of interest
earnings they had to forego on their reserve balances. Bankers who concluded
that this cost was not offset by the benefits of Fed membership would
drop out of the Federal Reserve System. In recent years, the cost of Fed
membership became increasingly heavy in the climate of high interest rates.
This caused a growing number of banks to relinquish their Fed membership,
resulting in a decline in the amount of deposits subject to Fed reserve
Another factor contributing to the unpredictability of the relationship
between reserves and deposits was that reserve requirements for Fed
members varied according to a bank's deposit size and according to the
mix of deposits in individual institutions. If a bank had demand deposits
of up to $14 million, it had to keep 7 percent of these deposits in
reserve. The more demand deposits it had, the higher percentage it had
to keep in reserve. If its demand deposits totaled over $280 million,
it had to keep 16 1/4 percent in reserve—this was the highest
reserve bracket. The reserve requirements for savings and time deposits
were similarly graduated, with further differences based on maturities.
As deposits moved from bank to bank, or as they shifted from one class
or maturity of time deposits to another, the amount of money that could
be supported by a given amount of required reserves would also change.
This was a further source of uncertainty or slippage in the relationship
between Fed policy actions and the money supply.
These developments were particularly relevant in view of the Fed's recent
decision to control money growth by placing more emphasis on the growth
of reserves. That decision, which was made in October 1979 prior to the
enactment of the new legislation, was made primarily because the earlier
procedures for influencing the growth of money had proven progressively
less reliable even over reasonably long periods of time. Money growth
had to be effectively controlled; for while there is no universally accepted
view of the precise way in which the money supply affects the economy,
there is virtual unanimity among policy makers and scholars that restrained
money growth is a necessary condition for lower inflation, lower interest
rates, and a healthy overall economy.
However, under the new procedure, as under the old procedure, monetary
control was further complicated by the fact that the information the
Fed received about the deposits of non member depository institutions
was based on a small sample of such institutions. Further, much of the
information was received too infrequently—once a quarter and too
late to be useful—sometimes after it was six months out of date.
Clearly, the Fed's understanding of developments relating to the growth
of the money supply was hindered by such insufficient and belated data.
Early in 1980, the problems of declining membership in the Federal
Reserve System, uneven reserve requirements, and inadequate information
on changes in the money supply were addressed by the Depository Institutions
Deregulation and Monetary Control Act. The far-reaching changes mandated
by this act will be phased in gradually over the next eight years. To
rebuild the declining portion of the nation's deposits that were covered
by reserves, this law created universal reserve requirements. Now all
deposits that can be used for transactions—checking accounts,
NOW accounts, share draft accounts at credit unions, and other accounts—must
be backed by reserves. Deposits in commercial or non personal savings
accounts must also be backed by reserves. Once the law is phased in,
it won't matter if these accounts are held by member institutions or
To create more even reserve requirements and to make their impact more
predictable, the new law makes reserve requirements not only universal
but uniform. Financial institutions, regardless of their total deposits,
will be required to maintain the same percentage of reserves. When the
law is phased in, institutions must maintain reserves of 3 percent for
transaction deposits that total $25 million or less and must maintain
reserves of 12 percent for the portion of their total transaction deposits
over $25 million. Institutions must maintain reserves of 3 percent for
commercial or non personal savings accounts, regardless of their total
To ensure that adequate and timely information is available, the law
requires all depository institutions to report their deposit levels directly
and promptly to the Fed. From those institutions that weren't directly
reporting to the Fed before, the Fed will receive the information on a
more timely basis. Institutions holding the majority of the nation's deposits
will report weekly, and the Fed will have useful information on the deposits
at non member institutions in a matter of weeks instead of months as was
the case before. While attempts have been made to minimize this reporting
burden. especially for small institutions, the expanded information on
the money supply and credit will help in the implementation of monetary
Over time as more deposits are affected by reserve requirements, as
reserve requirements become more uniform across depository institutions,
and as the data on which it bases its decisions about policy will have
been improved the linkage between the level of reserves and the supply
of money should tend to become more serviceable for the purposes of implementing
Fed policy than otherwise. However that result will not be achieved until
the phase-in is largely completed. In the meantime, necessarily complex
formulas for the phasing down of reserve requirements for current Fed
members and the phase-in of reserve requirements for nonmembers coupled
with the inevitable problems associated with new reporting requirements,
will be sources of new uncertainties and "noises" in the relationship
between reserves and money.
While the new law should ultimately enhance the Fed's ability to control
the money supply as it is currently defined, its longer-term impact
on monetary control is by no means certain. The structure of the nation's
financial system is not fixed. It will respond to the new environment
created by the law. With the passage of the new law, new competitive
forces exist—and they will alter the investment decisions of consumers
and businesses, perhaps creating new problems. For example, the huge
increase in the amount of financial resources flowing into money market
mutual funds that has been observed since January 1981 could continue
to gain momentum. Lack of a reserve obligation means returns on these
funds can be set higher, thus attracting resources away from financial
institutions to investment vehicles not subject to Federal Reserve jurisdiction.
In short, even before the ink is dry on the new act, new complications
are presented to policymakers.
The transitional problems and the new challenges should not, however,
detract from the importance of the new legislation to the Federal Reserve.
Indeed, its importance goes well beyond the manner in which it arrested
a potentially sharp deterioration in the effectiveness with which monetary
policy could be implemented. That is the enactment of the law gave a
clear signal—both here and abroad—as to the importance we
as a nation place on a strong and independent central bank. In that
regard, it is noteworthy that most national banking and thrift industry
trade groups supported these broadened powers for the Fed, even though
in many instances their affiliated institutions would be, for the first
time, faced with the burden of reserve requirements. That affirmation
as to the need for a strong central bank represents, we believe, a recognition
that solutions to our economic problems—while never easy—would
be considerably more difficult if market or other forces altered the
"independence within government" that has been a hallmark of our central
bank for almost seven decades.
Economic Efficiency Through Competition
In addition to arresting the potential deterioration in the effectiveness
of monetary control, the Depository Institutions Deregulation and Monetary
Control Act of 1980 fosters increased efficiency in the nation's financial
system. One important way it does this is by reducing the regulatory and
legal barriers that prevented one type of institution from competing with
another type. These barriers tended to inhibit the free flow of funds
to their most productive uses. Thus, by increasing the opportunities for
competition, powerful new forces will be working to help us get the most
out of our available financial resources.
In the past, the barriers to competition that were created by government
regulations and laws were formidable. Classes of financial institutions
were restricted to specific types of activities. Savings and loan institutions
could not compete with commercial banks in the market for checking accounts.
Commercial banks couldn't pay as much interest on saving accounts as savings
and loan institutions. In addition, interest rate ceilings effectively
prevented institutions of the same class from competing for deposits and
The new banking law allows financial institutions to compete more freely.
It expands the lending powers of thrift institutions in order to give
them more flexibility in managing their assets. It permits all depository
institutions to offer interest earning checking-type accounts to households
and certain kinds of businesses. Finally, it phases out, over six years,
ceilings limiting the interest that may be paid on time and savings
deposits at all depository institutions. Thus, the nation's 15,000 banks—large
and small—are in competition with 5,000 savings and loan associations,
500 mutual savings banks. and 22,000 credit unions. all having increasingly
similar powers. A basic principle of economics is that expanded competition
will, in time, result in a more efficient use of resources. For instance,
as interest ceilings are phased out, rates paid to savers will more
accurately reflect the value of the investment uses to which those funds
will be put. Thus, rates paid to depositors will be better able to attract
funds and direct them to their most productive uses. Because of the
new competition, every depository institution will soon be feeling the
pressure to be more efficient so that it can offer its customers better
service and lower prices than the institution down the street.
Exactly how the financial system will evolve under this fresh competition
is difficult to foresee, but some speculations are possible:
- The rates that financial institutions pay to depositors will probably
go up. The pressure to pay higher rates will exist because institutions
can now pay interest on checking accounts and other accounts on which
checks can be drawn and because some interest rate ceilings are being
phased out. Such a development, it might also be noted, is compatible
with the need to increase saving on a national basis.
- Operating margins at depository institutions may narrow. As competition
increases. the spread between interest rates on deposits and interest
rates on loans—that is, the operating margin—may be squeezed.
This could reduce profitability or alter the amount of capital needed
in depository institutions.
- The number of financial institutions may be reduced through merger,
acquisition, or perhaps even liquidation. In a more competitive market-place,
only the more efficient financial institutions will prosper.
- If the number of financial institutions is reduced, the Federal
Reserve and other regulators will have to consider modifying regulations
and practices that might impede the orderly consolidation of institutions.
Prohibitions against opening branch offices—both within and
across state lines—will have to be reconsidered. Similarly,
prohibitions that prevent banks and thrift institutions from consolidating
may have to be re-considered.
- In the future, financial institutions could look more alike than
different. As banks, savings banks, and savings and loan associations
all gain similar powers to choose their assets and liabilities, they
will be able to enter the same market arena. Many of these institutions
will continue to specialize by type, location, and size, but all institutions
will be better able to compete with others within the markets they
- The competition facing depository institutions from money market
funds, brokers. and large merchandisers will remain intense. Such
businesses, free of much of the regulation governing depository institutions,
have been innovative in the past. They will no doubt continue to compete
for balances in the future.
Deregulation will mean that financial institutions will, in some cases,
be subject to new and different forms of risk. Thrifts, for example,
might face higher risk than they used to, particularly during the period
when lending officers are acquiring expertise in making types of loans
other than mortgages. Similarly, as some interest rate ceilings are
phased out, small and medium-sized institutions might face higher risk
as they acquire expertise in setting the prices and the maturities of
their time and saving deposits.
But if there is higher risk, there is also more opportunity for competitive
forces to direct financial resources to the most productive uses. So the
new environment brings into clearer focus the trade-off between the benefits
of market-directed investment and the costs of added risk for the financial
system. This trade-off has always existed, and society has rightly designed
safeguards to control and limit risks in the financial system. Because
we as a nation have agreed that market discipline alone can't be the sole
guide for financial system functions, the financial system has been, and
will continue to be, guided in part by publicly imposed safeguards such
as supervisory examinations, Federal Reserve discount lending, and deposit
At issue, however, is not whether there will continue to be public constraints
on risk within the total financial system, but whether there will be at
least an incremental shift away from regulation of individual financial
institutions in favor of market-determined investment decisions. That
seems to be the promise of the new environment facing the financial system.
Systemwide safeguards and regulations will continue to control and limit
risk for the financial system in total, while individual institutions
have more discretion to follow market-based signals for productive investment.
As the transition to this new environment proceeds, we must remain vigilant
and alert so as to ensure that new and perhaps even unforeseen problems
are managed in an efficient and prudent manner consistent with the overriding
public interest in a safe and sound banking system.
Economic Efficiency Through Market Pricing
The new legislation will move in the direction of promoting efficiency,
not only by encouraging competition among private financial institutions
but by compelling the Federal Reserve to set prices for its services
in much the same way as any other business. For the first time, the
services of an agency in the public sector will be priced and offered
in competition with those of private firms. Fees will be charged for
check clearing and collection. wire transfer of funds and securities,
automated clearinghouse activities (electronic payments), settlements
of financial institutions' debits and credits, the safekeeping of securities,
and the transportation and insurance of currency and coin. Because of
these fundamental changes, the allocation of resources between the public
and private sectors will ultimately be governed more by market forces.
These two sectors will—based on relative efficiency—allocate
the available resources differently.
This new allocation of resources is probable because the incentives
now facing depository institutions are quite different than the ones
that used to face them. Under former laws, when the Federal Reserve
offered its services at no explicit charge, member banks benefited themselves
and their customers the most by using the Fed's services even when the
services' value fell below the value of the resources that were used
in providing them—below the real costs imposed upon the Fed and
the nation. This sometimes meant that member banks used the Fed's services
even when competing services that used less labor, better technology,
or fewer physical resources were available.
Now depository institutions have more incentives to choose the most
efficient provider of services. Since most Federal Reserve services
will be offered to all depository institutions at explicit prices, these
institutions may choose whether to obtain such services from the Fed
or from a private correspondent bank. Previously, a nonmember depository
institution did not—for all practical purposes—have this
choice, since it was not able to receive services directly from the
Fed. Thus, under the new arrangements all institutions will have the
incentive to use the service that imposes the least real cost on society
because this service will have the lowest price.
Consistent with its congressional mandate to promote efficiency, the
Federal Reserve will set its prices so that a truly competitive framework
for the delivery of financial services is established. The general pricing
guidelines provided in the new legislation plus the more detailed guidelines
established by the Board of Governors of the Federal Reserve System
require the Fed to determine its prices in the same fashion as a private,
competing firm. Its prices must fully cover its costs, including overhead.
To avoid unfairly undercutting its competitors' prices, the Fed must
even set its prices to cover taxes, profit, and other costs of doing
business like a private firm—although it pays no federal taxes
and does not try to earn a profit.
The shift from the old system of providing services only to members
at no explicit charge to the new system of providing services to all depository
institutions at an explicit price entails some major challenges for the
Fed. It must formulate rules for billing its customers, establish new
accounting systems, and decide the size of the balances it will require
for those who use its services. Once it has laid this detailed groundwork,
it must effectively communicate it to its potential customers. Every depository
institution, large or small, bank or thrift, must have this information
in order to select the best alternative for obtaining needed services.
Achieving the market discipline and the efficiencies contemplated by the
drafters of the legislation requires, among other things, that institutions
will make rational choices among alternative suppliers of like services.
Thus, one of the Fed's major responsibilities in this environment will
be to ensure that all depository institutions have a good understanding
of the nature of Fed services, their prices, and the operating rules under
which they will be available.
In order to promote that understanding, we at the Federal Reserve Bank
of Minneapolis have established an advisory council comprised of a cross
section of bankers, officials of savings institutions and credit unions,
and representatives of trade associations and bank regulatory agencies
to assist us in better anticipating the needs of all depository institutions
in the context of the various requirements of the Monetary Control Act.
It is difficult, at this early date, to foresee how events will unfold
in this new environment of priced Fed services. Change will certainly
occur—perhaps even major change—but it seems that the process
will be gradual. Market pricing and service competition will yield substantial
rewards for innovation, good management, and technological advance by
competing service providers. including the Fed. For wholesale-level
customers, including banks and other depository institutions, there
will be the important flexibility to match their service needs with
In this setting, Federal Reserve people look forward to pricing, competition,
and resolution of the public service obligation issues. There is promise
of a new era where market forces will challenge and perhaps change long-standing
systems that, however worthy, have nonetheless been shielded from the
rigorous testing of the marketplace. Now the system is opened—with
risks for all players—but also with promise of efficient allocation
of resources, which is the pervasive order of the day. Moreover, in
those instances where it is deemed necessary to publicly support the
financial system to guarantee minimum service, the public costs will
The bottom line of this process is clear. We must recover our costs
and act in a fashion that is consistent with the goal of promoting efficiency
in the payments mechanism. The Federal Reserve has contributed and can
continue to contribute to achieving the goal of an efficient payments
system. The Fed will be a source of constructive competition, both as
an active and as a potential participant in the market, even if we, of
necessity, define our role in somewhat different terms than would a wholly
private entity. In short, while the trappings may differ, we in the Federal
Reserve are fully committed to the efficiency goal, and we have every
intention of moving forward in a manner consistent with that objective.
Meeting the New Challenges
The Federal Reserve will, in the 1980s, face new and difficult challenges
as the financial system—and the economy more generally—respond
to the new forces for change unleashed by the Monetary Control Act.
These forces carry with them great promise that our financial system
will become even more dynamic, more competitive, and more efficient.
But those same forces also bring with them the potential for greater
risk and greater uncertainties. Indeed, even the most clairvoyant among
us can, at best, foresee only the fuzzy outlines of how events will
unfold. Those uncertainties and that inherently fuzzy view of the future
must temper our attitudes and our actions as we navigate through previously
uncharted waters. Indeed, the drafters of the legislation—sensitive
to the need to balance caution with deliberate speed—built into
the legislation phasing provisions and elements of regulatory flexibility
with a view toward ensuring that the evolution proceeds in an orderly
While there are many areas of uncertainty associated with this evolution
to the new era, one thing is very clear. That evolution will proceed
far more smoothly and effectively in an environment of reduced inflation.
For example, if inflation were reduced, interest rates would almost
certainly be lower and Regulation Q, which sets interest rate ceilings,
could be eliminated much more easily—with fewer economic dislocations
and with fewer problems for those affected by this regulation. If interest
rates were running below the ceilings established in Regulation Q, few
would care whether it was gradually abolished or not, and its elimination
would have virtually no impact on the financial system. The inevitable
conclusion is that economic efficiency cannot be pursued in a vacuum;
it must be pursued along with price stability.