The Changing Financial Landscape
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
Meeting The Challenges of a New Banking Era
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
||Bache Group, Inc.
|American Express Company
||Shearson Loeb Rhoades
|Citizen's Federal Savings and Loan Association
||West Side Federal Savings and Loan of New York
||Washington Savings and Loan Association in Miami Beach
|Sears, Roebuck and Co.
||Dean Witter Reynolds Organization Inc.
||Coldwell Bank & Co.
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.
Traditional Regulatory Policy
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
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.
The Changing Regulatory Approach
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
Milestones in Deregulation
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
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
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
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
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.
The Process Seems Stalled
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
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:
Money market mutual funds
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
The Glass-Steagall Act
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.
The Public Policy Challenge
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
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.
The Parameters of Future Change
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
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
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
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.