A New Law, A New Era
Published January 1, 1981
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 requirements.
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 not.
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 deposits.
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 policy.
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 loans.
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 insurance.
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 market options.
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 be visible.
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 fashion.
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.