A History of the Federal Reserve, Volume 2 (58 page)

The System preferred not to own long-term securities, and it regarded agency securities as less marketable for resale, so its reluctance to hold FNMA obligations is not surprising. Political concerns overrode portfolio considerations in this case as in many others. Members of Congress and especially members of the Banking Committees would have objected strongly to refusal to purchase, or decisions to sell, housing securities. The System made no effort to show that buying agency securities had little effect on housing.

REGULATION Q

There were more regulatory changes affecting regulation Q than any other part of Board supervision. Chart 7.14 above shows one reason; market rates rose far above regulated rates from 1972 to 1974, and after decontrol of rates on large CDs from 1978 on. By 1980, Congress was willing to remove all ceiling rates gradually.

The relative increase in market rates increased the profitability to banks of holding regulated deposits, so many actively sought ways of increasing services and return on such deposits to stem the outflow. Also, savings and loans typically lost time and savings deposits to banks. Since their portfolios consisted mainly of mortgages, they had fewer opportunities to increase portfolio returns. Their growing problems helped to convince Congress to reduce interest rate regulation.

Innovation was perhaps most important. As market rates rose above ceiling rates, mutual funds and others offered money market funds. These funds took advantage of the deregulation of ceiling rates on certificates of deposit of $100,000 or more that followed the Penn Central failure. Money market funds bought large certificates of deposit (CDs) and, for a small fee, offered participations to smaller depositors. The rapid growth of money market funds drained deposits subject to regulation Q from banks and especially non-bank thrifts. Banks bought many of the deposits from the market by paying market rates. By early 1980, money market mutual funds held nearly $50 billion compared to $335 billion in savings deposits.

By late April 1974, savings and loan associations had to borrow heavily from the Federal Home Loan Banks (FHLBs) to cover deposit outflow. The Reserve Board’s staff estimated the increased borrowing at $50 million a day. At that rate, the FHLBs would exhaust their liquid assets by mid-May. The FHLBs could then borrow against a $4 billion line of credit with the Treasury. As a precaution, the Home Loan Bank Boar
d asked the
Federal Reserve to offer standby emergency assistance (memo, Peter Keir to Board of Governors, April 30, 1974, Box 431.2, Federal Reserve Bank of New York). The Federal Reserve agreed to provide the emergency loans as lender of last resort. Loans from reserve banks to FHLBs would be for no more than thirty days and secured by collateral acceptable to the reserve bank. Borrowing could be renewed only if the FHLB system acted to eliminate the need for Federal Reserve assistance. Loans to individual member and non-member institutions were left to the decision of the FHLBs. The interest rate on loans to savings bank and thrifts would be two percentage points above the discount rate, a 10 percent rate at the time.
¹⁸⁹

These extensions of its emergency lending recognized the Federal Reserve as lender of last resort to the financial system. The earlier, very narrow interpretation of its role had given way gradually but had not been fully reflected in operating rules and procedures. The thrift problems forced decisions that extended the lender-of-last-resort function by recognizing finally the role of the central bank that Walter Bagehot insisted upon one hundred years earlier.

Small depositors attempted to acquire large CDs to earn open market rates. One method was to pool deposits. The Board proposed to prohibit pooling on January 29, 1975, inducing greater use of money market funds. Governor Coldwell dissented because he thought the prohibition was unenforceable. The Board withdrew the ruling two years later.

Later that year Governor Coldwell dissented again when the Board voted to support a one-year extension of its authority to control interest rates under regulation Q. Coldwell did not agree to a provision calling for an eventual end to ceiling rates. He said that small institutions would be harmed. Congress was not ready to remove controls. In December 1975, it approved a provision intended to protect thrift institutions from competition. The spread between interest rates paid by banks and thrifts could not thereafter narrow unless the Board notified Congress. Thrifts now came under interest rate regulation with the right to pay slightly higher rates than banks. Both rates were below open market rates, so withdrawals continued.

At about the same time, the Board permitted banks to open savings deposits for small businesses. Account balances had to remain below $150,000. Governors Bucher and Coldwell dissented because they opposed the limitation on accounts size (Annual Report, 1975, 133–34). Earlier in
the year, the Board revoked authority for banks to open NOW accounts for governmental units and authorized member banks to permit depositors to transfer or withdraw deposits by telephone. This repealed a restriction adopted in 1936 (ibid., 118–19).

189. The guidelines did not cover mutual savings banks since they were not members of the FHLBs and did not have a comparable organization. The New York and Boston Reserve banks prepared guidelines for their emergency borrowing. A few months later, the Board clarified its rules for lending to non-member commercial banks (memo, S-2276, Board of Governors, March 31, 1975. File 431.2, Federal Reserv
e Bank of New York).

NOW accounts began in Massachusetts and New Hampshire. They permitted banks to pay interest on liabilities with most of the properties of demand deposits. Congress extended the use of NOW accounts to the four remaining New England states, and the Board amended regulation Q in February 1976 to permit member banks to pay interest on these accounts. Several members of the Banking Committee wanted to extend NOW accounts nationally and to permit banks to pay interest on the public’s demand deposits. The new Carter Treasury mistakenly opposed the proposed extension to New York, New Jersey, and Pennsylvania. Congress removed it from the bill extending regulation Q to June 1977 (letter, Blumenthal to Proxmire, Burns papers, Box B_892, February 23, 1977).

The Board in 1975 permitted banks to waive the penalty for early withdrawal of time deposits in IRA accounts if the depositor was older than 59.5ordisabled.An amendment on November 3,1976, extended the waiver to Keogh retirement accounts. In 1977, the Board set a minimum maturity of three years for these retirement accounts and permitted banks to pay the highest rate allowed on long-term time deposits. The aim was to encourage retirement accounts and to assist banks and thrifts to gain deposits. Thrifts, as usual, could pay 0.25 percentage points above the interest rates permitted to banks. In December 1978, the Board further liberalized withdrawals from these accounts.

Several other actions modestly increased the attractiveness of time deposits or the incentive to evade the regulations. Banks and depositors tried to circumvent penalties for early withdrawal by making loans to depositors. The Board required that such loans be made at a rate of two percentage points above the rate paid on the deposit. In November 1977, it reduced the differential to one percentage point (Annual Report, 1977, 138).

The Federal Reserve Reform Act, approved November 16, 1977, extended regulation Q for an additional year to December 15, 1978. The Board soon thereafter permitted automatic transfers for individuals from savings accounts to checking accounts. This was particularly useful if a depositor overdrew a checking account, and it saved the customer the large fees banks usually charged for overdrafts. Both banks and depositors could choose to adopt or avoid automatic transfers. The new authority amended regulation Q by permitting depositors to receive interest on their savings account up to the date of withdrawal. The Board’s announcement recog
nized that, in effect, the authorization was equivalent to allowing interest to be paid on part of a demand deposit account (B
oard Minutes, May 1, 1978).
¹⁹⁰

Pressured by the rise in market rates and loss of banks’ competitive position, effective June 1, 1978, the Board, joined by the FDIC and Home Loan Bank Board, announced two new instruments intended to permit banks and other deposit takers to “compete for funds to assure an adequate flow of credit into housing and to meet other borrowing needs” (Board Minutes, May 11, 1978). Deposit takers could issue a six-month certificate with minimum denomination of $10,000 that paid interest at the average yield on a six-month Treasury bill set at the most recent weekly auction. Savings and loans were permitted to retain their 0.25 percentage point higher rates. Soon after, the Board ruled that banks could not compound interest on the six-month certificates (Annual Report, 1979, 90).

At the time that it made this change, the Board introduced a new 4-year certificate with an interest rate 1.25 percentage points (1 percentage point for S&Ls) below the auction yield on 4-year Treasury securities, and it reduced penalties for early withdrawal from time deposit accounts. The new instrument was not sufficiently attractive, so in December the regulators replaced the 4-year certificates with a 2.5-year certificate that paid 0.75 percentage points less than outstanding Treasury securities of the same term to maturity. The Board’s statement was explicit about the problem. The action was taken “to help the small saver and to improve the ability of banks to compete for funds” (Annual Report, 1979, 93).

The same institutions could also issue an eight-year certificate of deposit, with minimum denomination of $1,000, that paid a maximum of 7.75 percent at banks and 8 percent at savings and loans and mutual savings banks. Later the Board eliminated the minimum denomination restrictions.

In 1978, banks in New Jersey, Pennsylvania, and Ohio began to issue bearer certificates of deposits with denomination of $100 or less. Some
banks highlighted the fact that they did not report the interest payment to the Internal Revenue Service (IRS) because the certificates were negotiable and they did not know who received the interest. Of course, the records showed who received the payment. Concern about tax evasion and about the effective breach of regulation Q ceilings concerned the Board. The IRS limited the practice by ordering banks to report the interest paid (memo, staff to Board of Governors, Board Records, March 15, 1978).

190. This feature drew many negative responses, including from 370 savings and loans, the Federal Home Loan Bank Board, and 42 or 45 members of Congress. But 424 individuals wrote to favor the proposal when it was under consideration. To partly deflect the concerns, the Board permitted depositors to make automatic transfers from savings and loans to commercial bank checking accounts. At about this time, the Board considered allowing interest on demand deposits. Burns suggested permitting nationwide NOW accounts, interest on reserve balances, elimination of the reserve city classification, and a lower minimum for reserve requirement ratios (Board Minutes, February 14, 1977). The Board approved the changes. Governor Coldwell dissented because of the cost to banks and omission of pricing membership services (ib
id., May 5, 1977).

The following year, the Board changed the definition of deposits to include repurchase agreements of less than $100,000 with maturities of ninety-days or more. This closed a means of evading regulation Q ceilings. As deposits, the instruments would be subject to ceiling rates (ibid., 92).

The Board and other regulators never found a satisfactory way to maintain interest rate ceilings during a period of rising interest rates and a growing difference between regulated and open market rates. The gap between regulated rates and open market rates invited innovation to avoid regulation. This brief history shows the great resistance to removing ceilings. In part, the Board and Congress had multiple objectives: maintain the relative positions of banks and thrifts, increase (or avoid reducing) funding for home mortgages, and prevent or hinder innovation that avoided controls. As open market rates rose, deposits at money market mutual funds soared. Regulators kept busy trying to improve the competitive position of their members and, at the same time, prevent innovations that circumvented restrictions. Congress was unwilling to prohibit money market funds and other means of avoiding regulation but unwilling also to recognize the failure of regulation in an inflationary period. And consumers slowly learned that they were penalized if they held regulated bank liabilities.

Pressure to remove regulation Q ceilings rose. By the late 1970s, Senator William Proxmire, chairman of Senate Banking, proposed regular gradual increases in ceiling rates until they reached the level of market rates. Congress approved the gradual end to ceiling rates in 1980.

Regulation did not save the thrift associations or maintain housing finance in an inflationary period. It took years for some cautious and poorly informed savers to recognize the opportunity cost of keeping their balances in regulated deposits instead of moving them to money market funds. The former were insured by a federal agency; the latter were not, so this slowed the transfer. By the end of the 1970s, however, many learned. Although many members of Congress served as directors of thrift institutions in their district, it became increasingly difficult to defend a policy of taxing mainly small, ill-informed savers. And it became clear that regulation induced innovation to circumvent the rules, requiring new or different rules and, in turn, bringing new innovation.

Reserves
and
Reserve
Requirements

As open market interest rates rose with inflation, the cost of reserve requirements rose. Many banks withdrew from the System. From January 1970 to January 1980, the proportion of commercial banks that were Federal Reserve members declined from 43 to 35 percent even as the number of commercial banks increased by about 12 percent. The System had been concerned about membership since its earliest days. Many now regarded the problem as acute.

One way to encourage membership was to reduce the cost of holding (non-interest-bearing) required reserves. In 1969, the Board subjected a member bank’s euro-dollar borrowing to a 10 percent reserve requirement ratio. The next year, it increased the ratio to 20 percent. In May 1973, it lowered the ratio to 8 percent, and in April 1975 to 4 percent. On October 15, 1975, the Board reduced the ratio from 3 to 1 percent on time deposits with an original maturity of four years or more (Annual Report, 1975, 120, 134). In December, it reduced the ratio from 3 to 2.5 percent for time deposits with maturity of six months to four years (Board Minu
tes, October 15, 1975, 2).

To assist smaller member banks facing seasonal changes in loan demand, the Board modified regulation A to reduce restrictions on borrowing. For the first time, it permitted banks to arrange seasonal borrowing in advance, in effect providing a line of credit. The Board “expected that small banks in agricultural areas would be the principal beneficiaries” (Annual Report, 1976, 145–46).

Periodically during the 1970s, the System considered the costs and benefits of using a reserves operating target instead of the federal funds rate. The New York desk opposed the change, arguing that banks used the federal funds rate to judge the System’s policy. A reserve target would increase variability of the funds rate and obscure the signal to the market. Heightened variability would make it more difficult for the desk to interpret changes in uncontrolled reserve factors (Paul Meek and Charles Lucas to FOMC, Board Records, February 17, 1976). A System subcommittee accepted this conclusion. It recommended against including a reserve objective in the short-run operating specifications. But it based this conclusion as much on the opposition of banks as on the control issue. In fact, it found that “contemporaneous reserve accounting would be more effective than the existing reserve accounting system with a two-week lag” (memo, Subcommittee on the Directive to FOMC, Board Records, April 13, 1976, 1). This decision failed to recognize the Federal Reserve’s social responsibility and gave greater importance to the wishes of some of its members.