A History of the Federal Reserve, Volume 2 (87 page)

REGULATION AND SUPERVISION

The Board made regulatory changes reflecting changes in banking and financial institutions after deregulation and the phasing out of regulation Q. It adjusted the components of M 1 by including NOW accounts and tax-exempt money funds. Money market deposit accounts, the banks’ substitute for money market funds, became part of M
₂
. Also, the Board exempted time deposits with more than eighteen months maturity from some reserve requirements. On October 1, 1983, regulation Q ceilings ended.

Board members, including the chairman, testified several times on regulatory matters. Most of the Board favored payment of interest on demand deposits but wanted to defer payment of interest on bank reserve balances until a later time. It singled out reserves against deposits that are directly competitive with money market funds, on grounds that it wanted to discourage growth of deposits outside the banking system. The main argument against paying interest on all reserve balances was to avoid a sizeable reduction in payments to the Treasury during a period of large budget deficits (letter, Volcker to Walter Fountroy, Board Minutes, May 16, 1983). Later, Congress approved interest payments on reserves.

The November 1983 meeting of the Federal Advisory Council (FAC) made an unusual report. The FAC criticized the Federal Reserve’s regulatory activities. These responsibilities “have not always been executed in a positive and constructive way. In a period of very rapid change in the financial services area, the Fed has been relatively slow in adapting to the competitive pressures that have confronted the banking industry. Its active support of legislation intended to strengthen the competitive environment has often been disappointing to bankers” (Federal Advisory Council, Board Minutes, November 4, 1983, 1–2). The bankers on FAC said the Federal Reserve’s regulation of bank holding companies did not encourage innovation. Also, the Federal Reserve had not eliminated all reserve requirements on nonpersonal time deposit accounts, putting banks at a disadvantage with corporate customers. The Board made the change in the 1990s.

The Federal Reserve relied on banks for support in Congress. The criticism came at a time of considerable deregulation but also a time of congressional activity to adopt and revise legislation affecting all financial institutions. Once again the Reagan administration’s task force, headed by Vice President Bush, proposed a consolidation of banking regulation
in a single banking agency. That proposal had a long history. The Federal Reserve usually opposed reduction in its regulatory and supervisory role by claiming that these responsibilities facilitated monetary policy. A more likely reason was that regulation, especially regulation of bank holding companies and authority to approve mergers and branches, sustained a powerful constituency that supported the Federal Reserve in its dealings with Congress. Proponents of a separate banking agency usually pointed out that many countries with successful monetary policy actions, such as West Germany, separated banking regulation and monetary policy.

The Board discussed the Bush task force’s proposals on November 22 and compared them to the proposals that Congress considered. The Board did not object strongly to letting the Justice Department handle anti-trust issues, particularly if Congress permitted interstate branching. No one objected to transferring decisions about stock market margin requirements to the Securities and Exchange Commission.

Regulation of banks and holding companies received the most attention. One member suggested that the Federal Reserve assume all supervisory and regulatory functions, but others said that was politically unattainable. Proposing it would reduce the ability to affect the legislation. “Board members were unanimous in the view that under any restructuring format, the Federal Reserve must continue to be involved in bank supervision in order to ensure the effectiveness of its monetary policy and other central banking functions” (Board Minutes, November 22, 1983, 2).

Board members agreed to communicate their views to the Bush task force, but they did not vote. They decided to wait until the task force sent its proposals to Congress. They agreed that “the draft proposals were not a substantial improvement over the existing system” (ibid., 5).

By March 1984, Congress approached the end of year-long hearings on revision of financial regulation. Several possible and actual conflicts arose about the proposed changes—small versus large banks, banks versus non-bank financial institutions, holding companies versus ordinary banks, national versus international concerns, especially concerns about risk. Issues arose about risk, equity, and conflicts of interest. Surprisingly, problems of growing size and the corresponding importance of “too big to fail” received little attention.
¹⁰

10. “Too big to fail” means that the consequence of failure by a “large” bank could not be accepted, so the Federal Reserve, the FDIC, or the government had to arrange financing to sustain the bank. Large was not defined. “Too big to fail” encouraged banks to expand their size. It violated Bagehot’s well-established principle that an insolvent bank should be allowed to fail and policy agencies should confine their efforts to preventing secondary consequences
in markets. The problem was that regulators preferred to use public money rather than accept the risk of (usually unspecified) disastrous consequences, if failure occurred. Failure did not require that the bank disappear; bank equity had to pay for losses, and bank management had to be replaced. Later, Congress restricted lending to weak and failing institutions.

On March 27, Paul Volcker testified on legislation under consideration in the Senate. He divided his testimony into five sections: (1) new definition of a bank, (2) definition of a qualified thrift, (3) procedures to streamline holding company applications, (4) powers of holding companies, and (5) statutory guidelines governing division of authority between state and federal government.

Volcker expressed concern about growth in the size and number of “nonbank banks” that took deposits but did not offer loans.
¹¹
He had proposed earlier that a bank was an entity eligible for FDIC insurance that took deposits and made loans. He now excluded (1) industrial banks that were not federally insured and did not offer deposit accounts with checking privileges, (2) state-chartered thrift institutions, and (3) non–federally insured thrifts and industrial banks that would not be covered by the Bank Holding Company Act (Paul A. Volcker statement, Banking Legislation, Federal Reserve Bank of New York, Box 97645, March 27, 1984, 5–6). He proposed that consumer banks should be included with other banks and that securities companies and others be required to divest non-bank banks.

The main concern about the regulation of thrifts was to regulate thrifts that engaged in banking activities as if they came under the Bank Holding Company Act. These were “qualified thrifts.” Thrifts that engaged entirely or mainly in mortgage lending would be exempt from banking rules. Volcker proposed 65 percent of the portfolio in mortgages as the cutoff.

Volcker favored extension of holding company powers to permit holding companies to sponsor and distribute mutual funds, underwrite and distribute revenue bonds and mortgage backed securities, engage in real estate and insurance brokerage, own thrift institutions, and offer other financial services (ibid., 14). Congress considered these additional powers in the legislation before the Senate.

Beginning in 1982 the Federal Reserve began to permit banks to invest across state lines. Congress was not willing to permit interstate banking or able to resolve conflicts between banks, investment banks, and insurance companies. Solvent existing banks were a principal source of capital, so the rules changed to permit acquisition of troubled banks by out-of-state
banks. Resolving conflicts between banks and others and legislation to permit interstate banking came in 1994. The Depository Institutions Act of 1982 permitted adjustable rate mortgages and eliminated interest rate ceilings for savings and loans.

11. Sears Roebuck and other retailers started to take deposits in the 1980s. The Federal Reserve disliked unregulated competition.

Reform of regulation faced two major obstacles. Institutions and their trade associations supported regulations that favored them or put their competitors at a disadvantage. They fought to keep their advantages. Although the history of regulation showed that regulation often stimulated innovation to circumvent a regulation, regulators (usually lawyers) preferred prohibition to incentives as a regulatory procedure. Eventually, Congress adopted rules, such as structured early intervention, that increased incentives for prudent behavior.
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POLICY ACTIONS IN 1984

Inflation continued to slow in 1984 and the unemployment rate fell a bit. It remained below the expected value. Real growth slowed markedly. Table 9.2 shows the principal measures for 1984. The twelve-month average of monetary base growth ending in December slowed steadily from 10 to 6.8 percent. Ten-year Treasury yields ranged between 12 and 14 percent until the fourth quarter. By December the ten-year rate reached 11.4 percent. Using these data, the real yield remained at an extraordinary 7 percent or higher during the year.
¹³

The Federal Reserve raised the federal funds rate from 9.6 in January to a local peak of 11.6 percent in August. By December the funds rate was back to 8.4 percent, an unusual reversal in a short period. Member bank borrowing followed a similar path, rising until August, then falling. Borrowing reached more than $7 billion in August, much of it lent to Continental Illinois Bank as extended borrowing to prevent failure. The FOMC excluded extended borrowing from the measure it monitored.

The Board approved an increase in the discount rate to 9 percent at seven banks on April 6 to more closely align discount and market rates and to reduce borrowing. This was the first change since 1982. It came after the Board dismissed two earlier requests in March and early April and two proposed reductions in January. Between April 6 and September 17, the Board dismissed or deferred fourteen requests for an increase in the discount rate to 9.5 percent. Beginning November 13, it received requests for reductions to 8.5 percent. It accepted a decrease on November 21. It approved a second
decrease to 8.25 percent on December 21. The discount rate lagged behind market rates throughout the year. The Board changed the rate to align it more closely with market rates. This required a change in the level of the borrowing target; otherwise, borrowing was not expected to change.

12. Benston (1997) is a thorough discussion of reasons for financial regulation and a proposal calling for increased use of incentives.

13. The Bureau of Labor Statistics revised computation of the CPI by replacing measures of rental cost by measures of “rental equivalency.” This raised reported CPI growth.

Much of the discussion in the first six months of 1984 repeated 1983. The members distinguished “flexibility” and “automaticity.” Flexibility meant discretion. The FOMC permitted Volcker to modify its instructions when he thought he should. Sometimes, but not always, the FOMC had a telephone conference. A minority opposed substantial discretion and urged automaticity—hitting the agreed target, especially the money growth target.

Volcker and the staff included in the directive three money growth rates—M
₁
, M
₂
, and M
₃
—a borrowing objective, and a range for the federal funds rate. Modest efforts to relate borrowing and the federal funds rate target did not succeed very well. Volcker and the desk concentrated on different targets at different times. This also gave Volcker considerable discretion. The FOMC members did not agree on whether they faced higher inflation, recession, or both in the near-term. Also, bank failures and financial fragility made most members hesitant to propose major changes. Some expressed concern about the effects of higher interest rates on emerging market debtors and therefore on lending banks in the United States.

Volcker expressed his uncertainty frequently. For example, at the May meeting, he said:

My bottom line is that we’ve run out of room for the time being for any tightening. . . . I don’t know for how long. I don’t know what is going to happen in the weeks or months down the road, either to the economy or to the aggregates or these other things. I don’t have any sense here that we should be easing. But I do think we have to be concerned about a very potentially volatile and actually volatile set of attitudes here and elsewhere. (FOMC Minutes, May 21–22, 1984, 27–28)

No one suggested that the lack of consistency in their actions added to uncertainty and volatility. There are, however, frequent statements about market anticipations of higher inflation. The lack of an accepted procedure
increased attention to current data, often with large random elements and subject to subsequent revisions. This increased volatility also.