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July 3,1 981 - - - ----------"---"--------"---------- Over The Limit Usury laws, an ancient device for setting legal limits on loan interest charges, have recently reduced consumer-credit availability in states with low statutory ceilings. Their effect thus has resembled the impact of interest-rate ceilings on the supply of passbook-savings deposits. Below-market interest-rate ceilings on deposits-deposits being loans made by consumers to depository institutions-have induced consumers to shift their funds from low-yield passbook-savings accounts into financial assetspaying a market rate of return. (The recent boom in money-market mutual funds exemplifies this trend.) Similarly, in periods of high interest rates, low fixed-rate usury ceilings have induced financial institutions to restrict their consumer lending in favor of other types of assetsyielding a market return. Consumer creditthus has contracted as financial institutions in usury-law states have shifted their loanable funds to other markets. The Depository Institutions Deregulation and Monetary Control Act of 1980 (MCA) represented an attempt to end low fixed-rate ceilings both on loans made by lenders to consumers (usury statutes) and on loans made by consumers to banks and thrifts (deposit ceilings). The provisions of the Act should reduce the likelihood, and severity, of the periodic consumer-credit crunches and deposit shortages caused by ceilings in the past. Following the trend started by the regulatory agencies' authorization of market-yielding money-market certificates in 1978, the Act provided for a phase-out of deposit rate ceilings over a six-year period. (Last week, the Depository Institutions Deregulation Committee set a definite timetable for the phase-out.) The Act also preempted usury ceilings on mortgage and consumer loans, as well as on some small business and agricultural loans. Why ceilings? Usury, in its archaic form, referred to the act of charging interest for the use of money. Today, the payment of interest is taken for granted throughout most of the commercial world-except for countries like Saudi Arabia, where religious strictures prevai I against the practice. But even in the present-day United States, debates continue about the charging of "usurious" or "exorbitant" interest. Almost all American states have usury ceilings of some type. These laws set maximum interest rates that lenders may charge on specific types of loans. The statutes typically "attempt to limit interest rates, fees, discount points, or other charges on loans to Individuals or small businesses. The ceilings may vary according to the type of lendercommercial bank, thrift institution, finance company, mortgage company, or individual -or they may apply to all lenders. Other factors-purpose of the loan, type of borrower, and size of loan -may also determine ceilings. In modern times, however, most stateshave Iimited the use of usury statutes to mortgages and consumer loans. Some states have set consumer-loan ceilings at a fixed rate. The state of Washington, for example, until quite recent months imposed a 12-percent ceiling rate. Some ceilings may be tied to a market-determined interest rate such as the Treasury bill rate-Washington'S new ceiling is four percentage points above the equivalent coupon yield on 26-week Treasury bills. Orceilings may be based on an administered rate, as in Alaska, where the ceiling is set at five percentage points above the discount rate charged by the Federal Reserve Bank of San Francisco. Legislatures typically have enacted usury ceilings to protect small borrowers, in an attempt to guarantee that available credit would be priced at a "reasonable rate." Supporters have argued that a legal maximum rate is necessary to protect borrowers from a possible lack of lED fu.CD) CBl101 II IFIT@Jl1 II l(C J (Q) Opinions expr2s:;ecl in thi::, nevvsletter do not reflect HH' of th!:' management of the Federal Reserve Bank of San Francisco, or of the Board of Covemors of the Federal Reserve Svstem. IIE'CeS';;(Hily are able to alter their portfolio composition, state usury laws thus tend to limit the total amount of credit available to consumers within affected states. competition in lending markets-and from the stronger bargaining position held by lenders because of their large size and easier access to information. Information on loan rates, maturities, fees, and repayment terms is costly for to obtain, so that they cannot easily shop around to obtain the most favorable terms. Legislatures thus utilize ceilings to limit lenders' ability to turn possible bargaining advantages into high interest rates and fees. In recent years, however, other legislation (such as the Truth in Lending Act) has aided consumers by standardizing the statement of contractual terms and by simplifying comparisons among lending agreements, thereby eliminating some of the supposed need for usury statutes. Moreover, financial markets have become more integrated and competitive over time, so that consumers normally have many borrowing options available to them. Ceilings also induce institutions to tighten their non-price terms of lending in order to reduce loan volume and to lower costs. To ration the dwindling supply of credit, institutions will tighten credit standards, allocate loans to existing customers, and limit maximum loan sizes. Also, as a means of reducing costs-especially loan losses and administrative expenses-institutions will allocate available credit to their most credit-worthy, low-risk borrowers. Thus, rather than insuring wide-scale availability of credit at artificially low rates, binding usury ceilings may simply guarantee availability of credit to the "best" customers. Borrowers who otherwise might qualify if institutions could charge above-ceiling rates will be left without credit. Unintended effects When market-determined interest rates soar above statutory ceilings, usury laws admittedly limit the price of credit. However, ceilings also effectively limit the return to lenders, making certain loans unprofitable without affecting yields on other types of lending. Limited yields on consumer loans thus induce financial institutions to restrict their consumer lending and also to tighten credit standards on such loans. Some depository institutions with heavy retai I or consumer orientation may find it difficult to switch from consumer lending into other types of lending. Large investment in staff training, marketing programs, and lending faci Iities -not to mention legal barriersmake it very costly for institutions to switch policy in this way, at least in the short-run. Institutions may be willing occasionally to take short-term losses on some loans in order to preserve profitable long-term relationships with "valued" customers. But now, with the high cost of new consumer deposits (especially money-market certificates), usury ceilings may make consumer lending even more unprofitable than in the past. Banks in particular have available a wide array of lending opportunities, so that they can adjusttheir assetand liability portfolios in response to ceilings placed on consumerloan rates. For example, they may increase their lending to the business community (through direct loans or purchases of openmarket paper), to the government sector (via purchases of new securities), or to other commercial banks (through loans of funds in the inter-bank Federal funds market). In many cases, they lend such funds to out-of-state corporations, governments, or financial institutions. Or they may simply reduce their total lending and their managed liabilities accordingly. Because financial institutions Credit availability Recent large-bank data from the San Francisco (Twelfth) Federal Reserve District provide support for this analysis. From the third quarter of 1 979 to the first quarter of 1981 -a period of generally very high market rates-outstanding consumer credit actually declined in states with usury-law limitations on consumer-lending rates. In 2 other states, consumer lending continued to grow, even in the face of sluggish economic conditions, high interest rates, and the spring-1 980 credit-control program. Usury ceilings may not account for all of this difference in states' growth patterns, but they undoubtedly explain a large part of it. problem, however, since the discount rate typically lags behind the market during periods of rising market rates. Moreover, the discount rate-as an administered, one-day, risk-free secured loan rate-is often well below market-determined rates. In light of this partial solution, state and Federal legislators have intensified their efforts either to rewrite usury statutes or to eliminate them altogether. Two Western states with rigid rate ceilings, Washington and Idaho, have just taken actions to liberalize their usury statutes, while the third, Oregon, is expected to do so soon. In this 1979-81 period, total consumer loans at large banks in Washington, Oregon, and Idaho, where ceilings were wei! below market rates, declined at a S.l-percent annual rate. In dollar terms, their outstanding consumer loans fell from $3.7 billion to $3.4 billion over this time-span, in quarterly average terms. Meanwhile, average consumer loans at large banks in five other Western states without usury ceilings rose at a 3.2-percent annual rate, despite all the negative factors affecting consumer markets atthattime. Recent and proposed legislative changes may result in higher fixed usury ceilings, variablerate usury ceilings or, in some cases, no ceilings at all. But in most cases, ceilings will now move with the market, rising and falling with the general level of interest rates. During periods of high interest rates, these changes will keep consumer credit from "drying up" as it did in the past. Moreover, a potential borrower who cannot obtain a loan at an artificially low rate may certainly prefer paying a higher rate to not obtaining a loan at all. Usury-law changes Recognizing the perverse impact of usury ceilings on the availability of consumer credit, Congress last year included several provisions in the Monetary Control Act to deal with this problem. First, the MeA preempted state usury ceilings on mortgage loans-unless states reinstate such ceilings by April 1, 1983. In contrast, the Act did not include an unlimited override of state ceilings on consumer loans. Instead, it authorized insured state-chartered banks and thriftsnational banks already had authorization -to set consumer-loan rates at a maximum of one percentage point above the basic Federal Reserve discount rate. This represented only a partial solution to the Consumer Loan Growth Large Western Banks 1979 III to 1981 I Annual rate of change (:;) 6 4 In a wider sense, elimination of consumercredit crunches should benefit not only consumers but also business activity generally in affected states. Finally, the shift to floatingrate usury ceilings, or even total elimination of ceilings, would be consistent with Congressional efforts to decontrol interest rates on both consumer loans and deposits. Gary C. Zimmerman States (5) without effective ceilings t 2 o -2 -4 -6 States with binding usury ceilings 3 SS"1::> !!l?Ml?H • ·l!le::> 'O:lSpueJ:I ues ZSL·ON llWHld OIVd lS Od ·s·n llVW SSV1::> lSHI:I • • uoSaJO • l?pl?!\aN • 04l?PI l?!UJO)!Il?:) • l?uozp'v' • l?>jSl?I'v' @li\\JJ@<§@@ :iJ, BANKING DATA-TWELFTHFEDERAL RESERVE DISTRICT (Dollaramounts millions) in . Selectedssets liabilities A and large CommercialBanks Loans (gross, adjusted) investments* and Loans (gross, adjusted) total# Commercial industrial and Realestate Loans individuals to Securities loans U.s. Treasury securities* Othersecurities* Demanddeposits total# Demanddeposits adjusted Savings deposits total Timedeposits total# Individuals, part.& corp. (Large negotiable CD's) WeeklyAverages of Daily Figures MemberBankReserve Position Excess Reserves )/Deficiency- ) (+ ( Borrowings Netfreereserves )/Netborrowed( ) (+ - Amount Outstanding 6/17/81 149,637 127,799 37,921 52,629 22,958 1,592 6,425 15,413 40,730 27,869 30,187 80,019 70,969 30,688 Weekended 6/17/81 n.a. 135 n.a. Change Change from yearago from Dollar Percent 6/10/81 - 333 9.3 12,673 10.7 12,361 214 13.4 4,487 350 12.6 5,876 118 3.9 30 920 57.0 578 83 1.2 78 18 1.6 238 101 - 2,596 - 6.0 923 2,893 - 9.4 -1,355 - 142 9.5 2,612 - 312 25.1 16,069 - 194 28.9 15,919 8,009 35.3 393 Comparable Weekended year-ago period 6/10/81 n.a. 173 n.a. - 73 1 - 73 * Excludes tradingaccountsecurities. # Includes itemsnot shownseparately. Editorialcomments maybe addressed the editor (William Burke) to the author.... Freecopies this to or of andother Federal Reserve publications beobtained callingor writing thePublicInformation can by Section, Federal Reserve Bankof SanFrancisco, Box7702,SanFrancisco P.O. 94120.Phone (415)544-2184.