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Statement by

Frederick H. Schultz

Vice Chairman, Board of Governors of the Federal Reserve System

before the

Committee on Banking, Housing, and Urban Affairs

United States Senate

December 17, 1979

I am pleased to appear before the Senate Banking Committee today to
present the views of the Federal Reserve Board on S. 1988.

This bill would

grant additional lender groups the authority, now limited to national banks,
to set loan rates up to one percentage point above the Federal Reserve
■
''count rate regardless of any state law stipulating a lower ceiling.

In

addition, it would permit any state to reimpose its state usury limits by
enacting overriding legislation.

Another provision of the bill, also

subject to state override, specifies that rates paid on deposits would be
exempt from state usury regulation.
The Board has long been concerned about the adverse impact that
usury ceilings can have on the availability of funds in local credit markets,
and has frequently stated its opposition to such artificial constraints.

In

general, regulatory limits on loan charges tend either to have little or
no effect (when market-determined rates are at or below the ceiling) or to
be counterproductive (when market-determined rates are above the ceiling).
When nominal market interest rates are high, as at present, usury ceilings
typically distort credit flows by inducing lenders to channel funds into
assets or geographic areas less affected by ceilings.

Nonprice lending

terms in restrained markets may be tightened severely to compensate for
the relatively low nominal interest rates that can be charged, and credit
may become totally unavailable except to the most highly qualified borrowers.
Because of the Board's view that credit markets function most
effectively when allowed to operate as freely as possible, we support in
principle the removal of impediments posed by usury laws.

Nevertheless,

serious concern has been expressed by some Board members about Federal




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preemption of state law.

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Also, the Board strongly recommends against

tying ceiling rates to the Federal Reserve discount rate.

The Board believes

that a more effective long-range solution to rate ceilings should continue
to be sought— for national as well as state banks and other institutions.
While a majority of the Board feels that S. 1988 can be supported as a
stop-gap measure, we urge that a more appropriate reference rate than the
Federal Reserve discount rate be selected, and that a sufficient differential
above that rate be specified to allow more adequate flexibility in various
credit markets.
Many members of the Congress are understandably reluctant to
preempt state laws or constitutional provisions.

The Board also feels that

corrective action at the state level would be the most desirable way to redress
the counterproductive effects of state usury laws.

Quite a few states, in

fact, have already revised their usury or other lending statutes since the
beginning of this year, although some revisions have been outdated by sub­
sequent market developments.

Further state action would await the next

legislative sessions or, as in Arkansas, the process of constitutional
amendment.
S. 1988 would immediately address the market dislocations due
to rate ceilings in any state.

As noted earlier, it also would honor

state prerogatives by enabling legislatures to reject the rate flexibility
provisions of this bill through passage of a new state law reaffirming
existing regulations.

In the view of the majority of the Board, this

approach would provide adequate preservation of state authority to regulate
lending practices.

However, some members of the Board have strong reservations

about endorsing legislation that would further encroach upon state powers.




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The proposed bill would peg the maximum permissible lending rate
at one percentage point above the discount rate on 90-day commercial paper
prevailing in the Federal Reserve district in which a lending institution is
located.

The Board recognizes that this formulation has applied to national

banks since 1933.

Nevertheless, we have strong reservations about it, and I

would like to invite your further reflection upon the advisability of indexing
loan rate ceilings to the discount rate.
The Federal Reserve discount rate is a short-term rate; by com­
parison, many of the target credit markets of the proposed bill involve
long-term lending, such as home mortgage loans, as well as shorter-term
credit.

It is unusual for interest rates across maturity categories to be

patterned in such a way that a one percentage point markup over the discount
rate would provide much practical relief from usury ceilings in all markets.
Even now, with the discount rate at a historically high 12 percent, a one
percentage point markup would leave the ceiling lending rate below average
home mortgage rates in many areas. .Moreover, the discount rate is an
administered rate, not a market rate, and may not always closely reflect
levels or movements even of short-term market rates.

In general, we feel it

unwise to single out a tool of monetary policy for a purpose, such as indexing,
not directly policy related.
As you know, other bills enacted or now under consideration by the
Congress deal with restrictive state usury ceilings in somewhat different
ways than S. 1988.

The recently enacted Public Law 96-104, which in effect

applies only to Arkansas, pegs permissible rates for business and agriculture
loans of $25,000 or more to the discount rate, but allows for a five percentage




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point differential.

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A provision in the proposed Financial Institutions

Deregulation Act would remove usury ceilings on home mortgage loans altogether
for a broad spectrum of lenders.

In contrast to these approaches, the indexing

formulation of S. 1988 provides relatively little relief from state usury
ceilings.

We suggest as an alternative that outright removal of ceilings be

considered, or if a ceiling is to be maintained, that a market rate of medium
or long maturity be used as a reference rate, and that a markup be established
to allow a wider degree of rate flexibility in the target credit markets.
In this connection, I would observe that experience with floating-rate
usury ceilings in several states has shown that even a market rate of appropriate
maturity may not always perform the pegging function in a fully satisfactory
manner.

Illinois, for instance, had employed a ceiling for residential

mortgage loans that was 2-1/2 percentage points above an index of long-term
U.S. government securities yields.

However, yields required by lenders on

home mortgage loans in unconstrained markets subsequently rose above this
floating ceiling, and the volume of home mortgage lending in Illinois was
curtailed.

Consequently, in November of this year, the Illinois legislature

suspended any ceilings on home mortgage rates through the end of 1981.
I would also note that the sponsors of S. 1988 have emphasized the
goal of equalizing competition among national banks and ocher depository
institutions.

The Board shares the view that, in principle, similarly situated

lenders should operate in similar regulatory environments.

The bill would

achieve partial competitive equality, inasmuch as the provisions now applicable
to national banks would he extended to all federally insured state-chartered
commercial and mutual savings banks, all federally insured savinqs and loan




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associations, certain federally insured credit unions, and all small
business investment companies.

However, various other lenders not covered

by the proposal would remain without relief, including all life insurance
companies, all mortgage bankers, and some credit unions.
In summary, because of the distortions in local credit markets that
result from unreasonably low interest rate limitations, the Board strongly
endorses efforts to remove the restraints of usury ceilings altogether.

We

would urge the states to reevaluate their usury laws in light of recent
experience with historically high market rates, and are pleased to note
that many states have been and are doing so.

In view of the pressing need

for some relaxation of usury ceilings and the time lapse before the scheduled
opening of legislative sessions in several states, the majority of Board
members supports S. 1988--subject to modification in order to incorporate
a more appropriate reference rate than the Federal Reserve discount rate—
as an interim measure until the statesr themsel ves or the Congress can
provide a more satisfactory soiutioiK •