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Statement on PROPOSALS TO PHASE OUT INTEREST RATE CEILINGS Presented to ibcommittee on Financial Institutions Supervision, Regulation and Ins RCommittee on Banking, Finance and Urban Affairs | M-o House of Representatives by vV t Irvine H. Sprague, Chairman Federal Deposit Insurance Corporation f 9:30 a.m. Wednesday February 20, 1980 2222 Rayburn House Office Building I appreciate this opportunity to give you our views on the legislation you are considering on the phaseout of interest rate ceilings. You have before you a number of proposals, including the St Germain plan and the following bills: H. R. 6198, the ’’Thrift Equality and Deregulation Act of 1980” introduced by Congressman Barnard; H. R. 6216, the ’’Consumer Savings Account Equity Act,” introduced by Congressman Patterson, and Senate amendments to H. R. 4986, the ’’Consumer Checking Account Equity Act of 1979" (or the "Depository Institutions Deregulation Act of 1979” as the Senate version is titled) which is now in conference. The question concerning interest rate ceilings is not whether they should be eliminated, but how and when. If we do not provide for an orderly phaseout accompanied by appropriate new asset powers for thrifts, economic forces may make the ceilings academic faster than we had contemplated, and with unpredictable results. Most certainly, much of the action would be transferred to innovative mediums outside the regulated financial institutions. We are now in our fourth period of sharply rising interest rates in the last fifteen years (1966 - 1969 - 1974 - 1979)« Each time rates have reached higher peaks. The result has been a progressive building up of pressure on Regulation Q and other administered ceilings on the amounts institutions may pay on time and savings deposits. The pressure is forcing the creation in the marketplace of new outlets for savers’ and investors’ dollars. - 2- Among the most conspicuous of these new outlets have been the money market funds which enjoyed mushroom growth in 1979« The Investment Company Institute reports that fund holdings quadrupled to $45 billion last year and stood at $53 billion at the end of January, 1980. The ICI now counts 76 separate money market funds, an increase of 15 from 1978, and more than 2.3 million account holders, up by about 1.9 million from 1978. Another product of market pressures — the $10,000 minimum, six-month certificate of deposit with interest rates pegged to Treasury bills — less than 20 months ago. has flourished since its inception At the end of 1979, outstanding certificates totaled almost $265 billion, an increase of about $185 billion for the year. And now we have the new two-and-a-half-year certificates that have no Federally required minimum investment and pay near-market rates of return. They are attracting small savers in increasing numbers. All these outlets have one thing in common — at present they pay roughly double the ceiling rate on passbook savings accounts. The certificates with interest pegged to market rates are making up an ever-increasing portion of the institutions’ deposit base. Through November, 1979, the proportion of lower cost passbook accounts had declined to 42 percent of all mutual savings bank deposits from 68 percent in 1973 and to 25 percent of all Federally insured savings and loan association -3deposits from 47 percent in 1973« In commercial banks, passbook accounts rose from 19 percent of deposits in 1973 to 25 percent in 1976 and then declined to 20 percent by November, 1979* The regulators found it necessary to authorize these new certificates of deposit — the $10,000 instrument in 1978 and the two-and-a-half-year instrument last year — to stem the reality of disintermediation from thrifts which finance much of the housing industry. This is not the first time that we have had to react to the market in this fashion. For example, in the early 1970Ts regulators eliminated ceiling rates on certificates of deposit of $100,000 or more. And it will not be the last time. The lesson is clear: economic forces are requiring that our banking system be more responsive to the market and to customer needs. Deposit interest rate ceilings of today have been outstripped by events. The ceiling originated for commercial banks in the econo mic chaos of the Depression in the 1930s. The purpose of deposit rate ceilings at that time was to prevent ruinous com petition among banks for deposits. In 1966, ceilings were extended to the thrifts, and the purpose was broadened to moderate the competition between commercial banks and thrifts in an effort to assure a steady source of credit for housing. Today the system has been modified again to enable regulated -4institutions to compete with other outlets, including the money market funds, for savers’ and investors’ dollars. Against this background, we must decide whether we are going to provide for an orderly phaseout of Regulation Q or whether we are going to permit a haphazard deterioration of effective interest rate ceilings. DEREGULATION PROPOSALS The array of proposals before you today is evidence that Congress and others are ready to meet the challenge. Let me describe these proposals briefly, beginning with the threestage plan you announced at the beginning of these hearings January 24, Mr. Chairman. Your plan calls for an absolute end to interest rate ceil ings by December 31, 1985. In the interim, the differential would remain in effect and the regulatory agencies would be mandated to raise the passbook savings rate by at least onehalf percent within the first year. Also, in the interim the regulators would make further increases in ceiling rates as they determine to be advisable, after taking account of market interest rates and other relevant economic considerations. Also, Mr. Chairman, you have suggested staged removal of ceilings on longer-term deposits, prior to complete abolition of Regulation Q, along the lines proposed in H. R. 6198. -5The bill in conference, H. R. 4986, as passed by the Senate by a vote of 76-9 November 1, would freeze existing Regulation Q ceiling rates through 1981, and, beginning January 1, 1982, would require the agencies to raise Regulation Q ceilings by at least one-half percentage point annually through January 1, 1989« The differential would be maintained throughout the phaseout period. Under Section 107(b)(2), the Federal Reserve, after con sulting with the other agencies, could postpone or reduce any annual increase if it finds that economic conditions warrant or that such postponement or reduction is necessary to avoid a threat to the economic viability of depository institutions. Likewise, under Section 108, the Federal Reserve, after similar consultation, could reimpose Regulation Q ceilings for periods up to one year if it finds an extreme economic emergency to exist after Regulation Q authority expires on January 1, 1990. H. R. 6216, introduced by Congressman Patterson, would provide for the phasing out of Regulation Q ceilings starting five years after the bill is enacted. At that point, each agency would be required to increase, as soon as possible, the rate of interest on passbook savings accounts to the market rate of interest. Further, each agency would be required to ’’specify the market rate of interest” for the year in its annual report as well as ’’the rate of interest on passbook savings accounts” during the year. If the rate on passbooks were less than the market rate, the agency would have to cite the ’’economic condi tions which [it] considered in establishing” the passbook rate. - 6 - H. R. 6198, introduced by Congressman Barnard, would mandate one-half percent annual increases in all Regulation Q ceilings beginning July 1, 1980, leading to complete decontrol by July 1, 1985« In the interim, certain categories of deposits would be decontrolled under the following schedule: (1) July 1, 1980 — all time deposits with initial maturities of six years or more and all IRA and Keogh deposits, (2) July 1, 1981 — all time deposits with initial maturities of four years or more. (3) July 1, 1982 — all time deposits of two and one-half years or more. (4) July 1, 1983 — all time deposits of one year or more. (5) July 1, 1984 — all time deposits of 90 days or more. BROADER ASSET POWERS FOR THRIFT INSTITUTIONS All three bills would give broader asset powers to Federal savings and loan associations by granting them consumer loan authority and authorizing them to invest in commercial paper, bankers acceptances, and corporate bonds, subject to an aggregate limit of 20 percent of assets (10 percent in H. R. 6198). H. R. 4986 and H. R. 6198 would also grant trust powers to Federal savings and loan associations, subject to regulations issued by the FHLBB. -7- COMMENT I support the thrust of this legislation — to provide for an orderly phaseout of Regulation 0 and to enhance the power of the thrifts. (1) Some general comments: The phaseout must be accompanied.by a strong and fair package of improved asset powers for thrifts. (2) The decision on delaying the phaseout or reimposing any interest rate ceiling should not be shifted solely to the Federal Reserve Board. (3) The regulators should be given further flexibility to expedite or slow down the phaseout of interest rate ceilings should conditions warrant, using 10 years as the absolute outside limit. Let me elaborate. First, the legislative proposals we are discussing would provide enhanced asset powers to federally chartered institu tions. Some State laws already grant certain of these powers to State-chartered thrifts. We seek in the legislation under discussion to set an example for comparable State action, where necessary, so that overall competitive balance among institutions is maintained while specific powers are improved. I will discuss this in more detail later in the statement. Second, action on Regulation Q matters has traditionally been a shared responsibility with participation by all finan cial regulators. The system has worked well, and we see no - 8 - reason to change it drastically. I believe that no single regulator should have an absolute say — nor a veto — neither a go-ahead on any decision to delay or accelerate the phase out or to reimpose any interest rate ceiling. For that reason, I would recommend that the final legislation provide that any action on delay, acceleration or reimposition by the Federal Reserve Board require consultation and the concurrence of at least one of the two other regulators, i.e., the FDIC or the Federal Home Loan Bank Board. This would give no one a veto; it would give no one a free hand. Finally, although the key element in any legislation is an absolute outside date after which all know there will be no more ceilings and no more differentials, it would useful to provide the regulators considerable flexibility in the interim as they work toward the end date. Mandated increases, perhaps within a stated range over each two year period, would be useful. This would combine a guaranteed phaseout with the retention of some regulatory flexibility. ASSET AND LIABILITY POWERS FOR MUTUAL SAVINGS BANKS Mutual savings banks have always had problems in an unstable economy because of the imbalance in maturities of their assets and liabilities, i.e. , mutuals have borrowed short at rates which can vary quickly and have loaned long at fixed rates, primarily on mortgages. The problems have become acute in the present economic conditions of double—digit inflation, high, volatile interest rates and an inverted yield curve in -9which interest rates are higher for short-term maturities than they are for longer term maturities or U. S. Treasury obligations'. Current problems of mutual savings banks can be alleviated somewhat by changes in asset and liability powers. Such changes should be complementary; for example, a new liability power, such as NOW account authority, should serve to attract new depositors and therefore to broaden an institution’s deposit liability base. A new asset power, such as consumer lending, would give thrifts the opportunity to expand the range of profitable uses of that deposit base. Besides nationwide NOW account authority for all kinds of institutions, H. R. 4986, as amended, would sanction other new asset powers for Federally—chartered thrifts, including authority to hold up to 20 percent of their assets in unsecured consumer loans, commercial paper, corporate debt securities and banker’s acceptances. The bill also would permit trust powers and credit card operations for Federally-chartered thrifts and would allow thrifts to pro vide overdraft loans on NOW accounts. Thrifts also would be able to invest in and deal in loans or investments secured by liens on residential real estate to the same extent as national banks. We recommend that nationwide authorization of NOW accounts be included in any legislation that emerges from conference. Experience with NOWs in New England, New York, and New Jersey, where they are now permitted, has amply - 10- demons t rated these accountsf acceptance by both consumers and financial institutions. NOWs have great potential for thrifts, although institutions which have had no experience with transaction accounts will need to develop their ability to manage NOW accounts profitably. Further, we recommend that the final legislation provide the Federally-chartered thrift industry with "leeway authority” — an immediate ability to invest up to 20 percent of their assets in a wide range of activities, many of which are not now permitted. You may even wish to consider higher leeway limits as the phaseout of Regulation Q progresses. Leeway authority, as now contained in Section 213 of H. R. 4986, as amended, reads as follows: A Federal mutual savings bank may make loans and investments without regard to any other limitation under Federal or State law, except that — (A) not more than 20 per centum of the assets of such a bank may be so loaned or invested; and (B) 65 per centum of such loans and investments must be made within the State where the bank is located or within 50 miles of such State. The section would provide that the 20-percent authority be phased in as five-percent increments two years apart. Our concern is with the broad language "without regard to any other limitation under Federal or State law." If read literally, such language might imply exemption from safety -11 and soundness, truth in lending, insider transaction and other such laws, as well as the intended limited variance from the prescribed uses of thrift asset powers, .We believe that leeway authority should incorporate appropriate safeguards. Many States with large numbers of mutual savings banks now have leeway provisions with specific constraints. New York, for example, limits leeway investments to two percent of an institution’s assets and imposes other restrictions. Massachusetts has a three-percent-of-deposits limit. Connecticut has a two percent of assets limit on leeway authority and restricts investments in corporate equity to four percent of any corporation's common stock. Other States having leeway authority are Maine, Vermont, New Jersey, Oregon and Washington State. We would suggest that leeway authority for Federal mutual savings banks be tailored to empower thrifts to con duct business and compete with commercial banks on an equal footing, up to the 20 percent limit. Hopefully, the States would also address the question of providing to State-chartered thrifts the same powers available to commercial banks, up to a given percentage of thrift assets, so that thrifts better serve their communities. - 12- Several areas would be affected by Federal and State action. Consumer loans would help thrifts broaden their base of household customers, improve their competitive position against banks, expand their sources of deposits,' and help stabilize earnings and thrifts’ capacity to finance housing. We would recommend that any final legislation include secured consumer loans as well as the authority for credit card operations and unsecured consumer loans now in H. R. 4986, as amended. Consumer credit cards are a special form of consumer loan which has the twin attributes of high rate and short maturity. Credit card operations lack some flexibility, however, in that the bank has no control over the time the consumer uses the account and the amount charged to it, so long as that amount is within the card limit. Additional expanded consumer loan powers, both in types and amounts of loans, could provide higher gross earnings and also flexibility in short-term maturities. Authorizing thrifts to exercise personal trust powers, as now in H. R. 4986, would give thrifts a service function which, if properly managed, may provide income at the same time it rounds out the package of financial services offered to individuals. Another promising source of new business for mutual savings banks is the business sector itself. -13Up to now, thrifts' activities have been restricted almost entirely to the personal-household sector. Mutual savings banks generally have been sharply circumscribed in the nature of services they can offer businesses. If mutual savings banks could offer a package of demand and time deposits to businesses, the institutions would have the opportunity to gain a new source of funds for investment. To make the deposit services sufficiently attractive, mutual savings banks also would need authority to lend these funds back to businesses. This would mean that these new business deposits would provide only a minimal increase in funds for residential mortgages. But the new business loans would have shorter maturities and thus would contribute some flexibility to asset structure. This could improve thrift profitability which would benefit housing in the long run. Later, mutual savings banks might also be given powers to provide trust services to businesses. We do not believe that mutual savings banks would enter the business service sector on such a scale as to imperil the flow of funds to housing. What we envision is merely a source of supplemental profit for thrifts and an additional support to institutional stability. -14Authority to serve the business sector would be a quantum increase in mutual savings bank powers. This could present a more difficult period of adjustment than any of the other changes discussed here. Most mutual savings banks probably would enter the business field slowly to gain the the necessary knowledge and experience. Some State laws already give mutual savings banks most of the statutory powers they need to invest in a full range of financial instruments or to issue obligations with varying maturities and conditions. Whatever clarification is desir able is mostly in the field of regulations. In FDIC, for example, we have issued a final rule, effective next month, which will permit mutual savings banks to sell unsecured, short-term commercial paper in denominations of $100,000 or more without regard to the limits on advertising and pay ment of interest. This will allow savings banks to tap new sources of funds in the commercial-paper and short-term securities markets. HOUSING Despite innovations such as NOV/ accounts, leeway authority, and expanded consumer lending powers, I believe that mortgage lending will continue to be the mainstay of thrift asset port folios. Thrifts are comfortable in this business; they are thoroughly experienced in it; and they have strong tax incen— tives to remain in it. -15It is not surprising, then, that we are seeing strong pressures to increase the return from the mortgage lending business. There is growing advocacy of alternative mortgage instruments which would shift the risk for interest rate increases from the lender to the borrower. Variable rate mortgages, in which the interest rate may vary within pre scribed limits, have already been authorized by some States and by regulation for certain Federal institutions. Renego tiated rate mortgages, in which the entire mortgage loan agreement is renegotiated at specific intervals, such as five years, are coming in for increasing discussion. I believe that competitive equity must be maintained. If any class of institutions in a State is permitted to issue alternative mortgage instruments, it then becomes desirable for all institutions in that State, including mutual savings banks, to have that authority. But in all instances alternative mortgage instruments must be accompanied by strict safeguards for the consumer, including the offering of a free choice between these new instruments and a conventional fixed—rate mortgage in which the borrower knows what he or she will pay over the life of the loan. The purchase of a home, a once—in—a—lifetime event for many, is a daily routine for the lending institution, which therefore has an enormous advantage in any negotiations. The holder of an alternative mortgage who faces potential increases in interest costs should not also be required to - 16- bear additional incidental cost. Specifically, we recommend that lenders be prohibited from charging any cost associated with renewal of the loan, that borrowers be permitted to repay the loan on the first renewal date without a prepayment penalty, that the renegotiated rate reflect the reduced risk of default associated with a renewed loan (viz., reduced loan principal, increased property value, and borrower’s established record of repayment), and that cause for refusal to renew be well defined so that a lender cannot seize upon a technical default, such as a single late payment. Additionally, we should elimi nate barriers to refinancing so that a consumer can take advantage of a beneficial change in financial position. Specifically, we should make title insurance transferable and provide that property surveys required by the lender and paid for by the borrower shall belong to the borrower. Elimina tion of these two costs would make refinancing a more viable consumer safeguard. In some States usury laws are distorting the free market, in some cases to the extent of providing national banks with an enormous competitive edge over State banks; so it may be wise to preempt State usury laws very briefly, perhaps for a year, to give States an opportunity to act. It may not seem consistent to argue for the dual banking system and the rights of the States to set their own ground rules and at the same time to ask for federal preemption of the usur-y laws. V -17However, because of the enormous disruption In some States at present, we should provide a very limited period in which the States can get their houses in order. STATE ACTION My discussion of possible new or modified asset and liability powers of mutual savings banks has been couched in terms of federally chartered institutions; I have been speak ing of federal law and regulations rather than State. State provisions vary, but federal preemption usually Is not necessary to obtain counterpart State action. Legislators, regulators and bank officers can be affirmatively influenced by changes in the laws and regulations of other jurisdictions. Example is as powerful as force in many cases. In instances when it is not, State-chartered mutual savings banks now have the additional leverage afforded by their authority to convert to a federal charter under Title XII of FIRIRCA. A New Hampshire mutual savings bank already has become the first in the nation to apply to the Federal Home Loan Bank Board for a federal charter. Several other mutuals are seriously considering conversion. One is located in Minnesota, and three or four are in New York, including some sizable institutions in New York City. BANK STOCK LOANS Finally, I would like to comment on H. R. 5700 which would prohibit the Federal Reserve Board from rejecting an application to form a one—bank holding company solely because - of specific debt terms. 18 - I believe that issues related to the financing of bank holding companies should not be dealt with legislatively. This is a safety and soundness matter that should be left to the bank supervisory agencies. Decisions on the formation of bank holding companies rest with the Federal Reserve Board. The Board recently put out for public comment a policy statement revising its conditions on the financing of small one-bank holding companies. CONCLUSION With regard to interest rate ceilings, the FDIC believes that Congress should recognize the reality that Regulation Q is not working, that Congress should phase it out in an orderly manner and should at the same time phase in added powers for our thrift institutions so they can compete with commercial banks in serving the credit needs of their communities.
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