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turn [ N E W S RELEASE FEDERAL DEPOSIT IN S U R A N C E C O R P O R A T IO N FOR IMMEDIATE RELEASE ( PR-26-79 (3-22-79) librar« „„ \ ‘2>^ * * 2 * £ * 0Statement on REGULATION Q DEPOSIT INTEREST RATE CEILINGS Presented to COMMERCE, CONSUMER, AND MONETARY AFFAIRS SUBCOMMITTEE Of the hout> COMMITTEE ON GOVERNMENT OPERATIONS y 7 U. S. House of Representatives by 0 Irvine H. Sprague, Chairman Federal Deposit''insurance Corporation March 22, 1979 FEDERAL d e p o s it in s u r a n c e C O R P O R A T IO N , 5 5 0 Seventeenth St. N.W., Washington, D.C. 20429 202-389-4221 Mr. Chairman, I find it difficult, yes, impossible, to rationalize a system wherein those with $100,000 receive a high rate of interest, those with $10,000 receive a rate of interest nearly as high, and those with $1,000 or less receive a low rate of interest. If we can thus agree at the outset, and I believe we can, then this discussion can be most useful in considering the ramifications of alternative suggestions, rather than rhetoric about inequities of the present system. Your committee is doing a service in providing a focus on this issue. As you know, the regulatory agencies earlier this month voted to reduce the spread between passbook accounts and money market certificates. The figures now are about 1/2 of 1 per cent closer than before we acted. And we now are considering how we might b^st provide a "consumer account" that would provide benefits to the small saver without unduly impacting on inflation or seriously jeop ardizing the institutions. You posed a series of specific questions in asking me to testify. AUTHORITY FOR UNILATERAL ACTION BY FDIC The thrust of one set of questions is to inquire about the legal ability and the regulatory desire of the FDIC to act independently on the issue of Regulation Q ceiling. - 2- The simple answer is we cannot act alone responsibly. ( I can think of nothing more destructive than for the regulatory agencies to go off in different directions — each ignoring the other, each following its own whim, each oblivious to the demands of the whole picture. You'd have one agency tinkering with a rate here, meddling with another one over there, getting out a new, more attractive CD some place else. You would touch off rate whipsaw among the institutions, sow confusion among the depositors, and erode the underpinning of the banking industry. Furthermore, even if we had any latent inclinations to act on our own, the law is quite specific — it requires us to maintain at least a quarter percent differential in interest payable by thrifts as opposed to commercial banks on passbook savings accounts. I suppose, theoretically, that the FDIC could by itself legally raise the rate for mutual savings banks alone and give them an unfair competitive advantage over commercial banks and savings and loans. Such action would be irresponsible in the extreme and we would not consider it. It is true that the letter of the law requires not only that the agencies consult before they act or decline to act, but the spirit of the law and the nature of the banking industry clearly demand joint action. That is the way the partner agencies have acted in the past; that is the way we must continue to act if we are to assure a safe and sound banking system. The interests not only of the banking industry, but also the public, including the -3- small saver, and the economy at large are at stake here. THE SMALL SAVER I would like to turn now to the major concern of your hearings, Mr. Chairman — helping the small saver. The question is not an isolated matter; it is deeply involved with the complex economic situation we face today. Let me discuss briefly the forces in our interest rate regu latory structure and how they affect the small saver today. Under regulatory ceilings,financial institutions have been permitted since 1973 to pay the going rate of interest on large deposits of $100,000 or over, with maturities of as little as 30 days. These actions were taken to offset the market alterna tives available to persons having large sums of money and to encourage these depositors to retain their money in financial insti tutions instead of driving them to other more lucrative invest ments. The market rate last week was about 10.5 month $100,000 certificates. percent on six- Last June the regulators authorized a new type of deposit tailored for the medium l e v e l — a $10,000 minimum, six-month certificate of deposit whose interest rate was tied to the weekly rate on the six-month Treasury bill. Two weeks ago we eliminated compounding and the differential over 9 percent on these money market CDs. (Last Friday's rate was 9.457 percent.) This leaves savers with less than $10,000 to returns limited by Regulation Q to five percent (and five and one-quarter percent for thrifts) on passbooks and six to eight percent on a variety of other kinds of deposits with maturities ranging from one to eight years or more. -4- It is this last group of savers that has become the focus of these hearings. One of the immediate questions before us is how to help the small saver without disrupting the flow of funds to housing or threatening the solvency of the thrift institutions on which housing and the small saver mutually depend. While commercial banks, with greater diversification of both their assets and liabilities, would not be as seriously affected by paying significantly higher rates to small savers, the picture is quite different for thrift institutions which specialize in home mortgage lending. For the mutual savings bank industry, which is the portion of the thrift industry directly subject to FDIC supervision, the squeeze would be very real. And if the regulators raised only the commercial banks, the effect on thrifts would be catastrophic. MUTUAL SAVINGS BANKS Before we acted to trim the compounding and differential costs on money market CDs, our projections showed that mutual savings banks would come out of 1979 nationwide, and in New York in particular, in worse financial shape than at any time in this decade and that includes the 1974—75 recession which was the worst since the great depression. If thrifts cannot improve revenues or reduce other costs, they will not be able to gener ate the means to increase their payments to small savers. At present high interest rates, it is likely that most time accounts and a substantial portion of savings accounts would be converted to six-month MMCDs if the $10,000 minimum were reduced -5- to, say, $1,000. It is clear, therefore, that increasing the cost and shortening the average maturity of liabilities in a substantial way could seriously impair the ability of the mutual savings bank industry generally, and the New York State industry in particular, to pay a satisfactory return to small savers. Any abrupt relaxation of Regulation Q could send interest costs sky rocketing and create further mismatching of short-term liabilities against long-term assets. This combination would deal a severe blow to the entire mutual savings bank industry. Projected higher returns cannot benefit the small saver if we jeopardize the thrift industry in the process. This is the dilemma we face. Let us review the background on Regulation Q. Congress first authorized the regulation of interest rates paid on time deposits in the Banking Act of 1933 which gave such authority to the Federal Reserve. authority to the FDIC. The Banking Act of 1935 extended that The purpose at that time was to safe guard the safety and soundness of banks by protecting them from unsound competition. In the mid-1960s the purpose was expanded to foster a flow of funds into the housing mortgage market. The Interest Rate Adjustment Act of 1966 extended deposit interest rate ceilings on a temporary one-year basis to savings and loan associations. The same year, in an effort to protect thrifts from disintermediation, the regulators established lower ceil ings for commercial banks. In 1975, Congress further buttressed the thrift institutions - 6 - by mandating retention of a differential on existing accounts. The differential was then and remains today a quarter-percent higher rate of interest to be paid to thrift depositors on pass book accounts and most time deposits The pressure did not abate, however, and the Regulation Q authority has been extended thirteen times by Congress, most recently until December 15, 1980, by Title XVI of the Financial Institutions Regulatory and Interest Rate Control Act of 1978. The history of the middle and late seventies has been a relentless pressure on these interest controls. As recently as 1976, the six-month Treasury bill rate was 5.25 percent — about the same as the Regulation Q passbook ceiling for thrifts. In little more than two years that Treasury bill rate has jumped to 9.457 percent while the Regulation Q ceiling has remained at 5.25 percent — unchanged since 1973. The result has been that money has sought means to higher returns, ways to circum vent the Regulation Q ceilings. In successive efforts to combat disintermediation of deposits in thrift institutions and thus a threat to the housing industry with all that this implied for the economy at large, the federal regulators created various kinds of time deposits — in the fall of 1973 four-to-six year certificates of deposit bearing higher than passbook interest rates and in the winter of 1974 six-to-eight year CDs with higher rates still. In mid-1978 permissible rates on governmental deposits and Keogh and IRA accounts were raised to eight percent, and two new CDs were established — an eight-year instrument with an eight percent ceiling and the $10,000 money market CD I have already mentioned. -7- INNQVATIVE AND UNREGULATED Still the assault on interest rate controls continues in a number of ingenious forms and imaginative devices of bank and nonbank financial institutions. Let me list some of their offer ings to the consumer market in the 1970s: Citicorp’s floating rate notes issued in 1974, Merrill Lynch's cash management account which allows customers to earn interest on margin accounts or use VISA card or write checks or perform other financial transactions, money market mutual funds offered by most large brokerage houses, and Sears' proposal to offer $500 million in medium-term, $1,000 notes to its 26 million credit card holders. None of these private financial innovations are subject to federal interest rate regu lation. With equal ingenuity, new kinds of accounts have been created to draw interest within the regulatory farmework: for example, NOW accounts introduced by New England thrift institutions and the pooling of numerous small deposits to be placed in larger certificates at negotiated rates of interest. These devices are part of a growing pattern of "cracks in the financial dam" — ways by which investors, including moderate- income consumers, can place their money to obtain better return than through the traditional savings account. COST IMPOSED ON SMALL SAVERS Let me turn now to the specific questions in your letter of nvitation. First, you have asked FDIC's views on costs imposed on small savers by deposit rate ceilings and minimum denomination - restrictions. 3 - Clearly, these impose a regressive and regrettable burden on the small saver. Lower-income groups do not have the financial resources to meet the minimum denomination requirements of the higher paying money market instruments. Moreover, econo mists have shown that small savers, in effect, subsidize large savers because the lower mortgage rates fostered by interest rate ceilings benefit higher-income persons who hold more of their wealth in real estate than individuals with lower incomes. You ask if the cost to small savers is small or large. That depends on the proportion of an individual's income or wealth held in time and savings deposits. We have no current data. most recent survey of which we are aware — ago — The done sixteen years revealed that the lower-income half of the population held almost twice as much of its income and three-quarters more of its wealth in time and savings deposits than did the upper-income half of the population. Even without a more current study, we can reasonably suspect that the proportion of lower-income wealth in time and savings deposits subject to rate ceilings is even greater today. This is, first, because the denomination on Treasury bills was raised from $1,000 to $10,000 in March 1970, making it more difficult for lower-income persons to take advantage of higher market rates. Second, the disintermediation experience of early 1978 indicates that large depositors are more likely to react to spreads between market rates and deposit rate ceilings by transferring their funds accordingly. 9 DOLLAR COSTS ON DEMOGRAPHIC GROUPS You have asked for numerical estimates of the costs of rate restrictions on identifiable demographic groups. An estimate prepared by David Pyle of the University of California projects total saver losses because of interest ceilings of $22 billion from 1953 through 1975, consisting of $13 billion at commercial banks and $9 billion at thrift institutions. A recent study prepared for the FDIC by Charles Lieberman, now on the faculty of Northwestern University, showed that the distributional impact of deposit rate ceilings is highly regressive. The study shows that in 1970 alone, those in the lower income half received approximately $420 million less than they would have if the loss of interest income caused by Regulation Q had been distributed in proportion to income. Moreover, the study shows that the redistributional impact of these ceilings benefited the young by about $1 billion at the expense of the old, the South by about $260 million at the expense of the Northeast, whites by $205 million at the expense of non whites, male-headed households by $248 million at the expense of female-headed households, families by $188 million at the expense of individuals, urban dwellers by $850 million at the expense of the non-urban, and the college educated by $189 million over the non-college educated. It should be noted that the Pyle and Lieberman results were derived from data in the 1960s, but the distributional pattern of the interest losses is believed still valid. 10 CONSTRAINTS ON REGULATORY AGENCIES The major policy considerations that constrain the regulators from permitting market-determined interest rates are, as you point out, the soundness of the thrift industry and the holding down of housing costs. In our effort to help the small saver, we cannot act reck lessly without regard for the danger of disintermediation or the financial health of the depository institutions. In addition to our housing responsibilities, we have the duty of cooperating with the conduct of monetary policy. Obviously, Mr. Chairman, it is not unusual when these various, major, differing objectives conflict. To illustrate, consider the potential impact of an immediate lowering of the minimum denomination of the six-month money market certificate to $5,000 or $1,000 at this time in an effort to help the small saver. That means the interest on a $1,000 CD is almost twice that on a $1,000 passbook savings account. It doesn't take any imagination to see that depositors will convert as soon as they can. These conversions, of course, introduce no new funds into mutual savings banks although they help retain funds already there. But unless the new instruments attract substantial inflows from other sources, there will be little increase in the funds mutual banks must invest in housing or elsewhere if they are to earn sufficient return to meet the higher interest cost we regula tors would have induced by creating the $5,000 and $1,000 certifi' cates. In addition, the liability structure of the thrift 11 institution would be materially shortened, thus introducing a potential for instability in deposit flow and aggrevating the maturity mismatch between the assets and liabilities of thrifts. We would be doing very little for housing and we would be impairing mutual savings banks in the process, which ultimately would have an adverse impact on the small saver himself. JOINT ACTIONS NOT REQUIRING LEGISLATION So where do we go from here? You have asked specifically about advantages and disadvantages of certain regulatory options n°t requiring legislation which could be undertaken jointly by the agencies. The agencies could take any one or combination of the following steps you suggested in your letter: (1) Rate ceilings on existing time deposits could be increased to reflect current rates on money market instruments with comparable maturities. This option has the advantage of being straightforward and easy to implement. Changing the account records would be simple because the basic terms of the deposit remain unchanged. Advertising could be easily adjusted to reflect the higher yields available to the small depositor. The disadvantages of this option are that it would make long-term borrowing more costly for financial institutions at the very time they are seeking relief from the high costs associated with short-term money market deposits. In addition, payment of higher rates on long-term deposits would tend to lock-in financial institutions to the higher costs involved, thus drawing 12 out their earnings problems for a longer period of time. This is offset to some extent by the wider range of asset investment options available as a result of the stability that long-term funds bring to an institution's deposit structure. (2) A second option would be to reduce the present $10,000 minimum denomination on six-month market certificates. This would provide a dramatic interest increase to,small holders. However, this has the disadvantages of increased cost, shorter maturities and resulting financial instability that I discussed / earlier. (3) Another option would be to extend the minimum maturity on money market certificates and couple the extension with either a fixed maximum interest rate or a floating rate ceiling lower than the present one. Of course this option is of limited value to the small depositor so long as there is no reduction in the $10,000 minimum denomination. This option has several disadvantages. Simply extending the minimum maturity of money market certificates does nothing to alleviate their cost. The disadvantage of imposing a fixed ceiling, or adopting a floating rate ceiling lower than the present one, is that both actions at some point defeat the pur pose of a certificate of deposit tied to short-term Treasury bill rates. If market rates on the Treasury bills far outstrip a controlled certificate, funds will flee the CD in search of richer money market investments, and I believe that flows from banks and thrift institutions would be considerable. 13 OTHER SMALL SAVER OPTIONS In each of these options the disadvantages clearly prevail. That brings us to such options as those additional you mention raising rate ceilings for deposit certificates maturing in four years or more or creating new account types (such as long term floating rate accounts) in small denominations. These and other alternatives aimed at the small saver have been receiving intensive consideration by the agencies. As you know, a special Interagency Task Force on Regulation Q is now working on recommendations to the President. force has not yet The task reached a consensus on several important issues, and I do not want to pre-judge its work. In addition, as I mentioned at the start, the Interagency Coordinating Committee has been holding extensive discussions ort*" how best to help the small saver. You specifically asked that we discuss only non-legislative solutions. I feel I must comment on what I believe to be the only real solution. The FDIC has long supported the elimination of deposit interest rate ceilings and the interest rate differential. We have recommended that Congress set a specific date by which rate ceilings will be abolished subject to an orderly phasing-out period, perhaps 5 years. Perhaps a grace period between the enactment of legislation and the effective date for decontrol or the sequential decontrol of long-term to short-term liability instruments would be useful. Stand-by authority to reimpose controls should be retained in order to deal with severe short term disruptions. v 14 The phasing out of Regulation Q would have to be balanced by enhanced powers for thrift institutions to enable them to stand their competitive ground with the commercial banks. Thrifts might be permitted to expand their activities into additional consumer lending and other household-related finan cial services and into investments available to commercial banks. Additionally, thrifts might be allowed the flexibility to lengthen the maturity of their liabilities and to vary interest rates to retain short-term deposits, and thrifts could be authorized to offer transaction account services to households. f '• '* » T •, . -, ..... .. -, i * RELIEF FOR THE SMALL SAVER The most promising remedies for small savers involve changes in the denomination and terms of savings instruments, adjustments of early withdrawal penalties and perhaps creation of a new kind of certificate. Proposals like these could provide some relief in the immediate future for small savers and give us time to work toward the long-range solution, the phasing out of Regulation Q. In this last instance, particularly, we need to move gradually and cautiously to cause as little disruption as possible to the processes on which rsmall savers' interests depend. We will need careful study of the groups and sectors of our economy affected by the ending of Regulation Q. We will have to give consideration to assisting the asset powers of mutual savings bank^ so that they will be able to compete for the funds with which to meet the increased demands of sn^all savers. 15 CONCLUSION Mr. Chairman, I have tried to give you the broadest possible view of the situation confronting small savers, the administrative options that the regulators now have to help them, the steps we are taking or contemplating, and the legislative options open to you.
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