U.S. Congress Deregulates Banks and Savings and Loans

Date March 31, 1980, and October 15, 1982

Deregulation in the banking and thrift industries redefined the roles of financial institutions and encouraged intense competition in financial markets.

Locale Washington, D.C.

Key Figures

• Paul A. Volcker (b. 1927), chair of the Federal Reserve Board, 1979-1987
• Jake Garn (b. 1932), U.S. senator from Utah and chair of the Senate Banking Committee, 1975-1984
• Fernand J. St. Germain (b. 1928), U.S. congressman from Rhode Island and chair of the House Banking Committee, 1980-1988
• Jimmy Carter (b. 1924), president of the United States, 1977-1981
• Ronald Reagan (1911-2004), president of the United States, 1981-1989

Summary of Event

Early in the 1980’s, the U.S. Congress passed two pieces of legislation that represented the most significant movement toward depository institution reform since the 1930’s. The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the Garn-St. Germain Depository Institutions Act of 1982 signaled the resolve of two presidential administrations to create a financial marketplace that would be more adaptable to changing economic conditions.

The U.S. government traditionally has held that regulation of the banking and thrift industries is vital to the safety and stability of the economy. Thus when the banking system nearly collapsed in the 1930’s, a number of regulations were introduced that restructured the industry. These regulations met most of their objectives for several decades because the system operated well in the prevailing environment of relatively stable prices and interest rates.

The status quo was overturned, however, by two disruptive forces. First, in the 1960’s, the United States attempted to simultaneously fight both domestic poverty and a war in Southeast Asia. The economy expanded tremendously, and demand for credit increased. Eventually, unprecedented high interest rates and inflation resulted. Second, in the 1970’s development of computer and communications technology created an ability to establish accounting and fund transfer systems that early bankers would have envied. These systems were easily accessible to nondepository institutions wishing to offer products and services comparable to those offered by banks and savings and loans. In some respects, nonbanks had a competitive edge because they were not regulated as heavily. By the late 1970’s, some regulations were seen as being detrimental to the financial industry’s health.

At this time, both banks and thrifts were restricted in the interest they could pay to depositors by Regulation Q of the Federal Reserve Act. Whenever market interest rates rose higher than Regulation Q ceilings, depositors removed funds from banks and thrifts. Money-market mutual funds were highly successful in drawing funds away from banks and thrifts simply because they could offer higher returns. This draining of funds, called disintermediation, restricted the lending activities of banks and thrifts.

Savings and loans had an especially difficult time in this environment of high interest rates because of their financial structures. The bulk of their assets consisted of long-term fixed-rate mortgages at interest rates below the market rates of the time. On the other hand, most liabilities were in the form of deposits that could be withdrawn almost immediately. Any increases in interest rates that the Federal Reserve Board allowed under Regulation Q immediately affected the institutions’ interest expenses, or the cost of funds. Consequently, as rates rose in response to competition, profit margins narrowed. Institutions that did not increase the rates paid to depositors, by choice or because of regulation, found their sources of funds drying up and therefore were unable to make new loans to take advantage of higher interest rates.

During the late 1970’s, the banking industry experienced another challenge. Many banks that were members of the Federal Reserve system (the Fed) gave up their memberships. Members were required to hold reserves (a fraction of deposits, meant to ensure that banks could meet depositors’ withdrawals) in non-interest-bearing accounts at the Fed. Nonmembers also were required to maintain reserves, but their reserves could be held at correspondent banks, where they could be traded for “free services.” As interest rates increased, the free services offered also increased and member fallout from the Fed increased critically.

Early in 1980, bankers lobbied for decontrol of interest rates on deposits and elimination of restrictions imposed on loan rates by state usury laws. Paul A. Volcker, chairman of the Federal Reserve Board, emphasized the seriousness of the Fed membership problem and warned of a crisis if action was not taken quickly. The Senate and House banking committees began holding joint meetings in March, 1980. Near the end of March, a compromise reform bill was presented to Congress and passed quickly. President Jimmy Carter signed the Depository Institutions Deregulation and Monetary Control Act into law on March 31, 1980.

The primary objective of DIDMCA was to create a more competitive environment for the depository institutions. The secondary objective was to improve the Fed’s power to control the money supply. In the most important provision, Regulation Q was phased out over a six-year period. Savings and loans were granted expanding lending powers, primarily the capability to invest in consumer loans. State usury laws were overridden for all federally insured lenders. Interest-bearing checking accounts were authorized for all depository institutions. Mutual savings and loans were allowed to convert more easily to a stock structure. In addition, deposit insurance coverage was raised to $100,000 per account.

The Fed membership problem also was addressed in an attempt to promote the Fed’s control of the money supply. All depository institutions would be required to meet the same reserve requirements. Moreover, they could meet those requirements only by holding their reserves in the vaults or at the Fed. This removed the advantage nonmembers previously enjoyed. At the same time, the Fed was required to offer its services to nonmembers. These provisions reversed the tide of Fed membership losses.

The objective of creating a more competitive environment was only partially met. The problem was that market rates were so high that competition with nondepository institutions was an unprofitable undertaking. For the thrifts in particular, it became increasingly difficult to avoid losses. By the end of 1980, about 36 percent of the thrift industry was losing money, despite DIDMCA. In 1981, that proportion rose to 80 percent.

In 1981 and 1982, various bills were introduced in Congress to assist the thrifts with their problem. After months of compromising, new legislation was signed by President Ronald Reagan on October 15, 1982. The Garn-St. Germain Depository Institutions Act of 1982—named for its sponsors, Senator Jake Garn and Congressman Fernand J. St. Germain—sought to rescue and support the thrifts and to reform the basic function of the industry. Among the major provisions of the act was authorization of money-market deposit accounts for banks and thrifts. Savings and loans were granted expanded powers. They were authorized to make commercial loans, more nonresidential real estate loans, and more consumer loans. The act also made it easier for troubled thrifts to be acquired. The Federal Savings and Loan Insurance Corporation (FSLIC) and the Federal Deposit Insurance Corporation (FDIC) were authorized to purchase “net worth certificates” from floundering thrifts or banks to keep them from failing. The act also overrode state restrictions on due-on-sale clauses, allowing lenders to adjust the rate on mortgage loans that were assumed by property buyers.

Significance

The larger, more aggressive thrifts welcomed DIDMCA. They saw potential profit in the ability to include shorter term consumer loans in their portfolios. Disintermediation was their biggest threat, so the demise of Regulation Q was welcomed. Not all smaller banks and thrifts were happy with DIDMCA. Many were not anxious to compete for high-cost funds and then enter into unfamiliar loan arrangements. There was another group of DIDMCA “losers”—banks that were not members of the Federal Reserve system. They were forced to place reserves into non-interest-bearing accounts. In return, they received the authority to purchase services from the Fed. They saw this as a poor trade.

In the first year after passage of DIDMCA, interest rates remained extremely high. This was a poor environment for institutions to test their new competitive powers. Consequently, the problems of disintermediation and thrift losses did not improve. Even the more extensive lending powers provided by the Garn-St. Germain Act did not have an immediate effect. One tool that did have an impact fairly quickly was the provision allowing money-market depository accounts (MMDAs). Money-market mutual funds had amassed more than $230 billion in accounts by 1982, mainly at the expense of banks and thrifts. At the end of 1982, depository institutions began attracting many of these funds back through MMDAs. By the end of 1983, MMDAs represented about 16 percent of the total deposits at banks and thrifts. Total deposits in MMDAs overtook deposits in money-market mutual fund accounts.

There was a negative side to this “success.” The legacy of deregulation will be that it created an era of expensive funds at depository institutions. Deregulation made it possible for banks and thrifts to compete, but shrinkage of margins between lending and borrowing rates made institutions vulnerable to failure. In the years following passage of the Garn-St. Germain Act, the number of bank and thrift failures was unprecedented.

From 1983 to 1986, unrelated to deregulation, inflation subsided and interest rates fell. The business climate improved, and the real estate market boomed. Thrifts made extensive use of their new power to make nonresidential loans. This prosperity turned around in just a few years. By the late 1980’s, problems in the oil industry and an overbuilt real estate market led the economy downward. The FSLIC could not handle the drain on its resources caused by numerous failures of thrifts. In response, Congress enacted the Financial Institutions Rescue, Recovery, and Enforcement Act (FIRREA) in August, 1989. In some respects, FIRREA was the counterpoint to the Garn-St. Germain Act. FIRREA put the clamps back on the thrift industry. It provided funds to support the industry, but it also imposed provisions to return the industry to its residential mortgage roots.

Several implications may be drawn from events since deregulation. First, individual institutions have made changes in their functions and in the products and services they offer. Different types of institutions are becoming more alike; there is a blurring of function among the various depository institutions. Second, greater competition has meant more competitive pricing and shrinking profit margins. Few banks and thrifts can afford to offer free or underpriced services as benefits to customers. This is likely to be a permanent feature of the industry. Third, shrinking profit margins have resulted and likely will continue to result in bank and thrift failures. This trend appears to be leading to an industry of fewer, but larger, institutions. Fourth, the increased incidence of failure has led to further government intervention. This reregulation is apparent in some of the provisions of FIRREA. Fifth, deregulation led some government analysts to the conclusion that there was regulatory overlap in the system. The FDIC absorbed the FSLIC through FIRREA. More such consolidations are probable.

One of the implications of deregulation for consumers is that they can expect to find market rates offered on financial services. Borrowers will pay market rates to obtain funds and may be asked to absorb more of the risk of changes in interest rates through variable-rate loan arrangements. Borrowers who had locked in low rates benefited tremendously in the 1970’s and early 1980’s. Depositors will seek market rates on the funds they invest in banks and thrifts. Consumers have become more sophisticated about the financial markets and will continue to show interest rate sensitivity in making deposit choices. In addition, consumers will be given more options through increased competition. Deregulation has brought about a proliferation of alternative financial services. Consumers should be able to tailor financial services to their needs.

Not all the implications of deregulation are positive. It is clear, however, that the impact of deregulation has been extensive and long-lasting. The structure of the financial markets has been changed profoundly. The roles of the banks and thrifts and the manner in which they conduct business have been revolutionized.

Bibliography

Bowden, Elbert V., and Judith L. Holbert. Revolution in Banking. 2d ed. Reston, Va.: Reston, 1984. Provides detailed analysis of changes occurring in the financial services industry during the early 1980’s and an outlook for the system from that era’s point of view. Represents an early attempt at putting deregulation of depository institutions into perspective. Includes numerous suggested readings on the topic.

Cargill, Thomas F., and Gillian G. Garcia. Financial Deregulation and Monetary Control. Stanford, Calif.: Hoover Institution Press, 1982. Presents the DIDMCA from a historical perspective. Written prior to completion of the deregulation process; presents an interesting foretelling of events yet to come. Emphasizes the impact of DIDMCA on the financial system, with an excellent review of the implications for governmental monetary policy.

Cooper, Kerry, and Donald R. Fraser. Banking Deregulation and the New Competition in Financial Services. Cambridge, Mass.: Ballinger, 1986. Extensive academic review of the literature concerning the revolution in financial services. Reviews and analyzes financial change; assesses the forces and events that forged the new structure. Describes the nature of changes as they existed and offers insights into possible future directions of the industry.

Goldberg, Lawrence G., and Lawrence J. White, eds. The Deregulation of the Banking and Securities Industries. Washington, D.C.: Beard Books, 2003. Compilation of academic papers presented on areas of regulation.

Lash, Nicholas A. Banking Laws and Regulations: An Economic Perspective. Englewood Cliffs, N.J.: Prentice Hall, 1987. A comprehensive but nontechnical review of the major laws and regulations influencing the banking/thrift systems. Completely describes the evolution and demise of Regulation Q. Clearly states the major provisions of both DIDMCA and the Garn-St. Germain Act.

Roussakis, Emmanuel N. Commercial Banking in an Era of Deregulation. 3d ed. New York: Praeger, 1997. Examines commercial banking in the framework of the entire U.S. financial services industry. Emphasizes the changes experienced by the industry at large, stressing the transformation of roles of various depository institutions. Examines the forces that shaped new trends in the financial markets. Places greatest emphasis on the management challenges of the new competition.