Roger Guffey

English

Research Papers in Economics

Regulation Tomorrow: 
Toward a New Framework for Competition 
By Roger Guffey 
President 
Federal Reserve Bank of Kansas City 
Not long ago, a thoughtful banker spoke on 
the theme that "banking isn't fun any  more." 
We  all  know  what  he  meant:  the  regulatory 
burden of banks is becoming heavier and seems 
to be getting in the way of a banker's  ability to 
do the job he wants to do in his community. 
More than 15 major new pieces of legislation 
affecting  banks  have  been  sent  forth  from 
Congress  in  just  the past  decade or so.  As  a 
regulator, I  am sensitive that we  are  more  or 
less  in  the  middle-striving  to adjust  to the 
constant  demands  of  new  legislation  while 
seeking to continue to serve banking effectively. 
With the onrush of regulations,  however, some 
days  it  isn't  fun  any  more  for  the regulators 
either.  But  it's  not  hopeless.  There  are  good 
opportunities ahead for  thoughtful bankers to 
work with regulators and legislators to develop 
a financial system that acknowledges the com- 
plementary needs of  financial  institutions and 
the  public.  Moreover, the opportunity for  all 
like  financial  institutions  to  compete  on  an 
equal basis-including S&L's,  mutual savings 
banks,  and  others-should  be  the  central 
theme of  our  mutual efforts.  I  am convinced 
that  a  financial  system  which  permits  the 
principles  of  the  free  market  to  operate, 
This article is excerpted from an address before the annual 
convention of  the Colorado Bankers Association. 
unfettered by oppressive regulation, is the most 
efficient  way  to  allocate  the  total  financial 
resources of our nation. 
Much of the current regulatory framework is 
a  heritage of  the traumatic  1930s, when  laws 
were implemented to restore public confidence 
in the banking system.  These laws emphasized 
the protection of  bank depositors and the pre- 
vention of  bank failure. 
Experience confirms that many of these laws, 
such  as the one  creating the  Federal  Deposit 
Insurance  Corporation,  served  their  purpose 
well.  Other laws, however, written for  another 
time and  another  purpose,  now  serve  only  to 
reduce  competition  without  appreciably 
improving  bank  soundness  and  safety.  A  key 
example  is  interest  payment  restrictions  on 
demand  and  savings  deposits,  originally 
designed  to  prevent  "excessive" competition 
among banks. 
The regulatory legacy of the '30s  is still with 
us  today.  However,  recent  changes  in  tech- 
nology, together  with the growing competition 
from nonbank financial institutions and contin- 
uing  inflationary  pressures,  have  resulted  in 
strong  incentives  to  alter  piecemeal  much  of 
this  regulatory  structure.  Although  the 
soundness  of  our  financial  system  must 
continue to be of paramount concern, increas- 
ing emphasis needs to be given to competitive 
Economic Review  July-August 1979 considerations  if  banks are to compete  effec- 
tively with other financial institutions and con- 
tinue to serve the deposit  and  credit needs  of 
the public.  Thus, I believe increased emphasis 
on enhancing competition should  be a primary 
ingredient of  future bank regulation. 
PAYMENT OF INTEREST ON DEPOSITS 
One  major  area  in  which  legislative  and 
regulatory  reform  will  significantly  increase 
competition-and  ultimately  economic  effi- 
ciency-is  the payment of  interest on all types 
of  deposits. The regulations on ceiling interest 
rates and the outright prohibition of interest on 
demand  deposits  are  rooted  in  the  Banking 
Acts of  1933 and 1935. These laws arose out of 
the  dangerously  unstable  condition  of  our 
banking system  in  the depths  of  the  Depres- 
sion.  Since  that time,  Congress  has extended 
this  ceiling  rate  authority  13  times,  most 
recently  through  Title  16  of  the  Financial 
Institutions Regulatory  and  Interest Rate 
Control Act  of  1978 (FIRA), which extends it 
through 1980. 
In  the  past  few  years,  pressure  has  been 
mounting  to eliminate  the  prohibition  against 
the  payment  of  interest  on  demand  deposits 
and to phase out what we  know as Regulation 
Q  ceilings.  These  pressures  stem  from  two 
sources:  the rise in  the inflation  rate, and  the 
public's desire to receive a fair rate of return on 
deposits.  As  recently  as  1976  the  six-month 
Treasury bill rate was 5.25 per cent, about the 
same as the Regulation Q ceiling on passbook 
savings. Since that time, however, the Treasury 
bill rate jumped to 9.5 per cent in 1979, while 
the passbook ceiling rate for commercial banks 
remained at the 1973 level  of  5  per cent  until 
July 1 this year, when it was raised to 5.25 per 
cent. To compensate for the disparity between 
market  rates  and  those  allowed  under 
Regulation  Q,  new  savings  instruments  have 
been introduced. The result has been the slow 
evolution  of  a  complex  array  of  time  and 
savings instruments with varying interest rates 
and  maturities. These instruments,  now  in  15 
varieties, have confused savers, have led to dis- 
crimination among classes of  savers, and  may 
have lessened the incentive to save. 
Depositors,  however,  are  not  the only ones 
penalized  by  interest  rate  ceilings.  Regulated 
financial  institutions  are  also  hurt.  While 
financial  institutions  have  experienced 
increased  operating  costs  associated  with  the 
multiple  types  of  instruments  available  to 
depositors,  they  have  also  suffered  serious 
problems  of  disintermediation  during  periods 
when  market  rates  have  risen  above  those 
allowed under Regulation Q. 
Although  some  argue  that  interest  rate 
ceilings  are  necessary  to ensure  a  source  of 
stable  and  low-cost  funds  to  the  borrowing 
public,  the  ceilings  have  not  provided  that 
result.  Rather,  the flow  of  funds  away  from 
institutions subject to Regulation  Q provisions 
has periodically caused a shortage of funds for 
borrowers  at  times  when  these  institutions 
could not compete with other market rates. 
Our recent experience with interest  rate pro- 
hibitions and ceilings has been less than satis- 
factory.  The problems they  have created  have 
led  to  increased  regulatory  and  legislative 
efforts  to do away with or sidestep  them.  For 
example, the NOW accounts permitted in  New 
England and  New  York  provide depositors an 
interest-bearing  transaction  account.  Auto- 
matic transfer services and bill-paying arrange- 
ments, until struck down by the U.S. Court of 
Appeals  this  past  April,  provided  depositors 
outside  New  England  and  New  York  with  an 
indirect method of earning a return on demand 
balances.  Currently,  bills  are pending  in 
Congress  which  would  phase  out  or  abolish 
interest rate prohibitions and ceilings,  and the 
current  Administration  has  put  its  support 
behind  a  gradual  phaseout  of  all  deposit 
interest  rate  controls.  In  my  judgment,  one 
result of these trends and developments is that 
Federal Reserve Bank of Kansas City we are on the threshold of having Federal legis- 
lation  to  authorize  NOW  accounts  for  like 
financial  institutions-including  banks--on  a 
nationwide basis. 
BRANCHING RESTRICTIONS 
Another area where legislative and regulatory 
change is likely to result in increased competi- 
tion  is  the  further  relaxation  of  branching 
restrictions on financial institutions. 
In  recent  years,  the  branching  topic  has 
become increasingly  important, as technologi- 
cal progress and the growing incursion by other 
institutions into the traditional banking service 
areas  have  required  greater competitive  flexi- 
bility  for  banking.  Advances  in  electronic 
payment mechanisms and the sharing of 
facilities by different banks and other financial 
institutions  have  led  to  the  development  of 
statewide and regional  electronic transfer 
systems. With the growth in electronic banking 
has  come  an  erosion  in  the  importance  of 
political  boundaries  in  governing  competitive 
interaction among financial institutions. Banks 
have, or soon will  have,  the capability to serve 
their  customers  electronically  over  great 
distances.  Restrictive  state  branching  laws, 
which did  not anticipate such advances or the 
ability  to  perform  interstate  and  even  inter- 
national  business  through  loan  production 
offices or Edge corporations, must adapt if  our 
banking system  is  to compete  effectively  with 
other  financial  and  nonfinancial  institutions 
which are unfettered  by  such restriction. 
To the extent  that state branching laws are 
not  sufficiently  flexible  to  allow  banks  to 
compete with these new  technologies,  they will 
force the creation of innovations to circumvent 
their restrictions. 
In my  judgment, technological  and competi- 
tive  considerations  will  bring  increasing 
pressure  for  reform  in  state  branching  laws. 
This reform  may come in  fits and starts, with 
development  of  reciprocal  branching  agree- 
ments  among  states  and  the linking  of  EFT 
systems.  But  most  of  us  would  prefer  that 
reform  evolve  in  a  more  comprehensive  and 
efficient manner by allowing nationwide linking 
of  electronic  systems  among  many  types  of 
financial  systems  while  clearly  defining  the 
allowable  types of  transactions.  Such  an 
approach would assure that no state would  be 
left  at a  competitive disadvantage and  would 
allow  financial  institutions  to  plan  for  the 
future in a more certain environment. 
RESERVE REQUIREMENTS 
Another competitive  issue is reserve require- 
ments. Member bankers feel strongly that the 
cost of  holding idle reserves has hindered them 
in competing with nonmember banks and other 
financial institutions.  And  as more and  more 
types of  institutions  begin  to offer transaction 
services,  greater  attention  will  have  to  be 
focused  on establishing equitable reserve 
requirements.  Increasing competition  for 
sources  of  funds,  rapid  inflation,  and  high 
interest  rates have combined  to force  bankers 
to take a close look at the cost of membership. 
Many banks have reacted by withdrawing from 
the System.  From 1945 to 1970 the proportion 
of U.S. banking deposits controlled by member 
banks fell from 86 per cent to 80 per cent, and 
from 1970 to 1979 shrank to 72 per cent, com- 
plicating  the  Federal  Reserve's  task  of 
implementing monetary policy.  Aside from the 
membership implications of the reserve burden, 
a  number  of  economists  have  attacked  the 
present  system  of  required  reserves  as 
inefficient, saying it allocates  resources poorly. 
They question whether a desired level of invest- 
ment  in  banking  can  occur  relative  to other 
industries  if  bankers  are  required  to  hold  a 
portion of their assets in nonearning balances. 
Thus,  if  our  banking  system  is  to  be 
competitive  with  other  financial  institutions, 
both  here  and  abroad,  and  with  other 
industries, the burden of idle reserves must be 
Economic Review  July-August 1979 eliminated.  As well documented  in  discussions 
of  the  membership  issue,  lower  reserve 
requirements and/or the payment of interest on 
reserves are the two primary methods suggested 
for lessening this reserve burden. 
Member  bankers  may  be  assured  that the 
Federal  Reserve  Bank  of  Kansas  City  will 
continue  to  urge  an  early  resolution  of  the 
membership issue and an easing of the reserve 
burden. 
SUMMARIZING THE ISSUES 
In summary, we  know now  that some of the 
1930s banking legislation serves only to reduce 
banking  competition  without  producing  any 
measurable  gains  in  the  efficiency  of  the 
banking  system.  Moreover,  as  a  result  of 
restrictions  on  bank  activities  and  deposit 
interest rates, and partly as a result of banker 
attitudes, the role of  commercial banks in  the 
financial sector has been gradually usurped by 
other  financial  institutions  and  new  credit 
arrangements.  This change has become  more 
rapid  since the late  1960s, as  the burdens  of 
interest  ceilings  and  reserves  have  increased 
with inflation, and technology has fostered new 
payment  practices.  Banks  have  been 
particularly vulnerable  to this combination  of 
circumstances,  given the nature of  their assets 
and their special need to attract both deposits 
and capital. 
What  concerns  me  most  about  the  recent 
financial growth  and  development outside  the 
banking sector is  that it  has  occurred  mainly 
because  banking  laws  have  been  too  slow  to 
adapt to changing conditions and the demands 
of the public, and not because  banks have lost 
their desire to  deliver  financial  services  in  an 
efficient  way.  Therefore,  bankers  and 
regulators should both have a strong interest in 
developing  and  supporting  a  new  regulatory 
framework  which  ensures  that  commercial 
banks are allowed to offer competitive services 
to the public.  At  the same time,  that frame- 
work must preserve the essential features which 
contribute to a sound banking system deserving 
of  public confidence. 
If we  continue to embrace the outdated and 
largely anti-competitive aspects of  the banking 
laws  of  the  1930s,  the  morass  of  piecemeal, 
patchwork  fixes so characteristic of  legislative 
and regulatory response will continue to hold us 
back. 
Change,  and  now  accelerating  change,  has 
brought  us  a  new  ballgame.  It  demands  a 
comprehensive understanding of how the game 
is to be played, not rules made up as the game 
goes  along.  We  all  should  support  a 
fundamental  review  of  the  environment  in 
which  financial  institutions  operate  and 
compete today, with a view toward legislating a 
financial  system  which  recognizes  the 
importance of  improved  competition  and 
economic efficiency in the financial arena. 
As  these issues are aired in  national forums 
in  the  period  ahead,  I  know  that thoughtful 
bankers  will  continue  to  draw  upon  their 
experience  to  counsel  their  lawmakers  and 
regulators. I hope that legislators  will consider 
fully the traditional principles of free enterprise 
in  their  decisionmaking.  I  hope  we  can 
establish a financial structure in which all like 
institutions can compete equitably. Let us have 
reasonable equity in  requirements for capital, 
liquidity,  and  taxation.  Let  the  marketplace 
decide  what  institutions  should  provide  what 
services and at what prices. 
As change inevitably occurs in  banking, and 
as bankers and regulators  join  to encourage a 
responsive  regulatory  framework  for  financial 
institutions,  the  Federal  Reserve  intends  to 
support a system that acknowledges  the needs 
of both banks and bank customers. 
Federal Reserve Bank of  Kansas City 

Regulation tomorrow: toward a new framework for competition

http://www.kansascityfed.org/PUBLICAT/ECONREV/EconRevArchive/1979/3q79guff.pdf

Regulation tomorrow: toward a new framework for competition

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Research Papers in Economics