Over the last half century, regulation of banks has generally diminished as governments have shed the controls implemented during the Great Depression. In the United States, as elsewhere, banking used to be a very staid business with its workings dictated more often by regulation than by competitive dynamics. Indeed, for decades, the interest rates paid on ordinary deposit accounts were capped by regulation and, for over a decade, the capped rate was the most common rate on offer by American banks. This was the result of a Federal Reserve rule known as Regulation Q. Before it was abolished in the 1980s, the rule and its side effects were significant in retail banking.
The Depression and Regulation Q
What became known as Regulation Q had its origins in the Great Depression. Among other things, the Banking Acts of 1933 and 1935 gave the Federal Reserve the ability to limit interest rates on deposit accounts. The first of these pieces of legislation was enacted in the early weeks of Franklin D. Roosevelt’s presidency and applied to Federal Reserve member banks; the latter extended this to nonmember banks. The laws altogether banned the payment of interest on demand deposits, like those in checking accounts, and gave the Federal Reserve the power to set interest rate ceilings on time deposits, like those in the form of certificates of deposit.
“No member bank shall, directly or indirectly by any device whatsoever, pay any interest on any deposit which is payable on demand … The Federal Reserve Board shall from time to time limit by regulation the rate of interest which may be paid by member banks on time deposits, and may prescribe different rates for such payment on time and savings deposits having different maturities or subject to different conditions respecting withdrawal or repayment or subject to different conditions by reason of different locations.”Section 11(b) of the Banking Act of 1933
On the surface, it may seem like a giveaway to banks, which were not exactly held in great esteem in America at the time. Though it did stand to benefit banks, Regulation Q had various objectives.
The first was perhaps the most obvious; deposit rate ceilings would limit competition for deposits among banks and would support their profitability. It was thought that this would reduce their need to take on risky loans to pay higher interest rates to depositors. Some blamed this for contributing to the Great Depression. Further, a ceiling on deposit rates would compensate banks for having to pay new deposit insurance premiums. Lastly, it was thought the rules would encourage smaller banks to use their deposits to lend locally rather than simply hold the money as deposits at larger banks which many believed were more likely to put that money to speculative use.
The Federal Reserve set the initial interest ceiling at 3.0% in November 1933; this was reduced to 2.5% in 1935. The level may seem low for a deposit rate ceiling but the average deposit rate paid by Federal Reserve member banks in 1935 was actually lower at 1.9%. Short term market rates, such as those on Treasury bills, were under 1%.
For much of this period, the Federal Reserve closely controlled U.S. Treasury yields and ensured they never got close to the deposit ceiling. As a result, there were few, if any, places to earn a risk-free return near 2.5%. In fact, up until 1965, Regulation Q only occasionally restrained interest rates because the legal limit, which was increased back to 3.0% in 1957, was set above the typical rate banks were interested in offering anyway.
Rising Rates, Stagnant Ceiling
If 1933 to 1965 saw few practical effects of the interest rate ceilings, 1966 saw a watershed moment in the history of Regulation Q. From 1966 on, the interest rate ceiling began to restrict interest rates on deposit accounts because the ‘market’ rate would have otherwise risen above the legal limit. This occurred despite increases in the legal limit to 5.5% in late 1965. Starting from 1966, yields on Treasury bills began to consistently exceed the deposit rate cap. That year, the restrictions were also extended to thrift institutions, like smaller mutual savings banks and savings and loan institutions. From 1966 on, deposit rate ceilings rose along with Treasury yields and inflation but far more slowly than either of those two rates,
Toasters and Televisions
After the mid-1960s, Regulation Q essentially prohibited banks and thrift savings institutions from competing through deposit rates. With so many banks paying the exact same interest rates on deposit accounts, consumers were essentially forced to choose a bank over its competition based on other metrics. Banks now had to compete with their peers through the number and location of their branches or the pricing and provision of services. They also competed for deposits by offering prizes for opening an account or adding more money to an existing one. Merchandise, ranging from free toasters to televisions, were given in lieu of interest or on top of interest earned on the account.
Regulation had essentially made competing based on money interest rates illegal but competing on the value of such giveaways was permitted. Subject to certain conditions, such as the value of the item, the Federal Reserve Board regarded free merchandise as a promotional expense of a bank rather than as a payment of interest. Even if a promotional giveaway did not meet these conditions, banks would still be encouraged to use free merchandise as a competitive tool. This was because even where it had to count towards the interest ceiling, only the cost to the bank of the free merchandise would be used as the basis of determining whether it breached the interest ceiling, not the higher retail or fair market value.
Take the example of the Republic National Bank of New York. The president of that bank explained in testimony to a U.S. congressional subcommittee that it offered free merchandise to its customers as an incentive for them to open accounts and to encourage them to save more in medium- or long-term deposits.
As an example, in 1979, a customer could deposit $1,475 for 3.5 years and would receive a Radio Corporation of America 17-inch color television. If they chose to deposit the same amount for 5.5 years, the customer would receive a 25-inch television instead. The value of the merchandise varied based on the size of the deposit and the maturity. A stereo with built-in disco lights could be had for a 5.5-year deposit of just $950. In 1978, the Republic National Bank gave out over $2.65 million in merchandise. Customers technically had to pay taxes on the value of the prizes they received but this detail was usually, according to popular understanding, conveniently ignored.
The deposit rate ceiling may have limited competition within banks but could not limit competition between banks and other financial institutions. Non-bank financial institutions and eurodollar markets, that is U.S. dollars lent in foreign money markets, provided alternative places to leave money, outside the control of the Federal Reserve.
The fact that these alternatives did not have capped interest rates meant that bank deposit growth was stagnant compared to these other deposit-like accounts. Unable to attract sufficient deposits at the controlled rates, banks themselves turned to other sources of financing, such as issuing commercial paper from holding company entities. This goes to show that the deposit rate ceilings had a negative effect on banks as well, limiting their ability to raise money by traditional bank deposits.
The beginning of the end for Regulation Q came in the 1970s when various exemptions to the restraints were created. In 1970, interest on 30-to-90-day deposits in denominations of $100,000 or more were deregulated; in 1973, this exemption was extended to all other maturities. Even for smaller depositors, interest rate ceilings on longer maturity time deposits were raised, culminating in the creation of a ceiling as high as 7.75% for bank deposits of eight years or longer.
The 1972 ‘President’s Commission on Financial Structure and Regulation’ recommended the gradual abolition of deposit rate controls. Negotiable Order of Withdrawal or ‘NOW’ accounts, essentially personal checking accounts, were permitted to begin paying interest starting in 1974. Then, in the late 1970s, 6-month money market certificates were tied to a floating ceiling linked to Treasury bill yields.
By 1980, money market mutual funds were offering the liquidity and conservative management of bank deposits without having to maintain required reserves, pay for deposit insurance, or cap interest rates. These exemptions and innovations meant that more money found its way into money market funds and other products outside the reach of Regulation Q controls. This raised questions about the effectiveness and desirability of deposit rate ceilings altogether.
The ‘President’s Inter-Agency Task Force on Regulation Q’ recommended the removal of interest rate ceilings in 1979 and this helped bring about some of the provisions of the Monetary Control Act of 1980. The legislation established the Depository Institutions Deregulation Committee which was tasked with phasing out bank regulations. Regulation Q’s gradual abolition continued through the early-to-mid 1980s.
“The Board may from time to time … prescribe rules governing the advertisement of interest on deposits by member banks on time and savings deposits.”12 U.S.C. § 371b (2021) – the Monetary Control Act of 1980 struck the following from the end of the sentence – “, including limitations on the rates of interest which may be paid” – with this amendment, interest rate caps on time deposits became a thing of the past
Banks were permitted to introduce money market deposit accounts in 1982. Through the 1970s and 1980s, the minimum deposit amounts for products exempt from the regulations were reduced until virtually all deposits were permitted to receive market interest rates. By March 1986, interest rate ceilings, which had now stood at 5.5%, were almost completely phased out save for checking accounts. From now on, the distinguishing features of different types of deposit accounts, including their minimum balances, interest rates, and service charges were determined by banks themselves rather than by regulation.
Whether Regulation Q was a prudent restraint or a misguided decree that particularly disadvantaged smaller savers was debated throughout the rule’s life. It was the arguments in favor of the latter view that eventually won out and the rule was relaxed over the course of the 1970s. This loosening and the widespread adoption of bank deposit-like products outside the rule’s reach begged the question of what should be the future of Regulation Q. Despite being a product of the post-Depression banking legislation and one of the most impactful on ordinary people, it was hardly missed. Savers and investors shifted money elsewhere – they had voted with their dollars and wanted to be paid their interest in more dollars and not in toasters and televisions.
More from the Tontine Coffee-House
In 1975, the U.S. Securities and Exchange Commission deregulated broker commissions, transforming another corner of American finance. Also read about some of the other powers vested in the Federal Reserve during the Great Depression. Consider subscribing to this blog’s newsletter here.
1. United States, Congress, Banking Act of 1933. 1933.
2. Calem, Paul. “The New Bank Deposit Markets: Goodbye to Regulation Q.” Business Review, 1985, pp. 19–29.
3. Canova, Timothy A. “The Transformation of U.S. Banking and Finance: From Regulated Competition to Free-Market Receivership.” Brooklyn Law Review, vol. 60, no. 4, 1995, pp. 1295–1354.
4. Cook, Timothy Q. “Regulation Q and the Behavior of Savings and Small Time Deposits at Commercial Banks and the Thrift Institutions.” Economic Review, 1978, pp. 14–28.
5. Gilbert, R. Alton. “Requiem for Regulation Q: What It Did and Why It Passed Away.” Review, vol. 68, Feb. 1986, pp. 22–37.
6. United States, Congress, House, Subcommittee on Government Operations. “Statement of Jeffrey C. Keil, Executive Vice President, Republic National Bank Of New York; Accompanied by Ernest Ginsberg, Senior Vice President, Legal Affairs.” 1979.