A History of the Federal Reserve, Volume 2 (126 page)

Congressman Patman, chairman of House Banking, introduced legislation to prohibit insured banks from issuing negotiable certificates of deposit, or similar negotiable instruments, and prohibiting these banks from issuing time deposits in amounts less than $15,000. The aim was to channel more savings into savings and loan institutions faced at the time with large outflows.
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The Board wrote a letter opposing the legislation and calling it “ unwise” (Board Minutes, May 17, 1966, 4). It did not send the letter, and softened its stance, when the Treasury proposed to permit different rates of interest on time deposits depending on whether the deposits were insured.

The Board continued to oppose the Patman bills. It said that the bills circumscribed competitive pressures (Board Minutes, May 23, 1966, 3). It welcomed the Treasury proposal as one way to increase flexibility, but it expressed concern that changes often had unforeseen consequences. It favored exploring the “ultimate as well as immediate effects” (ibid., 3).

On June 2, the Board agreed on steps to increase the flexibility of its control procedures. It favored: (1) “any legislation which would expand their flexibility in setting reserve requirements”; (2) graduated reserve requirements applicable to all (member and non-member banks); (3) “a minimum maturity of time deposits for a year or even six months” (Board Minutes, June 2, 1966, 1–6). Legislation permitting increased flexibility in setting ceiling rates became law in August.

The legislation extended ceiling rates of interest to savings and loan associations and insured non-member commercial banks. The Federal Home Loan Bank Board and the FDIC received authority to set ceiling rates for their members. Coordination with other deposit regulators by the Federal Reserve became mandatory. The new legislation also called on the regulators to reduce interest rates to the maximum extent feasible, regulated the compounding of interest, and required the reserve banks to accept agency securities as collateral.

The requirements were temporary, terminating in one year. In April 1967, the Treasury proposed to make the legislation permanent. Several Board members objected but, as a staff member reminded them, “it did
not seem reasonable to expect that Congress would repeal a clause in favor of low interest rates” (Board Minutes, April 24, 1967, 7). Chairman Martin disliked the legislation, but Governors Robertson and Maisel found it a useful tool. The Board decided to ask for a postponement of the legislation until it could study its experience.

242. Housing starts fell more than 20 percent in 1966 as mortgage rates rose above 6 percent for the first time since the 1930s.

One main purpose of the discussion was to respond to pressure to help the housing industry by changing reserve requirements and interest rates. In his testimony to the House Banking Committee on June 8, Chairman Martin said that most of the proposals were less effective than an increase in funds available to purchase mortgages by the government mortgage agencies. The common presumption was that more mortgage finance would increase housing production. Evidence to support this conclusion was lacking at the time (Meltzer, 1974). None of the officials suggested that the decline in housing starts resulted from reduced demand instead of constrained supply.

A second purpose was to limit credit expansion. The Board divided on whether increases in time deposit reserve requirement ratios were more effective than open market operations. Governor Robertson was the chief proponent of increased reserve requirement ratios. In August, he urged his colleagues to raise from 5 to 6 percent the requirement ratio for time deposits at banks with more than $5 million of deposits. Only Governor Shephardson supported his motion, so it failed.
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After 1966, the law regulating rates on time and savings accounts at banks and other financial institutions permitted savings and loans to offer an interest rate 0.75 percentage points higher than banks. Banks in competitive markets tried to find ways to compete. In 1967, some banks offered “golden passbook accounts,” a time deposit using a passbook similar to a savings account, with a rate of 4.5 or 5 percent depending on location. These accounts were more competitive with thrift institutions. Congress, always concerned about complaints from thrift institutions, questioned the legality of the accounts. The Board assured them that the accounts met the requirements of regulation Q. This was one of many incidents involv
ing efforts to improve competitive positions. Offering “free” merchandise premiums was one of the most common (Board Minutes, October 18, December 15 and 22, 1967).
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243. Among the more flexible rules was a decision by the Board to reclassify Christmas club deposits as saving deposits not time deposits, so subject to lower reserve requirements. The FDIC objected because that would lower the ceiling interest rate. The agencies retained the time deposit classification but lowered the reserve requirement ratio for these accounts. In February 1967, the Board proposed legislation changing reserve requirement ratios for demand deposits to a system graduated by size of deposits. There were three brackets with graduation at $5 million and $100 million. Requirements would apply to all insured banks. In return, banks would get access to the discount window. This was the first time the Board made a legislative proposal for this change (Board Minutes, February 20, 1967, 13–15).

At the same time that the Board acted to prevent domestic depositors from receiving market interest rates, it supported legislation permitting foreign governments, central banks, and international financial institutions to receive market interest rates. The justification was the financing of the balance of payments (Board Minutes, January 18, 1968, 7–16). Until October 1968, the Board required that the interest rate paid on foreign official deposits revert to the ceiling rate if the original holder sold the certificate to a non-exempt holder. In October 1968, the Board waived the restriction (ibid., October 7, 1968, 6–7).

Brokers found new ways to avoid regulation Q ceilings. The broker deposited a customer’s funds at the ceiling rate. In return, the bank made a loan to a specified borrower. The borrower paid a fee for the loan. The broker shared part of the fee with the depositor. The broker advertised a 7 percent interest rate, when the ceiling rate was 5 percent. The Board, the FDIC, and the Home Loan Bank Board added a provision to their regulations that prohibited advertisements of this kind. Enforcement proved difficult at times (Board Minutes, October 3, 1969, 5–8).
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Congress approved legislation on December 23, 1969, permitting the Board to regulate commercial paper issued by bank affiliates. The Board discussed interest rate ceiling and reserve requirement ratios on January 13, 1970, but could not agree on the timing of interest rate ceilings or the applicability of reserve requirement ratios. Eventually, ceiling rates became applicable, as discussed in the section on domestic policy.

The Board continued to request legislation authorizing reserve requirement ratios set by size of deposits. Congress continued to ignore the requests. Members especially disliked proposals to apply the requirements to all insured banks (letter, Burns to Sparkman, Burns papers, Box B-B93, May 21, 1971).

By the summer of 1971, several FOMC members wanted to remove re
gulation Q ceiling rates from all large negotiable certificates of deposit.
Burns raised the issue at the June 29 FOMC meeting. The New York bank supported the change. It wrote expressing doubt about the effectiveness of ceiling rates. “A major impact of Regulation Q ceilings on large CD’s, during periods of restraint, has been to force credit flows away from the domestic banking system and into channels—such as the Euro-dollar market and the commercial paper market—over which the Federal Reserve System has no direct control” (letter, William Trieber to Board of Governors, Federal Reserve Bank of New York, Correspondence File 240, July 18, 1971). The letter pointed out also that substitution of this kind distorted the data on which the System relied, and it urged suspension of the ceiling for CDs of $100,000 or more. Several other reserve banks wrote similar letters. The Board did not act.
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244. The maximum rate on a $100,000 CD was 6.25 percent in spring 1968. What if several persons pooled their deposits to buy a single CD? The Board told the bank that pooling was not illegal but they would amend the regulations to prevent it (Board Minutes, May 7, 1968). The Board could not prevent money market mutual funds from taking comparable action after these funds started in the 1970s.

245. Other devices used included soliciting deposits for branches of U.S. banks in Puerto Rico and the Virgin Islands. These branches were not subject to regulation Q. Banks also transferred funds to foreign branches to avoid reserve requirements (Board Minutes, June 3, 1969, 4–8; July 24, 1969, 8).

Lagged
Reserve
Requirements

An Ad Hoc Subcommittee on Reserve Proposals recommended a change in the timing of reserve requirements in 1966. Instead of maintaining requirement ratios based on current deposits, banks would use deposits at an earlier period to compute the requirement. The aim of the proposal was to reduce volatility of excess reserve holdings and to reduce uncertainty about the volume of required reserves. Banks with many branches had difficulty knowing the volume of deposits and reserves until after the settlement date for reserve balances.

Critics soon pointed out
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that the proposal restricted monetary policy operations because the System would have to supply a fixed volume of reserves either through discounting or open market purchases (including repurchase agreements). Nevertheless, the Board adopted the proposal in 1968 as part of its reappraisal of discounting. Under the new arrangement, banks would calculate weekly average required reserves based on average deposits two weeks earlier. Vault cash two weeks earlier would replace con
temporaneous vault cash when calculating reserves held to satisfy requirements, but current reserve balances would continue to be used. Banks could carry forward up to 2 percent surplus or deficiency.

246. The reserve banks undertook an extensive System-wide study of regulation Q. One paper by Philip Davidson and Robert McTeer of the Richmond bank challenged the basis for the regulation. They pointed out that the claim that competition drove up interest rates and induced banks to take excessive risk was false. Another paper by Max Klass of Philadelphia discussed the complexity of the regulation and the difficulty small banks had in interpreting the rules and complying. The System committee recommended the “eventual elimination on interest rate ceilings on thrift deposits” (Preliminary Report, Correspondence Box 240, Federal Reserve Bank of New York, undated).

247. Memo George Kaufman to Ernest Baughman, Federal Reserve Bank of Chicago, June 13,1966.I am indebted to George Kaufman for furnishing a copy of his memo. Axilrod (1997) pointed out that lowering membership cost was a main reason for the change. “It was my first big Board presentation on a major issue. I hinted strongly that maybe, this wasn’t the wisest thing. At the end Bill Martin first said that it was a very good presentation, then said ‘we ought to go ahead.’”

President Black commented that the main benefit would be in the “bank relations area” (Board Minutes, January 25, 1968, 8). No one made any claim that the step effected an important change in monetary policy. The proposal received few comments or suggestions for changes, so it was adopted in April 1968 and implemented on September 12. Governor Brimmer said banks could always go to the discount window if they had problems with reserve volatility. He saw no reason for the proposal. The staff, too, thought the proposal unnecessary (Board Minutes, April 23, 1968, 6–9).

At the time, the System used an interest rate or money market target. It responded to changes in demand for reserves by supplying reserves. A few years later, and again in 1979–82, the System set targets for money growth and bank reserves. Lagged reserve requirements made it harder to control reserves and money growth. Nevertheless, the Board retained lagged reserve requirements throughout those periods. It reverted to contemporaneous reserve requirements in 1984, after its policy of controlling reserves ended, and it returned to lagged requirements in 1998.

Discounting

In 1968 a System committee consisting of four Board governors and four reserve bank presidents, headed by Governor Mitchell, proposed changes in discount regulations and the operation of the discount window. The stated purpose was to use discounting to facilitate short-term adjustments of bank reserves.
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“A more liberal and convenient mechanism should enable member banks to adjust to changes in fund availability in a more orderly fashion and, in so doing, should lessen some of the causes of in
stability in financial markets without hampering overall monetary control” (Board of Governors, 1971, 3). The report envisioned a system in which open market operations supplied a volume of reserves and the discount window (along with federal funds transactions) adjusted the distribution of reserves for individual banks.
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248. Governor Mitchell’s testimony brought out the reasons for considering major changes in discounting at that time. First, the 1966 period of restrictive monetary policy affected the savings and loan industry heavily. The Senate came within one vote of authorizing the Federal Reserve to lend to the Home Loan Banks. Second, the borrowing line and seasonal adjustment credit assisted small, rural banks. Many had left the System. Mitchell testified that between 1957 and 1967, membership declined from 48.8 to 44.9 percent of commercial banks (Joint Economic Committee, 1968, 20). Third, the proposal kept the discount rate closely related to market rates and avoided announcements effects when the discount rate changed. This part of the proposal was not implemented; changes in the discount rate remained infrequent and often gave rise to announcement effects.

In internal discussion, Governor Mitchell added a fourth reason: borrowing had fallen to very low levels. Much of the decline resulted from uncertainty about what the 1955 revision of regulation A permitted after the Board’s ambiguous September 1966 letter restricting discounts (Board Minutes, May 28, 1968, 2).