Regulation Q

In response to the Wall Street Crash of 1929, Congress established the Federal Home Loan Bank Board (FHLBB) in 1932. The FHLBB regulatory framework ensured that savings and loans (S&Ls), thrifts and mutual associations that received consumer deposits and provided capital for home mortgages specialized in local home lending. Mortgage originations were restricted to single-family homes within a 50 miles radius of a bank’s headquarters and Regulation Q of the Federal Reserve Act imposed ceilings on interest paid on deposits. For decades, Reg. Q enabled thrifts to charge borrowers two to three points above the deposit-rate ceiling and still offer a reasonable mortgage rate. Scholars often described the financial sector as operating under the “3-6-3” rule.  Thrifts provided 3 percent interest on demand deposits, provided mortgages at an interest rate of 6 percent, and enabled their bankers to be on the golf course by 3 o’clock, so-called “bankers’ hours.” During periods of inflation and interest rate stability, Reg. Q worked reasonably well as short-term interest rates remained below regulatory mandates.

The first significant postwar financial crisis, the “Credit Crunch of 1966,” caused market interest rates to increase above Reg. Q ceilings. On June 16, 1970, President Richard Nixon commissioned a presidential task force – The Hunt Commission “to review and study the structure, operation, and regulation of the private financial institutions.” Most of the Hunt Commission recommendations received scanty notice and has become mere footnotes in the history of financial deregulatory reform. One of the proposed recommendations, however, the gradual elimination of federally mandated interest rate ceilings, received considerable attention and would become the blueprint for financial deregulation. In 1975, the House Banking further stimulated the discussion with hearings on a document called the Financial Institutions In Nation’s Economy (FINE), “Discussion Principles”.

When Jimmy Carter took office in 1977, the U.S. economy was still recovering from, what was at the time, the worst recession since the Great Depression. Describing inflation as “our most serious domestic problem”, President Carter presented an “anti-inflation policy” in a major address to the nation on October 24, 1978. A year later, the Iranian Revolution and U.S. Embassy hostage crisis caused a doubling of oil prices and increasing levels of inflation. Economists characterize this unprecedented period as economic stagflation — higher than historical standards of both inflation and unemployment rates. For example, a 1981 Congressional Budget Office Economic Outlook Staff Working Paper found that “the acceleration of inflation and record interest rates would continue to cause a slowdown, if not a decline, in economic growth and rising unemployment.”

President Carter appointed Paul Volcker Chairman of the Federal Reserve Board. Chairman Volcker adopted a radical monetary policy designed to control inflation by abandoning the Federal Reserve historical interest rate approach to monetary control in favor of controlling the growth rate of the money supply. In what became known as the “Saturday Night Special,” the Federal Open Market Committee gave unanimous support for a “series of complementary actions” in order to assure “better control over the expansion of money and bank credit, help curb speculative excesses in financial, foreign exchange and commodity markets and thereby serve to dampen inflationary forces.”

Economic conditions caused an alarming deterioration in home mortgage lending, in part because of thrifts’ inability to adjust their long-term mortgage portfolios to the high and widely fluctuating short-term deposit interest rates. Once interest rates increased, federally regulated thrift depository institutions were unable to match the higher market interest rates offered by alternative savings instruments. Economists defined this process as “regulation-induced disintermediation.” The United States League of Savings Institutions, at the time one of the most powerful lobbying organizations, advocated for the elimination of Regulation Q. The subsequent hardships experienced by consumers and the housing industry persuaded Congress to pass the most significant reforms of the financial sector since the Great Depression.

Next Page: Depository Institution Deregulation and Monetary Control Act of 1980