Regulation Q, which prohibited US banks from paying interest on checking accounts and allowed the Federal Reserve to set interest rate limits, was enacted in 1933 and removed in 1986 due to its mixed effects. It aimed to prevent savings from accumulating in commercial banks but forced short-term lending to finance long-term loans. The Depository Institutions Deregulation and Monetary Control Act of 1980 replaced it.
Regulation Q, a part of the US Code of Federal Regulations (CFR), was enacted in 1933 and removed in a six-year process ending in March 1986. The most visible component of Regulation Q was to prohibit US banks to pay interest on checking accounts, but it also contained various provisions whereby the Federal Reserve could set interest rate limits for various types of banks to influence the extension of credit.
The United States was suffering from the Great Depression in the early 1930s, and Congress wanted to influence the country’s banks emdash; savings and loans (S&L) and similar thrift institutions & emdash; to extend credit to local farmers and merchants. However, the practice of many banks was to deposit their funds with commercial banks and earn interest on those deposits. These deposits were demand deposits; They could be withdrawn at any time, on demand. Modern checking accounts are demand accounts.
Time deposits, such as certificates of deposit (CDs), generally paid higher interest rates, but the amounts paid on the CDs had to be left on deposit with the commercial bank for a period of time. Small savings needed the flexibility to withdraw their funds at any time, in order to meet the seasonal needs of their clients and the occasional panic, so they would deposit their funds in demand accounts at lower interest rates, but extremely reliable. .
To discourage savers from essentially hoarding cash in this way, rather than lending it out, Congress, in the Banking Act of 1933, included Regulation Q, which prohibited interest payments on demand accounts. It was felt that this would free up the funds that the country’s banks had been accumulating in commercial banks. This also responded to criticism from some that commercial banks were using the demand deposits of smaller regional banks for speculative purposes and preventing funds from being lent out for more productive purposes.
Regulation Q also allowed the Federal Reserve to set maximum interest rates that could be paid on time deposits. There were two main reasons for this. First, Congress considered that competing for deposits by increasing the interest rates paid was negatively affecting the profitability of banks, and that if the rates offered to depositors were capped, banks would not lose gains in competition for interest rates. interest. Second, it was considered that if smaller local economies were allowed to offer a slightly higher interest rate on time deposits than commercial banks, depositors would open accounts in those local economies, thus increasing the funds available for lending.
The effects of Regulation Q were mixed. While the intended purpose of preventing savings from accumulating large demand deposits in commercial banks was achieved, it forced savings into a practice of short-term lending to finance long-term loans. That is, the savings would use customer deposits, which were short-term in nature, to finance their loans, which consisted primarily of long-term residential mortgages. In addition, the interest rate cap set forth in Regulation Q, which was applied to the S&L industry in 1966, was seen by some as a form of pricing that precipitated the S&L crisis of the 1980s, a American banking calamity whose cost exceeded $200 billion (USD).
With the interest rate crisis of the late 1970s and early 1980s, it became clear that Regulation Q was not achieving the goals Congress had set for it. In addition, the maximum interest rate limits imposed were removed in 1970, for accounts of more than $100,000, thus altering the distribution of wealth and forcing the smallest savers to give up billions of dollars in interest. After determining that these interest rate caps caused problems for smaller institutions, discriminated against small savers, and did not increase the supply of residential mortgage credit, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 ( MCA). The MCA phased out limits on interest paid by banks and replaced the old provisions of Regulation Q, with the one exception that banks are still prohibited from paying interest on business checking accounts.
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