One of the most important pieces of legislation to affect the Federal Reserve in its hundred-year history is known formally as the Depository Institutions Deregulation and Monetary Control Act. It was signed into law by President Jimmy Carter on March 31, 1980. The title of the act itself indicates two major areas of concern that the legislation hoped to address – the deregulation of institutions that accept deposits and efforts to improve the control of monetary policy by the Federal Reserve.
The regulatory environment that banks and other depository institutions operated under required a major overhaul. Interest rates rose to double-digit levels, primarily as a result of high rates of inflation. However, the rates that depository institutions were allowed to pay on their deposits were limited by laws in effect since the Great Depression. Consequently, savers began to avoid banks as vehicles for their savings and placed their funds in unregulated entities such as mutual funds. Unfortunately, some savers, notably lower-income households, could not access such alternatives easily, and the rate on their savings was significantly below what was available in financial markets. This set of circumstances made saving less attractive and at the same time reduced banks’ traditionally important role in financial markets.
How to Increase Savings
Among the purposes of the act were “to provide for the gradual elimination of all limitations on the rates of interest which are payable on deposits and accounts, and to authorize interest-bearing transaction accounts.” Up until this time, the maximum interest rate that banks and other institutions could pay on deposits was regulated by the federal government under what was known as Regulation Q. In fact, banks were not allowed to pay any interest on checking accounts (or “demand deposit” accounts), and at the time the act was signed, the rate on savings accounts at banks was set at 5.25 percent. But market interest rates were in double digits, as witnessed by the rate on short-term Treasury securities of over 12 percent. So, banks and other traditional types of depository institutions were at a severe disadvantage in attracting deposits compared with less-regulated competitors, such as money market mutual funds. Because of restrictions on interest rates, savers who used traditional banks and other types of depository institutions were penalized by being denied a market rate of interest for their funds. Not surprisingly, funds flowed out of banks, and savings by households tended to suffer, a process known as “disintermediation.”
Title II of the act is known as the Depository Institutions Deregulation Act of 1980. It phased out restrictions on interest rates that depository institutions could offer on their deposits. To ensure an orderly transition to this new environment, the phase-out lasted six years. Eliminating restrictions on rates not only improved the ability of banks to compete for funds, it encouraged consumers to save more since they were now able to get a higher return on their savings accounts and had greater access to different accounts that paid a market rate of interest.