Financial System Still Coping with Interest Rate Changes

Article excerpt

Ten years after the last controls on interest rates were dismantled, the nation's financial system is still coping with the huge, and in many cases unexpected, consequences of those changes.

For consumers, the end of controls was a chance to earn more interest on deposits and to keep up with an inflation rate that peaked at more than 10 percent annually in 1979 and 1980.

For banks and savings and loan associations, the higher interest rates meant being able to compete for deposits with the rapidly growing money market mutual funds.

But the lifting of interest rate controls had its dark side as well. High rates on deposits ushered in a wave of new fees and fee increases on customer accounts, and led banks and savings institutions to make riskier loans as they looked for ways to increase revenues and pay for the higher interest rates on deposits.

The biggest change occurred in the weeks immediately after Dec. 14, 1982, when banks and savings institutions were allowed to offer money market "demand" accounts. These carried no regulatory cap on interest rates and allowed up to three withdrawals a month by check and an unlimited number of withdrawals in person.

The response was staggering: About $65 billion a week moved into the new accounts as consumers were attracted to introductory rates of about 10.5 percent, which were higher than the 8.1 percent then being paid by money market mutual funds and the even lower rates on savings and small certificates of deposit.

By Oct. 1, 1983, several years ahead of schedule, interest-rate ceilings were removed on small certificates of deposit. The interest-rate controls the government had imposed 50 years earlier to limit destructive competition among banks were gone, and bankers knew that their business would never be the same.

As was widely predicted at the time of these regulatory changes, savings institutions were the most vulnerable, because their holdings of low-rate mortgages issued in earlier years were suddenly unprofitable when they had to pay higher interest rates on deposits.

Less understood was how attempts by Congress and regulators to help savings institutions outgrow their problems would lead to the real estate lending boom of the mid-1980s followed by a collapse amid a glut of empty buildings and a rash of failures that would see the number of savings and loan associations drop to about 2,100, from more than 4,000 in 1978.

Among banks, the carnage was not as great, but the survivors grew more cautious about issuing loans. A result was tighter credit that put a damper on economic growth, and many economists say the credit squeeze is continuing today.

"The need for change was undeniable," said Albert M. Wojnilower, senior adviser to First Boston Asset Management. "But I think the experience of recent years has reminded people that the abolition of interest-rate controls was not an unmitigated blessing."

In a 1981 study published by the Brookings Institution, Wojnilower warned that lifting interest-rate ceilings would deprive policy makers of an important tool for controlling the economy and would have the effect of "freeing the financial markets to pursue their casino instincts."

Some advocates of removing the rate controls contend that the problems were a result not of lifting the controls but of inept regulation. …