Deregulation contributed to efficiency and innovation in the financial sector, but also to economic crises. Deposit institutions became less differentiated from one another, but each offered more diverse services to business and household customers.

During the Great Depression of the 1930’s, the federal government imposed many restrictions on the conduct of banks and other deposit institutions. For banks, these fell chiefly into five categories. First, entry into banking was severely limited. Chartering authorities such as the U.S. Comptroller of the Currency (for national banks) and state banking departments made it difficult to start a new bank so that existing institutions were protected from competition. Second, types of assets were severely restricted. In general, banks were forbidden to invest in stocks or real estate directly, and loans on such collateral were also subject to stringent limitations. Commercial banks were barred from engaging in investment banking (marketing new securities issues), and from providing brokerage, insurance, or real estate services. Thrift institutions were largely restricted to home mortgages and bonds.Deregulation;financial industryBanking;deregulation ofSavings and loan associations;deregulation of

Third, federal law gave states authority to set rules for establishing bank branches. Some states prohibited branching altogether (Illinois). Even where regulations were liberal (California) branches were limited to one state. Fourth, ceilings were imposed on interest rates paid on deposits. No interest could be paid on demand deposits. Time deposit rates were set by the Federal Reserve under Regulation Q, and were generally held at low levels to safeguard bank profits. Finally, all deposits of Federal Reserve member banks were subject to reserve requirements set by the Federal Reserve, and required reserves were to be held on deposit with the Federal Reserve banks. Nonmember banks had much lower requirements set by state authorities.

Interest rates were extremely low during the 1930’s and 1940’s, then they trended steadily upward. Reserve requirements were held at high levels during the inflationary conditions of 1942-1952. Requirements softened as the economy returned more nearly to normal. In 1959-1960, banks were allowed to count vault cash toward their required reserves. Banks experimented with holding companies as a way of participating in nonbank business activities and operating the equivalent of branches across state lines.

However, it was the severe Inflationinflation that erupted during the late 1960’s that precipitated serious deregulation. Market interest rates rose to unprecedented high levels–far beyond the ceiling rates permitted on deposits. In 1966, Congress extended deposit-rate ceilings to thrift institutions to try to forestall a bidding war for deposits. The invention of money market mutual funds in 1971 provided savers with safe, liquid, high-interest assets, and deposit institutions found themselves losing time and savings deposits. Problems were especially severe for savings institutions, which held most of their funds in mortgages or long-term bonds. Deposit withdrawals pressured the institutions to try to sell off assets, but those asset prices were falling as interest rates rose.

The focus of deregulation was the Depository Institutions Deregulation and Monetary Control Act of 1980Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA). The law and Federal Reserve actions pursuant to it brought these deregulations: All banks were brought under Federal Reserve rules for reserve requirements, but these were substantially reduced. Requirements on time and savings deposits were gradually eliminated by 1986. Checking deposits required a 10 percent reserve, but most corporate checking deposits escaped this by using sweep accounts. Ceiling interest rates under Regulation Q were phased out. Interest could now be paid on checking accounts of nonbusiness depositors. Savings institutions were now able to offer checking deposit services.

Though not an instance of deregulation, another provision of DIDMCA raised the coverage of deposit insurance of banks and thrift institutions to $100,000. This enabled deposit institutions to cash in on the two major deregulatory aspects of the law. They began issuing large, fully insured certificates of deposit (CDs), which they sold in the open market.

In 1982, the Garn-St. Germain Act of 1982Garn-St. Germain Act greatly liberalized the range of permitted assets for thrift institutions (savings and loans, or S&Ls, and mutual savings banks). These were now permitted to have as much as 40 percent of their assets in commercial real estate loans, 30 percent in consumer loans, and 10 percent in commercial loans and leases. The 1982 law authorized banks and thrifts to offer money-market deposit accounts, designed to compete with money-market mutual funds.

The 1982 law was undertaken in an effort to rescue savings and loan associations from insolvency resulting when the market value of their mortgage loan portfolios declined. Perhaps half the S&Ls in the country were technically insolvent by 1982. The result was that many S&Ls undertook very risky lending and failed. In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989Financial Institutions Reform, Recovery, and Enforcement Act undertook to clean up the mess, at a cost to the public of some $150 billion. Most of the 1982 liberalizations of the thrift industry were repealed.

In 1994, the Interstate Branching and Branching Efficiency Act of 1994Interstate Banking and Branching Efficiency Act removed the previous restrictions on interstate bank branching. In 1999, the 1933 prohibitions against banks engaging in nonbank financial business activities were largely eliminated.

As a result of all these laws, the financial system changed dramatically between 1975 and 2000. Legislated distinctions among different deposit institutions largely disappeared. A massive wave of bank consolidation reduced the number of institutions. In 1970, there were more than 13,000 commercial banks and more than 5,000 S&Ls. By 2006, there were about 7,400 commercial banks and 1,300 thrift institutions.

Deregulation gets very mixed reviews from financial experts. It opened the financial world to innovation and competition, paving the way for fuller participation in the global economy. However, it overwhelmed management and regulatory competence, as was evident in both the S&L crisis of the 1980’s and the subprime mortgage crisis of 2007-2008.

Financial deregulation was heavily criticized as contributing to the Financial crisis of 2008financial crisis of 2008, which centered on subprime Mortage industrymortgage lending. In 2000, Congress passed a bill prohibiting federal and most state regulation of loan-guarantee contracts (credit default swaps) and similar derivatives. Such contracts were central to the crisis. Some potentially beneficial existing regulations were not effectively enforced, notably the requirements for minimum capital of financial firms. All regulation is subject to political pressure, and all the pressure was toward expanding credit for subprime borrowers. Some regulations were criticized as aggravating the crisis, notably the accounting regulation known as marking to market. This required that asset values be recalculated frequently based on estimates of their current market price. Valuations of assets with no real markets were arbitrary and may have contributed to the perception that firms were insolvent. New regulations are likely to emerge in response to the crisis.

• Barth, James R., R. Dan Brumbaugh, Jr., and James A. Wilcox. “The Repeal of Glass-Steagall and the Advent of Broad Banking.” Journal of Economic Perspectives 14, no. 2 (Spring, 2000): 191-204. Detailed examination of the 1999 legislation which removed barriers to the activities banks can engage in.
• “Financial Market Deregulation.” In Economic Report of the President. Washington, D.C.: Government Printing Office, 1984. A very readable and systematic overview, stressing links to monetary policy.
• Litan, Robert E. “Financial Regulation.” In American Economic Policy in the 1980s, edited by Martin Feldstein. Chicago: University of Chicago Press, 1994. Develops the interaction between deregulation and the thrift crisis; two commentators provide additional perspective.
• Markham, Jerry W. A Financial History of the United States. Armonk, N.Y.: M. E. Sharpe, 2002. 3 vols. Largely chronological, this work is a gold mine of details, but not very analytical.
• Mishkin, Frederic. The Economics of Money, Banking, and Financial Markets. 7th ed. New York: Pearson Addison Wesley, 2006. Chapter 10 of this college-level text places deregulation in the context of financial innovation, regulatory policy, and the S&L crisis.

Bank failures

Banking

Federal Deposit Insurance Corporation

Financial crisis of 2008

Merger and corporate reorganization industry

Mortgage industry

New Deal programs

Savings and loan associations

Trickle-down theory