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What is Regulation Q?

By Dale Marshall
Updated May 16, 2024
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Regulation Q, a part of the US Code of Federal Regulations (CFR), was promulgated in 1933 and essentially phased out in a six-year process ending in March 1986. Regulation Q's most visible component was to prohibit American banks from paying interest on checking accounts, but it also contained various provisions by which the Federal Reserve could set interest rate ceilings for various types of banks to influence the extension of credit.

The United States was suffering through the Great Depression in the early 1930s, and the Congress wanted to influence country banks emdash; savings and loans (S&Ls) and similar thrift institutions &emdash; to extend credit to local farmers and merchants. However, the practice of many banks was to deposit their funds in commercial banks and earn interest on those deposits. These deposits were demand deposits; they could be withdrawn at any time, upon demand. Modern checking accounts are demand accounts.

Time deposits, such as certificates of deposit (CDs), generally paid higher interest rates, but amounts paid into CDs had to be left on deposit at the commercial bank for some period of time. Small thrifts needed the flexibility to withdraw their funds at any point, in order to meet seasonal needs of their customers and the occasional panic, so they would deposit their funds in demand accounts at lower, but extremely reliable, rates of interest.

To discourage the thrifts from essentially hoarding cash in this manner, instead of lending it out, Congress, in the Banking Act of 1933, included Regulation Q, which prohibited the paying of interest on demand accounts. It was felt that this would release the funds the country banks had been accumulating in commercial banks. This also answered the criticism by some that the commercial banks were using the demand deposits by smaller regional banks for speculative purposes and keeping the funds from being loaned for more productive purposes.

Regulation Q also permitted the Federal Reserve to set maximum interest rates that could be paid on time deposits. There were two main reasons for this. First, Congress felt that competing for deposits by increasing interest rates paid was adversely affecting banks' profitability, and that if the rates offered to depositors was capped, banks wouldn't lose profits in interest rate competition. Second, it was felt that if the smaller local thrifts were allowed to offer a slightly higher interest rate on time deposits than the commercial banks, depositors would open accounts at those local thrifts, thus increasing the funds available for lending.

Regulation Q's effects were mixed. While the intended purpose of preventing thrifts from accumulating large demand deposits in commercial banks was accomplished, it forced upon the thrifts a practice of short-term borrowing to fund long-term lending. That is, thrifts would use customers deposits, which were short-term in nature, to fund their lending, which consisted mostly of long-term residential mortgages. In addition, the interest-rate cap set under Regulation Q, which was applied to the S&L industry in 1966, was considered by some to be a form of price fixing that precipitated the S&L crisis of the 1980s, an 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 accomplishing the goals Congress set for it. Moreover, the interest rate ceilings imposed were eliminated in 1970, for accounts of over $100,000, thus altering the distribution of wealth and forcing smaller savers to forgo billions of dollars in interest. Having determined that these interest rate ceilings produced 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 gradually eliminated the caps on interest paid by banks and superseded the old provisions of Regulation Q, with the single exception that banks are still prohibited from paying interest on business checking accounts.

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