Brazil’s moves last week to stem the rise of its currency reflect the growing anxiety in many emerging economies about inflows of hot money. Fickle deposits in banks – ancient enablers of calamitous booms and busts in credit – deserve even wider attention. It is time to prohibit all banks – and depository institutions like money market funds – from paying more than the risk-free government bill rate. In short, we need to cap rates on all short-term deposits.
This might seem an unthinkable throwback. In the US interest rate ceilings were supposedly consigned to history along with the regulation of trucks and airlines – swept away by innovative money market funds and the deregulatory tide of the late 1970s and 1980s. Banks were forced, says the folklore, to pay market rates to long-exploited depositors, instead of giving away free toasters to attract custom.
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In fact deregulating rates on deposits was more like eliminating the inspection of truck brakes than freeing truck tariffs. Bankers had long feared that competing for deposits by paying high interest rates triggered races to the bottom in lending, while yield-chasing depositors were seen as a dangerous source of funds. Banks in good condition, the head of the Philadelphia National Bank said in 1884, did not pay interest to depositors.
Bidding for the deposits of banks with surplus funds was particularly problematic. The rules allowed anyone to start a bank in the US, but made it impossible to open many deposit taking branches. Urban banks, particularly those with Wall Street connections, competed with each other for the surplus funds of country banks. There was a nasty downside: unexpected withdrawals by country banks triggered panics. Yet exhortations by regulators and bankers’ associations to limit interest on interbank deposits were futile.
The 1933 Glass-Steagall act finally banned all payments on demand deposits by most American banks to “forestall ruinous competition”. In conjunction with tough controls on banks’ assets, rate limits worked wonders. Despite reputations for indolence, banks raised their lending by over 9 per cent a year in the 1950s and 1960s. The largest number of banks that failed in any year was just seven.
The Federal Reserve’s inability to control inflation in the 1970s, however, ultimately made deposit rate rules untenable. Banks only able to offer non-interest paying deposits, whose real value declined by the day, lost customers to money market funds that contained riskless but interest bearing T-bills. Later banks joined with their money market competitors to create a vast uninsured and unregulated funding system that fuelled an explosion of dodgy lending and made banks vulnerable to the sort of panicky withdrawals that the 1933 rules ought to have ended.
The story of US deposit regulation offers important lessons for bank regulators: pay attention to short-term liabilities – just focusing on bank assets to control contagious imprudence is unwise. Moreover controls (and explicit guarantees) have to be comprehensive and uniform: they cannot exclude the deposits of sophisticated investors or exempt intermediaries such as money market funds. Allowing large depositors to earn higher rates (under the fiction that they face more risk) is particularly dangerous when the mad music to which bankers dance heats up.
Sceptics may point to the problem Spanish banks faced last year when interbank lending markets seized up: If they had not been able to raise rates, banks might have had to take more emergency funding from the state. In fact, it was hot short-term deposits that put the banks on the brink in the first place. Comprehensive rate caps (and deposit insurance) would have made it difficult for banks to expand recklessly their lending – and protected them from a run by depositors.
Limiting rates paid to depositors also does not necessarily bestow windfall profits to banks. Rate caps have their most bite during boom times when they curb the volume of loans. Provided regulators do not allow banks to crank up their credit risks, profit margins on loans are restrained along with their volumes. Note that the deregulation that was supposed to put competitive pressure on bank profits in fact showered unimaginable wealth on bankers.
The writer is a professor at the Fletcher School of Law and Diplomacy, and author of ‘A Call for Judgment: Sensible Finance for a Dynamic Economy’