The Benefits of Bank Deposit Rate Ceilings: New Evidence on Bank Rates and Risk in the 1920s

For most ofthe last 50 years, to promote a safe banking system, the U.S. Congress has imposed interest rate ceilings on bank deposits. Federal legislation passed in the wake of the 1930s banking crisis prohibited banks from paying any interest on checking accounts and authorized the Federal Reserve Board of Governors to set upper limits on the rates banks could offer on time and savings accounts. The rationale for these ceilings appearedstraightforward. Ifbanks were not allowedto compete for deposits through interest rates, they would not be forced to invest in the high-yield, high-risk end of their portfolio opportunities. Limiting what banks could pay to their depositors, in other words, would limit the amount of yield they would need to earn and hence the amount of risk they would need to bearto be competitive. Without rate competition, that is, the chancesofrepeatingthe 1 930sbanking crisis would be reduced. By 1980,however, the deposit rate ceilings hadapparently become more costly thanthey were worth. The general rise in market rates in the 1970s made bank deposits subject to rate ceilings considerably less attractive than competing instruments offered at market ratesby other financial institutions. Late in the 1970s, this competition began to raise concerns about the viability of the traditional bank deposit. Furthermore, the rationale for deposit ceilings had been attacked. Studies done in the 1 960s found that before U.S. bank deposit rates were regulated there was little relationship between these rates and bank risk-taking; that is, contrary to what had beenthought in the 193 Os, there was no benefit to regulating deposit rates. Consequently, in 1980 Congressdecided to eliminate most deposit rate ceilings, phasing them out over several years. I am not questioning here whether Congress made the right decision. With market rates on the rise, existing depositceilings may very wellhave threatened the viability ofbank deposits. I am questioning, though, the research result that unregulated deposit rates and bank risk are not related. The result is unexpected because it is inconsistent with modern finance theory’s prediction that, in general, risk andreturn are positively correlated. The result is also suspect, and needs reexamination, because the studies which found it, while perhaps the best available in the 1 960s, were limited in critical ways. A not-so-limited reexamination became possible recently whenI found new and better data on banking in the 1920s. Specifically, I found bank examination records dating back to the mid1 920s which give researchers better measures of deposit rates than they have had before. Studying the 1920s with these new data, I find the positive correlation between deposit rates andbank risk that modern finance theory predicts. This new result, ofcourse, does not necessarily imply