Regulation Q was a United States federal rule, established under the Glass-Steagall Act of 1933, that fundamentally shaped American banking for over half a century. Its primary functions were to prohibit banks from paying interest on demand deposits (checking accounts) and to set interest rate ceilings on other deposit accounts, like savings and time deposits. Enacted in the wake of the catastrophic bank failures of the Great Depression, the regulation was designed to promote financial stability. The theory was that intense competition among banks for customer deposits—waged by offering ever-higher interest rates—had forced them into making increasingly risky loans to cover their costs, ultimately leading to widespread insolvencies. By capping the rates banks could pay, regulators aimed to remove this “destructive” competition, theoretically making the entire banking system safer. While well-intentioned, Regulation Q's story is a classic example of how market forces can ingeniously route around regulatory barriers, with profound and lasting consequences.
While Regulation Q might have worked in a low-interest-rate environment, it began to buckle under the pressure of rising inflation and interest rates in the 1960s and 1970s. As market rates on safe investments like Treasury Bills climbed far above what banks were legally allowed to offer, a massive economic incentive was created for savers to pull their money out of the banking system. This process is known as disintermediation. Financial entrepreneurs brilliantly capitalized on this regulatory loophole.
The most significant consequence of Regulation Q was the creation of the money market fund. In 1971, the first such fund was launched, offering a revolutionary proposition. By pooling investors' money and buying short-term, high-quality debt instruments, these funds could pass on the much higher market rates to savers. Crucially, because they weren't legally classified as “banks,” they were not subject to Regulation Q's interest rate ceilings. They even offered check-writing privileges, making them a direct and superior substitute for a traditional bank account. This innovation marked a pivotal moment in the rise of the shadow banking system—financial intermediaries that perform bank-like activities but operate outside the traditional regulatory umbrella.
Regulation Q also fueled the expansion of the Eurodollar market. U.S. dollars deposited in banks outside of the United States were not subject to the regulation's interest rate caps. Consequently, foreign banks and overseas branches of U.S. banks could attract dollar deposits by offering more competitive rates than their domestic counterparts. This drew a torrent of capital offshore, creating a deep and liquid international market for U.S. dollars that operated beyond the direct control of American regulators.
The competitive pressure from money market funds and the Eurodollar market made Regulation Q increasingly untenable. The U.S. government began phasing it out with the Depository Institutions Deregulation and Monetary Control Act of 1980, and it was finally and fully repealed by the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2011. Though now a relic of history, the story of Regulation Q offers timeless lessons for investors.