Economic Report of the President

task of helping them evolve in an orderly manner. Success willdepend in part on general economic conditions, and as these conditionschange, the regulators must be prepared to react.A case in point is the gradual removal in the last few years of ceilingson deposit interest rates. It was initially anticipated that relaxationof the ceilings, combined with an eventual liberalization of thetypes of assets that could be held, would allow thrift institutions togradually correct imbalances in their portfolio maturities and thuslimit their exposure to rising interest rates. But quick acceptance offloating-rate certificates by small savers at a time of rapidly rising interestrates has raised the interest expense of these institutions muchfaster than they have been able to increase the revenues on theirloans. While most of the thrifts will achieve a better asset/liabilitybalance in the long run, the current squeeze on profits resulting fromrapidly rising market interest rates threatens some of them with seriousfinancial difficulties.One way to deal with this problem would be to subsidize endangeredinstitutions, perhaps by buying their low-yield, long-maturityassets (mortgages) at above-market prices. This would involve a substantialbudgetary outlay, however. Another option would be topermit the troubled institutions to fail outright, but this approachwould risk destabilizing the financial markets arid could result in significantlosses to uninsured depositors and the Federal insurance organizations.Neither of these approaches responds directly to the inefficienciescreated by remaining regulatory practices which continue to compartmentalizedepository institutions. Thus, a third and preferred alternativewould be to remove restrictions that now prevent efficient consolidationamong financial firms. This would require further deregulationto allow mergers across State lines and between different typesof institutions, since these restrictions remain a major obstacle to theefficient reorganization of financial institutions. As a result of thesechanges, the weakest institutions would find more opportunities formergers. While this would not solve the problems of all endangeredinstitutions, it would allow a more stable reordering of the financialsector where appropriate while minimizing the budgetary cost andsharply reducing the risk to financial markets of policies aimed at theremaining problem.ConclusionsDuring the last two decades the pace of innovation in the financialmarkets has been quite rapid as depositors, borrowers, and financialinstitutions have sought new ways to adapt to high and variable interestrates. Unfortunately, a lag in both legislation and financial regulationmeant that a considerable amount of innovation was applied to114