of Governors of the Federal Reserve System, June 2000.         One example is Regulation Q, which for decades put a ceiling on the interest rates that banks were allowed to pay to depositors, until it was repealed by the Depository Institu- tions Deregulation and Monetary Control Act of 1980. These ceilings were supposedly a response to widespread bank failures during the Great Depression. By curbing interest rates, the government hoped to limit further failures. The idea was that if banks could not pay high interest rates to compete for depositors, their profits and safety margins presum- ably would improve. The result was predictable: Instead of competing through interest rates, banks competed by offering "free" gifts for initiating deposits and by opening more numerous and convenient branch locations. Another result also was predictable: Bank com- petitors stepped in to fill the void created by Regulation Q. The great success of money market funds in the 1970s came in large part from depositors leaving banks that were pro- hibited from paying competitive rates. Indeed, much financial innovation may be viewed as responses to government tax and regulatory rules.       1.4 THE ENVIRONMENT RESPONDS TO CLIENTELE DEMANDS   When enough clients demand and are willing to pay for a service, it is likely in a capitalis- tic economy that a profit-seeking supplier will find a way to provide and charge for that service. This is the mechanism that leads to the diversity of financial markets. Let us con- sider the market responses to the disparate demands of the three sectors.     Financial Intermediation   Recall that the financial problem facing households is how best to invest their funds. The relative smallness of most households makes direct investment intrinsically difficult. A small investor obviously cannot advertise in the local newspaper his or her willingness to lend money to businesses that need to finance investments. Instead, financial intermediaries such as banks, investment companies, insurance companies, or credit unions naturally evolve to bring the two sectors together. Financial intermediaries sell their own liabilities to raise funds that are used to purchase liabilities of other corporations. For example, a bank raises funds by borrowing (taking in deposits) and lending that money to (purchasing the loans of) other borrowers. The spread between the rates paid to depositors and the rates charged to borrowers is the source of the banks profit. In this way, lenders and borrowers do not need to contact each other directly. Instead, each goes to the bank, which acts as an intermediary between the two. The problem of matching lenders with borrowers is solved when each comes independently to the common intermediary. The