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Volume 2
REAPPRAISAL OF THE
FEDERAL RESERVE DISCOUNT MECHANISM

Board of Governors of the Federal Reserve System



PU BLISH ED IN D EC EM B ER 1971




Library of Congress Catalogue Card Number 70-609110
Copies of this report m ay be obtained from Publica­
tions Services, Division of Adm inistrative Services,
Board of G overnors of the Federal Reserve System,
W ashington, D.C., 20551. The price is $3.00 per copy;
in quantities of 10 or m ore sent to one address, $2.50
each. Remittances should be m ade payable to the
Board of G overnors of the Federal Reserve System in
a form collectible at par in U.S. currency. (Stamps
and coupons not accepted.)

Volume 2
REAPPRAISAL OF THE
FEDERAL RESERVE DISCOUNT MECHANISM

CONTENTS
THE LEGITIMACY OF CENTRAL BANKS

1

Kenneth E. Boulding
SELECTIVE CREDIT CONTROL

15

Lester V. Chandler
A REVIEW OF RECENT ACADEMIC LITERATURE
ON THE DISCOUNT MECHANISM

23

David M. Jones
SUMMARY OF ISSUES RAISED AT THE ACADEMIC
SEMINAR ON DISCOUNTING

47

Priscilla Ormsby
SOME PROPOSALS FOR A REFORM OF
THE DISCOUNT WINDOW
Franco Modigliani




59




CONTENTS

cont.

AN EVALUATION OF SOME DETERMINANTS OF MEMBER
BANK BORROWING

77

Leslie M. Alperstein
TOWARD A SEASONAL BORROWING PRIVILEGE:
A STUDY OF INTRAYEAR FUND FLOWS
AT COMMERCIAL BANKS

93

Emanuel Melichar
CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE,
AND PROPOSALS TO INCREASE AVAILABILITY
OF BANK CREDIT
Emanuel Melichar and Raymond J. Doll




107




THE LEGITIMACY OF CENTRAL BANKS
Kenneth E. Boulding
University of Colorado







THE LEGITIMACY OF CENTRAL BANKS

therefore, depend on the willingness of
other role occupants to give outputs, and
they will not do this continuously unless
there is legitimacy. Where people feel that
certain outputs are illegitimate they will
eventually find ways of stopping them. The
corresponding inputs will likewise stop. To
use a rather crude illustration, a bandit can
take your money once, but anyone who
wants to take it every week either has to be
a landlord or a tax collector, or perhaps
even a bank.
There are a considerable number of
sources of legitimacy, and the functions that
relate the determinants of legitimacy to its
amount are extremely complex. Such func­
tions are certainly nonlinear and they ex­
hibit discontinuities that are, to say the least,
disconcerting. Sometimes an institution, the
legitimacy of which seems to be absolutely
unquestioned, collapses overnight. All of a
sudden we reach some kind of a “cliff” in
the legitimacy function and the institution
suddenly becomes illegitimate. The same
thing perhaps can even happen the other
way, in which institutions quite suddenly
become legitimate after having been illegit­
imate. A good example of the former is the
collapse of the monarchy, beginning in the
17th century. The legitimacy of monarchy
survived the Cromwellian war in England,
largely because an ancient legitimacy is
like a capital stock—it takes a great deal of

The problem of legitimacy is one of the
most neglected aspects of the study of so­
cial systems. There may be good reasons
for this because legitimacy is inevitably a
hot subject. One can hardly discuss the
legitimacy of anything without seeming to
threaten it, for a great deal of legitimacy
depends on things being taken for granted
and not being talked about at all. The more
one looks at the dynamics of social systems,
however, the more it becomes clear that the
dynamics of legitimacy is one of the most
important elements in the total long-run
dynamics of society. It certainly ranks with
such things as population and demographic
movements, and even with technological
change with which it is closely intertwined.
Its importance can be seen in the remark
that a person or institution that loses legiti­
macy loses everything and can no longer
maintain itself in the social system. No
amount of wealth—that is, exchange capa­
bility—or power—that is, threat capability
—can keep an institution alive if there is a
widespread denial of the legitimacy of its
role in society. This is because the perform­
ance of any continuous and repeated role
requires an acceptance of its legitimacy on
the part of those role occupants whose roles
are related to it. A role in the social system
is a focal point or node of inputs and out­
puts of many different kinds, the output of
one role being the input of another. Inputs,




3

4

spending before it can be exhausted. At the
time of Louis XIV in the following cen­
tury one might have thought the legitimacy
of monarchy was absolutely unquestioned
and secure. In the 19th century, however,
monarchies collapsed nearly everywhere and
the only monarchs who survived were those
who abandoned their power and became
symbols of legitimacy, like the British,
Dutch, and Scandinavian monarchs. On the
other side, abortion has been an institution
that has been regarded as highly illegit­
imate and now in the face of the popula­
tion problem seems to be acquiring a sud­
den legitimacy.
We may distinguish at least six classes of
sources of legitimacy; that is, variables
in society that are functionally related to
legitimacy. The first consists of the payoffs
of the institution in question. If an institu­
tion provides good terms of trade with
those who are related to it, this contributes
to its legitimacy up to a point, especially in
the long run. The case is clearer on the
negative side. An institution that has very
poor payoffs—that is, demands a great deal
of input from other people and gives very
little output to them—is likely to have its
legitimacy eventually eroded on this ac­
count. The relationship, however, is cer­
tainly nonlinear and quite complex, and at
times may even be negative. Just because
an institution is useful and pays off well is
not sufficient to give it legitimacy.
Paradoxically enough, it is not merely
good payoffs that give legitimacy but also
bad payoffs; that is, sacrifices—the second
source. A sacrifice or “grant” may be de­
fined as a one-way transfer from one
decision unit to another, in contrast with
exchange, which is a two-way transfer,
from A to B and also from B to A. The
structure of one-way transfers of commodi­
ties and exchangeables, I call the “grants”



economy, and it is a good first-approxima­
tion measure of the extent and structure of
the integrative system in general. If A
makes a grant to B, the implication is that
A identifies with B, A and B are in a com­
munity together, and A clearly regards B
as legitimate. The dynamics of the grants
system is very complex because to some
extent grants are self-justifying. If A makes
sacrifices for B, it is very hard for A to
admit to himself that these sacrifices have
been in vain. This would be a threat to
his identity, which is the greatest threat
that any person can feel. There is, there­
fore, a strong tendency to “throw good
money after bad” and to continue making
sacrifices for some institution, even after
some possibly expected long-run payoffs
have failed to materialize. This is what I
call the “sacrifice trap.” We see this in the
family, for instance, where the devotion of
one spouse to an unsatisfactory partner
often continues for a long time in spite of
very unsatisfactory internal terms of trade.
A spouse who gives a lot to a marriage and
gets very little out of it may continue to do
so because of the threat to the personal
identity should the process ever stop. There
may come a point, of course, at which the
terms of trade become too bad altogether
and a break-up ensues. This is the “cliff”
phenomenon in the legitimacy function. The
same thing evidently happened to the mon­
archy, and it can happen to religion, like
the religion of the Aztecs. It could even
happen to the national state.
The third source of legitimacy is age.
Institutions build up legitimacy just by
sticking around, as long as there is an ex­
cess of production over consumption. Even
this function, however, may be nonlinear.
Up to a point increase in age increases legit­
imacy; beyond a certain point, however,
the senator becomes senile and the good
old things become old-fashioned. One can

LE G IT IM A C Y OF C EN T R A L B A N K S

detect, perhaps, three phases of the func­
tion. When things are new, they have the
special legitimacy of babies, young people,
or the new fashion. At a certain point they
become middle-aged or old-fashioned and
legitimacy declines sharply. Then as time
goes on, they become antiques and legiti­
macy increases once again. In the case of a
creative person, for instance, one often finds
a phase of rising legitimacy with age and then
a declining phase as he gets out of date,
and then an increasing phase as he acquires
a posthumous reputation, which is presum­
ably the personal equivalent of being an
antique.
The fourth source of legitimacy is mys­
tery. Something that is not understood but
that is dimly perceived as obscurely grand
and magnificent acquires an aura of legiti­
macy simply because it is secret and we do
not understand it. The temples and impres­
sive ceremonies of religion, the state of
kings, the mystique of the brass hat and
the military leader, the sanctity of priest­
hoods of all kinds, and even the mystery of
science and the laboratory are all related
to this aspect of legitimacy. It depends, of
course, on a class structure, on a distinc­
tion between the initiates and the common
people. Historically, it has been a very
powerful source of the willingness of the
common people to make sacrifices for the
benefit of the initiates and to afford them
a great deal of legitimacy, often in the
absence of much in the way of tangible
returns.
Closely related to this aspect of legiti­
mation is ritual or artificial order. Man has
always feared the randomness of his en­
vironment, the uncertainty of the weather,
the crops, accidental injury or death, dis­
ease, his whole future state. One of his
responses to this has been to create little
islands of artificial order, regularly repeated



5

rituals, liturgies, and human law. The role
that law plays in legitimation is closely re­
lated to this aspect of it as ritual. To say
that law and ritual are artificial orders is not
in any sense to deny them validity, nor does
it mean that these artificial orders are arbi­
trary. Where they are successful it is pre­
cisely because they reflect an order in the
real world, whatever that is. Nonetheless,
they are artificial in the sense that they
create an island, as it were, of life and ex­
perience that is separated from the rest of
the world. A monastery is a good example
of such artificial order; so is a law court.
Insofar as the need for legitimation is
closely related to the need for regularity
and for law in the broad sense of regularity
and nonrandomness, we can easily see why
the development of these artificial orders of
liturgy and legal procedure, of due proccess, and of repeatable and predictable be­
haviors and decisions are an important as­
pect in the legitimation process. Here, too,
however, we may run into nonlinear rela­
tionships. Beyond a certain point an arti­
ficial order becomes too artificial, and if
protest arises against it, the legitimacy of
the institution that is based on it may sud­
denly collapse. The Reformation, perhaps,
may be interpreted as a protest against too
artificial an order in the Roman Catholic
Church. The fact that law does not always
maintain legitimacy, as the experience of
prohibition indicated, also suggests that
law too may be “a hass” in the memorable
words of some unmemorable character in
Dickens, and when it is perceived to be
such, the legitimacy on which it is based
easily collapses. There are many countries
today, indeed, in which law is much less
legitimate than it is in the United States,
and the legitimacy of law itself is a prob­
lem to which we have given far too little
attention.

The sixth source of legitimacy consists
of the alliance of an institution with other
legitimacies. This is what might be called
the legitimacy syndrome. If there are in­
stitutions that already possess a great deal
of legitimacy, it is possible sometimes for
new and nonlegitimate institutions to ac­
quire legitimacy by identifying themselves
with the legitimate ones. It is easy to cite
examples of this. The United States built
Washington in the classical tradition of
ancient times. The United States, being a
new and therefore rather illegitimate Re­
public, sought to establish its legitimacy by
means of a “tie-in” with Corinthian col­
umns and handsome domes. The legitimacy
of a religion often permits highly radical
and otherwise illegitimate movements to
spring up within it, like the Franciscans, or,
in our day, the movement for racial equal­
ity or even the peace movement. Here again
we may run into nonlinearities in the rela­
tionship. The nouveau riche person who
builds a very fancy house may thereby
diminish rather than enhance his legitimacy
in the eyes of those he most wishes to im­
press. A country that wastes its scarce re­
sources on building a vast presidential pal­
ace or a grand new capital may not acquire
much legitimacy thereby, but only the sub­
tle sneers reserved for unwise decision­
makers. One interesting phenomenon here
is that the more legitimacy an institution
has, the less it has to worry about these
alliances. In the early days of a university,
for instance, it often builds elaborate
Gothic or classical buildings to tie in with
the legitimacy of the past and to pretend
that it has the legitimacy of spurious age.
As it acquires genuine legitimacy, how­
ever, perhaps in the process of providing
payoffs, its buildings become skimpier and
more austere and it puts less and less into
ritual and into elaborate architecture until




finally it ends up by abandoning gowns,
Gothic buildings, ivy, and even grass as it
lays down its campus to enormous parking
lots.
Let us now apply this analysis as far as
we can to the problem of the legitimacy of
the banking system, and of the central
banks in particular. The existence of social­
ist states shows that this is not an idle prob­
lem. Socialism indeed can be interpreted
largely as an attack on the legitimacy of
certain institutions of exchange, and in the
socialist states we see the very interesting
phenomenon of the gradual re-establish­
ment of many of these same institutions
with a different framework of legitimation.
In the Western World and especially in the
United States, the legitimacy of the bank­
ing system is almost completely taken for
granted. It must not be assumed, however,
that the banking system or any other insti­
tution necessarily creates its own legit­
imacy, and it must not be assumed that this
legitimacy could never disappear, even
though it might seem at the moment to be
quite unshakable. The possessors of un­
shakable legitimacy should always remem­
ber Louis XVI at least once a day, even
though the Federal Reserve is not the sort
of place where heads are likely to roll. It
will at least be an interesting exercise, there­
fore, to apply the six major sources of legit­
imacy to the banking system, and see if any
dynamic patterns emerge.
The payoffs of the banking system to
the rest of society are fairly positive and
also are fairly visible. Most people outside
the banking system have contact with it
either through using a checking account,
which is clearly a great convenience and
for which the payment does not seem ex­
orbitant, or through borrowing money,
which again we would not do unless we
thought that the returns were likely to be

LE G IT IM A C Y OF C E N T R A L B A N K S

greater than the costs. The banking system
is perhaps the purest example of an ex­
change institution. It lives almost entirely
by exchange, it does very little physical
transformation, and the utilities that it
creates out of which payoffs to the various
parties come are essentially exchange utili­
ties, such as the creation of convenient
forms of exchangeables like checking ac­
counts, or the separation of ownership from
control and the placing of asset complexes
in the control of those who presumably
know how to manage them best. The legit­
imacy of banking, therefore, falls or rises
with the legitimacy of exchange itself.
Even though the payoffs to the banking
system for those who deal with it are clearly
positive—for it is an essential characteristic
of exchange systems that continued ex­
change would not take place unless there
are positive payoffs to all parties—this in
itself is not sufficient to give legitimacy, al­
though it helps. The somewhat loose rela­
tionship between payoffs and legitimacy
may happen for two reasons. The first,
which applies to all exchange institutions,
is that an exchange, perhaps because it in­
volves so little in the way of sacrifice, does
not generate strong integrative sentiments
and feelings. My own bank once advertised
as “the bank that puts people first.” Every­
body knows, however, that this is a ritualis­
tic remark designed solely to create favor­
able sentiments. If, indeed, I thought it true,
I probably would not bank there, for what
we really want in a bank is that it puts
money first. In other words, we want ex­
treme probity in accounting, with not a
cent out of place, and if this involves some
sacrifice of a charming but careless accoun­
tant or a benevolent embezzler, I doubt
very much if we would fight for putting
people first. There have been a number of
cases, indeed, of benevolent bank officers




7

who embezzled in order to do good, and this
act is usually frowned upon quite severely.
I, at least, want banks to be honest, im­
peccable, and full of rectitude. I do not
necessarily want them to be lovable, in spite
of some of their advertising. Nevertheless,
this absence of lovability in exchange insti­
tutions not only seems to worry banks,
but it may occasionally lead to their over­
throw. Schumpeter, we may recall, argued
that capitalism would be overthrown by its
very success and because the rationalistic
attitude that it generated would destroy the
integrative institutions in, say, the family
or the church, or even the state, which en­
able exchange to be legitimated. Exchange
and exchange institutions, in other words,
simply pay off too well. They do not de­
mand any sacrifice. Thus an institution
that bases its legitimacy on its payoffs may
be challenged by another institution that
claims to have even better payoffs. This is
one reason, perhaps, why legitimacy that is
based merely on payoffs is a little insecure,
whereas a legitimacy that is based on
sacrifice is remarkably stable.
It is at least an amusing fantasy to sup­
pose that we might do a cost-benefit analy­
sis of the financial system and, indeed, of
competing financial systems. The costs are
fairly easy to identify. We could, for in­
stance, do a comparative study of, say,
Austria and Hungary, two countries at
about the same level of development, one
of which has a predominantly marketbased financial system and the other being
a socialist state. We could find out fairly
easily the costs of the two systems in terms
of resources absorbed into them based on
the economy in general. We could find out,
for instance, what proportion of the gross na­
tional product in each case was absorbed
by the financial system. The benefits, of
course, would be much harder to assess.

8

Indeed, I would almost despair of ever
making a quantitative assessment of them.
It is on judgments of this kind, however,
that the long-run competition between so­
cialism and capitalism may ultimately be
determined.
Merely asking a question of this kind,
however, may seem somewhat threatening
to the legitimacy of either kind of institu­
tion. The legitimacy of the institutions of
capitalism could depend a good deal on
their simple age; that is, just on the fact
that they are not questioned and that we
have gotten along with them for a long
time with reasonable success. It is one of
the curious problems of the dynamics of
legitimacy, indeed, that a threat to legiti­
macy is very hard to counter where the legit­
imacy itself is a function of age and ritual,
for even an attempt to defend a legitimacy
of this kind may destroy it. This perhaps is
one reason why the Marxist threat to the
legitimacy of capitalism was so much more
dangerous than would be the case if the
legitimacy depended merely on payoffs.
The payoffs to capitalism are actually
quite high. A good deal of its legitimacy,
however, depends on institutions like pri­
vate property, the legitimacy of which had
never really been questioned, and rests not
on the perception of long-run payoffs at all,
but simply on age, long use, and the ritual
of law. The legitimacy of socialist institu­
tions likewise depends in good measure on
the enormous sacrifices that have been
made to create them. The socialist state
stresses much more fiercely than the late
President Kennedy: “Ask not what your
country can do for you, ask only what you
can do for your country.” Because it has
demanded enormous sacrifices of its peo­
ple, in the interests of an ideal, its people
do not like to admit that the ideal might
not have much in the way of payoffs.




Hence, the suggestion that the relative
merits of the systems should be tested by
cost-benefit analysis would probably be
even more threatening to the socialist than
it is to the capitalist.
Let us now take a brief look at some of
the other sources of legitimacy and see how
they apply to the banking system. We have
already noticed that banks are not institu­
tions that demand sacrifice, except perhaps
sacrifice of temptations to dishonesty and
extravagance. Banks, therefore, are not
“heroic” institutions, and they cannot hope
to inspire the kind of love and loyalty that
such institutions as the church and the
national state inspire.
The banking system is, relatively speak­
ing, a fairly modem institution. It cannot
perhaps draw a great deal of legitimacy
from its age, although we do find banks
and institutions of all kinds advertising the
date of their foundation—when that is suit­
ably distant in time—as evidence of their
integrity, respectability, and legitimacy.
The Bank of England’s affectionate title as
“The Old Lady of Threadneedle Street”
indicates that age is perhaps not a negli­
gible factor.
The sense of mystery and charisma is also
far from a negligible factor in establishing
the legitimacy of banks. The bank may not
be a heroic institution, but it is certainly
mysterious to the ordinary person. Most
people who use banks, and indeed a good
many people who operate them, really do
not understand the operations of the bank­
ing system as a whole. There is, further­
more, a lingering sacred quality about
money itself. There is something a little
mysterious about the fact that mere green
pieces of paper or, even more remarkable,
a signature on a check is sufficient to buy
tangible objects. In the past, at least, banks
have contributed to the sense of mystery by

LE G IT IM A C Y OF C E N T R A L B A N K S

their very architecture, which has often
tended to be quasi-religious. Even if banks
shied away from the more subtle mysteries
of the Gothic, they have frequently en­
shrined themselves in pagan temples and
Corinthian columns, lofty ceilings, marble
floors, and a general air of hushed magnifi­
cence that hopefully induces in the cus­
tomer the frame of mind of proper respect
and reverence.
Ritual, likewise, plays a not insignificant
role in establishing the legitimacy of banks.
Regular hours, standardized procedures,
and a highly formalized accounting system
contribute to a sense of regularity and or­
der. The banking system, furthermore, is
strongly hedged about by legal safeguards
and the ritualistic language of contracts.
Alliances with other legitimacies are seen
not only in the architecture but also in the
institution of boards of directors—the mem­
bers of which are drawn from other respect­
able institutions in the community—and
also in the institution of the charter granted
by the state or by the nation, which brings
along with it a certain apparatus of in­
spection and oversight. We could even re­
gard national deposit insurance, quite apart
from its strictly economic aspects, as an
alliance with the enormous legitimacy of
the national state, for then behind even the
most private of banks stands the majesty
and legitimacy of government.
We now come rather belatedly to what
is supposed to be the main object of this
paper, which is the problem of the legit­
imacy of central banks. Central banking is
a rather late development in the banking
system. Even in Great Britain the Bank of
England did not begin to act as a central
bank until well into the 19th century. The
United States got along for the most part
without any central bank until 1913, al­
though before that it had something that




9

might almost be called an informal central
banking system. Until the establishment
of the Federal Reserve System, the neces­
sity of central banking was still a matter of
debate. The Japanese, for instance, when
they began to introduce Western institu­
tions started with something like the Amer­
ican national banking system, and devel­
oped a central bank only after a number of
financial crises. Today, however, the legit­
imacy, indeed almost the necessity, of cen­
tral banking seems unquestioned. Every
new country sets up a central bank almost
as soon as it is established. It is part of what
every well-dressed country will wear.
If we look down our six sources of legit­
imacy, we will see that almost everything
that can be said of the banking system
in general applies also to central banks.
Here they have unquestionably risen in
response to a felt need. There must, there­
fore, be some kind of a payoff to the or­
ganization. These, however, may be of two
kinds: market payoffs and political pay­
offs. The fact that even under a free bank­
ing system some strategically located banks
tended to perform the functions of a central
bank—in that part of their deposits were
owned by other banks and regarded as
reserves—suggests that the function of cen­
tral banking is something that will develop
even in a pure market system, simply be­
cause there are payoffs for this kind of
organization; that is, central banking can
provide adequate terms of trade for all
those with whom it exchanges. There are
clearly great conveniences, for instance, in
the clearing function and in commercial
banks holding their reserves in the form of
deposits in some central banks—whether
this clearing be public or private; the sheer
dynamics of a free financial market would
almost certainly throw up the institution
of central banking in one form or another.

10

Without any exception, as far as I know,
however, societies have not permitted cen­
tral banking to grow simply as a result of
market forces, but have always intervened
in the matter politically. At some point in
the development of the system, those who
are in control of the legislative process of
society perceive certain payoffs in the de­
velopment of a government central bank
that can then be used to control the pri­
vate banking system. In its political aspects
the government central bank can then be
seen as a partial movement toward the
socialization of the banking system; such
socialization leaves the ownership of most
of the institutions of the system in private
hands, but uses the government central
bank as an instrument of control. This may
be regarded for the most part as a problem
in the legitimation of power. Because of
the very structure of the system, a central
bank, whether public or private, will have
a great deal of power; that is, the decisions
of its responsible decision-makers will have
repercussions extending through the whole
system of the society. Power, however, as
we have seen, to be exercised continuously
must be legitimated, and governmental in­
stitutions are the principal agency of legit­
imation in modern society. Private power
will only be tolerated if it is small. This,
indeed, is the theory behind the encourage­
ment of competition as a regulating factor,
for in a competitive society the power ex­
ercised by any particular private decision­
maker is relatively small and is constantly
checked by his competitors. Central bank­
ing, however, as in electric power or tele­
phones, has the great advantage of monop­
oly, which means a concentration of
power, and if this concentration is to be
legitimated, it must be regulated in some
way through governmental organization.
Hence, it is not surprising to find a strong




tendency for government to take over the
central banks, even though, as in the case
of the Bank of England, nationalization
may make practically no difference to its
day-to-day operation or even its general
policy.
In this picture the Federal Reserve Sys­
tem presents some rather curious anomalies,
which may, however, in the American con­
text be more apparent than real. The Fed­
eral Reserve System, like the Bank of Eng­
land before its nationalization, is theoret­
ically privately owned and is a series of
interlocking corporations, theoretically
owned and controlled in large measure by
the member banks themselves. In reality,
of course, the Federal Reserve Banks are
public institutions, exercising the great
power that they have, not to make profit for
themselves, but to advance what they con­
ceive to be the public interest. Public rep­
resentatives sit on their boards of directors
and the members of the Board of Governors
of the Federal Reserve System are ap­
pointed by the President of the United
States and confirmed by the Senate. The
structure is thus less socialized than that of
the Post Office and more socialized than the
American Telephone and Telegraph Com­
pany, although there are certain parallels
between the Board of Governors of the
Federal Reserve System and a regulatory
commission for public utilities.
In the American system of legitimacy
these apparent anomalies actually make a
good deal of sense, for the American peo­
ple have a curious ambivalence towards
government. On the one hand government
is a strong source of legitimacy; on the
other hand it is also regarded as something
that is always potentially illegitimate and
can get out of hand. Hence, government
has to be hedged around with all sorts of
constitutional safeguards. The American

LE G IT IM A C Y OF C EN T R A L B A N K S

Constitution can be interpreted in consider­
able measure as a kind of treaty between a
people and its own government regarded as
a potential enemy! Consequently, in the
United States government does not have
any monopoly of the legitimating process,
and private institutions—simply because
they are private—have a certain legitimacy
of their own. It is not surprising, therefore,
to find in the United States this curious mix
of the public and the private that we find
in the Federal Reserve System, and it can
certainly be regarded, for its time, an op­
timum solution for the maximization of
legitimacy. Today, certainly, there seems to
be no major threat within the American
system to the legitimacy of the Federal Re­
serve System, although there have been
frequent and perhaps justified criticisms of
its policies. As far as I know, there are no
serious proposals either to nationalize the
Federal Reserve Banks, or to put them
under the U.S. Treasury, or to dissolve
them and go back to a system of free bank­
ing. The principle of separation of powers
is still very strong and the notion of the
Treasury and the Federal Reserve System
as two separate fiefs within a broad struc­
ture of governmental legitimation does not
seem to be seriously threatened.
Most of the other aspects of legitimacy
that we noticed as being characteristic of
the banking system also apply to the Fed­
eral Reserve System. Like the rest of the
banking system, Federal Reserve Banks
are not heroic institutions, although their
association with the national state hangs
over them a certain cloak of sacrificelegitimation, especially insofar as they may
have to sacrifice their own ideals of finan­
cial probity in times of war. Bankers of all
sorts tend to be deflationary- rather than
inflationary-minded and it must hurt their
souls a little to be accomplices in the infla­




11

tionary financial policy that invariably ac­
companies a war. This sacrifice of finan­
cial honor, however, is small compared
with the sacrifices of the soldier, although
it may not be insignificant in contribut­
ing to the legitimacy of the institution.
Certainly, if central banks were to oppose a
war effort on the grounds that it offended
their financial principles, their unwilling­
ness to sacrifice their principles would not
be taken kindly and would contribute rap­
idly toward the loss of their legitimacy.
Central banking is now old enough to
have acquired a little of the sanctity of
age, and it is certainly shrouded in a great
deal of mystery and acquires a certain legit­
imacy from this fact as well. Where or­
dinary men and ordinary brokers have at
least some familiarity with the operations of
the member banks, they may have no famili­
arity at all with the operations of the cen­
tral bank. I must confess myself that I was
an economist for 30 years, although not a
specialist in money and banking, before I
personally set foot within a central bank
of any kind, and my knowledge of such
banks and their operations, are derived
wholly from books and talk. Even in the
mind of a professional economist, therefore,
the central banks appear as abstractions
and cannot be visualized as flesh and blood
realities. Whether the central banks should
try to enlighten the public and to dispel the
mystery is a nice point. It may well be that
their own legitimacy is best fostered by pre­
serving a certain air of charismatic obscur­
ity about their operations. Their officers
might even take to wearing gowns and robes
and their public pronouncements might be
couched in even more mysterious and im­
pressive language than they now use.
The concept of a central bank as a
creator of artificial order and financial ritual
has some interpretive power and should not

12

be dismissed lightly. One of the real prob­
lems of central banking policy is that at the
heart of it there is a certain arbitrariness.
The movements of the bank rate, the deci­
sion to change the asset structures, the
changes in legal reserve ratios, and other in­
struments of central bank control have a
certain Delphic quality about them. They
emerge as the result of arguments that are
not disclosed, and yet they have very power­
ful effects on the total system. Furthermore,
the effects of these decisions are not always
easy to trace, and the feedbacks of informa­
tion are not easy to relate to particular
decisions. Under these circumstances, the
ritualizing of these decisions may be a very
important aspect in their legitimation. One
might even speculate on the value of ritual­
izing them more than is now the case. The
decisions of a board, for instance, might be
entrusted to a dramatically attired rider
who would deliver them to the White House
with the pounding of hooves and the flour­
ish of trumpets!
We might conclude with a brief look at
the possible threats to the legitimacy of the
System. The fact that the System survived
the Great Depression is a tribute to the re­
markable stock of legitimacy that it pos­
sesses. The extent to which the Federal
Reserve System contributed to the Great
Depression is still somewhat a matter of
controversy. It certainly cannot be blamed
for the whole episode; nonetheless, a strong
argument can be made that in this period
the payoffs of the System for the society as
a whole were strongly negative and that
disastrous mistakes in policy were made. In
the short run, however, as we have noticed,
the payoffs of the System are only loosely
related to its legitimacy and the other
sources of legitimacy for the Federal Re­
serve System are quite strong—strong
enough, indeed, to enable it to survive a




considerable decline in its payoffs to society.
The only source of loss of legitimacy that
seems even remotely on the horizon arises
out of the sixth factor; that is, the alliances
with other legitimacies. The Federal Re­
serve System is not allied at all with the
legitimacies that derive from religion, from
the family, from the arts, and from the
more poetic, heroic, and evocative aspects
of life. It is essentially and almost wholly
an institution of exchange. Its inputs and
outputs are exchangeables, and in itself
exchange is too rational an institution to
create much loyalty and affection and the
kind of legitimacy that proceeds from these
sources. I would argue indeed that an ex­
change institution should not try to derive
legitimacy from these other sources, for
if it does so it makes itself ridiculous. The
Federal Reserve should certainly not try
to become patron of the arts, an inspirer of
heroism, or a producer of poetry. To at­
tempt to do so would be like tying peacock
feathers on a work horse, and the ridiculous
incongruities that would result would lessen
rather than enhance the legitimacy of the
institution.
Insofar as the legitimacy of the central
banks is enhanced by alliances, it is with the
national state, and the national state alone.
In these days the national state is so fantas­
tically legitimate an institution that to sup­
pose that its legitimacy might decline or
even collapse seems almost absurd. Never­
theless, stranger things have happened. Par­
ticularly if the international system deterio­
rates much beyond its present deplorable
condition, the payoffs of the international
system for the human race will be so nega­
tive that the legitimacy of the national state
as the essential and primary institution of
the international system will itself be af­
fected. It may be, indeed, that before many
decades are up, if we live that long, the

LE G IT IM A C Y OF C EN T R A L B A N K S

national state itself will have to be “desacralized.” This, indeed, is what general
and complete disarmament and stable peace
would involve. To put the matter brutally,
some time in the future it may seem as
absurd to die for one’s country as it would
be today to die for the Federal Reserve.
In the long run, therefore, we may see
something very peculiar. The very common­
place and nonheroic aspects of the national
state may save it, and the strong alliance
that exists between central banks and gov­
ernments may turn out to be a two-way
street. At the moment, indeed, it is govern­
ment that confers legitimacy on central
banks to a considerable extent. It is not
wholly inconceivable that in the future it
will be the fact that the central bank is pri­
marily an agency for human welfare and
not for human destruction that will confer
legitimacy on the government, as we make
the subtle transition from the warfare state,
which threatens to engulf us all in a com­
mon destruction, to the desacralized com­
monplace, unheroic welfare state, which




13

works simply for human betterment. In the
long run I have a good deal of confidence
that payoffs in terms of human welfare are
the only ultimate and self-sustaining sources
of legitimacy. Sacrifice, age, mystery, and
ritual can fool some of the people some of
the time. If, however, they are not associ­
ated with real payoffs, they will be found
out. This, of course, does not answer the
question that we raised earlier as to whether
there is not some other form of social or­
ganization that has still higher payoffs and
lower costs than the existing banking struc­
ture. It would be rash indeed to argue that
we have exhausted the potential of social
invention in this regard. I am fairly cer­
tain, however, that whatever mutation may
supplant the existing system has not yet
been made, but if the legitimacy of the sys­
tem rests firmly on its payoffs then the so­
cial invention that will supplant it, if any,
should be welcomed with joy rather than
fear. It is only what I do not now mind
calling the fraudulent legitimacies that fear
competition.




SELECTIVE CREDIT CONTROL
Lester V. Chandler
Princeton University

Contents
Federal Reserve Discount Policy a s an Instrum ent for Selective C redit C ontrol_____________ 17
O ther B ases for Selective Credit C ontrols_______________________________________________ 19
Som e Further O bservations on Discounting_____________________________________________ 20




15




SELECTIVE CREDIT CONTROL

FEDERAL RESERVE DISCOUNT POLICY AS AN INSTRUMENT FOR
SELECTIVE CREDIT CONTROL

One strand of thought in the Federal Re­
serve Act and in the statements and actions
of Federal Reserve officials through the
years is that discount policy should be
used, at least on occasion, to influence the
uses to which credit will be put—that it
should be an important instrument, if not
the principal instrument, for selective credit
control.
This entire idea requires rethinking. For
purposes of argument, I shall concede that
on occasion the Federal Reserve may wish
to exercise some degree of selective control
over the uses of credit, by types of bor­
rower and/or by types of use to which the
credit is put. Selective control may be at­
tempted over (1) credit from all sources,
(2) credit from all commercial banks, (3)
credit from all member banks, or (4) credit
from banks that are currently borrowing
from the Federal Reserve. My thesis is that
primary reliance on discount policy to
achieve such results is likely to prove in­
effective, or to have undesirable side ef­
fects, or both. I believe Federal Reserve
history bears me out. If the Federal Re­
serve wishes to exercise selective credit con­
trols, it should rely primarily on other more
comprehensive controls.
To analyze this, consider some methods
that have been used.
Attempt to encourage certain types of
paper and to hold down interest costs on it




by giving it privileged access to the Fed­
eral Reserve Banks. This can, of course, be
successful if the Reserve Banks stand pas­
sively ready to buy all of the paper pre­
sented at the posted buying rate with no
onus on the sellers. For example, this
worked in the late 1920’s when the Federal
Reserve was the willing residual buyer of
acceptances. It would also work if the Fed­
eral Reserve stood ready to discount or lend
on the paper with no quantitative limit and
no onus on the borrower. The rate on the
paper could be held low relative to other
market rates. Note, however, that (1) the
Federal Reserve loses control over the vol­
ume of its holdings of the paper, and it has
to buy all of the supply that others are un­
willing to hold at the Federal Reserve rate,
and (2) it has no control over the types of
credit created on the basis of the newly
issued reserves.
Now alter the situation by imposing some
sort of quantitative control over the volume
of borrowing by individual banks. This
might be a “tradition against continuous or
excessive borrowing” or anything else that
would make it impossible or disadvanta­
geous to borrow fully on the basis of the
“favored” type of paper. In this case it no
longer follows that the favored type of
paper will enjoy a lower market yield rela­
tive to other yields or that there will neces­
sarily be a net increase in total demand for
17

18

the paper. To attract the marginal holder
necessary to make demand equal to supply,
the rate may have to be fully competitive
with other market rates. And it still remains
true that the Federal Reserve cannot con­
trol the types of credit created on the basis
of the new reserves.
Make “undesirable” types of paper in­
eligible as a basis for borrowing at the Fed­
eral Reserve. This might indeed reduce the
banks’ demand for this type of paper if
they did not hold “eligible” paper of other
types sufficient to cover likely needs for
borrowing at the Federal Reserve or to cover
the quantities the Federal Reserve would
be willing to lend, whichever is smaller. But
if banks have plenty of eligible paper, their
willingness to acquire ineligible paper will
be little reduced by its ineligibility.
Deny the discounting privilege to banks
that hold “undesirable types of paper”
or too much of it. The classic case oc­
curred in 1929, when the Federal Re­
serve wished simultaneously to curb “spec­
ulative security loans” and to maintain rea­
sonable rates for “legitimate business.” The
technique attempted was to deny, or at
least limit, Federal Reserve loans to banks
with speculative securities loans. Note that
this did not affect at all the broad classes
of lenders: all nonbank lenders, nonmem­
ber banks, and member banks that were
not in debt to the Federal Reserve and ex­
pected that they would not need to borrow.
This narrow coverage was enough to doom
the experiment. It probably did restrict
somewhat such loans by member banks that
were borrowing at the Federal Reserve or
who feared they might have to do so. But
the restrictive effects on such banks were
not nearly so selective as the Federal Re­
serve had hoped. Such banks had several
ways of getting out of debt to the Federal
Reserve or of avoiding borrowing there,
while maintaining speculative loans on se­



curities. (1) They bid the Federal funds
rate considerably above the discount rate.
(2) They sold acceptances, Government se­
curities, and other open market assets ex­
tensively. (3) They sold mortgages or re­
frained from buying them. (4) They even
went so far as to limit loans to business
customers.
In short, the whole attempt was a failure.
Loans on securities continued to rise up to
the eve of the crash and the restrictive ef­
fects were not selective; credit of all kinds
to all kinds of users was restricted. Gov­
ernor Harrison, of the New York Reserve
Bank, later claimed that this whole “moral
suasion” effort aimed only at borrowing
members made banks less willing to bor­
row at the Federal Reserve in the early
1930’s. Whether or not this is true, it is
plausible.
Not only this case but also other evidence
and a priori reasoning lead me to the con­
clusion that it is unwise to rely primarily,
or even heavily, on discounting policy as an
instrument for selective credit control.
When this is done, the offense is not that of
making “undesirable” types of loans; it is
that of making or holding such types of
loans by banks in debt to the Federal Re­
serve. Banks and others not in debt to the
Federal Reserve can make such loans with­
out restriction or onus. Moral: stay out of
debt to the Federal Reserve and thus main­
tain freedom of action. I believe that the ef­
fects of such policies, if resorted to fre­
quently, would be to:
1.
Inhibit use of the Federal Reserve
discount window and militate against the
development of discounting. Reluctance to
borrow would be augmented by “reluctance
to become subject to Federal Reserve selec­
tive controls.” Banks, especially the larger
ones, would develop even further their
capacity to “stay out of the Federal Re­
serve” through Federal funds, CD’s, re­

19

S E L E C T IV E C R E D IT C O N T R O L

purchase agreements, and other financial
arrangements.
2. Penalize the wrong thing; that is, bor­
rowing at the Federal Reserve rather than
making “undesirable loans.” Presumably the
prime purpose of selective controls is to
regulate the making of undesirable loans. To
penalize borrowing at the Federal Reserve
is a clumsy, ineffective, and inequitable way
of trying to inhibit banks from making un­
desirable loans.

3.
Lead to an inefficient allocation of
credit. Consider, for example, an attempt
to limit business loans by controlling access
to the discount window. Is there any reason
to believe that the most efficient allocation
of credit would require the smallest expan­
sion by those banks that, for one reason or
another—such as deposit drains or inability
to attract CD money—were borrowing at
the Federal Reserve, or feared they would
have to?

OTHER BASES FOR SELECTIVE CREDIT CONTROLS

As indicated earlier, I believe that selec­
tive credit controls, if they are to be used,
should be based upon Federal Reserve
powers broader than the power to discount
and applied more widely than to member
banks who are in debt to the Federal Re­
serve or fear that they soon may be. Ideally,
such controls should have at least the fol­
lowing characteristics:
They should apply to all lenders, or at
least to all potentially important lenders,
in the market involved. They should not
discriminate against banks borrowing at
the Federal Reserve, or member banks, or
commercial banks. In some cases it may be
enough for the regulations to cover only
commercial banks; in other cases they should
apply more widely.
They should be based upon the social
desirability of controlling selectively the
type of credit involved and justified on
the basis of Federal Reserve responsibility
to exercise such controls, rather than on its
power to discount.
They should be implemented with meas­
ures appropriate to the selective ends being
sought. I do not pretend to know what
these measures should be. However, some
possibilities may be suggested, at least
some of which would require permissive



legislation. (Some readers may be shocked
by the degree of selective intervention im­
plied. But can selective controls be ex­
pected to work otherwise?)
(1) Margin or downpayment require­
ments. (Implies knowledge of
true values.)
(2) Maximum periods of repayment.
(3) Differential reserve requirements
against various types of assets, or
differential marginal reserve re­
quirements against increases in
various types of assets above
some base.
(4) Quantitative limitations on in­
creases of selected types of assets
above some base date; that is, not
more than 5 per cent above the
level at the end of 1966.
(5) Limitations on selected types of
assets as a percentage of total as­
sets, or total deposits, or net
worth, or some other base.
(6) Limitations of changes of selected
types of assets as a percentage of
changes in total assets, or total
deposits, and so forth.
(7) Methods of encouraging banks to
hold or even to increase their
holdings of selected assets:

20

(a) Secondary reserve require­
ments in the form of the fa­
vored types of assets equal to
at least a stated percentage of
deposits or of assets other
than cash.
(b) Marginal secondary reserve
requirements calling for in­
crease of favored assets equal
to at least some percentage of
increase of other earning as­
sets. This, and variations of
it, offer interesting possibili­
ties and problems.
(c) Permit banks, in computing
required reserves, to deduct
from their deposits (demand
or time) all or a fraction of
their holdings of the favored
assets. (This percentage need
not be the same as the per­
centage reserve requirement
for the bank.)
Those who are more ingenious can think
of other possibilities. The types of measures
suggested above, and modifications of them,
could be used in various combinations. Just
one imaginary example. Consider the case
in 1966 when the Federal Reserve wished

to discourage both the expansion of busi­
ness loans and bank liquidation of certain
favored assets. It might (given the legal
power) have proclaimed the following:
“Until further notice, the required reserves
of any bank will be equal to its regular
required reserves against deposits plus an
amount equal to 10 per cent of (the
change of its business loans over a specified
base date minus the change of its holdings
of favored assets over the same specified
base date).” Consider three cases in which
a bank increases its business loans by $100.
1. It increases its holdings of favored
assets by the same amount. It has no re­
quired reserves against assets.
2. It holds constant its holdings of fa­
vored assets. It has required reserves against
assets of $10.
3. It decreases by $100 its holdings of
favored assets. It has required reserves
against assets of $20.
Of course, this would encourage banks to
try to borrow rather than sell favored assets.
So, if you wish, you can impose a reserve
requirement on all bank liabilities, includ­
ing outstanding repurchase agreements.
This is one principle; you work out the
details!

SOME FURTHER OBSERVATIONS ON DISCOUNTING

Here are a few brief comments on lessons
from the 1920’s and early 1930’s.
As I have indicated earlier, I believe
bank willingness to borrow from the Federal
Reserve and to remain in debt to it, as well
as bank demand for excess reserves, fluc­
tuate in a procyclical manner, even when
cycles are mild. One reason is the wide fluc­
tuations of customer demands for loans.
Another is that banks share the euphoria of
boom and the hesitancy of recession. A




third is that banks want to retire debt and
build up liquid assets in depression because
they fear less liquidity will be provided by
net flows of funds to them. The moral of
this, as many have pointed out, is that out­
standing discounts should be liquidated
through open market purchases at the on­
set of recession. This should be obvious but
was not to most Federal Reserve officials in
1930 and 1931.
Discounting does not appear to be a very

SE L E C T IV E C R E D IT C O N T R O L

effective device for supplying additional
funds to credit-scarce areas over a pro­
longed period. In the 1920’s this was tried;
country banks in some cases were encour­
aged to borrow, agricultural paper of
longer maturity was made eligible for re­
discount, and the Federal intermediate
credit system was created. But the results
seem to have been rather limited. The rea­
sons for this were probably numerous, but
important were the facts that banks had to




21

endorse the paper and bear the risk, that
they had in many cases too little capital to
make this a sound practice, and that many
banks lacked the inclination to extend them­
selves.
As I read the lesson, success in remedy­
ing credit scarcity over a prolonged period
requires credit institutions that can bypass
the banks and put credit in the hands of
ultimate users. Admittedly, however, “suc­
cess” is a relative term.




A REVIEW OF RECENT ACADEMIC LITERATURE
ON THE DISCOUNT MECHANISM
David M. Jones
Federal Reserve Bank of New York

Contents
Introduction_________________________________________________________________________

25

Major Issues and Related Findings_____________________________________________________ 25

Borrowing and monetary restraint
Determinants of member bank borrowing
Nonprice rationing
Announcement effects
Proposals for change
Concluding observations
Discounting and M onetary C ontrol_____________________________________________________ 29

Borrowing and monetary restraint
Determinants of member bank borrowing
Nonprice rationing
Announcement effects
Proposed C hanges in th e Discount M echanism__________________________________________ 37

Abolition of discount mechanism
Nondiscretionary approach
Discretionary approach
Tobin's proposals
Bibliography_________________________________________________________________________ 4 2




23




A REVIEW OF RECENT ACADEMIC LITERATURE
ON THE DISCOUNT MECHANISM

INTRODUCTION

in interest rates is of particular concern in
this regard. An effort will also be made to
cover in some detail the wide range of pro­
posed changes in the current discounting ar­
rangement.
The primary intent of this paper is to
present the post-accord literature on dis­
counting in such a way as to highlight the
major points of emphasis in recent analysis.
Hopefully, information of this type can
serve as important background material for
a reconsideration of the role of the Federal
Reserve discount mechanism. The paper
does not attempt to make an assessment of
the affirmative and negative sides of the
many technical issues that are raised in the
academic literature.

After approximately two decades of disuse,
the Treasury-Federal Reserve accord of
1951 prompted renewed interest in the
nature and effectiveness of the discount
mechanism. ‘Analysis since the accord has
been devoted in large part to the unre­
solved controversy over the nature of the
relationship between discounting and mone­
tary control.
This paper discusses only the post-accord
academic literature that bears directly on
the implications of discounting for mone­
tary control. Special emphasis will be
placed on the determinants of member bank
borrowing, including a review of the major
issues and related empirical findings. The
responsiveness of borrowing to movements

MAJOR ISSUES AND RELATED FINDINGS

borrowing; (3) the significance of nonprice
rationing; and (4) the announcement ef­
fects of changes in the discount rate.

The fundamental issue raised by post­
accord literature dealing with the Federal
Reserve discount mechanism is whether
this mechanism operates to subvert or to
supplement over-all monetary control. Crit­
ics have argued that the discount function
as it currently operates is fundamentally
antagonistic to monetary management. Re­
lated to this position, issues have developed
around a number of topics, namely: (1)
the effects of borrowing during periods of
restraint; (2) the factors that determine




Borrowing and m onetary restrain t

On one hand, the discount mechanism may
be viewed as a sort of “safety valve” that
cushions but does not offset the usually
uneven impact on individual banks of re­
strictive shifts in monetary policy. Tempo­
rary reserves are allocated through the dis­
count window directly to those banks com25

26

ing under greatest stress, and thus the Sys­
tem is free to act more decisively than other­
wise would be the case.
The case favoring the present discount­
ing arrangement turns on the contention
that reserves supplied through the discount
window are by nature more restrictive in
terms of credit and deposit expansion than
reserves supplied through other means. Bor­
rowing from the Federal Reserve is looked
upon as only a temporary source of funds
for the individual bank, usually requiring
some form of asset adjustment in order to
effect prompt repayment. Thus, the larger
the over-all volume of borrowing relative
to other sources of reserves, the greater the
restrictive impact on credit growth.
The academic critics of the existing dis­
count mechanism have not sought to refute
directly the points raised above. Their posi­
tion is founded instead upon the following
three general considerations:
1. The initiative in using the discount
mechanism rests with the borrowing banks
themselves rather than with those charged
with the responsibility for monetary control.
2. Member bank borrowing from the
Federal Reserve adds to total reserves,
whereas sales of Treasury bills or other
means of reserve adjustment available to
the banks do not.
3. Member bank borrowing tends to
rise during periods of monetary restraint
and fall during periods of monetary ease.
In essence, the critics hold that over-all
monetary control is weakened to the extent
that discounting counters the impact of
Federal Reserve open market operations
on the reserve base. Working in the con­
text of models linking bank reserves to the
money supply, and the money supply to
economic activity, some economists have
argued that borrowing accentuates cyclical
swings.




D eterm inants of m em ber bank borrowing

Inasmuch as discounting is at the banks’
own initiative and, therefore, difficult to
predict, post-accord inquiry has focused on
the determinants of member bank demand
for borrowed reserves. To what extent are
banks’ decisions to borrow influenced by
profitability considerations? And how strong
is the so-called “tradition against borrow­
ing”? These questions are remnants of the
old need versus profitability issue, which was
debated at length in the 1920’s and 1930’s.1
The “need” concept has never been clearly
defined by its advocates, but according to
common interpretation banks that borrow
out of “need” do so only to meet temporary,
unexpected reserve deficiencies. At the
same time, the needy banks supposedly
make every effort to repay these debts as
soon as possible. This view of borrowing
behavior presumes a strong traditional re­
luctance on the part of banks to be in debt
to the Federal Reserve.
On the other hand, the strict version of
the “profitability” thesis posits that banks
will borrow whenever additional funds can
be invested in assets that earn yields higher
than the discount rate. In short, banks bor­
row out of a calculated effort to profit from
rate differentials, rather than simply in re­
sponse to the unpredictable swings in mar­
ket factors that produce temporary reserve
deficits.
Expressed in these terms, “need” and
“profitability” appear to be conflicting mo­
1 See, for example, W. Randolph Burgess, The R e ­
serve B anks and the M on ey M a rk e t ; Lauchlin Currie,
The Supply and C ontrol o f M on ey in the U n ited
States; Charles O. H ardy, C redit P olicies o f the F ed­
eral R eserve S ystem ; Seymour E. H arris, T w en ty
Y ears o f F ederal R eserve P olicy; Winfield W. Riefler, M on ey R ates and M on ey M arkets in the U nited
States; and R obert C. T urner, M em b er Bank B o r­
rowing, . F o r an excellent discussion of the points
raised in these earlier writings, see A. Jam es Meigs,
Free R eserves and the M on ey S u pply , pp. 6-31.

27

A C A D E M IC LIT E R A T U R E ON D IS C O U N T M E C H A N IS M

tives. In effect, the borrowing-out-of-“need”
proponents postulated that such borrowing
was insensitive to levels of interest rates,
while the “profitability” school visualized
that borrowing was affected by rate levels.
One of the few important contributions
of the post-accord literature on discounting
has been the theoretical resolution of the
need versus profitability issue. But even this
accomplishment rests in large part on a
modified concept of profitability that dates
back to Turner’s work in the 1930’s. The
argument runs roughly as follows: Given
a reserve deficiency or the need to borrow
—whether the cause is an unexpected surge
in required reserves, or a sudden cash drain,
or some other reserve-absorbing factor—
the extent to which a bank makes use of
the discount window for its reserve adjust­
ments depends upon the relative costs of
borrowing and of other means of replenish­
ing reserves. For example, the higher the
Treasury bill rate—that is, the larger the
loss of revenue from reducing the bill port­
folio—relative to the discount rate, the less
the relative cost of borrowing (or the
greater the profitability) to meet a given re­
serve deficit. Thus, a reluctant bank that
borrows only to meet its immediate needs
can, at the same time, be sensitive to the
rate differentials between its alternative
sources of short-term funds. By using this
modified concept of profitability, it has
been demonstrated with some rigor that it
is possible to integrate, into a consistent
theory, bank reluctance to be in debt to the
Federal Reserve and the profit incentive for
such borrowing.
During periods of monetary restraint, the
discount rate tends to lag behind rising
market rates on alternative sources of funds,
and borrowings rise. Conversely, the dis­
count rate remains above falling market
rates on the same sources of funds during




periods of monetary ease, and borrowings
fall. This fact represents one basis of the
contention that borrowings tend to accen­
tuate cyclical swings.
Nonprice rationing

The attitude of banks toward the nonprice
terms applied at the discount window has
an important bearing on their decisions to
borrow. Yet it appears that the Reserve
Banks find it quite difficult to admin­
ister these terms. A wide variation in
nonprice terms, among the various Federal
Reserve districts and/or over time, can
serve to diminish significantly the predic­
tability of borrowings. It is difficult, if not
impossible, to separate—and measure in
relative terms—the effects of nonprice ra­
tioning from the effects of bank reluctance
to borrow. It has been argued that these
two factors have a mutually reinforcing ef­
fect on bank borrowing. But there has been
very little in the literature on this subject. In
general, there seems to be a dissatisfaction
with nonprice rationing, explicitly on the
grounds that the price mechanism would
operate more effectively.
A nnouncem ent effects

A major source of contention in the litera­
ture has been the question of whether dis­
cretionary changes in the discount rate have
undesirable effects on expectations. On the
one hand, it is argued that one must make
inconsistent assumptions about the behavior
of lenders and borrowers in order for the
announcement feature of discount rate
changes to have desired effects. It has also
been argued that, at best, the announce­
ment effects will be unpredictable.
There are, however, those who see some
merit in announcement effects. They argue
that discretionary changes in the discount
rate have two basic advantages. First, the

28

changes are widely publicized and espe­
cially useful as a universal means of signal­
ing the intent, for example, to stem a bal­
ance of payments drain. Second, discount
rate adjustments, the only m ajor m onetary
instrument that has no direct effect on re­
serves, can play a unique and often helpful
role as an index of the course of policy.
P roposals for change

Proposals for changing the discount m ech­
anism have run the gam ut from, abolishing
the mechanism altogether to allegedly m ak­
ing it the most powerful tool of m onetary
policy. Elim ination of the discretionary
aspect of discount-window administration
is the object of nearly all of the proposed
modifications.
A plan often suggested would eliminate
discretionary discount rate changes by tying
the discount rate to the m arket rate on some
alternative source of ready funds. This type
of arrangem ent usually involves setting the
discount rate high enough above the anchor
rate to m ake it a “penalty” rate. M ost ad­
vocates of such a device would rely on the
price mechanism alone to allocate Federal
Reserve credit and to keep borrowing in
check; they would, in effect, discard the
present borrowing “privilege” with its non­
price connotations in favor of granting
banks the “right” to borrow. There has
been controversy, however, on the appro­
priate m arket rate to which the discount
rate would be anchored.
A somewhat m ore radical plan calls for
the payment of interest at the discount rate
on m em ber banks’ excess reserves. Through
adjustments in the discount rate, the F ed­
eral Reserve would then have direct con­
trol over the opportunity cost of bank lend­
ing. U nder such an arrangem ent, banks
would be tem pted to increase their excess
reserves and reduce their holdings of short­




term Government securities. The discount
rate would then take on sharply increased
importance among the m ajor instruments
of m onetary policy.
There are, in addition, those who would
abolish the discount mechanism. Two rea­
sons for such a move have been advanced.
First, by doing away with borrow ing at
the banks’ initiative, the Federal Reserve
would greatly improve its control over total
reserves. Second, it has been argued that
the discounting function is no longer neces­
sary in view of the substantial postw ar
growth in banks’ holdings of short-term
Government securities, which can be used
to m ake the necessary adjustments in re­
serve positions. Needless to say, the latter
argum ent has little relevance under circum ­
stances in which bank holdings of short­
term Government securities are minimal.
It has also been proposed, however, that
the discounting terms should be fully dis­
cretionary. The basic contention is that the
discretionary approach not only entails the
power to control total borrowing but also
makes possible the selective control of bank
lending practices.
Concluding observations

Although most of the m ajor issues raised
in the academic dialogue on discounting re­
m ain unresolved, it is possible to draw some
general conclusions. Discounting does not,
for example, appear to weaken m onetary
control to any significant extent during
periods of m onetary restraint. Indeed, the
discount mechanism is, for the most part, a
useful complement to open m arket opera­
tions. Those favoring the current arrange­
ment argue, in particular, that shifts in
m onetary policy are cushioned by the pro­
vision of tem porary reserves through the
discount window to those banks that suffer
the greatest stress. A t the same time, bor­

A C A D E M IC LITERAT U RE ON D ISC O U N T M E C H A N IS M

rowed reserves have less expansive implica­
tions for credit and deposit growth than a
corresponding am ount of reserves supplied
through other means.
On the other hand, regardless of how
limiting the effect of borrowed reserves on
credit growth may be, the fact remains that
m onetary control is rendered less precise
under conditions in which banks borrow at
their own initiative. Hopefully, the predict­
ability of borrow ing can be improved by
reliable quantitative measurements of the
relative effects of interest rates and other
factors that influence banks’ decisions to
borrow.
W ith regard to adm inistration of the dis­
count window and general supply consid­
erations, there is almost unanimous agree­
ment among economists on the desirability
of complete reliance on the price m ech­
anism to control borrowing. But regardless
of how appealing the “tied” rate plans may
be, there has been no agreement on the
m arket rate to which the discount rate

29

should be linked nor on the appropriate
spread to be m aintained. A lthough experi­
ence suggests that there should be some
substantial revisions in the present nonprice
discounting guidelines, it seems that both
price and nonprice terms will continue to
be necessary to insure effective m onetary
control.
Finally, the predom inant view in the
literature is that under present circum ­
stances the announcem ent effects of
changes in the discount rate will be am ­
biguous at best. A t the same time, those
who fear that changes in the rate will have
adverse effects on expectations may have
overrated their case a bit. In particular, it
is not likely that discount rate changes
alone, whatever their effects on expecta­
tions may be, dom inate the behavior of
borrowers and lenders. Indeed, these rate
adjustments are only one of m any factors
that influence expectations about the course
of m onetary policy and future economic
conditions.

DISCOUNTING AND MONETARY CONTROL
Borrowing and m onetary restraint

As noted earlier, those favoring the current
discount procedures often assume that bor­
rowed reserves are less expansive in terms
of credit growth than a corresponding
am ount of reserves provided through open
m arket operations.2 It is argued that banks
will seek to extinguish their borrow ed re­
serves promptly, usually through some form
of asset adjustment. In Roosa’s w ords:3
2 See, for example, B oard of G overnors of the
Federal Reserve System and the U.S. Treasury, The

Federal R eserve and the Treasury: A n sw ers to Q ues­
tions from the C om m ission on M on ey and Credit,

p. 118.
3 R obert V. Roosa, “Credit Policy at the Discount
Window: Com m ent,” p. 334.




In the A m e ric an settin g th e fa c t th a t b an k s b o r­
ro w o nly as a privilege m e a n s th a t even th o u g h
an y in d iv id u al b a n k ca n te m p o ra rily , in effect,
cau se th e crea tio n o f reserv es b y •b o rro w in g a t
th e d isco u n t w indow , th a t sam e b a n k sim u ltan e ­
ously takes on an o b lig atio n to find w ays o f ex­
tin g u ish in g th o se reserv es— th e m o re p ro m p tly
th e b etter, in o rd e r to p reserv e its p rivilege fo r
use ag ain w h en u n e x p e c te d reserv e d rain s o ccu r.
T h u s, as a gen eral ru le, th e la rg e r th e aggregate
vo lu m e o f b a n k b o rro w in g fro m th e F e d e ra l
R eserve, the g re ate r w ill b e th e effo rt going on,
th ro u g h th e b a n k in g system , to lim it cred its an d
b rin g reserves in to b a lan c e w ith th e re q u ire m e n ts
against deposits.

The fact that Roosa casts his discussion
in terms of the actions of an individual
bank is not to deny that a high or rising
volume of borrowings for the banking sys­

30

tem as a whole m ay persist for long periods
— as for example, when an increasing num ­
ber of banks turn to the discount window for
tem porary reserve relief. But the key point
is that aggregate borrowed reserves have a
restrictive im pact on credit expansion; and
the higher the level of such borrowing, the
greater the restriction involved.
A part from the special nature of bor­
rowed reserves, Samuelson has argued that
the tendency for borrowings to offset in part
the reserve effects of open m arket opera­
tions actually strengthens m onetary policy.
He observes th a t:4
W hile it is tru e th a t d isco u n tin g o fte n acts
c o u n te r to o p e n -m a rk e t o p eratio n s, th e re is n o
evidence th a t a u n it ch an g e in o p e n -m a rk e t o p ­
eratio n s in d u ces an o p p o sin g ch an g e in d isc o u n t­
ing larg e en o u g h to rev erse o r su b stan tially w ip e
o u t th e orig in al effect. So it is n o t really diffi­
c u lt fo r th e p la n n e rs o f o p e n -m a rk e t o p e ra tio n s
to tak e all th is in to ac co u n t; an d precisely b e ­
cau se th e y k n o w th a t th e d isc o u n t w in d o w p ro ­
vides an escap e valve, th ey can be m o re c o u ra ­
geous in th e use o f o p e n -m a rk e t o p eratio n s.

Am ong the critics of the present dis­
counting arrangem ent, M ilton Friedm an
looks upon borrowing with somewhat more
alarm. He contends that since the banks
can discount at their own initiative, the
System is unable to exert direct control over
m onetary expansion.5
W arren Smith, another academic critic
of the current discount mechanism, asserts
that those who emphasize the restrictive
nature of borrow ed reserves overlook the
all-im portant fact that member bank bor­
rowing adds to total reserves. “Therefore
. . . borrow ing constitutes an offset to the
restraint that brought it about to the extent

that the supply of reserves is thereby in­
creased.”6
Finally, the procyclical fluctuations in
borrowings have been criticized by Aschheim 7 and Brunner and M eltzer8 among
others. In this regard, Aschheim observes
that “. . . however strong the commercial
bank tradition and however potent the Fed­
eral Reserve policy, they have not stood in
the way of cyclical fluctuations in the vol­
ume of rediscounting.”9 B runner and M elt­
zer go into somewhat m ore detail on this
m atter: 10
T h e a d m in istra tio n o f th e d isc o u n t w in d o w co n ­
trib u te d b o th in th e tw en ties an d th e fifties to
th e cyclical v a ria b ility o f th e m o n e y supply. T h e
d isco u n t ra te ty p ically lags b e h in d th e m o v e­
m en ts o f th e m a rk e t rates. A cy clical u p sw ing,
g en e ra ted o r re in fo rc e d b y n o n m o n e ta ry fa c ­
to rs, p u sh es m a rk e t rate s ah e a d o f th e d isco u n t
rate, a n d in d u ces b an k s to e x p a n d th e ir b o rro w ­
ing. T h e risin g v o lu m e o f d isco u n ts a n d ad v an ces
increases th e [reserve] base a n d co n seq u e n tly in ­
creases th e m o n ey su p p ly. A reverse o p e ra tio n
o c cu rs in a dow nsw ing. T h e cy clical v ariab ility
o f th e m o n e y su p p ly is th u s am plified b y th e
o p e ra tio n o f th e d isc o u n t w in d o w .

D eterm inants of m em ber bank borrowing

M ost of the post-accord dialogue on the
factors that influence banks in their deci­
sions to borrow has been conditioned by the
need versus profitability issue that was de­
bated extensively in the 1920’s and 1930’s.
Recent attempts have been m ade to isolate
and quantify the im pact of interest rates on
borrowing, and general comments on the
6 W arren L. Smith, “The Discount Rate as a
Credit Control W eapon,” p. 172.
7 Joseph Aschheim, Techniques o f M on etary C on ­
trol.

8 U.S. House of Representatives, Subcomm ittee on
Domestic Finance, A n A ltern ative A pproach to the
4 Paul A. Samuelson, “Reflections on M onetary
Policy,” p. 266.
5 M ilton Friedm an, A P rogram fo r M on etary
S tability , p. 38.




M on etary M echanism .
9 Aschheim, op. cit., p. 91.

10 U.S. House of Representatives, Subcommittee on
Domestic Finance, op. cit., p. 35.

A C A D E M IC LITERA T U RE ON D ISC O U N T M E C H A N IS M

sensitivity of borrowing to rate movements
are abundant in the literature. Somewhat
less attention has been devoted to the ques­
tion of bank reluctance to borrow. One of
the more interesting contributions in the
post-accord literature is a theoretical recon­
ciliation of these two motives.
Interest rates and borrowing. M any of those
who feel that the present discount m echan­
ism weakens m onetary control are alarmed
by evidence suggesting that borrowings are
sensitive to interest rates and that they
therefore work systematically against open
m arket operations. Although the extent to
which borrowings respond to rate move­
ments is clearly an empirical question, the
evidence is scanty. Typical of the casual
observation in this area is the following:
“No doubt it is true that banks are reluc­
tant to borrow, but like m any ordinary per­
sons, bankers allow their reluctance to be
overcome by more attractive alternatives.”11
Aschheim theorizes in a similar vein:12
T h e F e d e ra l R eserv e p refe rs to state th a t in tim e
o f m o n e ta ry tig h tn ess th e re is a g re a t “n e e d ” on
th e p a rt o f m e m b e r b an k s fo r red isco u n tin g .
E co n o m ically , th e m o re in fo rm a tiv e fo rm u la tio n ,
h ow ever, is th a t in tim es o f m o n e ta ry tightness
it is m o re p ro fitab le fo r b a n k s to b o rro w fro m
th e F e d e ra l R eserve th a n in o th e r p erio d s.

W arren Smith is somewhat m ore specific
about the way in which he feels that in­
terest rates influence borrowing decisions,
but he too stays prim arily in the realm of
supposition in observing that while bank
dem and for readily available funds to sat­
isfy the kind of urgent needs that commonly
induce banks to borrow at the discount
window is probably quite interest-insensi­
tive, the extent to which banks actually turn
to the Federal Reserve to satisfy these needs
H E a rl Rolph, “Discussion,” pp. 413 and 414.
12 Aschheim, op. cit., p. 91.




31

rather than relying on other sources m ay be
significantly affected by rate m ovem ent:13
In m o st cases, b a n k s h a v e a c h o ice o f o b ta in in g
a d d itio n al fu n d s b y b o rro w in g a t th e F e d e ra l
R eserve o r by liq u id a tin g seco n d a ry reserv es o r
o th e r in v estm en t securities. S urely, th e m a jo r
fa c to r influ en cing th e c h o ice w ill be th e re le v a n t
cost o f fu n d s o b tain ed b y th e v a rio u s m eth o d s,
a n d th is d ep en d s chiefly o n th e re la tio n b etw een
th e d isco u n t rate an d th e ex p ected yield o n assets
th a t th e b a n k m ay c o n sid e r liq u id a tin g .

Meigs, who actually focuses on bank
demand for free reserves (excess reserves
less borrow ing), concludes that “aggregate
m ember bank borrowing is indeed influ­
enced by the net yields obtainable on bo r­
rowed funds, within a considerable p art of
the range of interest rates and other condi­
tions observed.”14 In this connection Meigs
makes the point that the hypothesis that
member bank borrowing is not responsive
to changes in m arket interest rates cannot
be confirmed solely by demonstrating that
banks are reluctant to borrow. R ather, the
characteristics of the dem and schedule m ust
be determined by direct empirical observa­
tion of borrowing and interest rates.
M ore recently, de Leeuw has concluded
from empirical estimates of bank dem and
for borrowed reserves (based on quarterly
data for the 1954-62 period) that the re­
sponse of borrowings to the differential be­
tween the discount rate and the yield on
3-month Treasury bills is “m oderate,” with
implied long-run elasticities with respect to
the discount rate and the yield on Treasury
bills of —0.7 and + 0 .5 , respectively.15 de
Leeuw uses a stock-adjustment form ula­
tion of the borrowings dem and function in
deriving these results. A ccording to the
Smith, op. cit., p. 172.
14 Meigs, op. cit., p. 89.
15 F rank de Leeuw, “A M odel of F inancial Be­
havior,” pp. 512 and 513.

32

stock-adjustment principle, changes in bank
borrowings in any given period are a func­
tion of the discrepancy between the desired
level of borrowings in that period and the
actual level of borrowings in the preceding
period, de Leeuw posits that desired
amounts of borrowing are dependent, in
turn, upon (1 ) the differential between the
Treasury bill rate and the discount rate,
(2 ) the Treasury bill rate level, and (3 )
the net inflow of bank funds (that is,
changes in private dem and deposits plus
Federal Governm ent dem and deposits plus
private time deposits less m em ber bank re­
quired reserves less holdings of loans and
other private securities).
In an empirical study patterned closely
after de Leeuw’s work, Stephen Goldfeld
has estimated borrowing dem and functions
for city and country banks, separately.16
He found the short-run elasticity of changes
in borrowings with respect to the discount
rate to be —0.875 for country banks and
—0.979 for city banks. Com parable elas­
ticities with respect to the Treasury bill
rate were + 0 .7 8 5 and + 0 .8 7 7 for country
and city banks, respectively. Goldfeld’s
long-run elasticity estimates for these vari­
ables were substantially higher than de
Leeuw’s and, surprisingly, were higher for
country banks than for city banks. Specifi­
cally, the estimates of long-run elasticity of
borrowings with respect to the discount rate
were —2.926 and —2.382 for country and
Stephen M. Goldfeld, C om m ercial B ank B e­
havior and E conom ic A c tiv ity . G oldfeld’s short-run
elasticities were calculated by —

. _L_ where B
dr

B

represents bank borrowing and r is the relevant in­
terest rate. N ote th at the relevant m ean used was that
of the level of borrowing, B. The m ean of the flow
variable cannot be used because it could well be
zero in some cases. The long-run elasticities were
obtained by setting the borrowings flow, AB, equal
to zero, solving fo r the steady-state B, and differen­
tiating as above.




city banks, respectively. The Treasury bill
rate elasticities were + 2 .6 2 5 for country
banks and + 2 .1 3 4 for city banks.
In yet another empirical study, Goldfeld
and Kane have gone still further by deriv­
ing estimates of dem and for borrowings for
four separate classes of member banks.17
A nother distinguishing feature of this study
is that the empirical dem and estimates are
based on w eekly data for borrowings. From
a demand function that relates borrowings
to the Treasury bill-discount rate differen­
tial, lagged borrowings, and changes in non­
borrowed reserves, Goldfeld and Kane cal­
culated implicit short-run elasticities with
respect to the bill rate of 0.56 for New
Y ork City banks, 0.08 for Chicago banks,
0.15 for other reserve city banks, 0.21 for
country banks, and similarly, 0.21 for total
m ember banks. Goldfeld and Kane note
that the long-run elasticity of borrowings
with respect to the Treasury bill rate ranged
from 2.8 to 3.9 for the various groups of
member banks and that such figures are
thus generally consistent with Goldfeld’s
quarterly results. (C om parable elasticity
estimates for the discount rate were not
presented in this article.)
The Federal Reserve System has not
always been completely clear on the im por­
tance it attributes to interest rate considera­
tions in the decisions of banks to borrow.
The following is among its pronouncem ents
on the subject:18
B anks are g en erally re lu c ta n t to b eco m e in ­
d eb ted to th e F e d e ra l R eserve ex c e p t fo r v ery
sh o rt p erio ds, a n d w h en in d e b t feel co n stra in e d
to liq u id ate assets. T h e d e te rre n ts to b o rro w in g
17 Stephen M. G oldfeld and Edward J. Kane, “The
D eterm inants of M em ber Bank Borrowing: A n
Econom etric Study.”
18 U.S. Congress, Joint Economic Committee,
E m ploym en t G row th and Price L evels, Hearings, p.
755.

A C A D E M IC LITERA T U RE ON D ISC O U N T M E C H A N IS M

are greatly w e ak en ed if m a rk e t yields o n sec u ri­
ties ow n ed b eco m e an d re m a in su b stan tially
h ig h e r th a n th e d isc o u n t rate.

Going into greater detail on the relation­
ship among borrowings, m arket rates, and
the discount rate under conditions of m one­
tary restraint, the System has commented
th a t:19
. . . it is o f p rim e im p o rta n c e th a t th e g eneral
re lu ctan ce o f b a n k s to b o rro w a t th e F e d e ra l
R eserve be re in fo rc e d b y a d isc o u n t ra te w ith
real d e te rre n t p o w e r a t tim es w h en a te m p e rin g
o f b a n k cred it g ro w th is in th e p u b lic in terest.
In o th e r w ords, in o rd e r to m a k e th e d isco u n t
m ech a n ism an effective su p p le m e n t to o p en m a r­
k e t o p eratio n s th e F e d e ra l R eserve is obliged to
m a in ta in d isco u n t rate s n o t m a rk e d ly lo w er th a n
m a rk e t yields o n th e m o st re ad ily av ailable a lte r­
n ativ e so u rce o f b a n k reserves, T re a su ry bills. If
th e F e d e ra l R eserve in these circu m sta n ce s did
n o t ad ju st its d isc o u n t rates to k eep th em “in
to u c h ” w ith m a rk e t rate s, th e ta sk o f a d m in iste r­
ing th e d isco u n t w in d o w to p re v e n t excessive
cre d it expansio n w o u ld b eco m e v ery difficult.

On the other hand, the System has more
recently concluded that a comparison of
the costs of alternative sources of ready
funds with changing amounts of borrowed
funds “does not suggest that there is a pow­
erful borrowing response to changing cost
considerations.”20
Reluctance to borrow. Attem pts to discern
the nature of the tradition against borrow ­
ing date back to the need versus profitabil­
ity discussions of the 1920’s. Bank reluc­
tance to borrow is commonly associated
with the notion that since banks are al­
ready “in debt” to their depositors, with
repaym ent due in m any cases on demand,
it is im prudent for them to incur additional
debt that is of a prior-claim. nature.21 C on­
tinued borrowing has been viewed as a con19

Ibid., p. 756.

Board of G overnors of the Federal Reserve
System and the U.S. Treasury, op. cit., p. 134.
21 Ibid., p. 129.
20




33

fession either of weakened condition or of
poor m anagem ent.22 There is general agree­
ment that the reluctance to borrow varies
m arkedly in intensity among banks. N ever­
theless, it has been argued that “in most
cases” bank reluctance to borrow is “a
deterrent sufficiently strong to prevent ex­
cessive use of discounting.”23
A t first glance, one might readily inter­
pret any prem ium in excess of the discount
rate that banks pay for Federal funds as a
manifestation of bank reluctance to bor­
row from the Federal Reserve. In fact,
however, large banks, which are the ones
prim arily responsible for bidding up the
Federal funds rate, are almost certainly not
insensitive to rates in a way that the tradi­
tional meaning of reluctance would imply.
R ather, these banks m ay be viewed as add­
ing an implicit cost factor to the discount
rate in order to take account of scrutiny by
the discount authorities. U nder such cir­
cumstances, the effective cost of borrowing
to these large banks will exceed the pub­
lished discount rate, and the Federal funds
prem ium may be largely illusory.
Theoretical
reconciliation.
Polakoff has
demonstrated that it is possible to integrate
into a consistent theory bank reluctance to
be in debt to the Federal Reserve and the
profit incentive for such borrowing.24 The
key assumption in Polakoff’s theory is that
member banks display a “reluctance elas­
ticity” when borrowing from the Federal
Reserve; in other words, it is true not only
that there is a reluctance to borrow at all
times but also that this reluctance increases
22 Charles R. W hittlesey, “C redit Policy at the D is­
count W indow,” p. 213.
23 Board of G overnors of the Federal Reserve
System and the U.S. Treasury, op. cit., p. 130.
24 M urray E. Polakoff, “Reluctance Elasticity,
Least Cost, and M em ber Bank Borrowing: A Sug­
gested Integration.”

34

as the volume of discounting grows. View­
ing member bank decisions to borrow in the
context of a “preference” system, Polakoff
reasons that as borrowings rise in response
to an increasing differential between the
yield on Treasury bills and the discount
rate, the disutility of borrowing relative to
the utility of profit will eventually become
so great that member banks will no longer
borrow. He argues, in effect, that the banks’
marginal propensity to borrow declines as
the spread between the bill and the discount
rates widens.
To test his hypothesis, Polakoff relates
(in scatter diagrams) both weekly and
monthly data on member bank borrowings
to specific spreads between the bill and dis­
count rates over the July 1953 to Decem­
ber 1958 period. He concludes that “the
expansion paths of borrowings suggested
by the various scatter diagrams are all con­
sistent with the theoretical results deduced
from the integration hypothesis.”25 How­
ever, these empirical findings are not sup­
ported by Goldfeld’s results from quarterly
data for the somewhat longer period, 1950III to 1962-11. Taking account of the im­
pact of loan demand and reserve avail­
ability on borrowing behavior (something
Polakoff failed to do) Goldfeld tests spe­
cifically for the relationship between bor­
rowings and the rate spread postulated by
Polakoff. He finds that while borrowings
are in general interest-sensitive, there is no
tendency for the marginal propensity to
borrow to fall as the rate differential
widens.26
25 Ibid., p. 18. In a more recent article, Polakoff
has fitted a quadratic function to his empirical data
and offered this as further proof of his theoretical
scheme. See Murray E. Polakoff, “Federal Reserve
Discount Policy and Its Critics,” pp. 205-07.
26 Goldfeld, op. cit., pp. 150 and 151. In their
more recent test using weekly data covering the July
1953 to December 1963 period, Goldfeld and Kane




Nonprice rationing

The guiding principles of Regulation A (as
amended in 1955) have been interpreted
and applied only with considerable diffi­
culty. The appropriateness of borrowing
under these nonprice terms turns on the
intent of the borrower. A bank is not, for
example, to borrow willfully in order to
make a profit from, rate differentials. But
this is basically a subjective determination,
and it is difficult, if not impossible, to pin­
point the uses to which borrowed reserves
are put.
Distinctions between appropriate and in­
appropriate borrowing may be quite fine,
as evidenced by the following case cited by
a former Federal Reserve discount officer:27
. . . if a bank borrowed temporarily to meet a
commitment to make a loan to a business concern
at 4 per cent, with reasonable expectations of
having funds at hand shortly to pay out, the bank
would not be borrowing to earn a rate differen­
tial even though it was borrowing at the lower
rate (in one market) and re-lending at a higher
rate (in another m arket).

With regard to the stability of discount­
ing terms over time, Professor Whittlesey
has set out to correct what he terms a
“common misconception” that nonprice
discount window standards are adjusted to
changing business conditions. According to
came up with what they consider to be “limited
support” for the relationship between borrowings
and rates hypothesized by Polakoff. See Goldfeld
and Kane, op. cit., p. 513. The evidence offered by
Goldfeld and Kane in support of the Polakoff hy­
pothesis has recently been brought into question by
Polakoff and Silber in “Reluctance and MemberBank Borrowing: Additional Evidence.” Polakoff
and Silber argue that high collinearity in Goldfeld
and Kane’s observations bearing on Polakoff’s hy­
pothesis “sheds serious doubt on the validity of these
results.” In place of Goldfeld and Kane’s analysis,
Polakoff and Silber present their own evidence,
which is interpreted as verifying the operation of the
“reluctance/surveillance” motive in periods of “tight”
money.
27 George W. McKinney, Jr., The Federal Reserve
Discount Window, pp. 106 and 107.

35

ACADEM IC LITERATURE ON DISCOUNT MECHANISM

Whittlesey, “the fact is that neither the way
in which the discount window is adminis­
tered nor the standards by which member
bank borrowing is judged are modified to
conform to over-all monetary policy.”28
Roosa is of a similar opinion:29
Insofar as human frailties permit, it is always the
same [discount] window, open in the same way
at all times for borrowers of the same circum­
stances. What makes the impact of these con­
tinuous standards seem to vary is that the cir­
cumstances of the banks themselves change.

The relative importance of discount-win­
dow administration and the tradition
against borrowing in borrowing decisions
has been a point of contention. Professor
Whittlesey argues, for example, that the ad­
ministration of the discount window is not
a significant feature of over-all credit con­
trol but that it merely acts in an indirect
and admonitory manner “. . . to keep alive
and reinforce the tradition against borrow­
ing, without which discount policy as pres­
ently conducted could quickly break
down.”30 According to Whittlesey, “. . . the
privilege of borrowing, despite conventional
statements to the contrary, is, in practice,
tantamount to a right.”31
Roosa, for one, does not appear to be
convinced that discount-window adminis­
tration does in fact play such an unimpor­
tant role in borrowing decisions. Without
attempting to determine precisely where the
influence of discount-window surveillance
begins and the influence of the traditional
reluctance to borrow runs out, he contends
that “both are certainly present; and when­
ever the check imposed by tradition might
begin to falter, the limits imposed by sur­
veillance would begin to take hold.”32
28 Whittlesey, op. cit., p. 209
29 Roosa, op. cit., p. 334.
30 Whittlesey, op. cit., p. 216.
si Ibid., pp. 214 and 215.
32 Roosa, op. cit., p. 336.




Finally, the difficulties in administering
the provisions of Regulation A may have
contributed to variations in nonprice terms
among Federal Reserve districts. This is con­
tended in a recent study of the relationship
between borrowed reserves and total re­
serves in the various Federal Reserve dis­
tricts. The evidence provided, however,
cannot be considered conclusive.83
The dominant view in the literature is
that there should be greater reliance on the
price mechanism and less on nonprice ra­
tioning in the allocation of Federal Reserve
credit through the discount window. As will
be seen in a subsequent section of this pa­
per, proposals by Aschheim, Brunner and
Meltzer, and Tobin all call explicitly for an
“open” discount window— that is, one at
which banks may borrow all they wish at
the existing discount rate.
Announcement effects

There has recently been a growing concern
with the impact of discount rate policies on
expectations. Some do not necessarily agree
with C. E. Walker’s observation that
changes in the discount rate are “a simple
and easily understandable technique for in­
forming the market of monetary authori­
ties’ views on the economic and tredit sit­
uation.”34
According to Kareken, some asymmet­
rical assumptions about the behavior of
lenders and borrowers are necessary in or­
der to argue that the “announcement ef­
fects” of discount rate adjustments are
necessarily stabilizing. In particular, lenders
must be expected to interpret an increase in
33 See David T. Lapkin and Ralph W. Pfouts,
“The Administration of the Discount Function”;
and Jimmie R. Monhollon and James Parthemos,
“Administration of the Discount Function: A Com­
ment.”
34 C. E. Walker, “Discount Policy in the Light of
Recent Experience,” p. 229.

36

the discount rate as a sign that tighter credit
conditions lie ahead and to react with a
more conservative lending policy; borrow­
ers, on the other hand, must view the in­
crease in the discount rate as a signal of the
end of good times and cut back their spend­
ing plans and loan demands accordingly.35
Samuelson is not so sure that the borrow­
ers in fact react in such a manner. He rea­
sons that:36
Today, financial men know that the Federal Re­
serve “leans against the breeze,” tightening money
when it thinks the forces of expansion are strong
and easing money when deflation seems a threat.
Therefore it is rational for an investor to say,
“Aha! the ‘Fed’ is raising interest rates; they
must know that the current outlook is very bull­
ish, and if that is going to be so, I’d better ex­
pand my operations.” Conclusion: Announce­
ment effects are often ambiguous.

Taking a position similar to Samuelson’s,
Warren Smith concludes that “the effects of
discount rate increases on business expec­
tations are likely to be destabilizing or, at
best, neutral,” but he hastens to add that
he believes such effects to be “rarely of
major importance” because the discount
rate is only one of many kinds of informa­
tion that go into the formulation of busi­
ness expectations.37
According to Smith, changes in the dis­
count rate also induce shifts in expectations
about monetary policy and bring on related
“unsteadiness” in market rates. For ex­
35 John H. Kareken, “Federal Reserve System Dis­
count Policy: An Appraisal,” p. 109.
In a more recent article, Warren Smith has ex­
pressed these conditions under which announcement
effects can be assumed to be stabilizing in Hicksian
terms. That is, lenders must have elastic expectations
about future interest rate movements while borrowers
act on inelastic expectations. See Warren L. Smith,
“The Instruments of General Monetary Control,”
pp. 61-63.
36 Samuelson, “Recent American Monetary Con­
troversy,” p. 10.
37 Smith, “The Discount Rate,” p. 174. A similar
argument is advanced by Smith in “The Instruments,”
pp. 63 and 64.




ample, failure to increase the discount rate
when the Treasury bill rate rises to or above
the level of the discount rate may trigger a
decline in interest rates, especially if cur­
rent business indicators happen to be point­
ing downward even the slightest bit. In
attempting to smooth such a swing, the
System might bring about tighter monetary
conditions than would otherwise be de­
sirable. Monetary control may also be
undermined, Smith argues, when a technical
increase in the discount rate, to bring it in
line with market rates, is interpreted as a
sign of tighter monetary policy ahead and
causes a sharp rise in those rates. Appro­
priate action by the monetary authorities
in this case might result in a relaxation of
restrictive policies, before such a move were
deemed appropriate on general grounds.
Still another expression of concern with
announcement effects is offered by Culbert­
son, who observes in particular that the
November 1957 reduction in the discount
rate “precipitated the most extraordinary
bull market in bonds, a development that
would have been most untimely had reces­
sion not been in the offing. The [Novem­
ber 1957] discount rate reduction seems to
have served waiting debt speculators in the
capacity of a starter’s gun, and thus, to have
contributed unduly to the speculative flavor
of the bond market.”38
On the other hand, the System has ob­
served that discretionary changes in the
discount rate are a useful complement to
the other major tools of credit policy be­
cause they are probably the most widely
publicized step that a central bank can
take— and yet they have no direct effect on
the available supply of bank reserves.39
38 John M. Culbertson, “Timing Changes in Mone­
tary Policy,” pp. 157 and 158.
39 Board of Governors of the Federal Reserve
System and the U.S. Treasury, op. cit., p. 146.

37

ACADEM IC LITERATURE ON DISCOUNT MECHANISM

PROPOSED CHANGES IN THE DISCOUNT MECHANISM
The critics of the present discounting ar­
rangement have offered alternative pro­
posals that range from abolishing the
practice to making it the most powerful
tool in the central banker’s kit.
Abolition of discount mechanism

Perhaps the most adamant advocate of
abolishing discounting is Milton Friedman,
who argues that since member banks dis­
count at their own initiative, the Federal
Reserve System cannot determine the
amount of money it creates either through
the discount window or through a combina­
tion of discounting and open market opera­
tions.40 Regarding discount rate policy in
particular, Friedman is highly critical of
those who have looked to the level of the
discount rate rather than its position rela­
tive to other rates as an indication of the
tone of monetary policy. Under a discre­
tionary discount rate policy, an unchanged
rate is accompanied, according to Fried­
man, by unintended shifts between mone­
tary tightness and ease as market rates
change relative to the discount rate. More­
over, the occasional but usually substantial
changes in the discount rate are viewed as
a source of general instability. Friedman
sums up his feelings as follows:41
. . . rediscounting should be eliminated. The Fed­
eral Reserve would then no longer have to an­
nounce a discount rate or to change it; it would
then have direct control over the amount of
high-powered money it created; it would not be
a source of instability alike by its occasional
changes in the discount rate and by the un­
intended changes in the “tightness” or “ease” of
policy associated with an unchanged rate, nor
would it be misled by these unintended changes;
and it would be less subject to being diverted
from its main task by the attention devoted to the
“credit” effects of its policy.
40 Friedman, op. cit., p. 38.
41 Ibid., p. 44.




However, Friedman adds one vital quali­
fication to his argument for total abolish­
ment. He reasons that since required re­
serves are calculated after the fact, some
discrepancies between required and actual
reserves are unavoidable. As an alternative
to the current charge of the discount rate
plus 2 percentage points on realized reserve
deficits, Friedman offers a fixed rate of
“fine” that “should be large enough to make
it well above likely market rates of interest.
The fine would then become the equivalent
of a truly ‘penalty’ discount rate . . . [but]
no collateral, or eligibility requirements, or
the like would be involved.”42
It seems that Friedman was not aware of
how much this one qualification weakens
his solution. As Ahearn has pointed out,
this qualification would replace the discount
mechanism with an “overdraft system” un­
der which everything would depend on the
height of the penalty rate. If market rates
of interest moved up, the penalty rate might
have to be adjusted upward to keep it a
penalty, which means in essence that the
discount mechanism would have crept back
under another name.43
Professor Kareken also views the aboli­
tion of discounting as a possible alternative
to the present system.44 He reasons that in
view of the growth in the public debt— and
especially, of the expansion in the stock of
Treasury bills— during and after World
War II, there is no longer any need for
discounting in order to make reserve adjust­
ments. With the closing down of discount
facilities, banks short of reserves would, ac­
cording to Kareken, be forced to sell short­
term Government securities. But those
42 Ibid., p. 45.
43 Daniel S. Aheam, Federal Reserve Policy R e­
appraised, 1951-1959, p. 140.
44 Kareken, op. cit., pp. I l l and 112.

38

banks with reserve excesses would have a
strong incentive to retain their Treasury
obligations, and perhaps to acquire more.
Aheam contends that this analysis is
faulty because Kareken assumes that Gov­
ernment securities sold by reserve-deficient
banks will be bought up by other banks,
and this assumption ignores the fact that
broad swings in reserve positions affect
nearly all banks in roughly the same way at
about the same time. If bank reserve posi­
tions were tightening, Ahearn asserts, it
would actually be rational for banks with
excess reserves to husband their reserves
and, indeed, to sell Government securities
in anticipation, before reserve positions
tightened further and depressed prices of
securities lower.45 In the light of more re­
cent developments, there is, of course, the
additional argument that bank holdings of
short-term Government securities may ac­
tually drop so low as to limit sales of such
securities as a means of reserve adjustment.
Nondiscretionary approach

A general dissatisfaction with the discre­
tionary features of discount policy is re­
flected in nearly all of the suggested modi­
fications in this mechanism. The proposals
along this line rest on the assumption that
considerations of “profitability” do, in fact,
bear heavily on borrowing decisions. The
central feature of the proposed nondiscre­
tionary discounting arrangements is a dis­
count rate that is “tied” to the Treasury bill
rate or some other money market rate that
is relevant to borrowing decisions. Such an
arrangement appears to be motivated in
large part by the desire to: (1) stabilize the
rate differentials that influence borrowing
decisions, thus hopefully stabilizing the
aggregate amount of borrowing, and (2)
eliminate the threat of adverse announce­
ment effects stemming from discretionary
■15 Ahearn, op. cit., p. 140 (n. 51).



changes in the discount rate. When coupled
with a penalty-rate concept, this system
establishes a basis for relying entirely on
the price mechanism for the allocation of
credit at the discount window.
The practical problem of how high to
set the penalty rate is an important one. If
the rate is set too high, borrowing from the
Federal Reserve Banks may cease to be a
practical alternative for banks unexpectedly
in need of reserves. Many regard this
lender-of-last-resort function as an impor­
tant central bank responsibility, however,
and the adverse effect on the attractiveness
of membership in the System is also a con­
sideration. On the other hand, if the penalty
rate is set too low, the volume of borrow­
ing may become “excessive.” Another prob­
lem— perhaps even more thorny— is
created by the fact that market interest
rates do not move in perfect tandem with
each other. Thus if the discount rate were
tied to some particular rate, movements of
other market rates relative to the chosen
rate could result in continued interest-rateinduced instability in the aggregate volume
of borrowing.
The choice of the market rate to which
the discount rate would be tied and of the
size of the differential to be used hinges in
significant part on the question of whether
banks balance borrowings against rates on
other sources of readily available funds or
whether borrowings are related to the rate
that banks can earn on loans. A penalty
discount rate that is effective under condi­
tions in which borrowings are balanced
against rates on marginal assets (that is,
Treasury bills) may not inhibit borrowing
decisions that are related to the higher re­
turns on other types of earning assets.
Moreover, even if the discount-window
authorities effectively preclude borrowing
to lend at a profit under the terms of Regu­
lation A, a given penalty rate may become

ACADEM IC LITERATURE ON DISCOUNT MECHANISM

ineffective as banks shift from one short­
term source of funds to another. For exam­
ple, if the discount rate is set at some spec­
ified margin above the Treasury bill rate
and a substantial number of banks turn to
other sources of short-term funds such as
certificates of deposit (CD’s), the discount
rate may lose its initial penalty properties.
Warren Smith has observed that, on prac­
tical grounds, the discount rate should ex­
ceed the Treasury bill rate by a margin that
is sufficient to discourage unnecessary bor­
rowing without imposing too heavy a pen­
alty on banks that are forced to borrow
because they lack salable securities. On this
basis, he determines that the discount rate
should be set a full 1 percentage point or
more above the Treasury bill rate.46
Smith has been careful to distinguish be­
tween his penalty-rate system, in which the
use of the discount window is penalized in
cost terms relative to other sources of short­
term funds, and the British plan, in which
the penalty rate is related to the return on
earning assets— which happens in the case
of the British discount houses to be almost
exclusively Treasury bills. The British pen­
alty-rate concept is held to be impracticable
in the United States “because there are sev­
eral thousand member banks able to bor­
row directly from the Federal Reserve and
invest their funds in a broad range of assets
carrying widely varying interest rates.”47
46 Smith, “The Discount Rate,” p. 176. More
recently, however, Smith has voiced reservations
about using the Treasury bill rate as an anchor
rate. At a Federal Reserve seminar on the discount
mechanism in May 1966 he noted that in the last
few years many banks have come to use CD’s
rather than Treasury bills in their reserve adjust­
ments. At the same time, Smith indicated that he
has become less certain of the appropriate penaltyrate spread: “There is a fuzziness about what a
penalty rate is here. Does it have to be sort of
higher than any rate that any bank can earn on an
asset, at one extreme, or does it have just to be
a little bit above the lowest rate [at which] any
bank can turn out any asset, at the other extreme?
It’s probably somewhere in between.”
47ibid., p. 171 (n. 3).




39

In another “tied” discount rate plan,
Ahearn proposes that the discount rate be
anchored to the bill rate but that the Fed­
eral Reserve be allowed to vary the differen­
tial in accordance with monetary policy
aims. “This would retain needed flexibility
in the relation of the discount rate to other
money market rates but also minimize the
possibility of market misinterpretation of
the meaning of discount rate changes.”48
Brunner and Meltzer also call for an ar­
rangement in which the discount rate would
always exceed the bill rate, but not neces­
sarily by a fixed margin. They envision a
market-determined discount rate and sug­
gest that the discount window should be
kept “open” at the penalty rate.49 Precisely
how the penalty rate would be determined
is not spelled out, however.
Aschheim presents a plan in which the
discount rate would be tied to the rate on
Federal funds instead of the Treasury bill
rate because Federal funds are considered
to be the closest substitute for reserve ac­
commodation from the Federal Reserve. As
did Brunner and Meltzer, Aschheim also
envisions (but fails to spell out) a penaltyrate scheme in which “the ‘principles of
prudent discounting’ that are currently ap­
plicable to the System’s rediscount facility
could be dispensed with.”50 He concludes:51
Where . . . open market operations are feasible,
nonpenal rediscounting is— in effect— an escape
mechanism for commercial banks seeking to over­
come the constraint o f restrictive open-market
policy. Last-resort reserve accommodation via a
penalty rate eliminates this escape mechanism
while retaining the safety valve of central-bank
lending to member banks at the latter’s initiative.
Thus, in monetary systems possessing the insti­
tutional setting for open-market operations, pen­
alty-rate rediscounting enhances the effectiveness
of central bank control.
48 Ahearn, op. cit., p. 144.
49 U.S. House, Subcommittee on Domestic Fi­
nance, op. cit., pp. 89 and 90.
50 Aschheim, op. cit., p. 94.
51 Ibid., p. 98.

40

Some technical difficulties appear to
exist, however, in attempting to tie the dis­
count rate to the Federal funds rate in
instances where resort to the “window” is
unlimited. The predetermined and fixed
penalty spread would have to be added to
some past value of the funds rate to deter­
mine the current discount rate, say, the
average effective funds rate for the pre­
ceding week. The balance of supply and
demand in the funds market is very shiftable, however, and the rate tends to be
quite unstable. As long as the current funds
rate remained below the current week’s dis­
count rate, borrowings would probably be
very low. If the current funds rate should
rise to the discount rate, however, banks
would be indifferent between the funds
market and the “window” as a source of
reserves, the funds rate would rise no fur­
ther, and borrowings could rise indefinitely
until the demand for reserves was satisfied
at the existing discount rate. Thus, it would
appear that considerable instability in the
volume of borrowings would be reintro­
duced.
In summary, those advocating a nondiscretionary discount mechanism would at­
tempt to minimize the variability in borrow­
ings by fixing the differential between rates
pertinent to the borrowing decision and to
hold down the average level of borrowings
by setting the discount rate at a penalty
level.52

Discretionary approach

As an alternative to his proposal for abolish­
ing discounting, Kareken suggests that the
discretionary features of discounting be
strengthened.53 In his view, there is no basis
for thinking that nonprice rationing is in
principle any less effective than price
rationing in curbing unwanted expansions
of Federal Reserve credit. Indeed, the dis­
cretionary approach entails the power to
control total indebtedness and also to con­
trol bank lending practices selectively.
The selective control of bank lending is
considered to be a means of influencing two
factors of “special significance” in the con­
temporary inflationary process— namely,
inventory speculation and money wage
pressures. To the extent that funds needed
to finance an inventory build-up or an in­
crease in corporate transactions balances
(in order to make larger wage payments)
must be limited by member banks that
make use of the discount window, the in­
ventory and wage sources of inflationary
pressures would be blunted.
Kareken notes that his plan would re­
quire the establishment of appropriate non­
price eligibility conditions such as a maxi­
mum figure for the ratio of loans to total
loans and investments. In addition, and in
marked contrast to most of the proposed
modifications in discounting, it would be
necessary to keep the discount rate below
the penalty level. “If banks are to avail
52 Some interesting variants of the “tied” rate plan themselves of the System’s discount facili­
were offered at the Federal Reserve seminar re­
ties and thereby to submit to the regulation
ferred to in footnote 46. It was proposed, for ex­
ample, that the discount rate should be linked to
of their activities it must in some sense be
the Federal funds rate but that the spread should
profitable for them to do so.”54 Aschheim
increase with both the size and duration of an in­
dividual bank’s borrowing from the Federal Reserve.
indicates general disapproval of this scheme
Another plan called for a given bank to pay a bor­
by asking the obvious:55
rowing rate that is fixed in relation to its return
per dollar of loans and invc s<n:cv,ts on the grounds
that since the most efficient bankers con "itute the
hard core of borrowers, a single penalty discount
rate for the system as a whole might have perverse
effects by penalizing least those that tend to borrow
the most. For an excellent summary of the dialogue
and proposals at the seminar on discounting in May




1966, see: Priscilla Ormsby, “Summary of Issues
Raised at the Academic Seminar on Discounting,”
starting on p. 47.
53 Kareken, op. cit., pp. 119 and 120.
54 Ibid., p. 121.
55 Aschheim, op. cit., pp. 96 and 97.

ACADEM IC LITERATURE ON DISCOUNT MECHANISM

If the purpose is selective lending control, why
confine it to those banks that choose to subject
themselves to it? If many banks choose to shun
the discount window to avoid central-bank reg­
ulation of their lending practices, how far down
shall the discount rate go or how watered down
shall the selective lending control be in the effort
to lure more banks to the discount window?

Tobin’s proposals

Professor Tobin advocates a radical de­
parture from the current discounting ar­
rangement that would make the discount
rate “the most powerful tool in the central
bankers’ kit.”56 He makes two basic pro­
posals:57
(1) The Federal Reserve Banks should pay in­
terest at the discount rate on member bank re­
serve balances in excess of requirements;
(2 ) Banks should be released from the prohibi­
tion of interest payments on demand deposits and
from the ceilings on interest rates on time and
savings deposits.

According to Tobin, the purpose of the
first proposal is to tighten the control of the
Federal Reserve over the opportunity cost
of bank lending. By raising the discount
rate, the Federal Reserve would “clearly,
directly, and quickly” make lending less
attractive to all banks, regardless of whether
they are in debt to the Federal Reserve or
not. The discount rate would become a
floor to the rate on Treasury bills and simi­
lar short-term paper that banks might hold
as secondary reserves.
The purpose of the second proposal is
to tighten the Federal Reserve’s control
over the opportunity cost that bank deposi­
tors charge against any alternative invest­
ment of funds. “The rate that banks pay
depositors will be closely geared to the dis­
count rate since a bank will always be able

56 James Tobin, “Towards Improving the Effi­
ciency of the Monetary Mechanism,” p. 279.
57 ibid., pp. 277 and 278.




41

to earn a fraction of the discount rate (one
minus the required reserve ratio) on a new
deposit.” Among the advantages claimed by
Tobin for the second proposal are the elim­
ination of the “unproductive efforts” de­
voted to economizing on cash in periods of
high interest rates, and the replacement of
the existing “wasteful and imperfect” non­
price competition with price competition.
“Better to pay depositors interest than to
seek their patronage by organ music, free
silverware, and plush surroundings.”58
Another important feature of Tobin’s plan
is that the Federal Reserve would make a
perfect Federal funds market at the dis­
count rate. Among the implications fore­
seen by Tobin for his proposals are that
much of the short-term Government debt
would be transferred to the Federal Re­
serve from banks and corporations, leaving
them to hold excess reserves and bank de­
posits, respectively. Also, Tobin suspects
that monetary control under his system
might require much wider fluctuations in
discount rates and connected short-term
interest rates “than we have yet had the
courage to try.”59
By way of criticism of the Tobin scheme,
Ahearn points out that the potential for
inflationary enlargement of the reserve base
would be enormous; yet the only adminis­
trative defense against member bank bor­
rowing would be the power to raise the
discount rate.60 The problem would be com­
pounded by the difficulties in carrying out
offsetting open market operations under
conditions of dried-up public short-term
Government security holdings.61
58 Ibid., p. 278.
59 Ibid., p. 279.
60 Ahearn, op. cit., p. 133.
61 This point is made by Jonathan Levin in “Pro­
fessor Tobin on the Monetary Mechanism,” an
internal memorandum of the Federal Reserve Bank
of New York, Sept. 8, 1960, p. 5.

42

BIBLIOGRAPHY
Books

Ahearn, Daniel S. Federal Reserve Policy Reappraised, 19511959. New York: Columbia University Press, 1963.
Aschheim, Joseph. Techniques of Monetary Control. Baltimore:
Johns Hopkins University Press, 1961.
Board of Governors of the Federal Reserve System and the U.S.
Treasury. The Federal Reserve and the Treasury: Answers
to Questions from the Commission on Money and Credit.
Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1963.
Burgess, W. Randolph. The Reserve Banks and the Money Mar­
ket, rev. ed. New York: Harper and Bros., 1936.
Currie, Lauchlin. The Supply and Control of Money in the United
States, rev. ed. Cambridge: Harvard University Press, 1935.
Friedman, Milton. A Program for Monetary Stability. New York:
Fordham University Press, 1959.
Goldfeld, Stephen M. Commercial Bank Behavior and Economic
Activity. Amsterdam: North Holland Publishing Co., 1966.
Hardy, Charles O. Credit Policies of the Federal Reserve System.
Washington: The Brookings Institution, 1932.
Harris, Seymour E. Twenty Years of Federal Reserve Policy.
Cambridge: Harvard University Press, 1933.
McKinney, George W., Jr. The Federal Reserve Discount Win­
dow. New Brunswick, N.J.: Rutgers University Press, 1960.
Meigs, A. James. Free Reserves and the Money Supply. Chicago:
University of Chicago Press, 1962.
Riefler, Winfield W. Money Rates and Money Markets in the
United States. New York: Harper and Bros., 1930.
Roosa, Robert V. Federal Reserve Operations in the Money and
Government Securities Markets. New York: Federal Reserve
Bank of New York, 1956.
Turner, Robert C. Member-Bank Borrowing. Columbus: Ohio
State University Press, 1938.
U.S. Congress, Joint Economic Committee. Employment Growth
and Price Levels, Hearings, “Part 4— The Influence on
Prices of Changes in the Effective Supply of Money,” 86th
Cong., 1st sess. (May 25-28, 1959).
U.S. House of Representatives, Subcommittee on Domestic Fi­
nance. An Alternative Approach to the Monetary Mechan­
ism by Karl Brunner and Allan H. Meltzer, 88th Cong., 2nd
sess. (Aug. 17, 1964).
Willis, Parker B. The Federal Funds Market. Boston: Federal
Reserve Bank of Boston, 1957.




ACADEM IC LITERATURE ON DISCOUNT M ECHANISM

Periodicals and Other References

Alhadeff, David A. “Monetary Policy and the Treasury Bill Mar­
ket,” American Economic Review, vol. 42 (June 1952), pp.
326-46.
Board of Governors of the Federal Reserve System. Annual Re­
port. 1952, 1953, 1957.
---------- . “Excess Profits Taxes of Commercial Banks,” Federal
Reserve Bulletin, vol. 37 (June 1952), pp. 602-19.
---------- . “Interest Rates and Monetary Policy,” by Stephen H.
Axilrod and Ralph A. Young, Federal Reserve Bulletin, vol.
48 (Sept. 1962), pp. 1110-37.
---------- . “Regulation A— Effective February 15, 1955,” Federal
Reserve Bulletin, vol. 41 (Jan. 1955), pp. 9-14.
Carr, Hobart C. “Federal Funds,” in Money Market Essays. New
York: Federal Reserve Bank of New York, 1952, pp. 13-16.
Culbertson, John M. “Timing Changes in Monetary Policy,”
Journal of Finance, vol. 14 (May 1959), pp. 145-60.
de Leeuw, Frank. “A Model of Financial Behavior,” in The
Brookings Quarterly Econometric Model of the United
States, eds. James S. Duesenberry et al. Chicago: Rand, Mc­
Nally and Co., 1965, pp. 465-530.
Federal Reserve Bank of Atlanta. “The Discount Rate and Bank
Lending,” by Thomas R. Atkinson, Monthly Business Re­
view (Feb. 1953), pp. 9 and 10.
Federal Reserve Bank of New York. “Borrowing from the Fed,”
Monthly Review, vol. 41 (Sept. 1959), pp. 138-42.
---------- . “The Significance and Limitations of Free Reserves,”
Monthly Review, vol. 40 (Nov. 1958), pp. 162-67.
---------- . “Techniques of Member Bank Borrowing at the Fed­
eral Reserve,” Monthly Review, vol. 46 (Apr. 1964), pp.
66 - 68 .
Federal Reserve Bank of Philadelphia. “Discount Rate and Dis­
count Policy,” Business Review (Jan. 1959), pp. 16-26.
Federal Reserve Bank of St. Louis. “The Discount Mechanism
and Monetary Policy,” Monthly Review, vol. 42 (Sept.
1960), pp. 5-9.
----------. “Some Misconceptions in Public Understanding of Mone­
tary Policy,” Monthly Review, vol. 41 (Nov. 1959), pp.
1 2 4 -2 8 .
Goldfeld, Stephen M., and Kane, Edward J. “The Determinants
of Member-Bank Borrowing: An Econometric Study,” Jour­
nal of Finance, vol. 21 (Sept. 1966), pp. 499-514.
Hodgman, Donald R. “Member-Bank Borrowing: A Comment,”
Journal of Finance, vol. 16 (Mar. 1961), pp. 90-97.




44

Kareken, John H. “Federal Reserve System Discount Policy: An
Appraisal,” Banca Nazionale del Lavoro Quarterly Review,
No. 48 (Mar. 1959), pp. 103-24.
Lapkin, David T., and Pfouts, Ralph W. “The Administration
of the Discount Function,” National Banking Review, vol.
3 (Dec. 1965), pp. 179-86.
Lindow, Wesley. “The Federal Funds Market,” Banker’s Monthly,
vol. 77 (Sept. 1960).
McKinley, David H. “The Discount Rate and Rediscount Policy,”
The Federal Reserve System, ed. Herbert V. Prochnow. New
York: Harper and Bros., 1960, pp. 90-112.
McWhinney, Madeline. “Member Bank Borrowing from the Fed­
eral Reserve Banks,” in Money Market Essays. New York:
Federal Reserve Bank of New York, 1952, pp. 8-12.
Monhollon, Jimmie R., and Parthemos, James. “Administration
of the Discount Function: A Comment,” National Banking
Review, vol. 4 (Sept. 1966), pp. 89-92.
Polakoff, Murray E. “Federal Reserve Discount Policy and Its
Critics,” in Banking and Monetary Studies, ed. Deane Car­
son. Homewood, Illinois: Richard D. Irwin, Inc., 1963, pp.
190-212.
---------- . “Reluctance Elasticity, Least Cost, and Member Bank
Borrowing: A Suggested Integration,” Journal of Finance,
vol. 15 (Mar. 1960), pp. 1-18.
Polakoff, Murray E., and Silber, William L. “Reluctance and
Member-Bank Borrowing: Additional Evidence,” Journal
of Finance, vol. 22 (Mar. 1967), pp. 88-92.
Rolph, Earl. “Discussion,” American Economic Review, Papers
and Proceedings, vol. 45 (May 1955), pp. 411-14.
Roosa, Robert V. “Credit Policy at the Discount Window: Com­
ment,” Quarterly Journal of Economics, vol. 73 (May
1959), pp. 333-38.
---------- . “Monetary Policy Again: Comments,” Bulletin of the
Oxford University Institute of Statistics, vol. 14 (Aug.
1952), pp. 253-61.
Samuelson, Paul A. “Recent American Monetary Controversy,”
Three Banks Review, No. 29 (Mar. 1956), pp. 3-21.
---------- . “Reflections on Monetary Policy,” Review of Economics
and Statistics, vol. 42 (Aug. 1960), pp. 263-69.
Simmons, Edward C. “A Note on the Revival of Federal Reserve
Discount Policy,” Journal of Finance, vol. 11 (Dec. 1956),
pp. 413-21.




ACADEM IC LITERATURE ON DISCOUNT MECHANISM

----------. “Federal Reserve Discount-Rate Policy and MemberBank Borrowing, 1944-50,” Journal of Business of the
University of Chicago, vol. 25 (Jan. 1952), pp. 18—29.
Smith, Warren L. “The Discount Rate as a Credit-Control
Weapon,” Journal of Political Economy, vol. 66 (Apr.
1958), pp. 171-77.
----------. “The Instruments of General Monetary Control,” Na­
tional Banking Review, vol. 1 (Sept. 1963), pp. 47-76.
Tobin, James. “Towards Improving the Efficiency of the Mone­
tary Mechanism,” Review of Economics and Statistics, vol.
42 (Aug. 1960), pp. 276-79.
Walker, C. E. “Discount Policy in the Light of Recent Experi­
ence,” Journal of Finance, vol. 12 (May 1957), pp. 2 2337.
Whittlesey, Charles R. “Credit Policy at the Discount Window,”
Quarterly Journal of Economics, vol. 73 (May 1959), pp.
207-16.
Young, Ralph A. “Tools and Processes of Monetary Policy,”
United States Monetary Policy. New York: The American
Assembly, Columbia University, 1958, pp. 13-48.
Youngdahl, Richard. “Monetary Policy in Recent Years,” Amer­
ican Economic Review, Papers and Proceedings, vol. 45
(May 1955), pp. 402-08.







SUMMARY OF ISSUES RAISED AT THE ACADEMIC
SEMINAR ON DISCOUNTING
Priscilla Ormsby
Board of Governors of the Federal Reserve System

Contents
Introduction______________________________________________________________

49

Role of the Discount Mechanism_______________________________________________ 50
Reallocation of Reserves_____________________________________________________ 50
Regional reserve reallocation
Sector reserve reallocation

Use of Discount Rate to Control Volume of Borrowing______________________________




47

53




SUMMARY OF ISSUES RAISED AT THE ACADEMIC
SEMINAR ON DISCOUNTING

INTRODUCTION
On May 11, 1966, an Academic Seminar
on Changes in the Discount Mechanism
was held at the offices of the Board of Gov­
ernors of the Federal Reserve System in
conjunction with the “fundamental reap­
praisal of the discount mechanism” under
way within the System. This paper repre­
sents an attempt to organize and sum­
marize what was by design a far-ranging
and unstructured exchange of ideas and
opinions at that seminar. The issues dis­
cussed there have been explored much more
extensively in the academic literature by
these same professors and by others. How­
ever, this paper presents the arguments only
as they developed during the seminar and
does not evaluate them— other than to com­
ment at times on the course of the seminar
discussion, or to trace their origin.
The following professors participated in
the seminar:
Professor Lester V. Chandler, Prince­
ton University, Chairman
Professor G. L. Bach, Carnegie Insti­
tute of Technology1
Professor Edward E. Edwards, In­
diana University
Professor Hyman Minsky, Washington
University
Professor Franco Modigliani, Massa­
chusetts Institute of Technology

Professor Paul A. Samuelson, Massa­
chusetts Institute of Technology
Professor Richard T. Selden, Cornell
University
Professor Warren L. Smith, University
of Michigan
In addition, a large number of academi­
cians submitted brief papers on the gen­
eral topic of the role of the discount mech­
anism. The ideas presented in those papers
appear in this summary only insofar as they
were again reflected at the seminar itself.
The first section reviews, in a general
way, the present and possible future roles of
the discount mechanism: whether it is neces­
sary, and if so, what purposes it should
serve. The other sections contain detailed
considerations of the two major issues dis­
cussed at length during the seminar: (1 )
the role of discounting in the reallocation
of reserves; and (2 ) the use of the discount
rate to control the volume of borrowing. A
number of connected issues, which while
important in themselves were treated only
peripherally in the course of the seminar,
are also discussed in these sections. They
include the influence of existing banking
structure on credit needs and the operation
of the discount window, the relationship of
discounting to general monetary policy, an­
nouncement effects of changes in the dis­

i Now of Stanford University.




49

50

count rate, and nonprice rationing at the
window.
For the most part, the ideas brought
forth were not restricted by the working of

the present discount mechanism and there­
fore they should not be evaluated in terms
of laws and regulations that are in existence
today.

ROLE OF THE DISCOUNT MECHANISM
The participants in the seminar were dis­
satisfied with the discount mechanism as it
currently existed; the two chief complaints
concerned “nonprice rationing” and “an­
nouncement effects.” However, unsatisfac­
tory as the present discount mechanism
might be in the estimation of the partici­
pants, there was little sentiment at the semi­
nar for its complete elimination. The sug­
gestion was made by several participants
early in the discussion that perhaps, in the
interest of tightening up aggregate mone­
tary controls, the discount mechanism could
be dispensed with. However, the suggestion
was not pursued and subsequent discussion
lent no support to the proposal.
One major reason seen for keeping the
discount mechanism was uncertainty about
the future. It was noted that the banking
system is constantly changing and what
seems superfluous today may become vital
tomorrow; for instance, if the banking

system were to run out of the assets em­
ployed in open market operations, the win­
dow could become the major source of re­
serves. The possibility was also cited of the
window becoming important in a changing
political climate where oral suasion became
the order of the day.
Although no one felt that, in today’s
economy, the discount mechanism should
be used as the major tool of monetary
policy, a number of possible roles for the
discount window were suggested by the par­
ticipants. Some of these suggestions— with
varying degrees of support— were to pro­
vide a safety valve for correcting mistakes
in open market operations, to permit ad­
justments by the individual banks and re­
gions and to protect the unit banking sys­
tem. It was noted in this discussion that
the discount window could simultaneously
serve a variety of purposes and thus need
not be limited to a single, narrow role.

REALLOCATION OF RESERVES
One of the most basic and widely accepted
functions of the discount mechanism is to
provide temporary assistance to individual
banks and regions in adjusting to changing
reserve pressures. Thus, in a sense, shortrun reallocation of reserves is inherent in
the window’s operation, and none of the
professors questioned this sort of realloca­
tion. The desirability of permitting longerterm reallocation of reserves through the




discount window was regarded as much
more controversial, posing problems of both
a political and an economic nature.
While not totally separable, the realloca­
tion problem falls into two categories— re­
gional reallocation and sector reallocation.
Although many of the same considerations
apply to both, the pattern of the discussion
at the seminar seemed to warrant separate
treatment in this paper.

ISS U E S RAISED AT SEM INAR ON DISCOUNTING

Regional reserve reallocation

A basic consideration in evaluating the need
for regional reserve reallocation is the rela­
tive freedom of capital flows among differ­
ent parts of the country. The rapid growth
of the California economy in recent decades
was pointed to as demonstrating the ade­
quacy of this flow. It was estimated that,
during the period of most rapid growth,
about 40 per cent of the money in mort­
gages came from out of State. It was ques­
tioned whether one could generalize from
this experience, however. The example was
cited of an agricultural area in which meth­
ods of farming were becoming increas­
ingly capitalistic; however, deposits were
not growing at a pace sufficient to finance
this potentially profitable trend and no ap­
parent means, such as Federal insurance of
farm loans, existed for drawing in the neces­
sary funds from other areas. It was agreed,
however, that capital flows have become
somewhat more flexible and responsive
throughout the country since the early
1930’s, due to the development of Govern­
ment-sponsored protective measures, such
as deposit insurance for both commercial
banks and thrift institutions and mortgage
insurance through the Federal Housing Au­
thority and also the Veterans Adminis­
tration.
One of the professors severely criticized
the one-way flow of capital that he con­
tended was encouraged by the present dis­
count mechanism. According to his anal­
ysis, the New York money market banks
“raided” the small country banks, drawing
funds away— mainly through the use of
certificates of deposit— by paying higher
interest rates than the small banks could af­
ford. He would resolve this inequity by
having the Federal Reserve lend liberally
to the money market banks, satisfying their




51

demand for funds and keeping them out of
the small banks’ markets. To offset the re­
sulting reserve creation, the Federal Re­
serve would sell Government securities in
the open market. It is conceivable that these
securities could be bought directly by cus­
tomers of the country banks, resulting in the
same loss of funds on their part; but in con­
trast to the case with CD’s, such purchases
would not involve a personal commitment
of customers to a specific money market
bank.
This proposal met with very little sup­
port from the other professors. According
to traditional economic logic— and assum­
ing away any barriers to credit mobility—
the fact that the New York banks could
pay a higher interest rate indicated that the
funds “belonged” in New York. It was also
noted that the above analysis was con­
cerned with a “bank” allocation problem,
which might be quite distinct from the
“customer” allocation problem. If the de­
positors sending their money to New York
could, with equal ease, obtain loans from
the New York banks, the net result for the
region might be beneficial. If this were true,
then the capital flow would really not be
one way; it would be merely bypassing the
local bank.
In the final analysis, however, a majority
of the participants felt that the “small bank
problem” probably existed in some degree.
A second solution was offered that would
create a dichotomy of banks— money mar­
ket banks and nonmoney market banks. For
the money market banks, the Federal Re­
serve would adopt something similar to the
British technique of discounting— denying
them access to the window and fostering the
development of market operators who
would use the window. The nonmoney
market banks would retain access to the

52

window at a rate “considerably higher than
the money market rate.” This suggestion
likewise elicited little support from other
participants.
It was noted that one of the underlying
causes of whatever small bank problem
existed was the currently existing banking
structure. Those banks that were handi­
capped were typically unit banks and as
such were probably inherently limited in the
level of fundraising efficiency they could
attain relative to the larger banks. Mixed
views were apparent among the participants
as to whether the Federal Reserve should
work toward the liberalization of branch­
ing laws, should protect the traditional unit
banking system, or should take any action
in the area.
Sector reserve reallocation

The most commonly cited purpose of sector
reallocation of reserves was to bypass mar­
ket forces and to insulate part of the econ­
omy— the most frequently cited example is
probably the homebuilding industry— from
general monetary policy. This was generally
envisioned as being undertaken to offset im­
perfections already existing in the markets
and to ameliorate what would otherwise be
a disproportionately large impact of policy
decisions on specific sectors. The Federal
Reserve might offer such selective credit
assistance through the indirect method of
accepting the paper of those sectors for
discounting by member banks on a more
liberal basis, perhaps at a preferential rate.
The professors saw problems with this ac­
tion, apart from the question of its desir­
ability. It was pointed out that it was in fact
a reincarnation of the commercial loan
theory, long since proven ineffective. Unless
the window were to accept the specified
paper on a massive and perhaps unlimited




scale— a policy that could have serious con­
sequences for monetary management,
especially at a time when the over-all pos­
ture of the System was probably one of
tightness— there was very little assurance
that the funds thus provided would be used
for the desired purpose.
Other possible actions of the System in­
cluded the subsidizing of various agencies
that support specific sectors, such as the
Federal National Mortgage Association, or
the direct purchase of the paper of specific
sectors.3 The overwhelming sentiment at
the seminar, however, was toward keeping
any assistance as indirect as possible. None
of the professors felt that the Federal Re­
serve had a responsibility to support any
sector on a long-term basis. Perhaps if an
interest rate were obviously out of line the
System would be justified in stepping into
the relevant market temporarily, but the
border between a temporary situation and
a fundamental trend is necessarily hazy, and
it was noted that direct assistance to one
segment of the market, even in an extreme
situation, could set a precedent that would
result in an increasing number of requests
for such assistance.
The professors therefore favored con­
tinuing the present system of establishing
separate agencies, not endowed with the
power of reserve creation, to foster spe­
cific sectors. This left open the question of
how deeply the Federal Reserve should in­
volve itself in assisting these agencies; no
one doubted that the System would have a
responsibility to protect them from com­
plete failure, but the professors would pre­
fer to see the Federal Reserve remain, as
much as possible, in the role of lender of
last resort.
3 This
statute.

course would

require a change

in the

ISSU ES RAISED AT S E M IN A R ON DISCOUNTING

53

USE OF DISCOUNT RATE TO CONTROL VOLUME OF BORROWING
If a single recommendation could be said
to have come out of the academic seminar,
it would be for the Federal Reserve to
make more and better use of the discount
rate as a means of rationing credit. The
present rate system was almost unanimously
criticized, and most of the professors recom­
mended that the discount rate be tied to
some market rate. Recommendations were
also made for graduated rates based on the
amount of borrowing. Finally, a number
of specific models using rate as the principal
control device were recommended and dis­
cussed.
The major criticism of the present rate
system was of the ambiguous “announce­
ment effects” of a rate change. Without
careful inspection of market rate patterns
— and sometimes even with such inspection
— it can be difficult or impossible to deter­
mine whether the Federal Reserve is lead­
ing the market and opening a new phase
in monetary policy or lagging the market
and merely adjusting to existing conditions.
The value of an announcement effect was
not completely rejected, however; it was
pointed out that it might be extremely im­
portant in restoring international confidence
in a shaky currency,
A number of recommendations were
made to permit less ambiguous announce­
ment effects. The simplest suggestion was
for the Federal Reserve to issue a statement
saying exactly what it wanted to convey.
Such a direct method would seem to offer
less chance for misinterpretation, but it
would have drawbacks of its own. A state­
ment agreed to by seven Governors or 12
members of the Federal Open Market Com­
mittee would, by the very facts of human
nature, almost unavoidably be rather bland,
and even the most clear-cut statement would




probably have less effect than a lasting
change in rate.
A second proposal was to establish a
regular schedule of changes in the discount
rate. These changes would be frequent and
very small and therefore should be ac­
cepted and almost unnoticed by the public,
but they would allow the discount rate to
keep pace with changing market rates.
When the time came to announce a change
in monetary policy, a relatively large change
in the discount rate should accomplish this
without confusion. If the sole criticism of
the present rate system were the ambiguity
of announcement effects, adoption of this
proposal would probably be viewed as a
major improvement by the academic com­
munity.
The final proposal for improving the
announcement effect assumed that the dis­
count rate would be tied to some market
rate and vary with that rate automatically.
Any desired announcement effect could be
achieved by changing the differential be­
tween the two rates. The impact of a change
in this case might be even stronger than in
the previous proposal, since it would be a
voted and announced change after a period
of automatic and continuous adjustment.
Although the ambiguity of announce­
ment effects was the most frequently men­
tioned criticism of the present rate system,
most of the professors saw other benefits
that would result from a tied-rate policy.
One was simply an appeal to the principle
of parsimony; it is wasted effort to control
the money supply through open market op­
erations and set the discount rate more or
less independently when the work could be
cut in half by letting the market handle
the second task.

54

Other more positive benefits suggested
for the tied rate included the insurance of a
nationally determined rate automatically
and a stabilization in the amount of bor­
rowing. There was some doubt as to
whether the amount of borrowing would be
an invariant function of the spread between
the controlling market rate and the discount
rate, but it was agreed that shifts in this
relationship could probably be predicted
and offset.
Assuming the desirability of a tied dis­
count rate system, a number of specific
problems were identified in the establish­
ment of that rate. These included: the
choice of the market rate to which the dis­
count rate would be tied; whether the dis­
count rate should be a penalty rate, and if
so, just what constituted a penalty; and
whether there should be a freely open win­
dow at the established rate and what the
implications of such an arrangement would
be for general monetary policy.
The deciding factor in the choice of a
controlling market rate was deemed to be
the manner in which commercial banks
were financing their positions— that is, the
most typical source of short-term funds,
apart from the discount window, to which
they turned to adjust to changing reserve
pressures. It was recognized that, in the cur­
rent financial environment, a variety of such
sources were used by the banks and there
was therefore no one obvious answer to the
question. However, several nominations
were made for the role of controlling mar­
ket rates. Historically, the most logical
seemed to be the Treasury bill rate; here
was an extremely well-organized market
for an almost universally held instrument.
However, present trends suggested that the
sale of bills was becoming— and in some
cases had already become— obsolete as a
means of bank reserve adjustment. For




many banks, almost the whole of their de­
clining holdings of Government securities
are tied to specific purposes, such as col­
lateralizing public deposits.
A second possibility was to tie the dis­
count rate to the rate paid on certificates of
deposit, which is of increasing importance
but is still not a universally important rate
for commercial banks. Another problem in
this case was seen to arise from the fact that
CD’s are normally for maturities signifi­
cantly longer than the typical adjustment
borrowing at the discount window. The
Federal funds rate, also suggested, was not
regarded as a significant rate for all banks
and also was highly volatile in the short run.
While not seriously proposed, it was sug­
gested that the only really relevant rate for
some very small country banks might be
the rate they were making on their loans.
A proposal made earlier, to tie the discount
rate to some measure of the individual
bank’s profit rate, was rejected almost with­
out discussion, apparently because this
would not provide the single nationally de­
termined price for reserve credit that they
felt to be important.
There was also some discussion as to
whether the rate chosen really mattered. It
was pointed out that, in all but the very
short run, all the rates proposed were highly
correlated. Thus the choice of a base was
somewhat immaterial. However, it was
recognized as important that the initial
value of the discount rate be appropriately
set in relation to a market rate that was
significant for all commercial banks. The
wrong choice of the initial level was seen
as having possibly disastrous results, if with
that choice the Federal Reserve relin­
quished further control of the rate. For in­
stance, if the discount rate were set 50
basis points above the Treasury bill rate
( 4 Vi per cent) and banks were actually

ISSU ES RAISED AT SEMINAR ON DISCOUNTING

financing their positions with CD’s at 5 Vi
per cent, the discount rate would be V2 of
1 percentage point below the relevant rate.
With a freely open window, the money sup­
ply would increase drastically until banks
were out of CD’s and financing their posi­
tions at the discount window.
The second question relating to discount
rate policy was whether the rate should be
at a “penalty” level relative to market rates.
One of the participants, a consistent advo­
cate of increased discount-window use,
recommended that it actually be set below
market levels in periods of tight money.
The other professors present agreed that it
should be a penalty rate, but were hesitant
to commit themselves to specific figures,
which they regarded as incidental to the
concepts they were developing and better
worked out in practice. There did seem to
be general support for a penalty in the
vicinity of V2 of 1 percentage point— some­
thing that would provide a deterrent to bor­
rowing, but would “maintain the virtues of
a system that permits the individual bank
adjustment possibilities.” It was expected
that, should the Federal Reserve adopt a
tied penalty rate, a period of experimenta­
tion would be required before the appro­
priate differential could be judged.
It was suggested that, even with a freely
open window, discounting should be worth
more than other methods of obtaining
funds, since it provided increased liquidity
to the banking system as a whole. Therefore,
perhaps the entire differential of the dis­
count rate above the market rate should not
be regarded as a penalty.
Although participants in the seminar
were almost unanimously in favor of a tied
rate, there was some doubt expressed as to
how much such an arrangement would ac­
tually accomplish. It was pointed out that
the Federal Reserve had a major effect,




55

through its open market operations, in de­
termining the level of market rates, so
perhaps it was wrong to speak of an in­
dependently determined discount rate. In
the final analysis, the System played a major
role in both money supply policy and in­
terest rate policy, regardless of how it chose
to exercise these roles.
The question of an open window with
a tied rate was recognized as important for
general monetary policy. The problem in
the case of a poorly chosen discount rate
was discussed above. But even if the dis­
count rate were set above the appropriate
market rate, possible problems were fore­
seen. The increased cost of credit at the
window had to be looked at in conjunction
with the increased availability. Basically,
no matter how high the rate was set, the
central bank gave up direct control of the
volume of reserves created and supplied
through the discount window.
Advocates of an open window pointed
out that any undesired reserve creation
through the discount window could be off­
set by open market operations. This was
fairly generally accepted as true in princi­
ple— at least in the absence of a shortage of
assets employed in such operations, seen
by some as a possibility— but it was felt
that it could require continuous offsetting
operations and, in the extreme case, on a
massive and unheard-of scale. Some noted
that in the proper environment an open
window could have the advantage of avoid­
ing great scrambles for funds that some­
times result in disorderly rate patterns.
None of the professors advocated a per­
manently open discount window at a rate
that the Federal Reserve could not control.
The System should always have the option
of increasing the rate spread if borrowing
became obviously excessive. Two more
continuous methods of controlling the vol­

56

ume of borrowing within a tied-rate system
were suggested: (1 ) a graduated penalty
rate based in some way on the amount of
borrowing; and (2) the kind of administra­
tive, nonprice rationing employed today.
The first possibility, while not actively
supported by all those at the seminar, was
unanimously viewed as feasible. Advocates
of a graduated rate schedule variously sup­
ported two versions; the more popular
would base the schedule on the amount of
borrowing by the individual bank. This was
seen as consistent with the fact that the Sys­
tem was trying to influence individual deci­
sions and as more effective from an alloca­
tive point of view. The alternative version
would base the penalty schedule on the
aggregate amount of borrowing by member
banks. It was felt by some that such an
arrangement would avoid penalizing an in­
dividual bank that was the innocent victim
of an adverse situation rather than a guilty
party, or a bank with unusually profitable
opportunities which was therefore justified
in unusually large borrowing.
Nonprice rationing was rejected by the
seminar participants more by omission than
commission. The general feeling seemed to
be that it was too personal and apt to be
arbitrary. The only statement offered in its
defense was that it might prove useful if,
because of circumstances beyond the Sys­
tem’s control, the U.S. economy found it­
self in an extreme inflationary spiral. Under
anything approaching normal circum­
stances, however, the professors were unan­
imously opposed to its use.
The remainder of this section describes
a number of specific models using rate to
control the volume of member bank bor­
rowing that were proposed by seminar par­
ticipants. None of these represents a closed
and self-sufficient system, but they never­




theless represent a more structured level of
thinking than the earlier discussion.
In the first model proposed, the discount
rate would be tied to an average for the
past 2 weeks of the Federal funds rate. This
rate was chosen because the Federal funds
market is, like discounting, a short-term
source of funds and is, therefore, for the
member bank— although not for the Sys­
tem— the closest alternative to borrowing
at the window. The discount rate would be
set 100 basis points above this past average
of the Federal funds rate. With a freely
open discount window, this would limit
swings in the Federal funds rate by creating
a ceiling on that rate. In the short run, this
could create a spiral situation, since there
would be a tendency for the Federal funds
rate to increase until it was equal to the dis­
count rate. Thus, in the extreme, the dis­
count rate would equal a past value of it­
self plus the differential. However, in prac­
tice this tendency could be controlled by
open market operations conducted in such
a way as to reduce the banks’ necessity to
stay in debt, and it would have a natural
limit since, if the rate became too high,
banks would presumably find it desirable to
adjust their basic positions by such methods
as calling loans and selling off other assets.
The second model had as its immediate
goal the stabilization of the amount of free
reserves that, it was argued, would “give a
fairly rigid relation between what the cen­
tral bank directly controls and the total
amount of reserves.” The amount of bor­
rowing would be controlled by tying the
discount rate to a market rate— the rate
was not specified in this case. The discount
rate would be above this and would in­
crease with extensive use of the window;
the term “extensive” probably encom­

ISSU ES RAISED AT SEMINAR ON DISCOUNTING

passes both duration and amount of borrow­
ing. The amount of excess reserves would be
controlled by paying interest on them. This
rate would also vary with a market rate—
and here the Federal funds rate was spec­
ified— but would be below that market
rate. Advocates of this model would even
go so far as to impose a penalty on the
holding of excess reserves if the Federal
funds rate fell that low.
A somewhat more conventional model
proposed would employ a nationwide dis­
count rate tied to and slightly above some
market rate. Proponents of this model chose
the Treasury bill rate for this purpose but
felt that the choice was somewhat arbitrary.
They would decrease over time the amount
of nonprice rationing and eventually elimi­
nate it altogether. The rate could be ad­
justed as the system was perfected, but mas­
sive change would be employed only when




57

the Federal Reserve wanted to create an
“announcement effect.”
The final model would provide for auto­
matic determination of the discount rate,
not by tying it to any one market rate but
rather by having the System regularly auc­
tion a specified amount of borrowed re­
serves in a manner somewhat analogous to
the weekly Treasury bill auction. The Sys­
tem could then directly control the money
supply and would have the added advantage
that the discount rate would be auction
determined and would not be tied to any
market rate that could become obsolete. This
arrangement could result in tremendous
rate instability, however, in cases where
unusual circumstances caused a great
scramble for funds. To offset this, a penalty
rate could be instituted, above the auction
rate, at which reserves were available for
the rest of the period, or very frequent—
even daily— auctions could be held.




SOME PROPOSALS FOR A REFORM OF THE DISCOUNT WINDOW
Franco Modigliani
Massachusetts Institute of Technology

Contents
Goals to be Achieved________________________________________________________ 61
Proposed Devices to Improve Federal Reserve Control Over the Money Supply
While Permitting Unrestricted Use of the Window_____________________________

61

Sources of slippage between nonborrowed reserves and the supply of demand
deposits, and how to reduce them
Outline of proposed reform—basic features
Elaboration of the proposal
Behavior of free reserves and supply of demand deposits under the proposed
system
Choice of penalty rate—case for a sliding differential
Possible minor improvement: payment of interest on excess reserves
Proposal for Special Borrowing Facilities Aimed at Improving the Spatial Allocation
of Bank Credit-------------------------------------------------------------------------------------------- 72

Proposal outlined
How the term window could contribute to allocative efficiency
Operational aspects
How large a target volume of borrowing?
Some minor complementary suggestions




59




SOME PROPOSALS FOR A REFORM OF THE DISCOUNT WINDOW

GOALS TO BE ACHIEVED
The purpose of this paper is to outline
several proposals for a reform of the Fed­
eral Reserve discount window. These pro­
posals are aimed at achieving the follow­
ing major goals:
1. To eliminate the discretionary and
sometimes capricious elements that charac­
terize the present administration of the win­
dow by permitting unrestricted use of such
borrowing facilities by all creditworthy bor­
rowers that are willing to pay the discount
rate.
2. To reduce the slippage that exists
between nonborrowed (bank) reserves and
the supply of demand deposits by reducing
swings in free reserves, especially those of a
procyclical character, and thus improve
control of the Federal Reserve over the
money supply and interest rates.

3. To make available to smaller banks
facilities analogous to those provided by
the markets for Federal funds and certif­
icates of deposit, from which these banks
are now partially or totally excluded be­
cause of the small size of their operations.
4. To contribute through goal 3 and
other devices to an improved spatial alloca­
tion of bank credit.
It is believed that the proposed reform
would also make possible the achievement
of two other goals:
5. To eliminate the announcement ef­
fects that result from sporadic and hence
sizable changes in the discount rate, and
6. To provide a stronger inducement
than now exists for banks to become mem­
bers of the Federal Reserve System, which
would contribute to goal 2.

PROPOSED DEVICES TO IMPROVE FEDERAL RESERVE CONTROL OVER THE
MONEY SUPPLY WHILE PERMITTING UNRESTRICTED USE OF THE WINDOW
This section discusses six devices that it is
believed would improve Federal Reserve
control over the money supply while permit­
ting unrestricted use of the discount win­
dow.

serves, which the Federal Reserve controls
largely through open market operations,
and the supply of demand deposits can be
traced primarily to variations in free re­
serves. Our primary concern in this section
is with methods of reducing such variations
while at the same time keeping the discount
window open to all creditworthy borrowers
willing to pay the price.
Other major sources of slippage— such

Sources of slippage between nonborrowed
reserves and the supply of demand deposits,
and how to reduce them

As is well known, the slippage that exists
between the volume of nonborrowed re­




61

62

as variations in the reserve ratio as a result
of shifts of deposits between banks with
different reserve requirements and between
member and nonmember banks, changes
in time deposits, and currency drain—
would not be affected by the proposed re­
forms except indirectly through goal 6
to be achieved (see description on the pre­
ceding page).
The operation of the discount window
obviously affects free reserves through bor­
rowing. It is reasonable to suppose that
the volume of bank borrowing is influenced
in part by the profitability of borrowing, as
measured by the spread between the dis­
count rate and short-term market yields;
this supposition is supported by the em­
pirical evidence. It is also generally agreed
that a rise in aggregate demand and eco­
nomic activity tends initially to be accom­
panied by a rise in short-term market yields
unless it is accommodated by a commen­
surate expansion of the money supply.1
Under these conditions, as long as the dis­
count rate is kept unchanged, a rise in de­
mand tends to increase the profitability of
borrowing; and since the rise in market
rates also tends to reduce the demand for
excess reserves, the result is likely to be a
reduction of free reserves and thus a pro­
cyclical movement in the money supply,
relative to nonborrowed reserves.
Under the present system this tendency
is, of course, moderated by various limita­
tions on the use of the discount window
through regulations, frowns, and suasion.
Such administrative limitations in turn seem
unavoidable so long as the discount rate is
changed only infrequently, permitting siz­
able fluctuations in the spread between it
and short-term market yields and corre­
sponding variations in the incentive to bor­
row. Furthermore, since changes in the dis­
count rate have tended to occur infre­
1 See the discussion on pp. 64-69.




quently, and often only after some debate
within the Federal Reserve System, they
have come to acquire a symbolic meaning
(even if often a rather obscure one) apt
to generate wide repercussions. And this
very feature in turn has contributed to the
practice of avoiding frequent changes in
the rate.
Clearly the source of slippage between
nonborrowed reserves and the money sup­
ply described above would be reduced if
the discount window could be redesigned
so as to minimize fluctuations in the incen­
tive to borrow. The simplest way to achieve
this result, of course, would be to shut the
window altogether. But this solution is
clearly inconsistent with preserving the es­
sential role of the central bank as a lender
of last resort. Individual banks must have
an outlet to which they can turn in case of
“justified need” and, similarly, some
methods must be provided by which the
banking system as a whole can manage to
satisfy reserve requirements in a way that is
not unreasonably painful.
However, there is no reason in principle
why borrowing from the discount window
should not involve some significant penalty.
Accordingly, one possible device to limit
substantially the use of the window would
be to set the discount rate at some level
substantially above short-term market rates.
There would then be an incentive for banks
to avoid the risk of having to borrow and to
repay promptly any borrowing that might
have been incurred due to miscalculations
of or unanticipated contractions in non­
borrowed reserves. Yet banks could be al­
lowed unrestricted use of the window sub­
ject only to normal and prudent standards
of creditworthiness, for use of the window
would be limited by the cost of borrowing,
without any need for fiat or frowns.
However, this approach has two major
drawbacks: (1) Since the “penalty” would

PROPOSALS FOR REFORM OF DISCOUNT WINDOW

depend on the relation between the dis­
count rate and market rates, it would still
be necessary, in order to keep the penalty
reasonably uniform over time, to change
the discount rate from time to time. And
that would perpetuate the announcement
effects. (2) The method would in effect
discriminate against small banks, which
cannot make effective use of the Federal
funds market as a source of funds. Indeed,
if the banking system as a whole were out
of debt, which presumably would be the
normal circumstance under a penalty-bor­
rowing rate, the Federal funds rate would
tend to hover below the discount rate and
around short-term market yields, say the
rate on 3-month Treasury bills (hereinafter
referred to as 3-month bills, or in some in­
stances, bills). Thus, individual banks hav­
ing access to that market could make up
their deficiencies at that cost. Yet the smal­
ler banks would have to pay the signifi­
cantly higher penalty rate.
It is suggested that these shortcomings
could be eliminated, while retaining the
basic idea of a wide-open window at a pen­
alty rate, by reorganizing the operation of
the window along the lines set forth in the
remainder of this section.
Outline of proposed reform— basic features

1. The window would be open to all
borrowers willing to pay the discount rate
as long as they met some appropriate tests
of creditworthiness. To avoid uncertainties,
each bank would be informed about the
maximum amount of accommodation that
it could expect to receive. The ceiling
would be reviewed at stated intervals, ex­
cept under special circumstances requiring
a reappraisal of the bank’s credit standing.
2. The borrowing rate would be tied
to a short-term market rate, say for the mo­
ment, the 3-month bill rate. This device
would eliminate sizable, discontinuous




63

changes in the discount rate and associated
announcement effects.
3. To maintain the penalty character
of the window, the borrowing rate would be
fixed at, say, last week’s bill rate plus a fixed
number of basis points, or plus a fixed per­
centage. Considerations relevant in setting
the size of the penalty are set forth later.
4. Borrowing at the window would be
for very short terms— usually for a single
day— although automatically renewable at
the option of the borrower.
5. To avoid discrimination against
smaller banks, the Federal Reserve would
provide, for such banks, accommodations
similar to those obtainable through the Fed­
eral funds (hereinafter abbreviated FF)
market. Specifically, those entitled to the
special accommodation would be allowed to
borrow at the window at a daily rate equal to
that day’s average FF rate plus a com­
mission, consisting of a fixed but moderate
number of basis points or a moderate per­
centage charge, as noted above. This facil­
ity could be provided for banks not exceed­
ing a certain size, or for those at particular
locations, or perhaps more equitably, for
loans not exceeding a stated modest size. If
the last device were adopted, one might
expect that this facility would, in fact, be
used only by the smaller banks with in­
adequate access to the FF market.
Elaboration of the proposal

It should be noted that the reform outlined
above is only part of a broader plan. In­
deed, what has been proposed so far would
be of no help in achieving goal 4 — im­
proved spatial allocation of bank credit. To
that end there is a separate proposal, de­
scribed in the last section, to provide facil­
ities for longer-term borrowing. Accord­
ingly, the rest of this section is concerned
only with the operation of the “1-day win­
dow.”

64

The first questions that need to be con­
sidered are: To what rate should the dis­
count rate be tied? How large should
the premium be? These two questions are
closely interrelated. Clearly, it would be
desirable to anchor the discount rate to the
yield of some market instrument of major
importance— one that has a broad, wellorganized market. This would insure that
the chosen rate would be “representative”
and relatively free of erratic movements.
From this point of view, the 3-month bill
rate would seem to be an obvious choice, at
least under present arrangements.
There are, however, two related prob­
lems to be considered. First, any specific
instrument may, at times, reflect special in­
fluences. Second, there are some delicate
issues involved in tying a 1-day rate to a
3-month rate, if at the same time borrow­
ing is unrestricted. In particular, “term
structure effects” (for example, expectations
of a fall in the 3-month rate) might make it
profitable to borrow short at a rate negligi­
bly higher than the 3-month rate.
To avoid these problems, it would seem
desirable to peg the discount rate substan­
tially above the 3-month bill rate. One
relevant guide in deciding on the size of the
premium is provided by the consideration
that, with a truly open discount window,
the discount rate, by and large, would set
the ceiling for the FF rate. In other words,
as the FF rate approached the discount rate,
the demand for funds would become highly
elastic as would-be borrowers turned to the
window. This consideration suggests that
the premium should be sufficiently large to
allow the FF rate to deviate from the bill
rate as much as might be justified by term
structure and other special circumstances
affecting the bill rate, without making it
“profitable” to borrow at the window.
While it is impossible to set an absolute
limit, the above considerations suggest a



premium on the order of 100 basis points,
a margin somewhat larger than the largest
amount by which the weekly average FF
rate has exceeded the 3-month bill rate in
recent years. (Unfortunately, this experi­
ence is a very limited one since, as is well
known, until early 1965 habits and con­
vention prevented the FF rate from being
bid above the discount rate; this, of course,
also tended to distort the relation of the FF
rate to other rates.)
With such a differential, one could ac­
commodate substantial variability in the
proper relation between the FF rate and
the short-term rate to which the discount
rate was tied, without creating incentives
to borrow at the window and hence without
causing undesirable flurries in the volume
of borrowing. An alternative, and probably
more effective, device to guard against this
source of difficulty is discussed below. It
would be to rely on a floating differential.
But first, it is well to examine more
closely both the long-run and short-run be­
havior of the proposed system,— assuming
the premium over the bill rate to be sub­
stantial but of fixed size. We propose to
show that, under this system, free reserves
would tend to fluctuate rather narrowly
around a substantially constant “equilib­
rium” level. In other words, while fluctua­
tions of free reserves would not be— and
should not be— altogether eliminated, de­
viations of free reserves from the constant
equilibrium level would set up strong forces
tending to move these reserves back toward
equilibrium.
Behavior of free reserves and supply of
demand deposits under the proposed system

The analysis that follows is based largely on
some very definite views as to the major
forces that shape banks’ portfolio manage­
ment and their use of the discount window,
as well as the behavior of short-term mar­

PROPOSALS FOR REFORM OF DISCOUNT WINDOW

65

to their equilibrium level tends to occur
gradually over time— somewhat along the
lines of the textbook description of the
process of expansion of deposits in response
to an initial disequilibrium. In addition, the
process of adjustment gets disturbed by the
changes under (a). Thus free reserves tend
to be high when there is an unforeseen in­
crease in nonborrowed reserves or an un­
foreseen slackening in the demand for com­
mercial loans, and to be low when the un­
foreseen changes are in the opposite direc­
tion.
The evidence referred to above also sup­
ports the view that changes in short-term
market yields (say, the 3-month bill rate or
the commercial paper rate) are accounted
for largely by the interaction of the supply
of demand deposits, controlled by the forces
outlined above, and the demand for demand
deposits, which is basically controlled by
current and past levels of income and short­
term market yields. It further suggests that
in the short run (say, a quarter or less) the
level of income is largely unaffected by
variations in the money supply or short­
term interest rates (at least as long as these
remain within realistic limits). It therefore
follows that, in the short run, the level of
short-term market yields is controlled, in
the last analysis, by the behavior of the out­
standing stock of demand deposits.
In light of the above interpretation of
bank behavior, we can examine first what
would happen to the “equilibrium” level of
free reserves under the proposed system. To
this end, it is convenient initially to ignore
operations at the special discount window
provided for small borrowings.
It should be evident that by floating the
2 See especially Modigliani, Rasche, and Cooper, discount rate sufficiently above short-term
“Central Bank Policy, the Money Supply, and the
market yields the desired or equilibrium
Short-Term Rate of Interest.” Journal of Money,
Credit, and Banking (May 1970). Other results are
level of borrowing can be brought essen­
contained in yet unpublished memoranda of the proj­
tially to zero, and this would be true regard­
ect; it is expected that these results will be published
in the near future.
less of the level of the short-term rate. (By

ket yields. These views in turn appear to
receive strong support from the empirical
analysis of recent experience undertaken
in the course of the MIT-Federal Reserve
econometric research on the working of
stabilization tools.2
This evidence supports the view that the
volume of free reserves outstanding at any
given time reflects two basic sets of forces:
1. An “equilibrium” component, to wit,
the desired or equilibrium level of free
reserves. This equilibrium level itself is the
difference between (a) desired excess re­
serves, which depend on short-term market
yields and tend to decrease as these yields
increase, and (b) the optimum volume of
borrowing at the window, which is basically
controlled by the spread between short­
term market yields— such as the FF rate
or the 3-month bill rate— and the discount
rate. (Note, however, that the FF rate is an
adequate measure of short-term yields only
for the very recent period when that rate
was not conventionally kept at, or below,
the discount rate.)
2. A disequilibrium component reflect­
ing the inability and/or undesirability
of banks to adjust instantaneously to un­
foreseen (or transient) changes in their de­
posits or in the demand for commercial
loans. The unforeseen changes in demand
deposits in turn reflect (a) unforeseen
changes in nonborrowed bank reserves due
to Federal Reserve operations and changes
in currency holdings (and time deposits),
and (b) the unforeseen effect on demand
deposits of expansion and contraction in
bank credit itself. Component (b) implies
that, even in the absence of the changes
under (a), the adjustment of free reserves




66

contrast, under the present system a rise in
market yields increases the equilibrium
level of borrowings unless, and until, coun­
teracted by a rise in the discount rate.)
It then follows that the equilibrium level of
free reserves would itself tend to be con­
stant except for the effect of market yields
on excess reserves. However, this effect ap­
pears to be fairly moderate, except possibly
for extremely low levels of market yields
where “liquidity-trap phenomena” could
become significant.3 Furthermore, even this
effect could be eliminated by the device of
paying interest on excess reserves, as is dis­
cussed in the last part of this section. But
even without this device we are led to the
conclusion that the equilibrium level of free
reserves would tend to be stable (and pre­
vailingly positive) under normal condi­
tions, except for some tendency to decline
mildly with the prevailing level of market
yields.
Finally, we may note that if the system
were in a position of equilibrium, with bor­
rowings near zero and excess reserves in
equilibrium, then one could expect the FF
rate to hover around the bill rate. More
precisely, in the absence of term-structure
effects (that is, if short-term rates were
anticipated to stay unchanged in the near
future), it should tend to be quite close to
the bill rate, although term-structure effects
could cause it to deviate, within limits, on
either side of the bill rate. This proposition
seems fairly obvious and can be supported
by a more rigorous analysis, which we need
not spell out here.4 The above consideras Analysis of recent years suggests that an in­
crease of 100 basis points in short-term yields—in,
say, the 3-month bill rate—tends to reduce excess
reserves by somewhat less than $50 million within
1 month and by somewhat less than $100 million
within one to two quarters.
4 The above conclusion rests on the assumption
that bills will continue to represent an important com­
ponent of secondary reserves and sources of short­
term liquidity. Should this premise lose its validity
and bills cease to be held by banks in significant




tions have the following implication, which
is important for an understanding of the
workings of the proposed reform: provided
the discount rate were set significantly
above the 3-month bill rate, and if the sys­
tem were in a position of equilibrium, the
FF rate could be expected to be signifi­
cantly below the discount rate.
We can now reintroduce the special
“Federal funds window” for small operators
and show that this does not significantly
change the above conclusion. We need ob­
serve only that those who are eligible to
use the special window and who find it
economical to do so would be borrowing at
a rate differing only by a small commission
from the rate available to any would-be
borrower; namely, the FF rate. Since the
relation between the FF rate and short-term
yields was just shown to be such as to in­
duce the banking system as a whole to hold
positive-free reserves, regardless of the level
of short-term yields, we can infer that this
relationship would provide the same incen­
tive to special borrowers as a whole. Hence,
these borrowers would also tend to hold a
positive and relatively stable amount of
free reserves; these reserves would prob­
ably exhibit some tendency to move in­
versely, but moderately, with the level of
market yields. Note, however, that the
amount of borrowing at the special, in con­
trast to the regular, discount window would
not be zero since some operators would on
the average be borrowing there, just as
many other banks would, on the average,
be borrowing from the FF market. All we
are asserting is that the net free reserve
position of the group as a whole would
tend to be stable.5
quantity—except for the purpose of satisfying col­
lateral requirements—then the bill rate would no
longer provide a reliable yardstick of short-term
yields and hence would no longer be a suitable rate
on which to anchor the discount rate.
5 This note appears on opposite page.

PROPOSALS FOR REFORM OF DISCOUNT WINDOW

67

(whether at the window or in the FF mar­
ket) relative to other short-term market
yields would put pressure on banks to re­
duce their asset portfolios, thereby shrink­
ing the supply of demand deposits and re­
quired reserves, until the borrowing had
been eliminated and free reserves had
moved back to equilibrium. In the process
short-term market yields would, of course,
tend to move up, which is presumably what
the Federal Reserve intended. But note that
this rise would not per se reduce the pres­
sure for the banking system to get out of
debt. Indeed, with the discount rate floating
above the bill rate, a rise in the latter would
not reduce the incentive for individual
banks to avoid a net borrowed position.
2. Suppose instead that the Federal
Reserve wished to expand the money sup­
ply and lower short-term market rates, and
accordingly brought about an unanticipated
expansion of nonborrowed reserves. Here
initially free reserves would exceed the
planned amount, causing an increase in sup­
ply and a fall in demand in the FF market.
This would lower the FF rate relative to the
bill rate, encouraging an expansion of
banks’ portfolios and the money supply and
leading to an increase in required reserves.
The incentive to expansion would persist
until free reserves had moved back to equi­
librium, and thus the FF rate had re-estab­
lished its equilibrium relation to the bill
rate. Here again the bill rate would pre­
5 At a more refined level of analysis, one should
sumably fall in response to bank expan­
recognize that the incentive structure would be a
little different for those operating at the special win­
sion, as intended. But this fall would not
dow. In the first place, if banks were short of reserves,
reduce
the incentive to expand the money
they would be paying somewhat more than the larger
operator using the FF market. In addition, they
supply until the additional reserves had been
would probably earn less if they were long on re­
absorbed by higher required reserves; for as
serves. In fact, small operators would probably tend
to hold any excess funds in the form of excess re­
long as free reserves remained above equi­
serves yielding nothing, instead of lending them in
librium,
the FF rate would tend to remain
the FF market where they would yield the FF rate
less transactions costs. (However, these qualifica­
below the rate on bills and other short-term
tions do not require modifying our conclusions that
instruments.
their “equilibrium” level of net free reserves would
tend to be stable though probably somewhat higher
3. By relying on the reasoning devel­
than for the larger operators, and probably also some­
oped earlier, one can also readily establish
what less responsive to variations in market yields.)
We can now examine the short-run, dy­
namic behavior of the model in response
to developments pushing it out of equilib­
rium. For analytical purposes we can distin­
guish between disturbances originating in
the economy and those originating from
Federal Reserve actions, although of course
in general both types of disturbances may
occur simultaneously and reinforce or offset
each other.
1.
Consider first the response of the
banking system to a situation in which the
Federal Reserve wished to hold down the
money supply and raise short-term market
rates. To this end the Federal Reserve
would force an (unanticipated) contrac­
tion in nonborrowed reserves (relative to
the normal seasonal and secular pattern).
As a result, free reserves would initially
fall short of the planned level. This implies
an increase in the demand for, and/or a
decrease in the supply of, funds in the FF
market, which would immediately raise the
FF rate. If the Federal Reserve action were
sufficiently strong, the shortage of reserves
would be such as to push the FF rate to the
ceiling provided by the discount rate. At
this point some banks would be induced to
borrow at the window, thus acquiring the
additional reserves needed to satisfy reserve
requirements (plus the demand for excess
reserves, probably somewhat reduced).
But now the higher cost of borrowing




68
that the pressures and responses described
in (1) and (2 ) apply equally to the subset
of “small” operators having access to the
special “Federal funds window.”
In summary, an (unanticipated) expan­
sion or contraction of nonborrowed reserves
would, initially, be reflected largely in op­
posite movements of free reserves and of
the FF rate, relative to the bill rate. But
this would be only a temporary and (appro­
priate) cushioning reaction. For the move­
ment of the FF rate in turn would generate
incentives to actions that would tend to
bring free reserves back to the initial equi­
librium (except for the small effect of the
change in short-term market yields on ex­
cess reserves). With free reserves moving
back to the original position, the supply of
demand deposits would tend to move commensurately with the change in nonbor­
rowed reserves. The final change in short­
term market yields (that is, the bill rate)
would then depend on the size of the change
in nonborrowed reserves and the (shortrun) elasticity of demand deposits with
respect to short-term yields.
4.
Consider next the effect of an in­
crease in the demand for money— an up­
ward shift in the demand schedule relating
money demand to short-term yields. This
would tend to raise short-term market
yields, unless the money supply increased.
But there could be no significant increase
in the money supply so long as the Federal
Reserve kept the level of nonborrowed re­
serves unchanged. Indeed, under these con­
ditions, the money supply could expand
significantly only through an increase in
borrowing. But since the rise in the bill rate
would be accompanied by a commensurate
rise in the discount rate, there could be no
incentive for banks to expand their borrow­
ings. With borrowing unchanged, free re­
serves would also be unchanged, except
again for a moderate decrease in response




to the higher market yields, and hence the
money supply would be basically un­
changed, as stated above. Needless to say, if
the Federal Reserve wished to prevent the
bill rate from rising, it could do so by sup­
plying additional reserves, in amounts suf­
ficient to increase the supply of demand de­
posits pari passu with the increased demand.
The reasoning can be repeated mutatis mu­
tandis, in the presence of a decrease in the
demand for money and falling interest rates.
5.
A different and very important type
of disturbance originating from, the econ­
omy would be an (unanticipated) surge of
demand for commercial loans. Banks, as
suggested earlier, would initially tend to ac­
commodate the increase without a commen­
surate reduction in the rest of their port­
folio. Hence, the supply of demand deposits
and required reserves would in the first in­
stance rise. But with nonborrowed reserves
unchanged, the system would be short of
reserves, and hence the FF rate would tend
to be pushed to the discount rate ceiling,
opening up the window to an amount of
borrowing needed to satisfy reserve require­
ments. But again the increase in the cost of
borrowing (whether at the window or in
the FF market) relative to short-term mar­
ket yields would generate an inducement for
banks to reduce their portfolios and the sup­
ply of demand deposits until the borrowing
had been eliminated and free reserves had
moved back to equilibrium. Of course, the
reshuffling of bank portfolios would likely
involve some net liquidation of bills and
other market instruments to accommodate
the expansion of loans, which would result
in some increase in short-term market
yields. But once more this would not modify
the incentive for the banking system to get
out of debt to the Federal Reserve since the
discount rate would be moving pari passu
with the bill rate.
Similar conclusions hold mutatis mutan­

PROPOSALS FOR REFORM OF DISCOUNT WINDOW

dis, if an unanticipated decline occurred
in the demand for loans.
The above analysis has one implication
that is worth noting. It should be apparent
that under the proposed reform a level of
free reserves in excess of the constant equi­
librium level would tend to be accompanied
by an expansion of the money supply. Fur­
thermore, the larger the excess, the larger
the rate of expansion of the money supply
would tend to be. Conversely, free reserves
below that constant level would tend to be
accompanied by a contraction of the money
supply at a rate commensurate with the
negative gap. The proposed reform would
thus tend to validate a view of long stand­
ing that there is a direct, reliable association
between the volume of free reserves and the
rate of change of bank credit and the money
supply. Yet, paradoxically, this view is not
warranted under the existing set-up in which
the equilibrium level of free reserves is not
stable over time because of variations in
the spread between the discount rate and
market yields. It is not inconceivable that
reliance on that unwarranted view may have
been responsible for certain past failures
in monetary management.
Choice of penalty rate— case for a sliding
differential

We are now in a position to set forth the
main considerations that would seem rele­
vant in setting the size of the differential be­
tween the discount rate and the bill rate,
or other short-term rate, to which it was
tied.
It follows from the analysis of the pre­
ceding section that the essential implication
of a large differential is that banks would
tend to find it undesirable to stay sub­
stantially in debt for extended periods. But
this means, in turn, that the volume of de­
mand deposits could be kept under close
control by the Federal Reserve through its




69

control over nonborrowed reserves (and re­
serve requirements). At the same time,
since a temporary shortage of reserves could
push the FF rate as high as the discount rate,
a large differential would imply the possi­
bility of substantial short-run variability of
the FF rate and related very short-term
market rates. By the same token, a small
differential would imply more limited vari­
ability of the FF rate but at the cost of
tolerating a larger and longer-lasting de­
parture of the money supply from the level
determined by nonborrowed reserves— that
is, in essence, a looser coupling between
nonborrowed reserves and the money sup­
ply.
The above considerations suggest that
the choice of the differential would be de­
pendent in large part on one’s view concern­
ing the nature of the monetary mechanism.
Those holding that the cutting edge of
monetary policy rests on the effects of such
policy on interest rates and related financial
yields would presumably be led to favor a
set-up that minimized unintended move­
ments of interest rates and hence to prefer
a relatively small differential. On the other
hand, those leaning toward the view that the
money supply affects economic activity di­
rectly might well be led to favor a system
that minimized unintended movements in
the money supply, even at the cost of
larger short-run fluctuations in interest
rates.
In my view, however, a reasonable choice
of differential does not really require set­
tling the thorny issue about the nature of
monetary linkages. For whatever one’s view
on that issue, presumably it is generally
agreed that departures from the intended
course, whether of the money supply or of
very short-term market rates, can have a
noticeable effect on the economy if they
persist— but not if they are ephemeral. And
this is particularly true once the rules of the

70

game are well understood and stable and
the participants have had a chance to adjust
to them.
Hence, insofar as purely transient dis­
turbances are concerned, the choice of the
differential is unlikely to be of real conse­
quence. On the other hand, in the case of
marked and/or persistent departures, the
Federal Reserve would soon have to reach
a decision as to whether the most suitable
response involved modifying the interest
rate target or the money supply target, or
some combination thereof. In such circum­
stances, the choice of the differential would
therefore control only the character of the
short-run, semiautomatic response of the
model, while the Federal Reserve made up
its mind as to the appropriate eventual re­
sponse.
In any event, the dilemma of choosing
between a high or a low differential could
be avoided by adopting a “compromise”
system, which should prove largely agree­
able to both points of view. The compro­
mise would consist of tying the discount
rate to the bill rate with a variable peg. Un­
der this scheme the differential would re­
main fixed at some base level as long as ag­
gregate borrowing at the discount window
remained below some stated amount. But if
borrowing were to exceed this amount, then
the differential would rise with the volume
of aggregate borrowing, according to a preestablished schedule.
By making the base level of the differen­
tial relatively modest, moderate and tran­
sient variations in the demand for money
could be absorbed by an elastic money sup­
ply, with minor effects on market yields.
This feature appears especially desirable in
light of the difficulty in determining reliably
the demand-for-money schedule, and hence
the supply of deposits appropriate to a cer­
tain level of short-term rates. Yet, larger
and more persistent disturbances, while still



initially accommodated at the window,
would be accompanied by a larger increase
in the differential cost of borrowing, which
would put pressure on banks to eliminate
rapidly at least a portion of their borrowing.
Such disturbances would thus tend to be
communicated promptly to interest rates,
unless of course the central bank decided to
accommodate the larger demand by increas­
ing the supply of reserves, thus reducing the
effect on interest rates.
Finally, it should be noted that while the
schedule of penalty rates would influence
the response to a tight money situation, such
a schedule would have little influence in
shaping the response to a loose situation,
characterized by a rise in free reserves. That
response would be controlled by the fall in
the FF rate below market yields and by the
speed with which banks would respond to
this situation by expanding their portfolios
of earning assets.
Possible minor improvement: payment of
interest on excess reserves

I have noted, in setting forth the anticipated
behavior of the banking system under the
proposed reform, that some variation in
free reserves would continue to be present
because of the negative association between
equilibrium excess reserves and short-term
market yields. Even this source of variation
in equilibrium free reserves could be largely,
if not totally, eliminated by the simple de­
vice of paying interest on excess reserves at
a rate tied to short-term market yields.
It is suggested that the most effective ar­
rangement would be to peg the interest on
excess reserves a certain number of basis
points (or a fixed percentage) below the FF
rate. (The differential could be thought of
as something in the nature of a commission
paid to the Federal Reserve Bank for in­
vesting the free reserves of the banks own­
ing them.)

PROPOSALS FOR REFORM OF DISCOUNT WINDOW

This arrangement could be expected to
have the following major effects: (1) If the
differential were made sufficiently large—
say on the order of 50 basis points, or even
somewhat larger— there would still be an
incentive, at least for larger banks, to invest
unneeded reserves directly in the FF market
to avoid the differential. Thus, one would
largely preserve a well-working FF market.
(2) Smaller banks not having ready access
to the FF market would be able to derive an
income from their reserve surpluses com­
mensurate with that earned by the larger
banks, except for a reasonable commission.
(3) Because those now relying on the FF
market as an outlet for their surplus funds
would gain less from this activity than under
the old system— to be precise, they would
earn the differential instead of the full FF
rate— one would expect that the equilibrium
demand for excess reserves would increase.
(4) But under the new system the amount
gained by investing surplus funds in the FF
market instead of keeping them as excess
reserves would become a constant— the dif­
ferential— that would be independent of the
level of the FF rate. Thus, while the equilib­
rium level of excess reserves would presum­
ably tend to be generally larger than under
the present system, it would become in­
dependent of fluctuations in short-term
market yields.
Even greater stability in the level of ex­
cess reserves could be achieved by use of a
sliding differential similar to that proposed
above for the discount rate. That is, the
differential would be kept constant as long
as excess reserves were below some stated
amount; but if excess reserves grew larger,
the differential could be increased— thereby
encouraging investment in the FF market,
which would lead to a lower FF rate, and
thus finally, through portfolio expansion, to
a reduction in excess reserves.
One important caveat must be entered




71

at this point. The stabilization of excess
reserves results from making the opportu­
nity cost of holding excess reserves in­
dependent of the level of market rates. How­
ever, a difficulty would arise if the FF rate
became so depressed as to be lower than the
posted differential. Under such circum­
stances, because the interest paid on excess
reserves cannot be less than zero, the dif­
ferential itself would have to be reduced—
which would lead to an increase in the de­
sired level of excess reserves. What this
means, of course, is that the payment of in­
terest on excess reserves is an effective sta­
bilizer of excess reserves only so long as the
banking system does not encounter liquid­
ity traps; but it affords no protection against
a liquidity trap.6
6 It would be possible, in principle, to design the
proposal so that it could afford some protection even
against situations of very low returns from invest­
ments and associated very low market yields. But
this would require the radical step of applying the
differential even when the FF rate were so low as to
imply a negative interest—or in other words, the
levying of a penalty—on excess reserves. The gen­
eral effect of such a penalty, of course, would tend
to be that of making it possible for market yields to
become extremely low—indeed in principle even
negative. This, in turn, would clearly be a useful
stabilizing mechanism. I must hasten to add, how­
ever, that it is hard to say just how effective this
mechanism would in fact prove to be. For one thing,
faced with a penalty on excess reserves, banks not
finding any adequately yielding market instrument
might endeavor to turn depositors away. It is unlikely
that they would refuse deposits outright—because of
long-run considerations. They might instead have
recourse to service charges aiming at the same re­
sults. But this would still be a stabilizing influence
for it would imply a negative return for holding
money—a storage charge—which again would fa­
cilitate bringing market rates to very low or even
negative levels and would encourage investments in
real assets.
A great danger is the possibility that banks might
artificially increase their deposits, in order to absorb
excess reserves, by making fictitious loans to cus­
tomers. It is impossible to predict just how wide­
spread such a practice might become, what its
effects might be, and how it could be prevented or
limited. However, it hardly seems worthwhile to
dwell on the issue of a penalty on excess reserves
because, for the moment at least, the likelihood of
short-term market yields being so low as to create
real problems seems rather remote.

72

PROPOSAL FOR SPECIAL BORROWING FACILITIES AIMED AT IMPROVING
THE SPATIAL ALLOCATION OF BANK CREDIT
This section describes in brief fashion a
proposal for creation of special borrowing
facilities, the purpose of which would be to
improve the allocation of bank credit— that
is, goal 4.
Proposal outlined

The reform sketched in the previous sec­
tion would go a long way toward achieving
the first three goals set forth in the first
section. But it would do little toward goal 4
— improvement of the spatial allocation of
bank credit— except possibly insofar as it
would tend to make more uniform across
the banking system the cost of very short­
term borrowing and the rate of return from
very short-term lending.
In order to achieve goal 4 and as a
further contribution to goal 3, I would
like to advance a second proposal, the adop­
tion of which, incidentally, would be largely
independent of the implementation of the
reform set forth in the previous section. The
essence of the proposal is to set up a second
discount window (hereinafter referred to as
the “term window”) — one that would grant
credit for an essentially fixed term, say 3
months, not repayable until maturity (ex­
cept under special circumstances and/or
with some appropriate penalty). The term
window, too, would be open to any bank
willing to pay the price, up to some limit
determined by a creditworthiness standard.
At the same time, lending conditions would
again be structured so as to stabilize the
amount of borrowing, making it independ­
ent of the level of short-term market yields
or of other indicators of monetary string­
ency. But in contrast to the fiui window,
which would be designed for minimum
usage, the term window would be de­




signed to function as a substitute for an
interbank loan market; to perform this func­
tion on an adequate scale, the volume of
borrowing outstanding might have to be
substantial.
A market for interbank lending seems to
have developed only to a very limited ex­
tent, except for overnight lending in the FF
market and through the correspondent
banking system— a rather surprising phe­
nomenon considering the large number
of banks that make up the U.S. banking
system. To be sure, a satisfactory spatial
allocation of funds could be achieved even
in the absence of interbank lending, if there
were adequate devices by which banks
could attract funds from “surplus” areas to
“short” areas. But until rather recently such
a possibility has been very much limited by
the levels of ceiling rates on time deposits
and the prohibition of interest payments on
demand deposits. More recently, increases
in ceilings on time deposit rates and the
development of a market for CD’s have pre­
sumably led to some improvements. But
there is reason to believe that even these
developments fall short of adequacy since
the CD market is, in practice, accessible
only to large, prime banks. The proposed
term window could also be regarded as a
device to extend to smaller banks facilities
that are analogous to those provided by the
CD market.
How the term window could contribute to
allocative efficiency

Before inquiring how the terms of borrow­
ing could be set so as to reconcile the goals
of an open and extensively used window
with that of a stable volume of loans out­
standing, it would be well to ascertain in

PROPOSALS FOR REFORM OF DISCOUNT WINDOW

what sense the existence of the term window
could be expected to improve the spatial
allocation of bank credit.
Basically, the answer lies in the consid­
eration that a window open to all on the
same terms would tend to equalize the op­
portunity cost of funds among banks, and
hence presumably also the terms on which
credit would be available to would-be bor­
rowers. It might be argued that this uni­
formity already tends to prevail, in the sense
that under the present system all banks have
the opportunity to invest in a common set of
market instruments, and— what is more im­
portant— they all do invest, by and large,
in certain instruments such as Treasury
bills. It would therefore appear that the
Treasury bill rate represents the common
opportunity cost for all banks. But this, in
fact, is not a valid inference because such
bills are held not merely for their cash in­
come but also, in part at least, to satisfy
liquidity requirements (as well as certain
other requirements). One rather striking
piece of evidence in support of this proposi­
tion is provided by the observation that
many banks holding some bills in their port­
folios have been willing to issue CD’s at a
significant premium over the rate on bills.
We must conclude then that, even though
the cash yield is the same for all holders,
the “total” yield, including the “liquidity”
component, need not be the same. It fol­
lows that the opportunity cost of funds in­
vested in other assets need not be the same
for all banks, even if they all hold bills. In
particular, one would expect that when
banks are compared on the basis of the
relation of their supply of funds for lending
relative to their lending opportunities, the
opportunity cost would be higher for banks
with lower supply-to-demand ratios than for
banks with higher ratios.
Under these conditions we might expect




73

that if banks that are relatively short of
funds were enabled to borrow from banks
with excess funds at a rate somewhat above
the current bill rate they would, within some
limits, tend to take advantage of this oppor­
tunity. The borrowing banks would then
use the funds for expanding their loan port­
folios (and possibly even their portfolios of
short-term market instruments). For the
lending bank the investment in the loan
would presumably displace other assets, in­
cluding some loans. And the redistribution
of loans would presumably increase alloca­
tive efficiency.
The proposed term window would ac­
complish the same general result, although
by a somewhat different route. Suppose the
rate at the term window had been set some­
how and that at this rate banks would bor­
row a certain volume of funds with which
to expand their loans. In order to accom­
modate this demand, while keeping total
reserves unchanged, the Federal Reserve
would have to liquidate some of its port­
folio of market instruments. This would
raise market yields, thereby encouraging
some banks— presumably those better sup­
plied with funds— to acquire market instru­
ments at the expense of their other invest­
ments, including loans. Thus, the final effect
would be a redistribution of loans from
more amply provided to less well-provided
areas through a somewhat circuitous route.
In other words, the surplus bank would
choose as a substitute for direct loans to its
regular customers not loans to the less wellsupplied customers of other banks but
rather market instruments such as Treasury
bills; such purchases by the bank with sur­
plus funds would enable the Federal Re­
serve to exchange securities for cash, which
it would lend to the “short” bank, which in
turn would use those funds to expand its
loans.

74

It might be noted from the above that
one implication of the proposed reform
might well be an increase in the yield on
market instruments, especially short-term
ones such as bills. As is well known, this is
an effect that typically tends to accompany
any restructuring of the financial system, the
result of which is more reliance on pure
price rationing and less on other forms of
rationing. It also follows from this analysis
that the improvement in allocative efficiency
one might expect from the proposed reform
would depend on the views one had about
the effectiveness of present arrangements
for the spatial allocation of funds.
Operational aspects

Having thus laid out the basic argument in
favor of a term window, we can take up the
problem of how to achieve simultaneously
an open window and a substantial and yet
relatively stable volume of borrowing.
Abstracting for a moment from “practi­
cality,” one could readily suggest a device
that would accomplish the desired aim. Spe­
cifically, one could auction off on a regular
schedule, say every week, a block of funds
equal to the volume of loans that would
come due in that week, somewhat along the
lines of the present bills auction.
This approach probably deserves con­
sideration in the light of the experience
gained with the bills auction. Major draw­
backs might be (1) administrative com­
plexity and (2) the fact that the auction
might again give an edge to the larger
banks, which are better equipped to partici­
pate in it. It is hard to say without further
careful study how serious these shortcom­
ings might be.
As an alternative, it may be possible to
“simulate” closely an auction by a device
similar to that suggested for the 1-day win­
dow: reset the borrowing rate at frequent




intervals— say, once a week— and tie that
rate to a short-term market rate— say, the
3-month bill rate or the CD rate— with a
flexible differential, one that increases as the
volume of borrowing increases.
With this arrangement one could not al­
together avoid some variations in the vol­
ume of borrowing, but the variations could
be kept within moderate bounds. One im­
portant feature that would tend to insure
this result is that the shrinkage in the vol­
ume outstanding in any given week could
not exceed the amount reaching maturity.
Assuming a 3-month maturity, this amount
would be approximately 1/13 of the out­
standing volume. Furthermore, since this
window would not be designed as a device
for meeting short-run reserve requirements
(which would be handled through the 1-day
window), it would be quite appropriate to
require that applications for loans to be
taken down in a given week be filed some
time in advance. Under these conditions the
Federal Reserve would know in advance
how much variation in the volume of bor­
rowing at the term window would occur in
each week and could, if it wished, offset
such variations by open market operations.
One could readily conceive of slightly
more complex designs. For instance, the
window could announce, say, 2 weeks
in advance two or more possible rates and
ask for preliminary applications at each of
the indicated rates. On the basis of this
information it could set a final rate 1 week
in advance and could accept as final all ap­
plications received at that rate. In short,
it should not prove too difficult to design a
system that would minimize fluctuations in
the volume of borrowing outstanding and
that furthermore could offset any remain­
ing fluctuations through open market policy.
It should be noted in this connection that
there is little reason to be concerned with

PROPOSALS FOR REFORM OF DISCOUNT WINDOW

the danger that, in slack periods, the volume
of borrowings would shrink beyond con­
trol. In fact, with a variable differential one
could always go so far as to push the rate
to a level below the bill rate, at which point
the volume of borrowings would obviously
become highly elastic because any bank
could make a “hedged” profit by borrowing
and using the proceeds to buy bills. (It is
an open question whether under such con­
ditions it would be preferable to let the
borrowing shrink and to let the central bank
purchase bills through open market opera­
tions.)
How large a target volume of borrowing?

It should be apparent from the preceding
discussion that the smaller the target volume
of borrowing, the easier the task of mini­
mizing fluctuations in reserves caused by
fluctuations in borrowings at the proposed
term window. But it should be equally ap­
parent that keeping the volume of borrow­
ing low would reduce the effectiveness of
the proposal in achieving a better spatial al­
location of bank credit.
To see how far these goals might be
reconciled we might first ask this question:
If one neglects the problem of stabilizing
borrowing, how large a volume of borrow­
ing at the term window might, in the long
run, be optimal? An answer to this question
might be obtained by pursuing the idea that
for smaller banks the term window should
provide an alternative to the CD market.
This criterion suggests the following an­
swer: The volume of borrowing should be
such that the rate necessary to induce it
would be somewhat above prevailing CD
rates for a maturity comparable to that of­
fered at the window.
To understand the rationale for the sug­
gested criterion, we may first note that a
term-window rate close to the CD rate




75

would tend to equalize roughly the oppor­
tunity cost of funds for all banks that were
issuing CD’s and/or using the window. To
be sure, for banks not using either device
the opportunity cost could be lower, pre­
sumably as low as the bill rate. However,
since CD rates have tended, at least so far,
to stay reasonably close to the bill rate, the
difference in opportunity costs would re­
main within modest limits. At the same
time it should be recognized that a lower
rate at the term window would hardly be
feasible, unless the window were somehow
closed to banks issuing CD’s— which would
seem quite undesirable and even inconsis­
tent with the spirit of the proposal. The
reason is that, with a completely open win­
dow, the borrowing rate would tend to set a
ceiling on the CD rate. Or to look at this
from a different angle, the demand for bor­
rowing at the term window might be ex­
pected to become very elastic as the rate
approached the CD rate.
These considerations suggest an opera­
tional and pragmatic approach toward the
development of the term window. Suppose
the Federal Reserve started out with a fairly
modest target, say around $2 billion to $3
billion, which would imply a weekly turn­
over of $150 million to $200 million. If it
then turned out that the rate needed to clear
that volume of borrowing were on the
average substantially above the CD rate,
one could make two inferences: (1) that
the window seemed to be contributing sig­
nificantly to an improved allocation, filling
a function not performed by present institu­
tions (this inference could of course be
further tested by examining the distribution
of borrowing among banks and the ap­
parent use made of the marginal funds ac­
quired); and (2) that there was a primafacie case for moving in the direction of
increasing the target. It would then be pos­

76

sible to plan to have such an expansion oc­
cur gradually over time as experience was
gained with operation of the window and
with problems that might conceivably arise.
If on the other hand, even with a modest
target, one should find that the rate tended
to hover close to the CD rate and that the
window was being used by banks that could
have issued CD’s, then one could infer that
the target should be reduced, or even that
the reform was contributing so little to the
improvement of the system as to justify
abandoning it.
Some minor complementary suggestions

1. It would seem appropriate to make
the term window available only to banks
that are members of the Federal Reserve
System. This limited-availability feature,
when coupled with the payment of interest
on excess reserves (and a graduated system
of reserve requirements), could go some
distance toward providing an incentive for
nonmember banks to become members,




contributing to a better control of the money
supply and short-term market rates.
2.
One could relax the requirement
that all borrowing at the window be for a
single fixed term and allow some choice of
terms, say between 2 and 6 months. The
rate for such loans could be tied to rates
for the corresponding maturities on the
chosen market instruments, be it CD’s or
bills, through a single differential applied
to all maturities. However, this greater flexi­
bility would complicate the task of stabiliz­
ing the volume of loans maturing in any
given week. It is not clear that this refine­
ment is worth the cost since banks could
presumably manage, through other transac­
tions in short-term markets, to reconcile a
fixed-term borrowing with their require­
ments. If the volume of borrowing at the
window were sufficiently large, one might,
as an alternative, conceive of developing
some sort of secondary market, with or
without the participation of the Federal
Reserve.

AN EVALUATION OF SOME DETERMINANTS OF MEMBER
BANK BORROWING
Leslie M. Alperstein
Board of Governors of the Federal Reserve System

Contents
Summary of Findings and Conclusions__________________________________________ 80
Design of the Study_________________________________________________________ 82

Data
Description of explanatory variables
Results___________________________________________________________________ 83

Cross-sectional analysis
Time-series analysis




77




AN EVALUATION OF SOME DETERMINANTS OF MEMBER
BANK BORROWING

borrow, sensitivity to interest rates has tra­
ditionally been a popular determinant. The
literature from time to time has reflected
discussions, both theoretical and empirical,
on the influences of interest rate spreads on
banks’ sensitivity to borrowing. Interest
rates are examined closely for their influence
upon borrowing per se, as well as for their
degree of interaction with other determi­
nants of borrowing.
A discussion dating back only a few years
centered around the effects on member bank
borrowing of possible differences in the ad­
ministration of the discount window among
the various Federal Reserve districts. In
order to facilitate a closer look at this prob­
lem, an attempt is made to distinguish be­
tween supply and demand factors in deter­
mining borrowing among several Federal
Reserve districts.
The variables tested for their significance
in explaining borrowing from the Federal
Reserve and borrowing from other sources
were: (1) a liquidity ratio, designed to re­
flect the banks’ ability to meet loan de­
mands and unexpected deposit withdrawals
out of internally generated short-term as­
sets; (2) an interest rate differential be­
tween the discount rate and the 3-month
Treasury bill rate, to reflect the impact of
banks’ response to least-cost considerations;
(3) the size of the bank, to indicate dif­
ferences in the likelihood that some banks,

The major focus of this paper is to identify
the determinants of member bank borrow­
ing and to measure the relationships that
exist among these determinants. Regression
analysis is used to contrast various forms of
borrowing from the Federal Reserve with
borrowing from sources other than the Fed­
eral Reserve. The methodology was selected
so that it would be possible to assign meas­
urable weights to the casual factors felt to
be most responsible for borrowing and then
to compare for differences in the ability of
these factors to explain variations in bor­
rowing from alternative sources.
It is becoming increasingly clear that the
distribution of financial assets throughout
the banking system can materially affect the
speed and effectiveness of a given mone­
tary policy. Banks of various sizes may be
expected to respond differently over the
business cycle to changes in financial vari­
ables such as liquidity and interest rates.
To the extent that banks react to fluctuating
credit conditions by adjusting their liquidity
positions, they can affect to a significant
degree the amount of borrowing and credit
expansion that takes place. Consequently,
both bank size and liquidity are examined
in this paper and tested for their signifi­
cance in explaining different types of bor­
rowing.
Insofar as the structural characteristics
of banks that borrow from the Federal Re­
serve influence the degree to which they




79

80

for example those associated with financial
centers, might be less reluctant than others
to borrow from the Federal Reserve; and
(4) Federal Reserve district, to shed light
on the problem of alleged differences in the
administration of the discount window.
To lessen the degree to which the statis­
tical results would be affected by problems
associated with aggregated data, the initial
part of the study examined the borrowing
behavior of individual banks. Tests were
made on weekly reporting member banks for
six Federal Reserve districts during the
period July 1959 to October 1961.
The tests were divided into two parts:

cross-sectional analyses and time-series
analyses. The cross sections estimated the
relationship between the likelihood of bor­
rowing by a particular bank and factors as­
sociated with its indebtedness. Additional
cross sections estimated the relationship be­
tween the frequency of borrowing from the
Federal Reserve and the postulated deter­
minants of borrowing.
The time-series regressions estimated the
relationship between borrowing and the in­
dependent variables— liquidity, size, and
district— and then with the addition of the
temporal variable, the interest rate differen­
tial.

SUMMARY OF FINDINGS AND CONCLUSIONS
The results of the cross sections and the
time-series regressions suggest that the
liquidity condition of a bank’s short-term
asset portfolio, as well as the interest dif­
ferential between the discount rate and the
bill rate, contributed significantly toward ex­
plaining variations in borrowing. Of the two
factors, liquidity had a greater impact on
borrowing in all of the periods studied; but
in those periods when the discount rate was
less than the bill rate, the importance of
liquidity as an explanatory factor dimin­
ished somewhat in favor of the interestdifferential factor.
The behavior of the liquidity and interestdifferential variables supports the least-cost
hypothesis; that is, that banks, in general,
are sensitive to interest rate differentials to
the extent that they will borrow from the
least expensive source even when that source
is the Federal Reserve. In the period when
the bill rate exceeded the discount rate, the
ability of the bank liquidity variable to ex­
plain the likelihood of indebtedness to the
Federal Reserve was only about half as
great as when the discount rate exceeded
the bill rate. This suggests that banks are




less reluctant to borrow from the Federal
Reserve when it is the least expensive alter­
native source of funds.
During the period studied, banks bor­
rowed more often when it was profitable
to do so. The frequency of borrowing from
the Federal Reserve was negatively asso­
ciated with liquidity, corroborating the re­
sults of the conditional probability esti­
mates. Banks with relatively higher levels
of liquidity were more likely to borrow,
and borrow more often, from the Federal
Reserve when the bill rate exceeded the
discount rate. The cross sections demon­
strated that in the period when the bill rate
exceeded the discount rate (rb > rd) banks
were less willing to sell Treasury bills as a
secondary source of reserves and shifted in­
stead to the Federal Reserve.
The time-series regressions supported the
inferences made from the cross-sectional
analysis. When the interest rate differential
was explicitly included in the regressions,
banks were found to be sensitive to varia­
tions in the interest rate spread as well as
to variations in liquidity levels. Inasmuch as
aggregate data can sometimes mask the ef­

DETERMINANTS OF M EMBER BANK BORROWING

fects of microrelations, it is not immediately
clear whether the variations in relative
amounts of borrowing were being caused by
the same number of banks borrowing greater
amounts, the same number of banks bor­
rowing the same amounts but more often,
or fewer banks borrowing greater amounts.
To distinguish between these effects, an
estimate was made of the proportion of
banks in each Federal Reserve district that
were borrowing over time. The results in­
dicated that the number of banks per district
as well as the relative amounts of borrow­
ing from the Federal Reserve increased
when the discount rate was the least-cost
alternative.
On the basis of the regression results, it
was concluded that for the period studied
the incentive of banks to borrow stemmed
from the liquidity condition of their short­
term assets as well as, and to a lesser ex­
tent, the profitability of borrowing. It can­
not be concluded from these results that
banks borrow from the Federal Reserve to
reinvest in short-term Government securi­
ties. It was demonstrated that Treasury
bills were liquidated in periods when the
bill rate exceeded the discount rate. The re­
sults would have been the reverse if banks
had been engaged in “profiteering.”
Among the other determinants, bank
size was shown to have a significant, al­
though uncertain, effect on borrowing from
the Federal Reserve. Although considerable
differences were found to exist among banks
of varying sizes with respect to their likeli­
hood, as well as to their frequency, of bor­
rowing, no discernible pattern emerged
among size groups. Borrowing from other
sources, however, was found to increase
with size, a result which was not unexpected.
There were variations among Federal Re­
serve districts in relative amounts of bor­
rowing from the Federal Reserve, in the




81

proportion of banks borrowing, and in the
frequency of borrowing per bank. These re­
sults suggest the existence of other causal
factors not explicitly considered, such as
those with characteristics of demand or supply.
If nonuniformities in the administration
of the discount function were responsible
for the disparate pattern of borrowing among
districts, this pattern would be expected to
differ substantially from a market in which
nonprice rationing was nonexistent. Banks
are not precluded from borrowing else­
where, for example the Federal funds mar­
ket, on grounds other than price constraints
or smallness of transaction. Therefore, the
patterns of ex post borrowing among dis­
tricts between a price-determining market
and the discount window would differ to
the extent that funds were more accessible
at some discount windows by virtue of
easier lending policies. Although the six
districts differed substantially with respect
to borrowing from the Federal Reserve
after liquidity and cost were taken into
account, there was a similarity in the bor­
rowing for each district by type of borrow­
ing. The cross-sectional findings indicated
that roughly the same patterns of borrow­
ing existed among Federal Reserve districts
for borrowing from the Federal Reserve and
for borrowing from other sources. The timeseries analyses indicated that the patterns
of borrowing were precisely the same after
taking into account the liquidity condition
of the district as a whole and the interest
rate differential.
This does not prove that supply factors
are of no importance in the determination of
differences in borrowing among districts, but
rather that for the period of time covered
and the districts involved, differences in
demand explained to some degree the im­
portance of the Federal Reserve district as
a determinant of borrowing.

82

DESIGN OF THE STUDY
Data

The sample consisted of nearly all weekly
reporting member banks in the six Federal
Reserve districts for which adequate data
were available: Boston, Richmond, St.
Louis, Minneapolis, Dallas, and San Fran­
cisco. Banks for which complete records
were not available for one reason or another
were dropped from the sample. The Bank
of America was dropped because it was
believed that this bank was not of the same
nature as the other banks in the sample
and, because of its size, might bias the re­
sults.
Each bank was checked for changes in
structure. Banks that merged during the
period July 1959 to October 1961 were
deleted. When the sample of banks was
finally completed, the raw data from the
weekly balance sheets were averaged for
2-week periods, giving 35 biweekly observa­
tions for each of the 143 banks.
Information on interest rates was ob­
tained from the Federal Reserve Bulletin
and from Section 12 of the Supplement to
Banking and Monetary Statistics, 1966.
Special calculations required for weekly
averages of daily figures on 3-month Treas­
ury bill rates were made available by the
Government Finance Section of the Board’s
Division of Research and Statistics.

coin + Balances in banks in the United
States — Borrowing from the Federal Re­
serve — Lagged borrowing from, others) to
(Demand deposits adjusted + Time de­
posits — Required reserves).
The approach taken in this study is to
regard the maintenance of good bankercustomer relationships as the deciding fac­
tor in assessing the short-run “needs” or
liquidity of the bank. Accordingly, bankers
will alter their optimum asset portfolio in
order to accommodate customers who they
feel have long-run profit potentials out­
weighing current considerations.
P, measure of the cost of borrowing from
the Federal Reserve in contrast to borrow­
ing from other sources
where P — (rd — rb), rd = the discount
rate, and rb = Treasury bill rate. When
(rd — rb) is negative, there is a negative
cost associated with borrowing from the
Federal Reserve.
Li, measure of the bank’s demand deposit size
where Li = under $25 million; L2 = $25
million to $50 million; L3 = $50 million to
$100 million; L4 = $100 million to $300
million; L 5 = over $300 million.
In the regressions, the Li’s are represented
by dummy variables.

Description of explanatory variables

C, dummy variable indicating the bank’s
reserve classification

The variables used to explain the various
forms in which borrowing is presented in­
clude the following:

where reserve city banks were assigned a
value of 1 for variable C, country banks
were given a value of 0.

LQ, measure of a bank’s liquidity

Di, dummy variables representing the six
reserve districts

where LQ = the ratio of: (Loans to domes­
tic commercial banks + Loans to brokers
and dealers for purchasing or carrying other
securities + Treasury bills + Currency and




where D i = Boston; D 5 = Richmond; D 8
= St. Louis; D 9 = Minneapolis; D u = Dal­
las; D i 2= San Francisco.

83

DETERMINANTS OF MEMBER BANK BORROWING

RESULTS
Cross-sectional analysis

August 19, 1959

Ordinary least-square regressions were used
to ascertain if, and to what extent, a rela­
tionship existed between a bank’s borrow­
ing from the Federal Reserve and such
characteristics as size of bank, Federal Re­
serve district, and the liquidity position of
the asset portfolio. The conditional prob­
ability estimates predicted the likelihood of
nonzero borrowing. In addition, they served
to indicate the nature of the relationship
between the independent variables and the
likelihood of borrowing; that is, would
banks in one particular district be more
likely to borrow than those in another.
Likelihood of indebtedness. Four cross sec­
tions were taken: two for dates when the
Treasury bill rate was greater than the dis­
count rate— August 19, 1959, and Decem­
ber 23, 1959— and two for dates when the
bill rate was less than the discount rate—
July 22, 1959, and March 16, 1960. Esti­
mates were made for the likelihood of bor­
rowing from the Federal Reserve (Bf) and
from other sources (B0). The final equa­
tions for the conditional probability esti­
mates were:1

(2) Bf =

July 22, 1959

(1) B , =

.195 - .110(Di)
(.370)
(.119)
- .088(Ds) + .208(Do) + .017(Dn)
(.118)
(.136)
(.116)

-

.084(Di2) + .224(L 2 )* + .126(L3)
(.121)
(.090)
(.100)

+

. 1 5 3 ( 1 , 4 ) - . 0 7 4 ( 1 * ) - .001 (L Q )*
(.093)
(.145)
(.000)
i?2 = .152, F = 2.360*
December 23,1959

(3) Bf — .313 - .105(Di)
(.402) (.128)
-

.031 (D8) - .001 (Do) - .066( Du)
(.129)
(.144)
(.125)
- .129(Di2) + .07 3(1,2 )+. 030(L3)
(.130)
(.097)
(.111)

+

.147 (Li) — .154(1,5) — .001 (LQ)*
(.400)
(.149)
(.000)
R 2 = . 079, F = 1.126
March 16, 1960

(4) Bf = .624 - .236(Di) — .154(D S)
(.465)
(.149)
(.150)
- .058(Ds) — .038(D n) — ,184(Di2)
(.170)
(.147)
(.154)
+ ,052(L 2) + .0 8 7 ( L 3) - .065(1,4)
(.110)
(.130)
(.117)
+ . 1 2 2 ( 1 * ) - .002( LQ) *
(.206)
(. 0 0 0 )
R 2 = .113, F = 1.674

.549 - .353(Di)*
(.439)
(.141)
- .203(Ds) + ,039(Dg) — .115(D u)
(.140)
(.160)
(.137)
- .224(Di2) + .256(1,2)* + .108(L3)
(.141)
(.107)
(.121)
+ .194(L 4) + .015 (Ls) — .0 0 1 (L g )*
(.116)
(.161)
(.000)
R 2 = .203, F = 3.352t

+

1 In all of the equations * indicates significant at
.05 level of confidence and f indicates significant at
.01 level of confidence. Standard errors are in paren­
theses.

R 2 = .317, F = 6.121+




July 22, 1959

(5) B0 = .399 - . 0 5 4 ( D i ) - .099(D 8)
(.422) (.135)
(.135)
+ .180(D9) - .024(D u) — .235(D 12)
(.155)
(.132)
(.137)
.22 6(1,2 )* + .251 (L3)* + .493(L O t
(.1 0 2 )
(.116)
(.1 1 2 )
+ .533(L5) * - .002( LQ) *
(.155)
(.000)

84
August 19, 1959

(6) B o = .388 + . 0 3 3 ( D i ) - . 0 2 2 ( D s )
(.392)
(.126)
(.125)
+ .201 (De) + ,024(D u) — .175(Di2)
(.143)
(.123)
(.128)
+

.273(La) * + .279(L3)* + .595(L4) f
(.095)
(.106)
(.099)
+ .609 (L5)* — .002 (L<2) *
(.154)
(.000)
R 2 = .404, F = 8.934f
December 23, 1959

(7) B0 = .144 - . 0 2 2 ( D i ) + .122(D8)
(.384) (.123)
(.123)
+

.236(D») + .020(D U) + .077 (Du)
(.137)
(.120)
(.126)
+ ,374(L 2) f + 189(L3) + .680(L4) t
(.093)
(.103)
(.094)
+

.491 (L b) * - .001 (LQ )*
(.153)
(.000)
R2 = .407, F = 9.071t
March 16, 1960

(8) B0 =

.365 - ,1 06 (D i)— .017(D8)
(.379) (.121)
(.121)
+ .004(A)) — .008( D u ) - .098(D 12)
(.138)
(.121)
(.123)
+ .260(L2) f + ,409(L3) t + .572(L4) t
(.091)
(.104)
(.095)
+

.706(1*) t - .002(L<2)*
(.157)
(.000)
R 2 = .442, F = 10.484+
Of the eight regressions, six revealed the
presence of debt as being significantly related
to the three characteristics: size, district,
and liquidity. On each date borrowing from
other sources was more fully explained by
the independent variables than was borrow­
ing from the Federal Reserve. This was to
be expected, however, as certain unobserv­
able variables would affect borrowing from
the Federal Reserve in a different way than
borrowing from other sources. For instance,
an ostensibly important factor, the profit




spread, has not been considered explicitly.
Differences in the availability of funds from
the discount window in contrast to other
sources would also affect the ability of the
independent variables to explain borrowing.
It is inferred, therefore, that the relatively
lower R 2’s for borrowing from the Federal
Reserve are explained at least in part by
factors that constrain borrowing from the
Federal Reserve but not borrowing from
other sources; to wit, reluctance to borrow
and availability of supply.
In the two equations that showed a sig­
nificant relationship between borrowing
from the Federal Reserve and the factors
determining the likelihood of borrowing,
each of the variables was tested to determine
its net contribution in explaining the total
variation in indebtedness. The partial rela­
tionships for borrowing from the Federal
Reserve and borrowing from other sources
are given in Table 1. These partial relation­
ships indicate the amount of explanation
contributed by the addition of the factor
considered.
All three variables— liquidity, district,
and size— were found to contribute to the
explanation of borrowing. Worth noting are
the differences in impact of the independent
factors on borrowing from the Federal Re­
serve in contrast to borrowing from other
sources.
In terms of the size of the partial coeffi­
cient of determination, the Federal Reserve
district made the largest contribution to the
explained variation in borrowing from the
Federal Reserve. By comparison, the district
played a much smaller role in borrowing
from other sources, while size explained
most of the variation. On August 19, 1959,
when the bill rate was greater than the dis­
count rate indicating that banks could bor­
row more cheaply at the discount window,
the partial correlation coefficient for the

DETERMINANTS OF M EM B E R BANK BORROWING
TABLE 1
PARTIAL RELATIONSHIPS OF CONDITIONAL
PROBABILITY ESTIMATES OF BORROWING FROM
THE FEDERAL RESERVE AND FROM OTHER
SO U RCES1
Variables in
regression

Added
variable

July 22, 1959
Di

Li

Li

Di

Di

LQ

L{

LQ

d vlq

Li

l vlq

Di

D i Li

LQ

Partial coefficient of determination
Federal Reserve

Other sources

.065
(2.32)*
.010
(2.66) f
.083
(12.29) f
.082
(12.18) f
.052
(1.82)
.080
(2.28) *
.070
(9.93) f

.214
(9.04) f
.092
(2.69) t
.163
(26.38) f

.061
(2.16) *
.079
(2.28) *
.029
(4.06)f
.041
(1.57)
.062
(2.19) *
.068
(1.93) *
.030
(6.08) f

.272
(12.40) f
.095
(2.79) f
.186
(31.02) f
.168
(27.70) t
.232
(9.96) f
.066
(1.86)
.014
(21.70) |

.011

(16.55) f
.146
(5.60) f
.071
(2.00) *
.089
(12.94) f

Aug. 19, 1959
Di

Li

Li

Di

Di

LQ

Li

LQ

d vlq

Li

L VLQ

Di

D i>L i

LQ

1 F-ratios are in parentheses.
* indicates significant at 0.05 level of confidence,
f indicates significant at 0.01 level of confidence.

liquidity variable dropped more than 50 per
cent of the value that had prevailed when the
bill rate was less than the discount rate.
The finding that less importance is attrib­
uted to liquidity considerations when bor­
rowing from the Federal Reserve is profitable
lends support to the least-cost hypothesis.
Borrowing from other sources was in­
fluenced very little by liquidity when the
bill rate was greater than the discount rate,
indicating that banks are sensitive to changes
in interest rate differentials. During this
period, the bill rate was also greater than
the rate on Federal funds, and so it is
likely that banks tended to absorb Treasury
bills by meeting liquidity considerations
through the Federal funds market. This
hypothesis is supported by the behavior of
the size variable. During the period when




85

the bill rate was low in relation to other
rates, the partial coefficient for size was
0.146 and significant at the 1 per cent level.
When the bill rate was relatively high, the
larger banks were less reluctant to borrow,
as indicated by the increase in the partial
correlation coefficient to 0.232, significant
at the 1 per cent level.2
Comparisons by reserve districts between
borrowing from the Federal Reserve and from
others. The most interesting finding with

respect to the determinants of borrowing
was the behavior of the variables for Fed­
eral Reserve districts. It has been argued
that there are differences in borrowing
among districts and that these differences
reflect nonuniformities in the administration
of the discount window. If the different bor­
rowing patterns that emerge among districts
could be attributed to nonuniform adminis­
tration of the discount window, the patterns
of borrowing from the Federal Reserve
would differ among districts from borrow­
ing from other sources. On the other hand,
if differences in demand as distinct from
differences in supply, were responsible for
the borrowing patterns that emerged, the
patterns of borrowing among districts would
be similar for both types of borrowing.
In Table 2, the districts have been ranked
in order of the likelihood of borrowing from
the Federal Reserve and from other sources.
The order was obtained from the regres­
sions and derived from the coefficient at­
tached to the district variables. A negative
district coefficient in the regressions places
the district below D5 (Richmond was the
base district in the regression) in Table 2.
Banks located in the district with the largest
negative value on a given date show the
least probability of borrowing. Banks in the
2 The assertion that borrowing from other sources
is functionally related to size is explained more fully
later.

86
TABLE 2
DISTRICTS RANKED BY LIKELIHOOD OF BANKS BORROWING FROM
THE FEDERAL RESERVE AND FROM OTHER SOURCES
July 22, 1959
Order
Bf
1
2

D 12

3
4
5

Ds
P it

D*
D9

6

N ote.

Bo
d

8

jD1
D m

d5
D9

Aug. 19, 1959
Bt

Dec. 23, 1959

Mar. 16, 1960

Bo

Bf

Bo

Bf

d

*>12

Dx
Ds

Dt

12

D S

Ds

IX
K
D,

Dx

D0

D,
D UL
£>8

d

.

Bo

Ds

*>11

D 12
Ds

D .i

d

5

— Order is from least likely to most likely to borrow.

of which is the possibility that the liquidity
variable does not accurately reflect the de­
mands for credit in the various Federal Re­
serve districts.

district with the largest positive value show
the greatest probability of being in debt.
The comparative likelihoods of borrow­
ing from the Federal Reserve (Bf) and of
borrowing from other sources ( B0) are
roughly similar.
For July 22, 1959, only Di differed in its
ranking among the six districts borrowing
from the Federal Reserve and borrowing
from other sources. On August 19, 1959,
Di and D i2 changed position while on De­
cember 23, 1959, D 5 and D 12 changed their
order of rank. On March 15, 1960, only D 9
changed its rank between Bf and B 0.
Had the patterns of borrowing among
districts differed by type of borrowing, one
might conclude that some discount windows
are more accessible than others. However,
since the patterns are roughly the same be­
tween borrowing from the Federal Reserve
and from other sources, it remains only to
explain differences in the demand borrow­
ing among districts. There are, no doubt, a
number of conceivable explanations, one

Relationship between size of bank and borrow­
ing. A comparison by size of bank was

made for borrowing from the Federal Re­
serve and borrowing from other sources. The
order of comparison is shown in Table 3
where the banks by size are listed from least
likely to most likely to be in debt.
There appears to be a strong functional
relationship between size of bank and bor­
rowing from other sources. For each date
except December 23, 1959, the likelihood
of a bank’s indebtedness was an increasing
function of size. These results were not un­
expected for as credit tightens, smaller
banks draw down balances with their larger
correspondent banks— shifting the burden
of liquidity to them. The larger, more ag­
gressive banks usually carry smaller relative
quantities of excess reserves and therefore
would be expected to borrow more.
In contrast to borrowing from other

TABLE 3
BANK SIZE RANKED BY LIKELIHOOD OF BORROWING FROM THE
FEDERAL RESERVE AND FROM OTHER SOURCES
July 22, 1959
Order
1
2
3
4
5
N ote.

Aug. 19, 1959

Dec. 23, 1959
Bo

Bo

Bf

Bo

Bf

Lx

Li

l

5

Ls

l 5
Ls

l 2

Lx

Lx
L2

Lx

L3

Ls
L,

h

Ls
K

K

L2

Bt

L*
L .

—•Order




is

l 2

l 2

from least likely to most likely to borrow.

Mar. 16, 1960
Bf

Bo

L,

L,

Lx

L2
Lz

L2

DETERMINANTS OF MEMBER BANK BORROWING

87

sources, borrowing from the Federal Re­
serve showed considerably less association
with size of bank. On August 19, 1959, and
December 23, 1959, the largest banks were
less likely to borrow than the smallest banks,
as reflected in Table 3. Borrowing from the
Federal Reserve, unlike borrowing from
other sources, is neither anticipated nor
orderly. It is more spontaneous, and conse­
quently would be expected to show a less
discernible pattern.

(9) Ff = 14.575 - 1.398(Di)
(8.882) (2.950)
- 1.767(D8) + 5.194 (Z>9)
(2.872)
(3.288)
- 2.337( D u ) - 6.611 (D u )*
(2.817)
(2.950)
- 4.151(C)* + 5.399(L2)*
(1.805)
(2.144)

Frequency of borrowing at the discount win­
dow. Cross-sectional regressions were used

to estimate the relationship between the
frequency of borrowing from the Federal
Reserve and the variables that had been
used to estimate the likelihood of indebted­
ness, with the addition of a reserve classi­
fication variable (C).
The period from July 8, 1959, to No­
vember 2, 1960, was divided into three
subperiods. The subperiods were chosen to
emphasize patterns of borrowing when the
relationship between the bill rate and the
discount rate differed. In particular, all indi­
vidual bank data were aggregated to pro­
vide totals for the subperiod when the dis­
count rate was above the bill rate. A second
aggregation covered the subperiod when
the bill rate was greater than the discount
rate; the third aggregation covered the en­
tire period.
District, size, class, and liquidity variables
were used to explain variations in the fre­
quency of borrowing by banks in each of
the designated subperiods. The frequency of
borrowing from the Federal Reserve (Ff)
represented the number of weeks that a
given bank was indebted during the sub­
period considered. A weekly average was
made of the data within each subperiod.
For the entire period, July 8, 1959, to
November 2, 1960, frequency of borrowing
from the Federal Reserve was estimated by:




+

4.050(1*) * + 2.073 (L4)
(2.498)
(2.398)
+ 2.362(1,5) — M 0 ( L Q ) *
(3.741)
(.012)
R 2 = .209, F = 3.144t
In order to examine the effects of holding
short-term Treasury bills, the variable T was
substituted for LQ in equation 10.
(10) Ff = 9.768 .221 (Di)
(8.874)
(2.984)
-

1.640(D8) + 7.104(D<))*
(3.209)
(2.784)
- 2.890(D n) — 5.138(Dia)*
(2.893)
(2.893)
-

4 . 1 1 0 ( C ) * + 5.488(L2)*
(1.801)
(2.145)
+ 5.157(L3) * + 5.440(L4)*
(2.506)
(2.384)
- 1 0 . 3 7 1 ( 1 , 5 ) * - .055(T )*
(4.351)
(. 0 2 2 )
R 2 = .210, F = 3.169*
From August 19, 1959, to March 2,
1960, when the bill rate was above the dis­
count rate, the estimating equation was able
to explain to a lesser extent the variation in
Ff. In particular:
(11) Ff =

5.649 +
.444(D i)
(5.009)
(1.671)
+

.904(D 8) + 3.059 (D»)*
(1.616)
(1.834)
+
.352(D n ) — 2.157(D i2)
(1.583)
(1.636)
- 1.440(C ) + 2.852 (L2)*
(1.015)
(1.223)

88
+

2.326( L3) * + 1.335 (Li)
(1.364)
(1.334)
+ 1.498(Lb) - .0 16(L g)*
(2.149)
(.006)
R 2 = .153, F = 2.149*
(12) Ff =

2.897 +
.753(Di)
(5.071)
(1.723)
+
. 7 6 9 (D s ) + 3.954(Do)*
(1.635)
(1.830)
.147 (D u) - 1.492(Di2) — 1.201(C)
(1.584)
(1.639)
(1.019)
+ 2.995 (L2) * + 2.735 (L3)*
(1.240)
(1.385)
+ 2.889(L4)* + 4.984(L5)*
(1.337)
(2.433)
- .019(7")*
(.009)
R 2 = .132, F = 1.805
In the subperiod when the discount rate
(rd) was greater than the bill rate (rb), the
estimating equations using LQ and T were:
(13) Ff = 10.257 - 1.798(Di)
(5.046)
(1.679)
- 2.382(D8) + 1.809(D9) - 2.270(Du)
(1.630)
(1.823)
(1.599)
- 4.909(D 1 2 ) * — 2.843(C)*
(1.680)
(1.022)
+ 2.363(L2)* + 1.971(1*) +
.220 (L*)
(1.219)
(1.420)
(1.362)
+
.734 (Lb) .022 (L<2)*
(2.129)
(.007)
R 2 = .241, F = 3.792f




(14) Ff =

6.764 - 1.135(D i)
(5.126)
(1.709)
- 2.365(D « )+ 3.219(Do) — 2.741 ( Du)
(1.657)
(1.853)
(1.609)
- 3.744(D 12) * - 2.795(C )*
(1.671)
(1.041)
+ 2.309(L 2)* + 2.618(L 3) + 2.338(L 4)
(1.240)
(1.444)
(1.374)
+ 5.394(L S) * - .031 (T )*
(2.483)
(.014)
R 2 = .217, F = 3.306*
The cross-sectional regressions suggest
that the frequency with which a bank bor­
rows from the Federal Reserve is related to
its size, reserve district, portfolio of liquid
assets, and perhaps its reserve classification.
A compact arrangement of the variable co­
efficients is presented in Table 4.
In all three subperiods there was a signifi­
cant association between liquidity and fre­
quency of borrowing from the Federal Re­
serve. When the bill rate was greater than
the discount rate (rb > rd), liquidity be­
came less important as a determinant of
frequency. In contrast, when rd was greater
than rb, a smaller drop in the level of
liquidity prompted an increase in the fre­
quency of borrowing.
The movements in Treasury bills showed
much the same pattern as liquidity. Al­
though movements in bills were inversely
related to frequency in every subperiod,

TABLE 4
FREQUENCY OF BORROWING FROM FEDERAL RESERVE
By district, size, reserve classification, liquidity, and Treasury bills held
Equation

Period
Entire

When
rb > rd

(
)

1V

9
10

(

11

\
When
rd > rb

(

1I

12
13
14

Constant
14.575
(8.882)
9.768
(8.874)
5.649
(5.009)
2.897
(5.071)
10.257*
(5.046)
6.764
(5.126)

D8

Do

Du

£>12

—1.767
(2.873)
—1.641
(2.873)
.940
(1.616)
.769
(1.635)
-2.382
(1.630)
-2.365
(1.657)

5.194
(3.288)
7.104*
(3.209)
3.059
(1.834)
3.954*
(1.830)
1.809
(1.873)
3.218
(1.853)

-2.337
(2.817)
—2.890
(2.784)
.352
(1.583)
- .147
(1.584)
—2.270
(1.599)
-2.741
(1.609)

-6.611*
(2.950)
—5.138*
(2.894)
-2.157
(1.636)
—1.492
(1.639)
—4.909f
(1.680)
—3.744*
(1.672)

Di.
-1.398
(2.950)
— .221
(2.984)
.444
(1.671)
.753
(1.723)
—1.798
(1.679)
—1.135
(1.709)

* indicates significant at 0.05 level of confidence,
f indicates significant at 0.01 level of confidence.

DETERMINANTS OF MEMBER BANK BORROWING

89

banks were less willing to reduce holdings
of bills when their yield exceeded the cost
of funds at the discount window. This find­
ing supports the hypothesis that banks ad­
just reserves in accordance with the leastcost alternative; that is, banks with low
levels of liquidity chose to borrow more
often at the Federal Reserve when it was
the least expensive source of funds. When
the discount rate exceeded the bill rate
(rd > rb), the frequency of borrowing was
related to larger swings in holdings of bills,
and banks displayed a greater willingness
to liquidate bills rather than borrow from
the more costly discount window.
The regressions explained less of the
variation in the frequency of borrowing
when the yield on Treasury bills exceeded
the discount rate. Two reasons for this may
be cited. First, the exclusion of the price
variable reflects more importance when the
bill rate is greater than the discount rate.
Least-cost considerations demonstrate their
impact during this time at the expense of
liquidity considerations. It appears, then,
that banks are more inclined to borrow
from the Federal Reserve when it is least
costly. Consequently, the reduction in li­
quidity, which has been shown to be a sig­
nificant factor in determining borrowing,
reduces the explanatory power of the equa­
tion when the bill rate is greater than the
discount rate.

The second reason for the lower explana­
tory values concerns the element of control
over borrowing at the discount window. As
the bill rate rises relative to the discount rate,
discount officers must remain alert to the
potential for banks to take advantage of the
interest rate differential. As administrative
factors and, therefore, unspecified supply
factors increase in importance, the demand
factors are less able to explain the variations
that occur in the frequency of borrowing
from the Federal Reserve.

L2

£3

l4

l

5.399*
(2.144)
5.488*
(2.145)
2.852*
(1.223)
2.995*
(1.241)
2.363
(1.220)
2.309
(1.240)

4.050
(2.498)
5.157*
(2.506)
2.326
(1.364)
2.735
(1.385)
1.971
(1.420)
2.618
(1.444)

2.073
(2.398)
5.441*
(2.384)
1.335
(1.334)
2.889*
(1.337)
.220
(1.362)
2.338
(1.374)

2.362
(3.741)
—10.371*
(4.351)
1.498
(2.140)
4.984*
(2.434)
.734
(2.128)
5.394*
(2.483)

5

C

LQ

-4.151*
(1.805)
-4.119*
(1.801)
-1.440
(1.015)
—1.201
(.019)
—2.843f
(1.023)
—2.795*
(1.041)

-.030*
(.012)

Time-series analysis

The inclusion of the price variable P =
(rd — rb) in a time-series analysis substan­
tiated a large part of what was suggested
by the cross-sectional analysis. The results of
the test indicate that both liquidity and rela­
tive prices play significant roles in the
amounts of borrowing that banks, on bal­
ance, will wish to undertake and that these
relative amounts differ among Federal Re­
serve districts.
The objective of the time-series was to
observe over time the effect of liquidity, dis­
trict, and cost on the patterns of borrowing.
In order to do this, the cross-sectional vari­
able for the reserve district had to be pooled
with the temporal variable P. The procedure
was to aggregate all banks within each dis­
trict for each date; this provided six district
observations for each of the 35 dates, or a

T

—.055*
(.022)
-.016*
(.006)
—.019
(.010)
—.022f
(.007)
—.031*
(.014)

R2
.209f
(3.144)
.210f
(3.169)
.153*
(2.149)
.132
(1.805)
.241f
(3.772)
.217f
(3.306)

N o t e . — Standard errors are in parentheses under variables. F-ratios are in paren­
theses under R 2.




90

total of 210 observations. The districts were
represented by dummy variables.
Two forms of borrowing were estimated.
The first was designed to show the relation­
ship between relative amounts of borrowing
and the explanatory variables. This relation­
ship is represented by the ratio of borrowing
from the Federal Reserve to demand de­
posits adjusted (Bf / DDa) and of borrow­
ings from other sources to demand deposits
adjusted (B„/DDa). The second form of
borrowing was designed to show how the
proportion of banks that borrowed in each
district was affected by changes in liquidity
conditions or interest rate differentials. The
proportion of banks borrowing from the
Federal Reserve was represented by (Bn)
and the proportion borrowing from other
sources by (B„f).
The amount of borrowing from the Fed­
eral Reserve and from other sources is esti­
mated in equations 15 and 16, respectively.
(15)

Bf = .0 3 9 (P )f — .150(L<2)f
DDa (.008)
(.019)

+ 18.86(D 1) f + 2 5 .1 5 ( D ,,) f
(2.120)
(2.478)
+ 30.43 (D s) f + 31.33 (Da) f
(2.983)
(1.600)
+ 3 3 .9 6 (D n ) t + 11.02(Dio)f
(3.494)
(1.539)
R* = .74 , F = 79.28
(16) Bo/DDa ~

.019(Pi)*
(.009)
- .348(L <2)f-f 5 0 .3 1 2 (D i)f
(.023)
(2.673)
+ 55.827 (D s)t + 78.997 (D s)f
(3.125)
(3.762)
+ 76.675(D 9) f + 99.761 (D n )f
(2.018)
(4.407)
+ 37.895(D 12) f
(1.940)

^2 = .95, F — 514.876




In both equations 15 and 16, borrowing
was explained by the interest rate differen­
tial, liquidity, and district variables.3
It should be recalled that borrowing in
the cross sections was related to Federal Re­
serve district. The variation in borrowing
among districts gave rise to the question of
causal factors not explicitly considered in
the equations. This problem was handled by
demonstrating that borrowing from other
sources also varied significantly among dis­
tricts and the patterns that resulted from
ranking the districts in order of their likeli­
hood of borrowing were roughly the same
for Bf and B0. It was concluded, therefore,
on the basis of the cross sections, that the
variations among districts reflected mainly
demand factors.
The relative amounts of borrowing from
the Federal Reserve differed among districts
in the time series as well as the cross sec­
tions. However, when the districts were
ranked in order of the amounts borrowed
from the Federal Reserve and from other
sources, the rankings were found to be
precisely the same (Table 5). Once again
the differences in borrowing among districts
TABLE 5
DISTRICTS RANKED BY RELATIVE
AMOUNTS OF BORROWING
FROM THE FEDERAL RESERVE AND FROM
OTHER SOURCES
Order

B f/ D D a

1
2
3
4
5
6

D5
D8

N o te . —

B 0/ D D a
d

12

5
Db

d

*>n
Order is from least likely to most likely to borrow.

3 The coefficients of the district variable reflect
deviations from the district average. For instance, if
this average were 25.0, membership in
would
mean a less-than-average level of borrowing from
the Federal Reserve in equation 15, given the liquidity
condition and rate differential. Similarly, membership
in D n would imply a greater-than-average level of
borrowing.

DETERMINANTS OF M EMBER BANK BORROWING

91

would seem to be associated with demand
factors.
Equations 17 and 18 are used to estimate
the proportion of banks in each district that
borrowed from the Federal Reserve (Bff)
and other sources ( B0f), respectively.

proportion of banks borrowing from the
Federal Reserve is roughly the same as the
relative amounts borrowed. The rankings
by district for relative amounts and propor­
tions are combined in Table 6.

(17) Bf f = -

.779(Fi)f — 1.915( L 0 ) f
(.115)
(.264)

+

38.562(Di) + 541.160(Ds)t
(30.142)
(35.231)
+ 488.728 (Ds) f + 465.152(D9) f
(42.417)
(22.752)
+ 513.350 (Du) f + 280.008 (Di2) t
(49.684)
(21.884)
R 2 = .871, F = 181.300
.048(F) — 1.746(L<2)f
(.068)
(.197)
+ 568.572(Di)f + 714.378(D5) t
(22.454)
(26.246)
+ 518.473 (D8) f + 480.353 (Do) t
(31.598)
(16.949)

TABLE 6
DISTRICTS RANKED BY RELATIVE AMOUNTS
( B f/DDa AND B 0/DDa ) AND PROPORTIONS OF
BANK BORROWING (B fr AND B of)
Order
1

2
3
4
5

6

B f /D D a
D 12
D'i

D,
Da
Do

On

B 0/ D D a
D 12

B or
D,

Ds

Do
Ds
Dt
Dn

Dn
d 5

*>13
£>5

*>1

5
Ds
d

*>n

v*

N o t e .— Order is from least to most amount and proportion
of borrowing.

(18) B0f = -

+ 5 7 1.2 5 9 (D n )f+ 5 9 0 .2 3 3 (D i2) f
(37.012)
(16.303)
R 2 = .971, F = 961.70
Equation 17 demonstrates that a strong
relationship existed between the proportion
of banks in each district that borrowed from
the Federal Reserve and the explanatory
variables. The proportion of banks that
borrowed from the Federal Reserve varied
inversely with the profit spread and liquidity
position. This indicates that at least part of
the increased amounts of borrowing that
took place when the bill rate exceeded the
discount rate resulted from an increase in
the number of borrowing banks. This find­
ing supports the view that the effects of
tight money are passed from one bank to
another, affecting greater proportions as
alternative sources of liquidity dry up.
As in previous equations, there were dif­
ferences in borrowing among districts. The




Equation 18, which focuses on the pro­
portion of banks borrowing from other
sources, is rather difficult to explain. In the
first place, the sign of the cost variable P
is negative. This suggests that as the cost of
discounting becomes greater than the rate
on borrowing from other sources, the pro­
portion of banks borrowing from other
sources falls. This seems unlikely. The vari­
able P itself, however, was not statistically
significant.
As with borrowing from the Federal Re­
serve, the proportion of banks borrowing
from other sources varied noticeably among
districts. However, in the former this varia­
tion was attributed to demand factors on the
basis that the same patterns of borrowing
were prevalent for borrowing from the Fed­
eral Reserve as for borrowing from other
sources. The proportion of banks borrow­
ing from other sources varied among dis­
tricts, but the rankings were not similar to
the rankings of borrowing from the Federal
Reserve. The reason for the unusual pattern
of borrowing from other sources is not im­
mediately clear. An appropriate explana­
tion would require further investigation.




TOWARD A SEASONAL BORROWING PRIVILEGE: A STUDY OF
INTRAYEAR FUND FLOWS AT COMMERCIAL BANKS
Emanuel Melichar
Board of Governors of the Federal Reserve System

Contents
Objectives and Procedures----------------------------------------------------------------------------------- 95
Fund Flows at Individual Banks: Definition_______________________________________

96

Calculation of trend-adjusted intrayear changes
Special terminology for assets, liabilities, and flows
Fund Flows at Individual Banks: Two Examples___________________________________

98

How the examples were chosen
Computation of trend-adjusted intrayear flows
Relative changes and flows
Portfolio adjustments in response to fund flows
Preliminary lessons from the examples
Origin of Intrayear Fund Flows_________________________________________________101

Changes in I PC deposits
Changes in nonfinancial loans
Independence of loan and deposit changes
Coincidence of loan and deposit drains
Fund Outflows: Summary of Aggregate Data______________________________________102
Relative Outflows at Individual Banks___________________________________________103
A Seasonal Borrowing Privilege________________________________________________104

Design of a seasonal discount program
Potential borrowings by period and by size of bank
Potential borrowings under alternative deductible levels




93

Preface

In contrast, the seasonal borrowing privi­
lege later proposed by the Steering Commit­
tee specifies somewhat different definitions
of loans and deposits to be used in the
calculation of seasonal needs of individual
banks, suggests a monthly or 4-week moving-average basis, and presumably utilizes
more rigorous methods to separate seasonal
from trend, cyclical, and irregular move­
ments in loans and deposits. In formulating
its proposal, the Committee was also guided
by other studies that tested its effect while
using data and methods more closely at­
tuned to its specifications.
Therefore, the reader is warned that the
estimates presented herein cannot be inter­
preted as representing, even roughly, flows
and borrowings to be expected under the
seasonal borrowing privilege as now pro­
posed. But hopefully, the relationships
found in this study continue to be broadly
indicative of the need for and design of a
seasonal borrowing privilege.
An earlier version of this paper that
presents more detailed and disaggregated
data is available from the author upon re­
quest.
Emanuel Melichar
December 1970

When the Federal Reserve System initiated
a reappraisal of the discount mechanism,
one avenue of investigation was concerned
with facilitating the provision of discount
credit for seasonal purposes. Such study re­
quired evidence on seasonal fund flows at
individual commercial banks throughout the
Nation. To help meet this need for data, the
project reported herein was developed to
estimate intrayear flows of funds between
call dates on a uniform basis for all banks.
These data helped in assessing the need for
seasonal discount credit and in designing a
mechanism through which such credit could
be provided on a routinized basis.
This study, undertaken during 1966-67,
measures intrayear fund flows at individual
banks and provides estimates of potential
borrowings under assumed alternative sea­
sonal discount arrangements. These esti­
mates are based on certain definitions of
loan and deposit flows, and flows so defined
were calculated solely for standard (calen­
dar) quarterly and semiannual periods. It is
unlikely that even these intrayear flows were
truly ascertained, as only crude adjustments
could be made for trends in loans and de­
posits.




94

TOWARD A SEASONAL BORROWING PRIVILEGE: A STUDY OF
INTRAYEAR FUND FLOWS AT COMMERCIAL BANKS

OBJECTIVES AND PROCEDURES
To develop this statistical base for a sea­
sonal borrowing proposal, the following se­
quence is followed in this paper. First, a
specific definition of intrayear fund flows is
adopted and the fund flows at individual
banks are calculated for selected periods.
The flows at individual banks are then
summed to show their aggregate origin, di­
rection, and magnitude.
Next, attention is focused on banks
at which seasonal flows of funds are large in
relation to the size of the banks. Within the
considerable limitations imposed by the
data used, it is shown that a significant pro­
portion of banks do have large relative
seasonal outflows of funds; that these banks
tend to be small, presumably with limited
access to financial markets that larger banks
could use to meet such pressures; and that,
because these banks are generally small,
their borrowings under a seasonal discount
program designed to serve them would be
compatible with continuation of a limited
over-all role for the discount mechanism.
The report concludes with estimates of
total borrowings under alternative discount
programs that would allow these individual
banks to borrow a portion of the funds that
they need to meet their typical seasonal
outflows.

Among the aspects of discount operations
being reviewed during the fundamental re­
appraisal of the discount mechanism is the
attitude of the Federal Reserve System to­
ward member bank use of the discount win­
dow for seasonal needs. Present policy con­
templates that each member bank will main­
tain sufficient liquidity to meet seasonal
swings that it might normally expect, with
assistance at the window confined to deal­
ing with variations of unusual amplitude.
However, because the liquidity of many
banks has been reduced since this policy
was formulated, it is pertinent to examine
whether banks should now be permitted to
meet a larger portion of their seasonal needs
through discounting.
Basic data required for such study are
the flows of funds at individual banks,
rather than the published summaries of
banking data that reveal only the net flow
totals for large groups of banks. The mag­
nitude and duration of individual seasonal
flows, as well as their distribution among
different types and sizes of banks, could af­
fect the advisability of liberalizing borrow­
ing at the discount window for seasonal pur­
poses. These factors would also be impor­
tant in formulating rules under which more
liberal borrowing might be implemented.




95

96

FUND FLOWS AT INDIVIDUAL BANKS: DEFINITION
Fund flows at each bank were calculated
from data obtained on reports of condition
(call reports) during two 12-month periods.
The year from July 1962 to June 1963
was processed on a quarterly basis and was
used because it is the latest period for which
spring and autumn call data are available
in machine-language form. To provide more
recent data as well as a second year for
comparison, the period from July 1965 to
June 1966 was also processed. These were
the latest data available when the analysis
was performed.
Reports of condition were available for
every member and insured nonmember
bank, but the only banks included in the
study were those for which comparable re­
ports could be constructed for each call date
in the period examined. Thus, banks that
had been newly created or liquidated during
the period were excluded, but banks in­
volved in a merger were retained by
summing their separate reports prior to the
merger to create data comparable to that
reported by the merged bank on subsequent
call dates. In this manner, the study of the
1962-63 period was able to cover 98 per
cent of all banks in existence on June 30,
1963. The 1965-66 study covered 99 per
cent of the banks in existence on June 30,
1966.
At the time of the study, call report data
constituted the only readily available series
on assets and liabilities of individual banks
of all sizes and in all regions. Such compre­
hensive coverage was greatly desired, given
the purpose of the work. The principal dis­
advantage of these series, however, was that
not enough measurements were provided
during the year to ascertain the peaks and
troughs of the seasonal swings at each bank




or to measure accurately the duration of the
flows. Also, in common with all data cover­
ing past bank performances, the call statis­
tics could not provide a measure of the ex­
tent to which banks may have curtailed
lending seasonally or held back on seasonal
loan expansion because of unavailability of
funds. Different seasonal loan patterns
might emerge at some banks if a seasonal
discount program were adopted.
Calculation of trend-adjusted
intrayear changes

Because each set of data covered only 12
months, it was impossible to calculate sea­
sonal components of pertinent bank asset
and liability items with anywhere near the
degree of sophistication commonly em­
ployed in seasonal adjustment of economic
time series. The trend could be estimated
only in a crude fashion, and there was no
basis for separation of irregular movements
from seasonal changes. In recognition of
these large departures from the usual mean­
ing of “seasonal” in economic studies, the
term “intrayear” is applied to the trendadjusted quarterly or semiannual changes
computed in this study.
Allowance for trend in a bank asset or
liability item was achieved by first calcu­
lating the June-to-June change in the item.
Then, one-fourth of this value was sub­
tracted from each observed quarterly change
in the item, and one-half of the value was
subtracted from each observed semiannual
change.
To illustrate this procedure, suppose that
a bank experienced an increase of $100
million in deposits between the June 1962
and June 1963 call dates. The quarterly
trend is calculated to be one-fourth of this

IN T R A Y E A R FUND FLO W S AT C O M M E R C IA L B A N K S

value, or an increase of $25 million. F ur­
ther, suppose that deposits at this bank ac­
tually increased by $10 million between the
June 1962 and September 1962 call dates.
The trend-adjusted change in deposits dur­
ing this quarter is therefore a decrease of
$15 million, calculated by subtracting the
quarterly trend increase of $25 million from
the observed increase of $10 million.
Examples for individual banks given in
the next section will further demonstrate
this statistical adjustment. Then, in the re­
mainder of the paper, all references to
changes in bank asset and liability items
will be to the trend-adjusted changes. To
simplify the exposition, the qualifying term
“trend-adjusted” will be omitted in those
sections of the paper.
Special term inology for asse ts,
liabilities, and flows

Several bank asset and liability items used
in this study represent special combinations
or adjustments of call report items. These
are defined as follows:
Net deposits are total deposits less cash
items in process of collection and unposted
debits drawn on the bank.
IPC deposits are demand, time, and sav­
ings deposits of individuals, partnerships,
and corporations, including time deposits
accumulated for payment of personal loans.
Nonfinancial loans are total gross loans
less loans to financial institutions and loans
for purchasing or carrying securities.
The bulk of the study is concerned with
examination of the net result of simultane­
ous changes in IPC deposits and nonfinan­




97

cial loans, which is termed the fund flow.
The study concentrated on changes in these
particular assets and liabilities because they
were thought to best approximate the sea­
sonal impact originating within the area
served by the bank. Also, these items are
relatively free of “window dressing” on call
dates. The value of the fund flow for any
given period was obtained by subtracting
the change in nonfinancial loans from the
change in IPC deposits, after both had been
adjusted for trend. If the result is positive,
it is called a fund inflow; if negative, a fund
outflow.
The calculation of fund flows in each
period was performed separately for each
bank. Aggregate fund flows for groups of
banks were later computed by summing the
flows at the individual banks. It was there­
fore possible to compute aggregate gross
outflow or gross inflow by summing individ­
ual flows only at banks with outflow or in­
flow, respectively. The aggregate net fund
flow for a group of banks was obtained by
summing their individual fund flows irre­
spective of their direction. The result is
either a net outflow or a net inflow, depend­
ing on its sign.
To facilitate comparison of fund flows
among banks of different size, relative fund
flow for a given bank in a given period was
calculated as the percentage that fund flow
in that period was of the trend value of net
deposits at the beginning of the period. In
some analyses, the relative change in par­
ticular bank asset and liability items was
also of interest, and in each case it was com­
puted in the same manner.

98

FUND FLOWS AT INDIVIDUAL BANKS: TWO EXAMPLES
The concept of a fund flow that is the net
result of intrayear changes in both deposits
and loans is not a common one, and so an
examination of how fund flows originated
at individual banks may assist the reader in
becoming comfortable with these data. The
two examples presented here each represent
the average experience of three banks that
were similar in deposit size and in the direc­
tion and magnitude of their fund flows. In
addition to showing how changes in deposits
and in loans entered into the calculation of
fund flow, the examples show how the rela­
tive magnitude of the flow is related to intra­
year changes in the loan/deposit ratio, and
how certain other asset items fluctuated in
response to the varying fund inflows and
outflows.
How the exam ples were chosen

These examples are being given prior to the
presentation and analysis of data for all
banks. But the examples were in reality
constructed after the analysis was com­
pleted, and therefore could be chosen to
illustrate some of the principal findings of
the analysis.
One such finding was that while the
major part of national intrayear fund flows
originates at large banks, the flows at such
banks are usually moderate in size when
compared to the assets of the banks. To il­
lustrate this typical case, Bank A was con­
structed by averaging actual data for three
fairly large Eastern banks, each of which
had total deposits in the neighborhood of
$500 million. The changes in deposits and
loans at these banks were representative of
the upper range of the moderate changes
found at other large banks, and thus pro­
vide an example of how the principal (in
terms of dollar amount) national flows
originated.



A second key finding was that numerous
smaller banks, usually serving rural areas,
are subject to rather severe intrayear fluc­
tuations in deposits and loans. The dollar
amounts involved in these cases are small
when compared to total national flows, but
large relative to the assets of the smaller
banks at which they tend to occur. These
cases are illustrated by Bank B, which was
constructed by averaging data for three
banks in Nebraska, each of which had total
deposits of about $3 million.
Com putation of trend-adjusted
intrayear flows

The presentation that follows uses data from
the 1965-66 period, in which the computa­
tions and analyses were made on a semi­
annual basis. Data for Bank A and Bank B
are shown in adjacent columns to facilitate
comparison.
Changes in IPC deposits. Outstanding IPC
deposits (in dollars) on each of the three
call dates used during 1965-66 were:
D ate

Bank A

June 30, 1965 ........... 488,409,000
D ecem ber 31, 1965 ..589,233,000
June 30, 1966 ............. 562,361,000

Bank B
2,684,000
3,549,000
2,952,000

The actual deposit changes during each
half-year period were therefore:
Period

Bank A

July-D ecem ber ...+ 1 0 0 ,8 2 4 ,0 0 0
Jan u ary -Ju n e .........— 26,872,000

Bank B
+865,000
—597,000

To find the trend-adjusted deposit
changes, the first step is to calculate the
average semiannual change that is due to
the deposit trend experienced at both banks.
One-half of the change in deposits between
June 1965 and June 1966 is regarded as
the change due to trend in each semiannual
period, as follows:
Period

Bank A

July-D ecem ber ....+ 3 6 ,9 7 6 ,0 0 0
Jan u ary -Ju n e ........... +36,976,000

Bank B
+ 134,000
+134,000

99

IN T R A Y E A R FUND FLO W S AT C O M M E R C IA L B A N K S

The trend-adjusted change in each period is
then computed by subtracting the change
due to trend from the actual change, which
gives the following trend-adjusted deposit
changes:
Period

Bank A

J u ly -D e c e m b e r.........+63,848,000
January-June ........... —63,848,000

Bank B
+ 731,000
—731,000

Note that, with only two “seasons,” the
trend-adjusted change for one period is
necessarily the mirror image of that for the
other period, as the sum of the trend-ad­
justed intrayear changes within any given
annual period must be zero.
Changes in nonfinancial loans. Similar com­
putations yield the trend-adjusted changes
in nonfinancial loans. The outstanding
amounts (in dollars) on the call dates were:
D ate

Bank A

June 30, 1965 ........... 367,640,000
Decem ber 31, 1965 . 409,705,000
June 30, 1966 ......... 439,497,000

Bank B
2,414,000
1,664,000
2,485,000

Thus the actual semiannual changes were:
Period

Bank A

July-D ecem ber . . . . +42,065,000
January-June ........... +29,792,000

Bank B
—750,000
+821,000

And the semiannual changes ascribed to
trend were:
Period

Bank A

J u ly -D e c e m b e r........... +35,928,500
January-Jun e ............. +35,928,500

Bank B
+35,500
+ 35,500

Therefore, the trend-adjusted changes in
nonfinancial loans were as follows:
Period

Bank A

July-D ecem ber .........+6,136,500
January-Jun e ............. —6,136,500

Bank B
-7 8 5 ,5 0 0
+785,500

Fund flows. The fund flow in each semi­
annual period is obtained by subtracting
the trend-adjusted change in nonfinancial
loans from the trend-adjusted change in IPC
deposits, which yields:
Period

Bank A

July-D ecem ber ...+ 5 7 ,7 1 1 ,5 0 0
January-Jun e . ...- 5 7 ,7 1 1 ,5 0 0




Bank B
+1,516,500
-1 ,5 1 6 ,5 0 0

Relative changes and flows

If the deposit and loan changes at each
bank are related to a common base, such
as assets or deposits of the bank, their
relative contributions to the fund flow be­
come readily apparent. The base employed
for all such comparisons in this study is the
trend value of total net deposits at the bank
at an appropriate date. Expressed as per­
centages of this deposit figure at each bank,
the trend-adjusted changes and the fund
flow are shown in Table 1.
TABLE 1
RELATIVE TREND-ADJUSTED CHANGES
AND FUND FLOWS
In per cent
Item
Change in deposits
Change in l o a n s ............
Fund flow ......................

July-December

January-June

Bank A

Bank B

Bank A

Bank B

+10.5
+ 1.0
+ 9.5

+23.3
-25.1
+48.4

-1 0 .5
— 1.0
— 9.5

-2 3 .3
+25.1
—48.4

These relative percentages provide desired
comparisons among banks and will be much
used in later sections. In this example, semi­
annual relative fund flow at Bank A, the
larger Eastern bank, was 9.5 per cent of
net deposits, whereas that at Bank B, the
smaller rural bank, amounted to 48.4 per
cent of net deposits, or about five times the
magnitude at Bank A. At Bank A, the main
semiannual swing occurred in deposits. To
the extent that loans did change, they rose
and fell with deposit volume and thus offset
part of the deposit flow. But at Bank B, both
deposits and loans exhibited relatively large
semiannual swings. Furthermore, they
moved in opposite directions— loan volume
fell while deposits increased, and rose while
deposits decreased— and thus accentuated
the intrayear fund flow with which manage­
ment had to cope.
The intrayear fund flow at each bank
obviously caused seasonal movements in
loan/deposit ratios, and it is interesting to
compare the changes in this familiar statis­

100

tic— (net lo a n s)/(n e t deposits), expressed
as a percentage:
D ate
June 30, 1965 ...............................
December 31, 1965 ....................
June 30, 1966 .............................

Bank A Bank B
75.8
72.7
77.6

77.8
40.4
74.9

The severe intrayear fund flow at Bank
B, and the correspondingly sharp seasonal
swing in its liquidity position, reflected the
seasonal demands of the agricultural econ­
omy on which this bank was largely depen­
dent. More than three-fourths of its loan
volume was in loans to farmers, both in
December and at the June peaks. To meet
crop production expenses in the spring,
farmer-customers of this bank drew down
their deposits and also secured additional
loans. The significant event from the bank’s
standpoint, however, was that these funds
did not remain with its other customers. Ap­
parently the funds were not spent locally,
or they tended to flow out of the community
after being spent. (Two of the three banks
averaged to form Bank B were in one-bank
towns; the third was in a two-bank town.)
The high degree of association with agri­
culture at Bank B was not unique, as 22 per
cent of the Nation’s banks had more than
half of their loan volume in loans to farmers
on June 30, 1966.
Portfolio ad justm ents in
resp o n se to fund flows

When a bank experiences a fund inflow or
outflow as defined here, other asset or liabil­
ity items must together show a net change
that exactly compensates for the fund flow.
As one part of this study, a look is taken
at changes in two asset groups— balances on
deposit at other domestic banks and hold­
ings of U.S. Government securities— in
which banks are generally able and likely to
make discretionary changes in direct re­
sponse to fund inflow or outflow.




Trend-adjusted semiannual changes in
these items were computed in the same man­
ner as previously illustrated for deposits and
loans. Then, to facilitate comparison of
these figures with the fund flow or with
other changes at the bank, and to permit
direct interbank comparisons, the relative
trend-adjusted changes in these items are
also shown in Table 2 as percentages of the
December trend value of net deposits.
TABLE 2
INTRAYEAR CHANGES IN TWO ASSET GROUPS
In dollars unless otherwise indicated
Asset
group
Balances with
other banks:

July-December
Bank A

+ 7,800,000
Trendadjusted .. + 6,930,500
Relative
+1.1
(per cent)
U.S. Govt.
securities:
A ctual.......... +14,141,000
Trendadjusted. . +14,189,000
Relative
+2.3
(per cent)

Bank B

January-June
Bank A

Bank B

+

231,000 — 6,061,000 — 156,000

+

194,500 — 6,930,500 — 194,500
+6.2

-1 .1

-6 .2

+1,160,000 -14,237,000 —1,236,000
+1,198,000 —14,189,000 -1,198,000
+38.2

—2.3

—38.2

At both banks, semiannual changes in
each of these components were in the direc­
tion expected as a consequence of the fund
flows. At Bank A, the two items together
accounted for the use of 36 per cent of the
semiannual fund inflow (or conversely, sup­
plied the same proportion of funds to meet
the outflow). At Bank B, the major part of
the adjustment to the severe fund flow ap­
peared to occur in these two items, partic­
ularly in the holdings of U.S. Government
securities.
Prelim inary lessons from the exam ples

The contrast between fund flows at the two
composite “banks” is typical. The general­
ization of these differences is the purpose of
this study and is thought to have major im­
plications for seasonal discount policies of
the Federal Reserve System.
At the larger and primarily urban bank,

101

IN T R A Y E A R FUND FLO W S AT C O M M E R C IA L B A N K S

the fund flow arose mainly through changes
in deposits. Deposits increased during the
second half of the year and fell during the
first half, whereas loan volume displayed
little change. But at the smaller rural bank,
loan volume underwent a substantial change
because of very high dependence of the
bank and the community on a single indus­
try that had a marked seasonal need for
funds. For the same reason, deposits at the
smaller bank also exhibited a greater rela­
tive intrayear change.
Relative to its deposits, the larger bank
found that small changes in U.S. Govern­
ment securities and in balances with other
banks sufficed to cope with its fund flow.
In contrast, the smaller bank had to make
relatively large changes in these items, and
on a relative basis its portfolio adjustment

problem loomed much larger than that of
the bigger bank. During part of the year,
relatively large amounts had to be kept idle
or invested in securities that could be readily
liquidated to meet the coming seasonal out­
flow of funds.
At the larger bank, the dollar amount of
the semiannual fund flow was much greater
than at the small bank— $57.7 million com­
pared to $1.5 million. However, the magni­
tude relative to the size of the bank— the im­
portance of the intrayear fluctuation to
banking operations— was much smaller at
the large bank— 9.5 per cent of net deposits,
compared to 48.4 per cent at the small
bank. Thus by providing a relatively small
amount of funds, the Federal Reserve could
materially assist the small bank in meeting
its relatively large seasonal pressures.

ORIGIN OF INTRAYEAR FUND FLOWS
As defined for this study, fund outflows and
inflows in a given quarter or half-year
period can originate through various com­
binations of trend-adjusted changes in IPC
deposits and in nonfinancial loans. (In the
remainder of this paper, all intrayear data
cited are trend adjusted.) These changes
are examined on a semiannual basis during
1965-66 and on a quarterly basis during
1962-63, the latest period for which quar­
terly flows could be calculated. (An ex­
amination of semiannual flows during
1962-63 showed marked resemblance to
those of 1965-66.)
C hanges in IPC deposits

The most prevalent influence on flows was
a tendency for deposits to increase during
the second half of the year and to decrease
during the first half. In 1965-66, 81 per
cent of member banks experienced this
movement.




Deposits rose at 64 per cent of the mem­
ber banks during the third quarter of 1962
and at 70 per cent over the fourth quarter.
They then decreased at 75 per cent of mem­
ber banks in the first quarter of 1963 and at
60 per cent during the second quarter of
that year.
C hanges in nonfinancial loans

At many banks, loan volume tended to in­
crease in the spring and decrease in the
fall. For instance, loans fell at 57 per cent
of the member banks during the second half
of 1965 and rose from January through
June of 1966. Loans decreased at 65 per
cent of the member banks in the third quar­
ter of 1962 and at 49 and 62 per cent in
the fourth quarter of 1962 and first quarter
of 1963, respectively. But on the other hand,
the volume of loans rose at 73 per cent of
the member banks during the second quar­
ter of 1963.

102

Independence of loan and deposit changes

During each period, the direction of the
change in loans at an individual bank ap­
peared largely independent of the direction
of the change in deposits. For instance, the
proportion of member banks at which loans
decreased during a given period was about
the same in the group in which deposits
were up as in the group in which deposits
were down. Among the member banks at
which deposits decreased from July to De­
cember 1965, for example, loans fell at 58
per cent and rose at 42 per cent. Among the
member banks at which deposits increased,
loans fell at 57 per cent and rose at 43 per
cent. Similar independence between loan
and deposit changes was observed in all
periods studied.
Coincidence of loan and deposit drains

However, such independence of loan and
deposit changes did not preclude loan and
deposit drains from coinciding at a large
proportion of banks during the spring sea­
son. Thus, in the first half of 1966 nearly
one-half of member banks experienced a
reduction in deposits combined with an in­
crease in loans, resulting in an outflow of
$5.5 billion. Another one-third experienced
a reduction in both deposits and loans, but
the generally greater deposit changes re­
sulted in a net fund outflow of $3.2 billion.
The first quarter of 1963 was charac­

terized by deposit reductions, which oc­
curred at three-fourths of the member banks.
Loan volume also went down at more than
half of these banks, but the total of the
deposit changes was much larger and re­
sulted in a net fund outflow of $3.3 billion.
Additional fund outflow of $2.1 billion oc­
curred at banks that experienced a rise in
loan volume while their deposits decreased;
such banks constituted 27 per cent of all
member banks. Only one-fourth of member
banks had deposit gains, for net fund inflow
of just $0.7 billion. Net outflow therefore
totaled $4.6 billion at all member banks,
the largest quarterly net outflow of the year.
The deposits-down, loans-up squeeze was
most common during the second quarter,
when 42 per cent of member banks experi­
enced a drop in deposits while loan volume
rose. Fund outflow arising from this squeeze
totaled $2.7 billion. At another 18 per cent
of the banks, at which both loan and deposit
volumes were reduced, there was an addi­
tional $0.6 billion of net fund outflow. Off­
setting net fund inflow of $0.8 billion oc­
curred at the 40 per cent of banks at which
deposits rose during this quarter. Total net
fund outflow at all member banks was there­
fore $2.5 billion, or only slightly more than
one-half of the net outflow of the first quar­
ter. As noted, however, more banks ex­
perienced the deposits-down, loans-up
squeeze than in the first quarter.

FUND OUTFLOWS: SUMMARY OF AGGREGATE DATA
In this section the primary focus settles on
banks with fund outflow during a given
period, in the belief that these banks con­
stitute the prime candidates for use of sea­
sonal discount credit during that period.
In examining fund outflow at a given
group of banks, two statistics seem very
relevant: the proportion of banks that ex­



perienced outflow, and the dollar amount
of that outflow.
On the semiannual basis, 22 per cent of
member banks had outflow during the sec­
ond half of 1965. This outflow totaled $0.9
billion and amounted to 1.7 per cent of net
deposits at these banks.
In the first half of 1966, 78 per cent of

103

IN T R A Y E A R FUND FLO W S AT C O M M E R C IA L B A N K S

member banks had outflow that totaled $9.1
billion and amounted to 4.7 per cent of net
deposits at such banks.
Semiannual data for 1962-63 exhibited
approximately the same relationships. Quar­
terly member bank data for this period were
as shown in the accompanying table. At the
banks with outflow, the amount ranged
from 2.2 per cent of their net deposits in
the third quarter to 3.8 per cent in the first
quarter.
The proportion of all member and in­
sured nonmember banks with outflow in
each period was virtually identical to the
proportion of member banks alone. But in

Q uarter

Percentage of
banks
w ith outflow

Outflow
(billions of
dollars)

3
4
1
2

31
37
68
69

2.1
.9
5.7
4.1

each period the outflow at those nonmember
banks with outflow was greater relative to
their net deposits.
In the remainder of this report, data will
be limited to member banks. These banks
constitute the group that would be immedi­
ately eligible to take advantage of discount
regulations designed to provide more sea­
sonal credit.

RELATIVE OUTFLOWS AT INDIVIDUAL BANKS
The relative size of the fund outflow for a
given period at each bank was measured by
comparing the outflow to the trend value
of total net deposits at the start of the
period, as described and illustrated earlier.
These percentages provide a basis for com­
paring outflows among banks of different
size that more nearly reflects the magnitude
of the portfolio adjustment and other prob­
lems posed by the outflow than does the dol­
lar amount of the outflow.
In each period studied, outflows at most
banks were limited to less than 10 per cent
of deposits. In fact, during each semiannual
period, about one-half of the banks with
outflow experienced outflows amounting to
less than 5 per cent of their net deposits,
and during each quarter over three-fifths of
the banks with outflow were within this
figure. The bulk of the total outflow oc­
curred at these banks with small or mod­
erate individual outflows. But in each period
some banks had relatively large outflow.
There were few large outflows on a rela­
tive basis during the second half of both
1965 and 1962, and the total outflow at
these banks was small (Table 3 ).



TABLE 3
FUND OUTFLOWS AT INDIVIDUAL BANKS
Relative outflow
(percentage of
net deposits)

Percentage of
all member
banks with
specified
outflow

July-December 1965 ........
Under 5.0 ......................
5.0-9.9 ............................
10.0 and over ..............
July-December 1962 ........
Under 5.0 ......................
5.0-9.9 ............................
10.0 and over ..............

22

January-June 1966 ..........
Under 5.0 ......................
5.0-9.9 ............................
10.0 and o v e r ................
January-June 1963 ..........
Under 5.0 ......................
5.0-9.9 ............................
10.0 and over ................

78
39
25
14
78
37
25
16

17
4

2
22
17
3

1

Total
outflow
(billions
of dollars)
.9

.6
.2
.1
.6
.4
.1
.1
9.1
3.8
3.9
1.5
7.7

2.6
3.6
1.6

D ata for the fourth quarter of 1962,
however, reveal a greater frequency of the
larger relative outflows— a finding that is
submerged in the semiannual data because
these banks had either fund inflow or only
small fund outflow during the third quarter.
During the fourth quarter, in which the
banking system as a whole was experiencing
its greatest net fund inflow, 12 per cent of
member banks had outflows amounting to
at least 5 per cent of their deposits, and at
4 per cent of banks the outflow equaled 10
per cent or more of deposits.

104

Large relative outflows were common in
the first half of both 1966 and 1963. About
one in every seven member banks experi­
enced outflow equal to at least 10 per cent
of its net deposits, and at some banks the
ratio of outflow to deposits was consider­
ably above this level (Table 3). However,
the banks with large relative outflows were
evidently the smaller banks. For instance,
in 1966 the 14 per cent of banks at which
outflow was at least one-tenth of deposits

accounted for only 16 per cent of the total
outflow of $9.1 billion.
About two-thirds of member banks had
outflows in each of the quarters in the first
half of 1963. In each quarter, one-fourth of
the member banks had outflow that equaled
or exceeded 5 per cent of their deposits.
About 8 per cent of the banks had outflows
exceeding one-tenth of deposits, and these
banks accounted for only a minor propor­
tion of the total quarterly outflows.

A SEASONAL BORROWING PRIVILEGE
Design of a seasonal discount program

It has been shown that only a minor part of
total fund outflow occurs at banks with large
relative outflow. Data presented in this sec­
tion further indicate that large relative out­
flows occur much more frequently among
small banks than among the larger insti­
tutions. Considered jointly, these findings
have several implications for the design of
a discount program that would permit more
seasonal borrowing by member banks.
To serve only banks with large relative outflows.

First, if the seasonal discount program were
limited to banks with the larger relative
outflows, a significant number of small
banks would be assisted in making portfolio
adjustments but the total amount of funds
supplied would constitute a small propor­
tion of total reserves in the banking system.
Second, the small banks that would com­
prise the majority of banks eligible for the
program are likely to be operating at a
disadvantage in the present financial mar­
kets that are commonly employed for port­
folio adjustment purposes. The discount
route for seasonal funds should therefore
be a relatively attractive one for such banks.
Third, many of the small banks with large
relative seasonal flows are probably involved




heavily in financing agriculture, a sector that
in recent decades has been generating credit
demands in excess of its contribution to the
growth of rural banking resources. The sea­
sonal discount program would therefore
provide a net addition to the lending re­
sources of such banks that currently find
it difficult to meet the aggregate local de­
mands for farm credit.
To require banks to fund part of outflow.

An additional practical consideration en­
ters into the design of a discount program
to serve banks with large relative seasonal
fund flows. Only that part of the seasonal
outflow exceeding a specified relative level
ought to be funded through discounting;
otherwise, banks would unwisely be given
an incentive to achieve seasonal outflows.
But if each bank were required to meet,
through portfolio adjustment, all seasonal
outflow up to a specified proportion of its
resources, the incentive to undertake opera­
tions that deliberately create or accentuate
seasonal flows would be largely removed. At
the same time, a bank experiencing large
relative seasonal credit demands that it be­
lieves should be met would be encouraged
to do so, and by discounting would be able
to obtain funds for this purpose to meet

105

IN T RA YEA R FUND FLO W S AT C O M M E R C IA L B A N K S

demands that it might otherwise be unable
to fulfill.
The level of the “deductible” quantity—
the amount of its seasonal outflow that a
bank would be required to meet from
sources other than borrowing at the discount
window— could be set at a given percentage
of average deposits. The level at which this
percentage is set affects both total poten­
tial borrowings and the distribution of the
potential borrowings among large and small
banks. As the level is lowered, more of the
larger banks that experience moderate in­
trayear outflows qualify for seasonal bor­
rowing, and potential total borrowings in­
crease rapidly. As the deductible is raised,
potential total borrowings diminish, but so
does the value of the program to those banks
with large relative outflows.
On the basis of the intrayear outflow
data that have been presented, deductible
levels of 5 and 10 per cent of net deposits
may represent approximate lower and upper
limits, respectively, of the deductible for a
seasonal borrowing program that might pro­
vide significant assistance to many banks,
yet keep potential borrowings within the
scope permitted to the discount mechanism
in recent years. Under the 5 per cent de­
ductible, potential borrowings in the spring
are estimated at $2 billion, with just over
one-half of the sum going to banks with
deposits of $100 million and over. Potential
springtime borrowings under the 10 per
cent deductible plan are estimated at $400
million, with perhaps two-fifths of the total
being borrowed by the large banks.
As a representation of real potential bor­
rowings, these estimates are subject to the
same basic weakness as the fund outflows
considered throughout the study— the in­
herent disadvantage of being based on quar­
terly or semiannual observations that are
unlikely to have measured the true seasonal




peaks and troughs, and the likelihood that
with discounting providing a source of addi­
tional seasonal funds, some banks would
make additional seasonal loans that they
were unable to make during the past periods
that have been examined.
Potential borrowings by period
and by size of bank

In both 1965 and 1962, relatively few
member banks had large or even moderate
relative outflows in the second half as a
whole. The amounts exceeding the deduct­
ible were small even under the 5 per cent
rule (Table 4 ). Most of the seasonal bor­
rowing that might occur in this period would
evidently be at small banks. This would be
particularly true in the fourth quarter of the
year, in which a fair proportion of small
banks, but no large banks, had large rela­
tive outflow. On a quarterly basis, poten­
tial borrowing demands appear larger in the
fourth quarter than in the second half as a
whole but are still relatively small sums.
TABLE 4
POTENTIAL BORROWINGS BY SIZE OF BANK
Net deposits
at bank
(millions
of dollars)
July-December 1965 . .
Under 1 0 ..................
10-99 ........................
100 and over ..........
Tuly-December 1962 ..
Under 1 0 ..................
10-99 ........................
100 and over ..........
January-June 1966 . . .
Under 1 0 ..................
10-99 ........................
100 and over ..........
January-June 1963 . . .
Under 10 ..................
10-99 ........................
100 and over ..........

Percentage
of specified
banks with
outflow over—
5% of 10% of
deposits deposits
5
7
3

1
6
3
1

5

39
43
34
32
41
44
35
36

2
2
1
1
2
1
14
19
7
5
16

20
8
6

Total outflow
(millions
of dollars)
over—
5% of
deposits
140
48
75
17
91
37
43

11

1,989
385
565
1,039
2,087
420
514
1,153

10% of
deposits
54
19
36
25
15

11

409
150

100

159
441
184
114
144

Major borrowing under a seasonal dis­
count program would evidently occur in
the first half of the year. A rather large
proportion of small member banks— about
one-fifth of those with deposits under $10

106

million— might be eligible for borrowing
even under the 10 per cent deductible plan.
Some large banks also would be eligible
and would account for a significant portion
of the total potential borrowings, on the
basis of data for 1966 and 1963 (Table 4 ).
At $2 billion, total potential borrowings un­
der the 5 per cent deductible were almost
five times the potential borrowings under
the 10 per cent plan. The proportion of
potential borrowings at large banks was
larger under the 5 per cent deductible.
On a quarterly basis, potential borrow­
ings appeared lower than those just shown
for the first half as a whole because many
banks had outflow in both quarters of the
period. The cumulative data covering both
quarters may therefore be more indicative
of the level that potential borrowings could
reach in this peak outflow period.
Potential borrowings under alternative
deductible levels

There are large differences in banks eligible
and in potential borrowings under the 5
per cent and 10 per cent deductible levels.




The 10 per cent level appears rather restric­
tive, unless it is found that many banks have
in fact been forced to limit seasonal lending
significantly in recent years. But the 5 per
cent deductible, under which two-fifths of
member banks might be eligible, perhaps
violates the intent to limit the program to
banks with relative outflows significantly
above average. Under other alternative de­
ductible levels within this range, using data
for 1965-66, potential borrowing is as
shown in Table 5.
TABLE 5
POTENTIAL BORROWINGS BY DEDUCTIBLE LEVELS
Outflow during
period exceeds
net deposits
by at least—
July-December 1965:
5 per cent ................
6
................
................
7
................
8
9
................
10
................
January-June 1966:
5 per cent ................
6
................
7
..........
8
................
9
................
10
................

Percentage
of member
banks with
specified
outflow

Total outflow
(millions
of dollars)
exceeding
specified
percentage of
net deposits

5
4
3
3

140
113
90
75
63
54

39
32
26

1,989
1,422

2
2
22
17
14

1,022
724
531
409

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE,
AND PROPOSALS TO INCREASE AVAILABILITY OF BANK CREDIT
Emanuel Melichar, Board of Governors of the Federal Reserve System
Raymond J. Doll, Federal Reserve Bank of Kansas City

Contents
I. Introduction_______________________________________________________________________ 109
II. Sum m ary of Findings and P roposals_____________________________________________ _ _ 1 0 9
Part 1.

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE_____________________ 114

III. Capital R equirem ents, 1 9 5 0 -7 9 ----------------------------------------------------------------------------- 115

Capital stock of agriculture, 1950-80
Capital requirements by asset group, 1950-79
Total capital flows, 1950-79
IV. Credit R equirem ents, 1 9 5 0 -7 9 ____________________________________________________ 129

How have capital requirements been financed?
Projected credit requirements, 1970-79
V. Sources of Credit, 1 9 5 0 -7 9 ________________________________________________________ 136

Sources of outstanding credit, 1950-68
Relative role of banks, 1950-68
Projected credit expansion by major lenders, 1970-79
Supply of funds at rural banks
VI. Seasonal Production C redit------------------------------------------------------------------------------------145

Seasonal capital requirements
Seasonal credit extensions
Institutional sources of seasonal credit
Part 2.

PROPOSALS TO INCREASE AVAILABILITY OF BANK CREDIT____________________150

VII. C orrespondent and Branch Banking----------------------------------------------------------------------- 151

Correspondent banking
Branch banking
VIII. Federal Reserve C redit---------------------------------------------------------------------------------------- 159

Seasonal discount credit
Longer-term credit
IX. Unified M arkets to Serve Rural B anks--------------------------------------------------------------------- 167

Organization
A secondary market for rural bank loans
Other services of unified markets
X.--Concluding C om m ents----------------------------------------------------------------------------------------— 1 7 2




107




CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE,
AND PROPOSALS TO INCREASE AVAILABILITY OF BANK CREDIT

I. INTRODUCTION
A large proportion of the Nation’s banks
are located in rural areas where agriculture
is the primary economic base. Deposit
trends at these banks— and loan demands
made on them— derive mainly from devel­
opments in the agricultural economy. Thus,
many aspects of the well-known “revolu­
tion” in the structure of agricultural produc­
tion and related rural business have had
major impact on rural banks and promise
to continue to exert similar influence for
some time. This study gives special atten­
tion to those problems of rural banks that
arise from the peculiar nature of and
changes in their agricultural environment.
It seeks to determine how the Federal Re­
serve discount mechanism might be made
more helpful to those banks.

The examination of past and projected
agricultural and rural banking trends, how­
ever, suggested that maintenance of the
present leading role of banks in rural lend­
ing will likely require institutional changes
beyond those that appear feasible in dis­
count administration and other Federal Re­
serve policies. Thus after documenting the
growing capital requirements of the agri­
cultural sector and the increasing inability
of rural banks to finance their usual share
of the resulting credit demands, this report
outlines a broad program designed to in­
crease materially the flow of funds from
national capital and money markets into
rural areas through the banking system.
This paper was first prepared in 1966, and
was expanded and updated in October 1969.

II. SUMMARY OF FINDINGS AND PROPOSALS
economy, which brought higher prices for
some purchased inputs and added to de­
mand for land. And a substantial portion
resulted from land price increases to which
farm enlargement, land improvement pro­
grams, and other technologically induced
pressures contributed. In addition, as agri­
culture purchased more production inputs,
capital requirements of related rural busi­
nesses also rose.
Several agricultural economists have re­
cently studied farm capital growth. Each
concluded that the value of capital stocks

Capital used in agriculture has been in­
creasing rapidly. Since 1950, for example,
the value of farm assets of a primarily pro­
ductive nature has risen by 131 per cent.
This growth is traced mainly to techno­
logical developments that have prompted
enlargement of individual farms and substi­
tution of purchased inputs for labor and
farm-produced inputs. Some of the capital
growth occurred as farmers added to physi­
cal stocks of machinery, livestock, and other
assets. Another part can be ascribed to
growth and price inflation in the nonfarm




109

110

will rise further, though they differed on the
rate of growth and on which assets will lead
the advance. By using information mainly
from these studies, three alternative capital
models are developed in this study. In the
lowest of these estimates, the value of farm
assets projected for 1980 is 28 per cent
above that of 1969, whereas the highest
estimate indicates a gain of 74 per cent.
From the projected capital stocks, esti­
mates are made of the implied yearly capi­
tal flows— the capital requirements that
must be financed in some manner. As the
capital assets of agriculture increase, larger
annual flows of capital are generally re­
quired to make real additions to stocks, re­
place equipment as it depreciates, and trans­
fer assets from one farmer to the next. An­
nual capital flows for these purposes are
estimated to have averaged $7 billion during
the 1950’s and to have been fairly stable
during the late 1950’s and early 1960’s. By
1965-68, however, the annual flow aver­
aged $11 billion per year. And under the
three alternative capital models formulated
herein, capital flows are projected at from
$13 to $19 billion in 1975-79.
Annual capital flows are financed either
internally from cash flow— depreciation al­
lowances and net income— or externally by
expanded use of credit. Upon comparing
estimated capital flows, known expansion of
credit, and estimated cash flows, it appears
that the proportion of cash flow allocated
by farmers to capital needs declined during
the 1950’s. Consequently, the share of capi­
tal spending financed by debt rose from 13
per cent in the early 1950’s to 31 per cent
in the early 1960’s. Then, the proportion of
income allocated to capital apparently sta­
bilized, but because capital spending rose
more sharply than income, the share fi­
nanced by debt reached 37 per cent during
1965-68.




These findings provide a framework
within which future farm credit demands
may be projected. For the estimates made
herein, capital flow requirements and de­
preciation allowances were taken as pro­
jected by the three alternative capital
models, net farm and nonfarm income was
projected on the basis of recent trends, and
the proportion of cash flow that farmers
would allocate to capital spending was pro­
jected at the level that prevailed in the
1960’s. Outstanding farm debt, which rose
from $10.7 billion in 1950 to $23.6 billion
in 1960 and $52.0 billion in 1969, in the
lowest projection increases to $91 billion by
1980 and in the highest to $137 billion. The
lowest projection implies that debt will in­
crease by about 5 per cent annually, a sig­
nificant slowdown from recent growth rates
averaging 9 per cent, but a rate that never­
theless calls for $3 to $4 billion of net addi­
tions to outstanding debt annually between
now and 1980. The highest projection calls
for debt to rise by $79 billion during the
next decade, which would require annual
rates of increase similar to those of the
1960’s.
Increased credit to agriculture has been
supplied in three important ways. First,
more sellers of farms have been taking mort­
gages or using land contracts. Individuals
have been providing about one-fifth of the
additions to outstanding farm debt. Second,
money and capital market funds have been
channeled into agriculture through the lend­
ing operations of life insurance companies,
Federal land banks, production credit as­
sociations, and national farm supply corpo­
rations. Such funds have provided about
one-half of the growth in farm credit. Third,
commercial banks have been supplying
about one-fourth of the additional credit.
Some of these loans have been made by
large money market banks, either directly

C A PIT A L AN D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

or through correspondent relationships with
rural banks; much of the loan expansion,
however, has occurred at smaller country
banks.
Rural banks have increased loans at a
much faster pace than their deposits have
grown, a divergence made possible by the
low ratio of loans to deposits found at most
banks when World War II ended. Through
lending supported by the past accumula­
tion of deposits, bank credit to farmers has
almost kept pace with the total expansion
of farm credit, even though deposits, being
dependent on gains in aggregate farm in­
comes and savings, rose at a much slower
rate.
However, expansion of bank lending by a
relative shift from security investments to
loans obviously could not be sustained for­
ever. Individual rural banks began to reach
a “tight” position during the 1950’s, and a
large proportion have now reached the point
at which further reductions in liquidity do
not appear feasible, given present institu­
tional arrangements. As these banks in­
clude most of the larger institutions and
those that have been most active in meeting
the credit demands of their areas, much of
the Nation’s farm loan volume is affected.
In the last few years, loan demands would
have pressed harder against rural banking
resources had not time deposits grown at
an extremely rapid pace. Unfortunately, a
lower rate of deposit expansion may realis­
tically be expected over the next decade.
When the three alternative farm credit de­
mand projections are compared with pro­
jected deposit expansion, two indicate that
banks as a whole will find it difficult to sup­
ply from their own resources the same share
of farm credit growth that they have pro­
vided since 1950. If rural banks are to
maintain their relative role in farm lending,
this analysis indicates that they must draw




111

increasing proportions of their loan funds
from sources other than local deposits.
Several existing arrangements permit
fund flows between urban and rural areas
via banks. In unit-banking States, city bank
participations in farm loans channel urban
funds into farm lending. A thorough ex­
amination of this mechanism, however,
leads to serious doubts that it can develop
sufficiently to fill the credit gap. Its present
use is largely restricted to dealing with over­
lines rather than with general credit deficits
at country banks; in fact, since the usual
“payment” for the service consists of de­
posits maintained at the urban correspon­
dent, the net flow of funds in most cases
appears to be to the city rather than the
rural bank. For those rural banks that are
short of loanable funds, correspondent
credit would be more helpful if it could be
paid for by fees rather than balances, and
development of this practice is advised.
However, the generally tight liquidity posi­
tions of city banks will hardly lead them to
favor this change or to increase significantly
the supply of correspondent credit if it were
adopted.
In States with large branch-banking sys­
tems, funds can flow internally from urban
offices to rural branches where loan demand
exceeds deposit inflow. Studies of branch
systems show that such flows do occur, and
that at particular branches the funds so ob­
tained are often relatively greater than a
unit bank would have been likely to obtain
through the correspondent-banking system.
Thus, in States that have well-developed
statewide branch systems and also urban
areas sufficiently large either to provide sur­
plus funds or to support a bank large
enough to tap national money markets, the
supply of bank funds to farm lending ap­
pears more likely to remain adequate pro­
vided that the managers of the branch sys-

112

terns maintain both interest and competence
in farm lending. But even if the latter con­
dition were met, it seems doubtful that ex­
pansion of branch banking to rural areas
of present unit-banking States will provide
an adequate near-term, solution to main­
tenance of banking’s role in farm lending.
If laws restricting branching are liberalized
at all, initial changes are likely to permit
only limited branching arrangements. Fur­
thermore, in some rural States with limited
urban development, even statewide branch
banking might not have a sufficient urban
base to increase materially the flow of funds
into the rural areas.
New approaches are therefore recom­
mended. To maintain farm lending opera­
tions of commercial banks in a fully viable
condition— in fact, to improve them at
banks that are already experiencing the diffi­
culties cited— two broad proposals for chan­
neling funds to rural banks are made herein.
First, greater amounts of Reserve Bank
credit should be provided directly to rural
banks through changes in the nature and
administration of the discount mechanism.
Second, new institutional arrangements
should be established to permit greatly in­
creased rural bank participation in national
capital and money markets.
Small rural member banks have made
limited use of System discount facilities in
recent decades. The discount window may
have been avoided partly because of the
manner in which it was administered— the
“reluctance to borrow” may have devel­
oped into a considerably larger deterrent
against borrowing by the smaller banks. In
addition, temporary fund needs at rural
banks are usually for relatively lengthy
periods such as a crop production season,
and borrowing arrangements at most Re­
serve Banks have been ill-adapted to han­
dling such needs. In fact, a strict interpre­




tation of the regulation held that borrowing
for normally expected seasonal outflows of
funds was inappropriate.
Thus, administration of the discount win­
dow that removes any previous stigma as­
sociated with borrowings for small short­
term adjustments, and that permits borrow­
ing for lengthy seasonal periods under
equally clear guidelines, should encourage
use of the discount window by rural banks.
Seasonal borrowing privileges, in particular,
would benefit the significant number of
small rural banks and the communities they
serve, because farm customers have a large
relative seasonal fund demand. By borrow­
ing from the Federal Reserve to meet such
seasonal outflows, these banks could employ
for other community loan needs the funds
that now must be set aside for the seasonal
demands and that therefore either remain
idle, or are temporarily invested outside the
community, for up to half the year.
A seasonal borrowing privilege appears
able to provide prompt and significant as­
sistance to rural member banks facing rela­
tively large seasonal demands, but could
not be employed by the many rural non­
member banks and would likely be rela­
tively insignificant to rural member banks
in areas of balanced crop and livestock
production, in which farm credit demands
occur throughout the year rather than sea­
sonally. A complementary and more gen­
eral approach— one that would benefit all
rural banks— would aim to reduce the capi­
tal market imperfections that now largely
prevent small and rural banks from using
these national markets as a source of funds.
To this end, a second set of proposals is
set forth under “Unified markets to serve
rural banks.” These markets would be de­
signed to place small and rural banks on a
more nearly equal competitive footing with
other participants in the national capital and

C A PITA L A N D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

money markets by minimizing the disadvan­
tages that result from the small size and
isolated location of these banks. The major
objective of unified markets is seen as facili­
tating sale of a wide variety of bank assets
and liabilities, thereby encouraging national
money market funds to flow into rural areas
through the banking system much as they
presently can through the cooperative credit
system. Unified markets could provide rural
banks with information and arrangements




113

for effective trading in Federal funds, Gov­
ernment securities, and certificates of de­
posit issued by these banks, in addition to a
secondary market for loans. In each of these
endeavors, they would strive to overcome
the market imperfections that now place
small and rural banks at a relative dis­
advantage, and would thereby secure more
equitable allocation of money market funds
among sectors of the economy and regions
of the Nation.

Part 1. CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

Farmers’ use of credit increased almost five
times in the aggregate and nine times on a
per-farm basis between January 1, 1950,
and January 1, 1969. Total debt (exclusive
of Commodity Credit Corporation debt)
rose from $11 billion to $52 billion; debt
per farm increased from $1,900 to $17,000.
Several factors combined to bring about
this large expansion: new technology
spurred upward trends in total farm capital
stocks and production expenses; technology
also permitted enlargement of individual
farms, with associated capital demands;
prices of some capital goods— particularly
real estate and machinery— advanced con­
siderably; and finally, farmers financed an
increasing proportion of their capital re­
quirements by borrowing. Farm debt as a
percentage of selected production assets rose
from 8.8 per cent in 1950 to 18.5 per cent
in 1969.
Since the major forces responsible for the
rapid growth of farm debt from its low
point of 1946 continue to prevail, there is
widespread expectation of further credit
expansion. Few studies, however, have at­
tempted to quantify these expectations in a
reasonably rigorous and comprehensive
fashion. One study that did cover all farm
debt was generally assumed to have reached
a bullish— perhaps even alarming— con­
clusion by projecting outstanding farm debt
of $100 billion in 1980. In fact, however,




this projection implied a substantial slow­
down in the rate of credit expansion, which
followed as a consequence of the much re­
duced rates of future capital spending and
land price inflation that were assumed in the
study. Other analyses of investment and
land prices appear to support much higher
expectations, but their authors stopped at
projecting the value of capital stocks rather
than also examining the implied capital
flows and credit demands.
This paper therefore attempts first to
ascertain and analyze postwar capital flows
in agriculture and then to remedy the
paucity of projections of such flows. In
Section III, the nature and magnitude of
past and future capital requirements are
explored. Uses of capital are identified, and
the flow of capital into each use is esti­
mated. Projections of capital flows for
1970-79 are then derived for each of three
projections of farm capital stocks in 1980
that have been published in studies by other
analysts.
Section IV then attempts to determine
likely future credit demands, given the pro­
jected capital flows. To provide a basis for
such credit projections, financial data for
1950-68 are examined to ascertain trends
in the manner that capital flows required in
this period were financed— whether intern­
ally from depreciation allowances and net
income or externally through increase in
114

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

debt. Then, with the aid of specific assump­
tions about future income and financial be­
havior of farmers, probable additions to
debt are projected. (With additional time
and resources, development of a model in
which capital, income, and savings flows are
jointly determined would be a preferable
procedure, and perhaps will be inspired by
these preliminary efforts.)
After projection of total credit demands,
attention turns to the various lenders that
may supply these funds. Again, although
apprehensions have often been expressed
about the continued ability of certain farm
lenders— particularly commercial banks—
to continue rapid expansion of farm credit,
no previous study has pitted specific alterna­
tive projections of credit demands against
projections of bank lending resources, in
order to determine the situations in which
those fears might be justified. This analysis
is attempted in Section V. First, sources of
additions to farm debt during 1950-68 are
examined in order to ascertain the share of
credit provided by each lender group. Then,

115

for each of the alternative credit projections
derived in the preceding section, estimates
are made of the amount by which banks
would have to expand their farm lending in
order to maintain their relative role in this
market. The various required rates of ex­
pansion in loans are compared with the
projected rate of growth in deposits, to de­
termine the conditions under which banks
are likely to experience future difficulty in
meeting farm loan demands from their own
resources.
Credit extensions to meet seasonal capital
requirements are treated separately in Sec­
tion VI. Because neither seasonal expenses
nor total seasonal loans are measured di­
rectly, little quantitative analysis of these
flows has been attempted at the national
level. However, in Section VI an attempt is
made to provide indicators of the trend in
seasonal capital needs and in seasonal credit
provided by banks and production credit
associations. The relative extent to which
these two lenders have met the increased
seasonal needs is then estimated.

III. CAPITAL REQUIREMENTS, 1950-79
Measurement, analysis, and projection of
capital used in agriculture have primarily
dealt with stocks of assets and with past
and expected changes in those stocks. The
U.S. Department of Agriculture annually
publishes the value of several categories of
farm assets such as real estate, machinery,
and livestock. Analytical studies have re­
lated observed changes in these series to
changes in various farm and nonfarm fac­
tors. On the basis of these observed relation­
ships, together with estimates of future
trends in the causal factors, several recent
studies have projected values of major farm
assets to 1980.
This section begins with a brief review




of past developments and of three selected
projections of capital stocks. • These data
alone, however, prove inadequate as indica­
tors of the actual flow of capital into agri­
culture, both past and future. The annual
capital flows, although related, are not
equivalent to changes in the value of stocks.
In particular, large amounts of capital are
required annually to replace machinery that
has worn out or become obsolete and to
finance transfers of real estate. Thus, in a
given year the value of stocks could remain
unchanged because of stable prices and no
net real investment, but several billion dol­
lars of capital would be required by replace­
ment and transfer transactions. Conversely,

116

although price increases of machinery or
land that cause assets to be revalued upward
would have the same proportional effect on
replacement and transfer transactions, the
dollar increase in the latter would be only
a small fraction of that in stocks, because
only a portion of the stocks is replaced or
transferred in any given year.
A significant analytical contribution of
this section, therefore, is calculation of past
annual capital flows and of flows implied
by the stocks projected for 1980. Data on
most kinds of capital spending were avail­
able from the USD A, but one very impor­
tant category— real estate transfers prior to
1965— had to be estimated. Capital spend­
ing and transfers implied by each projection
of stocks were also estimated, with attention
to whether an increase in stocks was ex­
pected to result from price rises or from
real additions. Each type of asset is dis­
cussed separately, to consider the factors
that probably caused past changes in the an­
nual capital flow that it required and hope­
fully to establish a basis for projection of
probable future change. The projected com­
ponents are then summed to obtain three
alternative projections of farm capital flows
during the 1970’s.
C a p ita l s to c k o f a g ric u ltu re , 1 9 5 0 - 8 0

The stock of various types of farm capital,
valued at current market prices, is estimated
annually by the USDA. Table 1 shows

that selected assets of a primarily produc­
tive nature totaled $281.1 billion as of Jan­
uary 1, 1969. These assets— machinery,
livestock, stored crops, working capital, and
real estate— constitute the capital analyzed
in this study. The account includes some
nonproductive assets such as dwellings, per­
sonal cars, and some forms of personal sav­
ings. It excludes the two other personal as­
sets included in the USDA’s Balance Sheet
of Agriculture— household equipment and
investments in cooperatives— as well as
other personal assets owned by farmers,
such as nonfarm investments and the cash
value of life insurance policies, that are not
included in the Balance Sheet. As in the
Balance Sheet, all farm assets of the selected
types are included in the totals, whether
owned by farmers, nonfarm landlords, or
other persons or institutions.
Composition and trends. The selected agri­
cultural assets increased in value in every
postwar year except 1950 and 1954, for a
total gain of $159.3 billion since the be­
ginning of 1950. Annual increases during
the 1950’s averaged 4.5 per cent, fell to
3.4 per cent during 1960-64, but then ac­
celerated to 5.9 per cent in the 1965-68
period.
Real estate remains the most important
farm asset, and indeed its relative value rose
from 62 per cent of total assets in 1950 to
72 per cent in 1969. Of the real estate
value, perhaps one-fifth is contributed by

TABLE 1
VALUE OF SELECTED ASSETS USED IN AGRICULTURE
Billions of dollars
A sset

Per cent of total

1950

1955

1960

1965

1969

1950

1955

1960

1965

1969

Vehicles, machinery, and e q u ip m e n t.................
L iv e sto c k .......................................................................
Stored c r o p s .................................................................
Demand deposits and cu rren cy ............................
Time deposits and savings bonds ......................
Real estate ...................................................................

12.2
12.9
7.6
7.0
6.8
75.3

18.6
11.6
9.6
6.9
7.5
98.2

22.2
15.2
7.7
6.2
7.6
130.2

25.5
14.5
9.2
5.9
7.9
160.9

32.6
20.1
10.5
6.3
9.0
202.6

10
11
6
6
6
62

12
7
6
5
5
65

12
8
4
3
4
69

11
6
4
3
4
72

12
7
4
2
3
72

Total selected assets ...........................................

121.8

152.0

189.1

223.9

281.1

100

100

100

100

100

S o u r c e . — T h e B alan ce S h e et o f A g ricu ltu re, 1968, U SD A , Jan. 1969, pp. 10, and 26 and 27. Data are shown as of January 1 of

each year.




117

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

farm dwellings and service buildings and the
remaining four-fifths by land and land im­
provements.
In second place among asset groups, the
machine stock— vehicles, machinery, and
equipment— comprised 12 per cent of assets
in 1969 and has roughly maintained this
proportion since 1950. Livestock ranked
third in 1969, at 7 per cent of the total.
Stored crops and financial working balances
each represented about 5 per cent and have
been declining in relative importance.
Changes in asset values over 5-year in­
tervals since 1950 are shown more explicitly
in Table 2 (dollar changes occurring during
1965-68 were multiplied by 1.25 to express
them as a 5-year rate comparable to the
previous periods). Prominent features in­
clude the following: (1 ) increases in real
estate values accounted for a large propor­
tion— an average of 80 per cent— of the
gain in total assets; (2 ) growth in value of
machinery and livestock involved consider­
able sums in some years, but varied con­
siderably over the period; and (3 ) asset
growth in 1965-68 proceeded at an extra­
ordinarily rapid rate, as growth in machin­
ery, livestock, and real estate values each
accelerated.
Real versus price changes. In contrast to
the changes in current value discussed
above, the total farm physical plant, often
referred to as real assets, has expanded
rather slowly since 1950 (Table 2 ).
According to USDA estimates, the se­
lected farm assets, when valued at constant
prices, rose by only 15 per cent in 1 9 5 0 68. As the current value of these assets
increased by 131 per cent, by implication
the total price rise during the period was
estimated as 101 per cent.
The separation of capital growth into its
real and price components is important to
analysis and projection of capital flows,




TABLE 2
CHANGES IN VALUE OF SELECTED
ASSETS USED IN AGRICULTURE
Asset

1950-54 1955-591960-64 1965-69*
5-year total (billions of dollars)

Vehicles, machinery, and
e q u ip m en t............................

8.9
7.0
1.6

6.4
—1.7
2.0

3.6
4.0
—1.9

3.3
—.7
1.5

—.1

—.7

—.3

.5

Real estate ..............................

.7
22.9

.1
32.0

.3
30.7

1.4
52.1

Total selected assets . . .

30.2

37.1

34.8

71.5

Stored crops ............................
Demand deposits and
currency ..............................
Time deposits and savings

Percentage change in
current value
Vehicles, machinery, and
eq u ip m en t............................
Stored c r o p s ............................
Demand deposits and
currency ..............................
Time deposits and savings

52
—13
26

19
36
-2 0

15
-5
19

—1

-1 0

-5

Real estate ..............................

10
30

Total selected assets . . .

25

35
48
18
8

1
33

4
24

17
32

24

18

32

Percentage change in
real assets
Vehicles, machinery, and
eq u ip m en t............................

37
11
11

-3

Stored c r o p s ............................
Demand deposits and
currency ..............................
Time deposits and savings

” 3

4
7
-2

—10

-1 6

-1 2

Real estate ...............................

—1
4

-6
2

—3
2

2
2

8

0

2

6

Total selected assets . . .

18
2
40
-3

Average annual percentage
change in current value
Vehicles, machinery, and
e q u ip m en t............................
Stored c r o p s ............................
Demand deposits and
currency ..............................
Time deposits and savings
Real estate ..............................
Total selected assets . . .

8.8
-2 .7
4.8

3.6
6.3
-4 .3

2.8
-.9
3.6

-.3

-2 .2

-1 .0

1.6

2.0
5.5

.3
5.8

.8
4.3

3.3
5.9

4.5

4.5

3.4

5.9

6.3
8.5
3.4

Average annual percentage
change in real assets
Vehicles, machinery, and
eq u ip m en t............................

6.5
2.2
2.1

-.7
” .6

.8
1.3
—.4

3.4
.5
7.1

-2 .2

-3 .5

-2 .4

—.6

Real estate ..............................

-.3
.8

- 1 .3
.4

—.7
.4

.4
.3

Total selected assets . . .

1.4

0

.3

1.3

Stored c r o p s ............................
Demand deposits and
currency ...............................
Time deposits and savings

* Data shown for 1965-69 are actual values for 1965-68
multiplied by 1.25 to facilitate comparison with previous 5-year
periods.
N o t e . —-Users of the data on real assets are referred to p.
118-19 for a discussion of a probable bias in these estimates.
S o u r c e . —Table 1 and additional data from U SD A .

simply because these flows over time differ
for varying mixes of real and price increases
in stock. Efforts to allocate changes in stock
values to real and price components are

118

greatly handicapped, however, by the fact
that capital goods change over time as
technology advances. The tractors and land
of today are not the same products as in
1950, and so one cannot be sure how much
of the increase in their current price rep­
resents price inflation and how much is due
to gains in quality or productivity of the
assets. As such gains often occur in subtle
ways that defy measurement, the USDA
estimates of real assets may understate the
progress that has occurred, and the price
increase may therefore be overstated.
Nevertheless, it appears that real estate
and machinery prices rose rather steadily
during 1950-68, with very significant im­
pact on total asset values. On the other
hand, prices of livestock moved in a direc­
tion opposite to livestock numbers, so that
when the real livestock inventory increased,
its current value tended to decrease, as in
1950-54 and 1960-64.
The rate at which physical additions were
made to stocks of machinery, livestock, and
crops varied substantially from one period
to the next. Machinery stocks were easily
the most volatile component, with especially
rapid increases in the early 1950’s and again
in 1963-67.
Projected capita! stocks in 1980. Three
widely circulated projections of 1980 stocks

constitute the point of departure for esti­
mation of capital flows in the intervening
period. The stocks projected for 1980 in
current (1980) dollars are summarized in
Table 3. To facilitate comparison with cur­
rent values, Model NC (no change) shows
the value of stocks (and later also of flows)
if neither price nor real changes occurred
after January 1, 1969.
The first set of projected stocks, Model
HT, is based primarily on projections for
1960-79 published by Heady and Tweeten
in 1963 after extensive econometric anal­
ysis of the determinants of demand for vari­
ous farm capital goods.1 The HeadyTweeten projections were made in real
terms only, but the machinery, financial
assets, and real estate values shown in Table
3 are altered to reflect moderate price ad­
vances. For real estate, the current-dollar
projection employs a Heady-Tweeten price
equation that is relatively successful in ex­
plaining the postwar course of farmland
values.
The second projection, Model B, is based
on current-dollar projections of 1980 stocks
published by Brake in 1966, with the real
1 E arl O. Heady and L uther G. Tweeten, R esource
D em and and Structure of the A gricultu ral Industry
(Ames, Iowa: Iowa State University Press, 1963).

TABLE 3
ALTERNATIVE PRO JECTIO NS OF SELEC T ED FARM A S SE T S
Asset

Model
NC

Model
HT

Model
B

Model
HM

32.6
20.1
10.5
15.3
202.6
281.1

Vehicles, machinery, and equipment
Livestock ...........................................................
Stored crops ....................................................
Deposits, currency, and savings bonds . .
Real estate ........................................................
Total selected assets ............................

12
7
4
5
72
100

40.5
21.4
10.0
25.2
392.9
490.1

36.4
23.2
11.4
15.7
272.2
358.9

64.2
21.9
10.0
25.2
288.4
409.7

(per cent of total)




8
4
2
5
80
100

10
6
3
4
76
100

Model
HT

Model
B

Model
HM

Change during 1970’s
(billions of dollars)

Amount in 1980
(billions of dollars)
Vehicles, machinery, and equipment
Livestock ..........................................................
Stored crops ....................................................
Deposits, currency, and savings bonds . .
Real estate ........................................................
Total selected assets ............................

M odel
NC

7.3
1.2
-.5
9.2
177.8
195.0

3.5
2.8
.8
.4
64.1
71.5

29.6
1.6
—.5
9.2
79.2
119.1

(average annual percentage change)
16
5
2
6
70
100

2.0
.6
—.4
4.6
6.2
5.2

1.0
1.3
.7
.2
2.7
2.2

6.4
.8
—.4
4.6
3.3
3.5

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

estate estimate as updated by Brake in
1968.2
The final projection, Model HM, is based
primarily on one of several projections of
real stocks of machinery and livestock and
of price changes of real estate published by
Heady and Mayer in 1967, in a project
executed for the National Advisory Com­
mission on Food and Fiber.3 The estimates
used here assumed that land retirement pro­
grams of the present “feed-grain” type are
continued for wheat and feed grains and are
also applied to cotton production, and that
exports increase in accordance with 195065 trends. As with Model HT, the machin­
ery and real estate projections were modified
to reflect trends in machinery prices and in
the general price level, respectively. In ad­
dition, because Heady and Mayer did not
project values of stored crops or of financial
assets, these items were projected at the
same levels as in Model HT.
The three projections agree in one impor­
tant respect: that the total value of farm
assets will increase considerably during the
next decade. Beyond this, there are differ­
ences that appear likely to have considerable
impact on capital and credit demands: (1 )
the projected total increase in value varies
from $71.5 billion under Model B to $195.0
billion under Model HT— an average dif­
ference of $12 billion per year over the de­
cade, and (2 ) growth projected for major
asset components differs greatly. Model HT
projects a relatively rapid rise in real estate
values, but only moderate gains in the ma2 John R. Brake, “Im pact of Structural Changes
on Capital and Credit N eeds,” Journal of Farm
Economics (Dec. 1966), pp. 1536-45. Also “Dim en­
sions of the C redit D oor,” unpublished speech at
Blacksburg, Va., Aug. 5, 1968.
3 E arl O. Heady and Leo V. Mayer, Food Needs
and U.S. Agriculture in 1980, Technical Papers, vol.
1, U.S. N ational Advisory Commission on Food and
Fiber (W ashington: Govt. Printing Office, Aug.
1967).




119

chine stock. The reverse is true of Model
HM, whereas Model B anticipates relatively
moderate growth in all components but with
rising real estate values dominant.
In the next subsection, the bases for these
stock projections are briefly noted, and the
capital flow requirement that appears im­
plied by each model is calculated. The
framework for the analysis both here and
in the next section draws heavily on the pio­
neering capital study of Tostlebe, which is
also the source of many insights into long­
term trends.4 A comprehensive and more
recent capital and credit study by Johnson
was also very useful.5
C a p ita l re q u ire m e n ts b y a sse t g r o u p ,

1950-79
Farm capital flows and credit demands arise
in three important ways. First, they origi­
nate from expenditures to maintain or ex­
pand the capital plant. In this category one
finds spending for (1 ) replacements and
additions to the stock of vehicles, machin­
ery, equipment, buildings, and land im­
provements; (2 ) additions to inventories of
livestock and of crops stored for feed and
seed; and (3 ) additions to financial working
balances. Second, capital flows and credit
demands arise when the capital plant—
especially real estate— is transferred from
one owner to the next by means other than
gift or inheritance. Estimates for 1950-68
of the various capital flow requirements of
these two types are summarized in Table 4.
Third, seasonal credit demands occur when
additional working capital is needed to fi­
nance seasonal production processes for
4 Alvin S. Tostlebe, Capital in Agriculture: Its
Formation and Financing Since 1870 (Princeton:
Princeton University Press, 1957).
5 D. Gale Johnson, “A gricultural Credit, Capital
and C redit Policy in the U nited States,” Federal
Credit Programs, Commission on M oney and Credit
(Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1963),
pp. 355-423.

120
TABLE 4
CAPITAL FLOWS, 1950-69
In billions of dollars
5-year total*
Type of flow
Gross capital expenditures:
Vehicles, machinery, and equipment
Buildings and land improvements . . .
To increase:
Livestock inventory .................................
Stored crop inventory ............................
Demand deposits and currency .........
Time deposits and savings bonds
Required by real estate p u rc h a se s...............
Total capital flow

1950-54
15.4
7.7
2.4
.4

1955-59
14.0
6.9
.5
.8

1.3

- .2

1.7
11.0

13.5

37.4

35.1

39.4

.1

* Data shown for 1965-69 are estimates for 1965-68 multi­
plied by 1.25 to facilitate comparison with previous 5-year
periods.
S o u r c e .— Machinery and building expenditures from F arm
In com e S itu a tio n , U SD A , July 1969, p. 60; increase in live-

which the level of cash assets normally
maintained does not fully provide. These
seasonal demands are discussed in Section
VI.
Vehicles, machinery, and equipment. Im­
proved vehicles, machinery, and equipment
(all grouped under “machinery”) consti­
tute a readily visible example of the impact
of technological change on the capital goods
of agriculture. And in addition to all the
new equipment purchased for production
on farms (with which this study is con­
cerned), there has been considerable non­
farm investment in such allied industries as
hatcheries and feed mills, which perform
work that in earlier years had been done on
farms.
Expenditures for machinery now consti­
tute a significant capital requirement, over
two-fifths of the total flow. Analytically,
these expenditures are of two types: to re­
place stock that has worn out or has be­
come obsolete, and to expand the total stock
in order to increase output or reduce labor
requirements. Expenditures arising from
either need are affected by the course of
machinery prices.
To maintain the machine stock at a given
real level requires an annual expenditure
equal to about 14 per cent of the value of
the stock, according to recent depreciation




16.0
6.4

- .3
.3
16.0

-.1

- .7

1960-64

Annual average
1965-69

1950-54

23.6
6.4

3.1
1.5

.2

.5

1955-59
2.8

1.4

1960-64

1965-69

3.2
1.3

4.7
1.3

—.1

.1

1.4
.5
1.4
20.7

2.2

2.7

3.2

.3
.1
.3
4.2

54.2

7.5

7.0

7.9

1 0 .8

.1

.2

-.1

.1

.1

stock and crop inventories are unpublished data from U SD A
(livestock and crop total is published in F arm In c o m e S itu a ­
tion, July 1969, p. 53); increase in financial assets from T he
B alan ce S h eet o f A g ricu ltu re, 1968, U SD A , Jan. 1969, p. 10;
capital flows required by real estate purchases are estimated
by Emanuel Melichar.

allowances estimated by the USDA .6 With
the stock valued at $32.6 billion in 1969,
annual replacement requirements are thus
around $4.6 billion.
Machinery prices, however, appear likely
to increase over time. Prices set by manu­
facturers are likely to reflect the general
upward course of unit costs in the capital
goods sector of the nonfarm economy. The
implicit price deflator for the total farm
machine stock rose at annual rates of 4.4
per cent in 1955-59, 2.0 per cent in 1 96064, and 2.8 per cent in 1965-68. If, in view
of this record, one projects annual machin­
ery price increases averaging 2.5 per cent in
1969-79 and no real growth, the value of
the stock would still rise to $42.8 billion by
1980. Annual replacement requirements
would by then average $6.1 billion.
Any physical additions to the total stock
constitute a capital flow requirement super­
imposed on the replacement expenditures.
In this century, periods of rapid real expan­
sion have alternated with extended periods
of little or no growth. A spending boom
that nearly tripled the real stock between
1945 and 1954 was succeeded by 10 years
of little growth or of small declines. Re6 USDA, Farm Incom e Situation
Govt. Printing Office, July 1969), p. 61.

(W ashington:

121

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

TABLE 5
PAST A N D PROJECTED RATES OF C H A N G E IN
M A C H IN E ST O C K S A N D PRICES, 1946-79
Average annual rate of change, per cent
Period
1946-48 .............................
1949-51 ............................
1952-55 ............................
1956-60 ............................
1961-62 ............................
1963-64 ............................
1965-67 ............................
1968 ...................................
1970-79:
Model HT .................
B ......................
HM ...............

Total

Real

Price

23.2
18.2
3.7
2.5
2.1
6.0
6.7
4.5

18.4
14.5
2.7
- 1 .3
-.8
4.0
3.8
1.8

4.0
3.2
1.0
3.9
2.9
1.9
2.8
2.8

2.0
.9
6.2

-.5
.3
3.6

2.5
.6
2.5

N o t e . — Users of the data on prices and real stocks are
referred to pp. 118-19 for a discussion of a probable bias in
these estimates.
S o u r c e . — Past annual rates of change in total stock were
computed from data in The B alan ce S h eet o f A g ricu ltu re, 1968,
U SD A , Jan. 1969, pp. 26 and 27. Estimates of past real stocks
were supplied by the U SD A . Price changes shown are for the
implicit price deflator for the total machine stock, as computed
from these two series.

newed rapid expansion beginning in 1963
lifted real stocks by another 23 per cent be­
fore 1969.
Some projections of machinery require­
ments emphasize the spur from continued
technical innovation, combined with desires
and incentives (higher wage rates) to re­
duce labor requirements. Such projections,
as in Model HM, indicate substantial real
increases in future machine stocks.
Other analysts have been more impressed
with the substantial upgrading of stocks that
can occur in the course of the large replace­
ment expenditures. For instance, structural
analysis by Heady and Tweeten suggested
“a mature agricultural economy in terms
of machinery. A large amount of new
machinery will continue to be purchased not
only to replace worn-out machines but also
to substitute for machines that are inade­

quate for large holdings. This will offer siz­
able opportunities for machinery to replace
labor, despite the rather small increment in
machinery assets.”7 This view is represented
in Models HT and B.
The historical record since World War II
taxes analysts seeking to determine the more
appropriate view, as the growth rates shown
in Table 5 demonstrate. Heady and Mayer
analyzed the record of 1949-64 and found
a strong upward trend over these years. The
large expenditures shown for Model HM in
Table 6 are based mainly on assumed con­
tinuation of this trend. In 1975-79, annual
expenditures would average $9.6 billion.
But Heady and Tweeten, writing in the early
1960’s, thought the relative stability of
1952-60 to be more representative of the
future, and thus projected little real expan­
sion. Brake, although writing in 1966 after
expenditures had again accelerated, also
expected relatively slow future growth.
Models HT and B both project average
annual expenditures of about $5 billion in
1975-79, or little higher than those at the
peak of the recent boom.
Buildings and land improvements. Construc­
tion of farm dwellings, service buildings,
and various other structures and land im­
provements such as fences, wells, ponds,
terraces, and tile lines comprises a sub­
stantial continuing capital expenditure, cur­
rently about 12 per cent of total capital
? Heady and Tweeten, op. cit., p. 492.

TABLE 6
ALTERNATIVE PROJECTED EX P E N D IT U R E S FOR M A C H IN E R Y
In billions of dollars
5-year total
Projection

195054

195559

196064

196569

14.0
16.0
23.6*
Actual .................................................. 15.4
Model NC .........................................
HT ........................................................................................................
B .............................................................................................................
HM ........................................................................................................
* Expenditures for 1965-68 multiplied by 1.25.




Annual average
197074

197579

195054

195559

196064

196569

3.1

2.8

3.2

4.7

23.1
24.3
24.4
35.6

23. i
26.8
25.5
48.2

......................................................
.......................................................
.......................................................

197074
4^6
4.9
4.9
7.1

197579
4.6

5.4
5.1
9.6

122

flow. Tn some regions, construction of items
such as irrigation systems and commercial
feed lots has been expanding. Nationally,
however, expenditures have been declining
absolutely as well as relative to other capi­
tal uses.
The downward drift in construction fol­
lowed large gains in the years immediately
after World War II. Expenditures for farm
operators’ dwellings reached a peak of $702
million in 1948 but by 1968 were reduced
to $493 million. Construction of other
buildings and land improvements topped at
$949 million in 1952 and was down to $812
million in 1968.
One factor reducing new farm construc­
tion is the rapidly declining number of farm
units and families. From 1950 to 1968, the
number of farms fell by 46 per cent, or by
about 2.6 million units. Each farmstead that
was abandoned or became a rural residence
for a nonfarm family tended to reduce fu­
ture farm building needs.
In addition, expenditures for new service
buildings have been negatively affected by
various technological developments. Greater
efficiency in livestock production— more
milk per cow, faster growth of hogs and
broilers— enabled farmers to increase out­
put without proportional increases in animal
housing space. Greater use of purchased
mixed feeds and virtual elimination of
horses and mules tended to reduce farm feed
storage requirements. Less costly types of
buildings, such as those employing poletype
construction,
were
increasingly
adopted.
Projected construction expenditures used
in Models HT, B, and HM are based on a
recent study by Scott and Heady.8 They
8 John T. Scott, Jr., and E arl O. Heady, A ggregate
In vestm ent D em an d fo r Farm Buildings: A N ation al ,
R egional and State Tim e-Series A nalysis, Research
Bulletin 545 (Ames, Iow a: A gricultural and H ome
Economics Experim ent Station, Iow a State University,
July 1966), pp. 704-36.




project an average annual real decrease of
0.9 per cent and assume that prices of build­
ing materials will continue to rise at the 2
per cent annual average experienced from
1947 to 1963. Thus, yearly current-dollar
spending would average $1.4 billion during
1970 to 1974, and $1.5 billion in 1975 to
1979.
Livestock inventory. Additions to the quan­
tity of livestock on farms entail a capital
flow equal to the value of the physical quan­
tities added. There is general agreement
that expanding domestic population and
rising per capita income will continue to
raise aggregate demand for livestock pro­
ducts, and that the greater output will re­
quire larger livestock inventories on farms.
However, inventories are likely to rise more
slowly than output. As Tostlebe noted after
his study of 1890-1950, “the most signifi­
cant technological advances in agriculture
. . . have quite consistently been connected
with the production of livestock and of
livestock products. . . . Improvements in
the breeds of livestock and in livestock feed
and management have been sufficient to
permit animal products to become increas­
ingly important in the farm-product mix,
while the investment in productive live­
stock per dollar of total farm product de­
clined greatly.”9 This effect remains impor­
tant. Excluding horses and mules, the num­
ber of animal units of breeding livestock on
farms in 1967 was the same as in 1919 and
somewhat below levels of the 1940’s and
1950’s. However, production per breeding
unit was 116 per cent larger than in 1919,
38 per cent above that of 1950, and up 13
per cent since I960.10 The larger numbers
of feeder livestock and poultry have since
1950 required capital flows that varied
9 Tostlebe, op cit., p. 126.
10 USDA, Changes in Farm Production and Effi­
ciency (W ashington: Govt. Printing Office) June
1955, p. 23; June 1968, p. 10.

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

greatly from year to year, but averaged only
$228 million annually (Table 4 ).
As with the machinery projections, anal­
ysts again apparently differ as to relative
future impact on inventories of the divergent
influences of greater consumer demand and
increased production efficiency. Heady and
Tweeten projected an average annual gain
of only 0.75 per cent in the real livestock
inventory, which would require yearly ex­
penditures of about $120 million during
the next decade. But Heady and Mayer
specifically assumed no further improve­
ment in the inventory/output ratio and thus
projected an average real gain of 2.8 per
cent annually between 1965 and 1979.
Even if livestock prices receded to 1965
levels by 1980, this growth would require
expenditures of more than $700 million an­
nually during the 1970’s. Brake also pro­
jected similar real growth, with 1980 prices
14 per cent over those of 1965. Annual ex­
penditures of $600 million would be re­
quired to achieve this projection.
Although the projections vary consider­
ably, even a relatively faulty livestock fore­
cast does not introduce a large relative
error in projected total capital flows. Pro­
jected livestock expenditures have the great­
est relative importance in Model B, but even
there they account for only 5 per cent of
total capital flows anticipated.
Inventory of stored crops. The value of net
physical additions to farmers’ holdings of
stored crops constitutes a volatile but minor
capital flow that averaged $144 million an­
nually in 1950-68. Diverse influences ap­
pear to be operating on the long-term trend.
Larger livestock production leads to growth
in feed inventories, but the rise is moderated
by upward trends in the animal output ob­
tained from a given quantity of feed and
in the proportion of total feed purchased
from commercial mixers. To the extent that
feed inventories are held by feed companies



123

and dealers, the associated capital require­
ment has been transferred to the nonfarm
economy.
Each capital model projects a continued
small upward trend in real stocks. How­
ever, because 1969 inventories represent a
considerable bulge over the long-term trend
— one of several sizable fluctuations ex­
hibited over the postwar period— these pro­
jections translate into a small amount of dis­
investment between 1969 and 1980.
Financial assets. Farmers must hold money
balances to carry on their business trans­
actions, primarily involving payment for
current operating and family living ex­
penses. Historically, these balances have
risen both in absolute terms and as a pro­
portion of total assets, reflecting the growth
of cash operating expenses as each farm unit
has become less self-sufficient and more
dependent on purchases from other farms or
from the nonfarm sector.
During 1950-65, however, growth in
money holdings was at least temporarily
interrupted as farmers reduced their demand
deposits and currency by $1.1 billion, or
16 per cent. The upward trend in operating
expenses continued during these years, but
offsetting influences on the money stocks
— such as the decline in the number of
farms and in the farm population— were ap­
parently more powerful. In addition, an up­
ward movement in interest rates put an
increasing opportunity cost on cash bal­
ances. Ready availability of seasonal pro­
duction credit may also have enabled
farmers to reduce the relative amount of
cash assets held on January 1, the day on
which these stocks are estimated for the Bal­
ance Sheet.
In response to higher interest rates paid
on time and savings deposits and perhaps
also as a result of improved farm financial
management, farmers may have been more
likely to hold seasonally-idle working capi­

124

tal in time and savings rather than demand
deposits. Thus the change in these assets,
which tended to increase during the post­
war period, has been included among capi­
tal requirements. At the same time, farmers
have reduced their holdings of U.S. savings
bonds, which have also been included among
the financial assets here enumerated.
Projection of financial balances must con­
tend with these diverse influences. Heady
and Tweeten projected a 23 per cent total
real gain in cash for operating expenses be­
tween 1960 and 1980. To achieve this real
growth as prices paid by farmers rise by an
assumed 2 per cent a year, farmers would
have to add $917 million per year to their
holdings of the financial assets listed. This
estimate is used in Models HT and HM.
But Brake projected a slow rise in current
dollars; farmers would have to add only $36
million annually to financial assets to fulfill
his projection, which is used in Model B.
Real estate purchases. Most farm real estate
is owned by individuals and is transferred
from one owner to the next by sale rather
than inheritance. Of the total number of
transfers in the year ending March 1, 1969,
for example, only 13 per cent were inheri­
tance or gift transfers. Voluntary sales by
retiring or retired farmers and others and
by executors of estates averaged $5.5 bil­
lion annually over the 4 years ending on
March 1, 1969.11 Thus, annual purchases of
land are somewhat larger than expenditures
for vehicles and machinery.
Capital flows required by land transfers
are lower than the value of sales, however.
The total capital flow required equals the
money removed from the agricultural pro­
duction sector by sellers who are retiring or
retired farmers, nonfarmer heirs, or nonn USDA, Farm R eal Estate M arket D evelopm en ts
(W ashington: Govt. Printing Office) Aug. 1969, p.
22; M ar. 1969, p. 11; Apr. 1968, p. 14; June 1967,
p. 13.




farmer investors who are withdrawing from
farmland ownership. To calculate the capi­
tal flow, therefore, the value of sales must
be adjusted for the amount of outstanding
debt on the property— which is either as­
sumed by the purchaser or is repaid as a
result of the sale— and also for the proceeds
of land sales that are used to buy other farm­
land.
There is little data on which to estimate
these adjustments and so derive required
capital flows from value of sales. One in­
dication of the amount of outstanding debt
is provided by a 1967 survey showing that
assumption of outstanding property mort­
gages accounted for 9 per cent of credit in­
volved in land transfers, which puts assump­
tions at about 5 per cent of transfer value.
A 1964 survey indicated that about 10 per
cent of total voluntary sales were made by
farmers who continued in farming after the
sale, and who therefore may have bought
other tracts with the proceeds.12 No data
seem to be available on debt repayments or
on the subsequent activities of nonfarmer
sellers.
For estimates of capital flows, land sales
were adjusted downward by 25 per cent to
obtain the capital flow required. In 1965—
68, capital flows associated with real estate
transfers were therefore estimated to aver­
age $4.2 billion per year, or 38 per cent of
total farm capital flows.
For the years prior to 1965, estimates
are made still more difficult by lack of data
on the value of real estate sales. For these
years, only transfer rates and total real
estate values are provided by the USDA.
Since in 1965-68 the value of sales aver­
aged 78 per cent of the figure obtained by
multiplying the transfer rate by total value,
this relationship was used to estimate capi­
tal flows required in 1950-64 (Table 7 ).
12

ib id ., Dec. 1968, p. 23; Aug. 1965, p. 31.

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

125

TABLE 7
ALTERNATIVE PROJECTED CAPITAL FLOWS R EQ U IR E D BY REAL ESTATE P U R C H A SE S
In billions of dollars
5-year total
Projection
Estimated actual ............................
Model NC .......................................
HT .......................................
B ...........................................
HM .......................................

195054

195559

196064

196569

11.0

13.5

16.0

20.7*

Annual average
197074

197579

22.7
28.1
24.9
25.4

22.6
37.3
28.0
29.3

195054

195559

196064

196569

2.2

2.7

3.2

4.2

197074

197579

4.5
5.6
5.0
5.1

4.5
7.5
5.6
5.9

* Estimated flows in 1965-68 multiplied by 1.25.

The estimates indicate a steady upward
trend that about doubled the required flow
between 1950 and 1968, as the effect of
higher land prices easily overwhelmed the
effect of lower transfer rates.
The same relationships were used in pro­
jecting future capital flows. With a con­
tinued small decline in the transfer rate, re­
quired annual capital flows would average
about 2.2 per cent of any projected value of
the real estate stock. Thus if the value of
land and buildings were to stabilize at the
1969 level, as in Model NC, the transfer
capital required would be $4.5 billion per
year. In the other models, the capital flows
depend on the projected course of real estate
prices.
An econometric study by Twee ten and
Nelson that attempted to measure the rela­
tive strength of pressures on farmland
prices in 1950-63 ascribed 52 per cent to
farm enlargement (of which an unspecified
portion was thought due to Government
programs), 20 per cent to demand for
nonfarm uses, 17 per cent to the expectation
of further capital gains, and most of the
remainder to reduction in quantity of land.13
Since the land price index was deflated by
the wholesale price index prior to analysis,
participation by farmland in a general price
13 Luther G. Tweeten and Ted R. Nelson, Sources
and R epercussions of Changing U.S. Farm R eal
Estate Values, Technical Bulletin T-120 (Stillwater,
Okla.: O klahom a State University A gricultural Ex­
perim ent Station, Apr. 1966), p. 18.




uptrend was also assumed. Because of the
many alternative ways in which a land-price
model could be specified and estimated, this
one study is not definitive. But perhaps it
indicates the principal forces bearing on
land prices and exerting through them a
major influence on capital and credit re­
quirements.
In this view, the basic factor behind
increases in land prices is technological
change. First, innovations have increased
the productivity of land. Higher crop yields
resulting from new technology and better
management have tended, ceteris paribus,
to lower unit production costs and increase
net returns. Second, other new technologies
— principally larger tractors and machines
— have permitted a farmer to operate a
larger land area and thereby also to lower
unit overhead costs.14 This incentive to en­
large farm units has created an active de­
mand for land. Competitive bidding among
the more successful farmers— those able to
achieve above-average net returns from
each added tract— has led to increased
prices; in effect, the higher net returns have
been capitalized into land prices.15 Also, as
this experience prevails over many years,
14 Ibid., pp. 45-47.
15 A lbert A. M ontgom ery and Joseph R. Tarbet,
“Land Returns and Real Estate Values,” A gricultu ral
Econom ics Research, USDA (W ashington: Govt.
Printing Office, Jan. 1968), pp. 5-16. W illiam H.
Scofield, “Land Prices and F arm Earnings,” Farm
R eal Estate M arket D evelopm en ts, U SD A (W ashing­
ton: Govt. Printing Office, Oct. 1964), pp. 39^42.

126

the upward course of land prices is prob­
ably further reinforced as buyers discount
expected future advances in technology and
therefore in net returns— or, what is equiv­
alent if less sophisticated, they discount
capital gains from an expected future up­
ward trend in land prices.16
Much of the same new technology that
reduced unit costs, however, also tended to
increase total farm output.17 Output gains
could occur in two ways: through improve­
ment in inputs and farming practices and as
farm consolidation places more of the total
resources into the hands of the more effi­
cient and specialized operators. Government
output control programs kept the potential
output increase from being fully achieved,
but the gain has been sufficiently large rela­
tive to the slower expansion of demand to
exert a depressing influence on output
prices. The latter effect tended to offset the
favorable impact of unit cost reductions
on net returns and would have been more
pronounced in the absence of the Govern­
ment programs.18
In these circumstances the commodity
programs, by restricting total production
and either maintaining output prices or sup­
plementing net incomes, have allowed a
higher portion of the benefits of cost-reducing technology to accrue to farmers rather
than to consumers. To the extent that Gov­
ernment programs have thus preserved the
technologically induced gains in net returns
that have in turn been capitalized into land
prices, such programs may contribute to the
rise in land prices.19 The effect has been
particularly obvious in cases where benefits
16 Tweeten and Nelson, op. c i t pp. 19-22.
17 Gene L. Swackhamer, “Agriculture and Tech­
nology,” M on th ly R eview , Federal Reserve Bank of
Kansas City (M ay-June 1967), pp. 5 and 6.
is Tweeten and Nelson, op. cit., pp. 23-25.
19 Ibid., pp. 15-18 and 47.




of an effective program have been tied to
specific parcels of land; for instance, land
with a tobacco allotment has been valued at
several times the price of similar land that
lacked an allotment.20
Insofar as the future course of real estate
values depends on technological advances
and the extent to which these foster further
farm enlargement, their direction in the
relatively near future does not seem in doubt.
Numerous studies continue to indicate that
the optimum sizes of family farms— given
known technology— are far above present
averages. It is reasonable that price projec­
tions to 1980, as made in the three models,
be based mainly on the upward thrust from
this source, but with realization that prices
can be materially affected within that time
by changes in the nature and extent of Gov­
ernment programs and in export levels, gen­
eral price trends, and the degree to which
expected land price increases are discounted.
Over a longer period, changes in the rate
and nature of technological advances— par­
ticularly in the extent to which they would
continue to foster enlargement of the land
area of individual farms— become a greater
source of uncertainty.21 Changes in popula­
tion growth and in the nature of urban ap­
petites for residential and recreational lands
also become larger considerations.
Of the projected real estate values, that
of Model HT represents most closely an
extension of the past historical relationship
between land prices and farm enlargement.
Prices are projected to rise by 6.2 per cent
20 William H. Scofield, “Land Returns and Farm
Income,” Farm R eal E state M arket D evelopm en ts,
USDA (Washington: Govt. Printing Office, Aug.
1965), p. 51.
21 Bruce B. Johnson, “An Active Land Market in
Perspective,” F arm R eal Estate M arket D evelopm en ts,
USDA (Washington: Govt. Printing Office, Dec.
1968), pp. 34 and 35.

127

C A PITA L AND C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

annually, causing required transfer capital
flow to rise rapidly to an annual average of
$7.5 billion in 1975-79 (Table 7 ). In
Model HM, on the other hand, an average
yearly price increase of 3.3 per cent is de­
rived by assuming that land values will re­
flect projected increases in the economic
rent to cropland as well as general price in­
flation averaging 2 per cent yearly. Annual
capital flows required by this model attain
an average level of only $5.9 billion in
1975-79. Model B reflects Brake’s assump­
tion that land prices will rise by an average
of 3 per cent yearly, with implied capital
flows therefore similar to those of Model
HM.
Total capital flows, 1 9 5 0 -7 9

Total capital flows— past, present, and pro­
jected— are summarized in Table 8.
In the 1950’s, total flows averaged $7.3
billion annually. Real estate purchases rose
throughout the decade, but in the second
half machinery expenditures and additions
to livestock inventory slackened enough to
stabilize the total. In 1960-64, additions to
machinery and livestock holdings were re­
sumed and together with increasing real
estate purchases raised total flows to an
average of $7.9 billion per year. Then in
1965-68, a sharp increase in machinery
expenditures and a steady rise in land prices
combined to raise capital flows to an annual
average of $10.8 billion.

If the capital stock were to be stabilized
at the level existing at the beginning of
1969, both in real terms and in current dol­
lars as Model NC assumes, future capital
flows would average $11.3 billion per year.
About two-fifths of this sum would arise
from real estate transfers, a similar share
from expenditures required to maintain the
stock of vehicles and machinery, and the
remaining one-fifth from maintenance of
the stock of buildings and land improve­
ments.
It is evident, therefore, that any further
increases in prices of capital goods and any
further additions to the physical plant would
raise total capital flows above the present
level. Each of the other three models en­
vision some price and real increases during
the next decade and therefore project higher
capital requirements. They differ only in the
magnitude of the increases in requirements
expected.
Model B, which projects moderate land
price increases and small gains in machinery
expenditures, envisions only a moderate
gain in the required capital flow. By the
second half of the next decade, annual flows
would average $12.8 billion. Real estate
transfers would rise somewhat in relative
importance, from 38 per cent of total flow
in the period 1965-68 to 44 per cent a
decade later.
Model HT projects only moderate gains
in machinery expenditures and very small
additions to livestock inventories, but strong
increases in farmland prices. By 1975-79,

TABLE 8
ALTERNATIVE PROJECTED TOTAL CAPITAL FLOWS
In billions of dollars
5-year total
Projection

195054

195559

196064

196569

Estimated actual ............................... 37.4
39.4
54.2*
35.1
Model NC .........................................
HT ........................................................................................................
B .............................................................................................................
HM ........................................................................................................
* Estimated flows for 1965-68 multiplied by 1.25.




Annual average
197074

197579

195054

195559

196064

196569

7.5

7.0

7.9

10.8

56.2
63.7
59.0
75.9

56.8
76.8
64.0
94.4

.......................................................
.......................................................
......................................................

197074

197579

11.2
12.7
11.8
15.2

11.4
15.4
12.8
18.9

128

required capital flows would consequently
average $15.4 billion per year, with real
estate transfers contributing 49 per cent of
this total.
Model HM, on the other hand, projects
moderate increases in prices of land, but
very large real additions to machinery
stocks. Because of the latter, the capital
flows projected are the largest of the three
models, averaging $18.9 billion annually
during the late 1970’s. Of this total, 52 per
cent would consist of machinery expendi­
tures and only 31 per cent would stem from
real estate purchases.
The projections differ considerably. But
to emphasize the differences, and the un­
knowns that they reflect, would be to lose
the principal message of the estimates. Re­
call that over the past 10 years annual capi­
tal flows rose by $4 billion; in relative terms,
by 54 per cent. The projections for the next
decade show annual requirements rising by
$2 to $8 billion; in relative terms, by 19 to
75 per cent. The message is clear: capital
demands will rise further from the high
level of the last few years; in number of ad­
ditional dollars, the gain could easily ex­
ceed that of the last 10 years; relative to
the new high level of current requirements,
the additional demands may represent a
somewhat slower advance, but under some
conditions might equal or exceed the recent
sharp rise.
The unanimous projection of a signifi­
cant further increase in capital flows ap­
pears well grounded. The two primary
sources of future capital flows— machinery
purchases and farm enlargement— have a
common root in technological advance. The
fund of technological knowledge now avail­
able but not yet applied and the high like­
lihood of additional discoveries indicate that
growth in total investment and investment




per farm will continue for some time.22 The
National Advisory Commission on Food
and Fiber recently summarized these expec­
tations as follows:23
T here is little doubt th at farm ing will continue
to use m ore capital in the future.
First, science and technology are continually
advancing n ot only in application to farm ing but
throughout the economy.
Second, reflecting increased productivity, the
relative cost of capital keeps declining. Capital
becomes continually cheaper, com pared w ith labor
and land, so farm ers will continue to use m ore
capital.
These changes n ot only m ake it possible for the
individual farm er to increase his volum e of opera­
tions— they m ake it necessary fo r him to do so.
He m ust expand his investm ent and then spread
costs over m ore units of product to rem ain com ­
petitive.

Thus, even though agriculture is already
one of the more capital-intensive sectors of
the American economy, a further rise in the
capital/output ratio in current prices seems
certain. The ratio of the value of farm
productive assets to the gross national prod­
uct produced in agriculture has been esti­
mated as at least 6:1 in the 1950’s com­
pared with a ratio of about 1.5:1 in the
nonfarm economy.24 By 1964-66, the ratio
in agriculture averaged 8:1. These data hint
that the annual capital demands of farming
place a relatively severe and rising strain
on the income flows from which they are
either initially or ultimately financed. These
relationships are examined next— first as
they have evolved since 1950, and then as
they might develop under each of the altern­
ative capital projections.
22 Federal Reserve Bank of Kansas City, “F in an ­
cial Requirem ents of A griculture,” M on th ly R eview
(Sept.-O ct. 1964), pp. 5-7.
23 U.S. N ational Advisory Commission on F ood
and Fiber, F ood and F iber for the Future (W ash­
ington: Govt. Printing Office, July 1967), p. 240.
24 D. G ale Johnson, op. cit., p. 355.

129

C A PITAL AN D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

IV. CREDIT REQUIREMENTS, 1950-79
Given the prospect of substantial capital
flow requirements, this section projects the
share that will be financed from cash flow—
depreciation allowances and net income—
as opposed to the share financed by ex­
panded use of credit. Thus, one preliminary
task is to project depreciation and net in­
come, and the other is to project the share
of these amounts that may be allocated to­
ward meeting capital needs. After examina­
tion of the postwar history of these series,
such projections of internal financing are
made here. They are then compared with
the projected capital flows to secure esti­
mates of future credit demands and farm
debt expansion.

investment is expected to pay its own way
from, farm income and land price apprecia­
tion.
Of total annual cash flow averaging $32.5
billion in 1965-68, net farm income rep­
resented 50 per cent, capital consumption
allowances 17 per cent, and nonfarm in­
come 33 per cent (Table 9). Although the
principal component is still net farm in­
come, its relative importance has been de­
clining. Fifteen years earlier it had con­
tributed 61 per cent, while capital con­
sumption allowances had represented 13
and nonfarm income only 26 per cent.
TABLE 9
FINANCING OF CAPITAL FLOWS, 1950-69

How have capital requirem ents
been financed?

In billions of dollars unless otherwise indicated
Sources of—

1950-54

1955-59

1960-64

1965-69

5-year total*

It is analytically useful to view capital
flows required by the farm production sec­
tor— including nonfarm landlords— as being
met either (1) from a cash flow consisting
of income remaining after operating ex­
penses are paid or (2) by borrowing.25
Financing from cash flow. Cash flow is esti­
mated as the sum of net farm income of
operators and landlords, plus the capital
consumption allowances that were included
in estimated production expenses (estimated
depreciation of buildings, land improve­
ments, vehicles, machinery, and equipment,
as well as accidental damage to these capital
goods), plus nonfarm income of the farm
population. Nonfarm income is included in
cash flow because most farm families ap­
parently continue to pool farm and non­
farm income prior to meeting living and capi­
tal investment needs. Nonfarm income of
farm landlords is not included because such
25 Tostlebe, op. cit., p. 132.




Capital financing
Increase in debt ...........
From cash flow ...........
Total capital flow . . .
Cash flow
Capital consumption
allowances .............
Net farm income . . . .
Nonfarm income ...........
Total cash flow . . . .

4.7
32.7

8.2
27.0

12.4
27.0

20.0
34.3

37.4

35.1

39.4

54.2

16.2
73.9
31.9

19.6
63.3
33.1

22.0
68.3
40.7

27.7
80.9
54.0

116.0

131.0

162.5

122.0

Annual average
Capital financing
Increase in debt ...........
From cash flow ...........

.9
6.5

1.6
5.4

2.5
5.4

4.0
6.9

Total capital flow ..
Cash flow
Capital consumption
allowances .............
Net farm income . . . .
Nonfarm income .........

7.5

7.0

7.9

10.8

3.2
14.8
6.4

3.9
12.7
6.6

4.4
13.7
8.1

5.5
16.2
10.8

Total cash flow . . . .

24.4

23.2

26.2

32.5

Per cent
Analytical ratios
Capital flow /cash flow
Proportion of cash flow
used for capital
Average annual growth
rate during period:
Selected assets
(Table 2) ...............
Debt ............................
Debt/assets,
end of period . . . .

31

30

30

33

27

23

21

21

4.5
7.6

4.5
8.9

3.4
8.8

5.9
9.6

10.2

12.5

16.1

18.5f

* Data shown for 1965-69 are estimates for 1965-68 multi­
plied by 1.25 to facilitate comparison with previous 5-year
periods.
f As of Jan. 1, 1968.
S o u r c e . —Capital flows from Table 4, debt from Table 13,
assets from Table 2, and cash flow components from F arm
In com e S itu a tio n , U SD A , July 1969, pp. 48, 52, 57, and 61.

130

Cash flow averaged $24.4 billion annu­
ally in the first 5 years of the 1950’s, de­
clined slightly when farm income dropped
in the next 5-year period, more than made
up this loss during the first half of the
1960’s, and then jumped to an annual rate
of $32.5 billion in 1965-68. In this last
period, however, the relative gains in cash
flow did not keep up with those in required
capital flows. Whereas capital flow aver­
aged 30 per cent of cash flow in the 1950’s
and early 1960’s, this ratio increased to 33
per cent in 1965-68 (Table 9 ). Thus the
burden posed by capital requirements,
viewed in relation to the cash flow from
which they might be financed, has increased.
Over the 1950’s, when the relative capi­
tal burden was running at about 30 per cent
of cash flow, farmers progressively reduced
the proportion of cash flow they devoted to
meeting capital requirements. In the first
half of the 1950’s, the 27 per cent of cash
flow that was used for capital purposes met
the bulk of capital requirements. By the
early 1960’s, however, only 21 per cent of
cash flow was being used for capital pur­
chases, and the same share was also used
in 1965-68 in spite of relatively greater
capital spending.
Relative reliance on credit, 1950-68. Credit
thus became increasingly important as a
source of funds for capital expenditures. In
the early 1950’s, only 13 per cent of capi­
tal flows were met by an increase in debt.
Ten years later this ratio had risen to 32
per cent, and by 1965-68 it averaged 37
per cent.
One must go back 50 years to find a
similar degree of reliance on credit. Writing
in the 1950’s, Tostlebe noted:26
To a rem arkable degree, farm ers have financed
the increase in farm capital w ith their own in­
comes and savings. A com parison of the volume

26 ibid., p. 19.




of new capital th at was financed by loans and
book credits w ith th a t w hich was financed w ith
funds derived from gross farm incom e and sav­
ings shows th at in every decade fo r w hich we
have inform ation, save the one im m ediately pre­
ceding 1920, farm ers supplied by far the greater
part of the funds th at financed the capital acquisi­
tions.

A few years later, Johnson was still able to
state:27
. . . even when it is assumed th at all increases in
loans and credit were used to increase agricultural
assets, their contribution has generally been less
im portant over the past two decades [1940-59]
than either depreciation or net income as a source
of financing.

According to our estimates, however, in
1958 credit became a more important
source of capital than net income. In fact,
increases in debt have recently rivaled de­
preciation allowances for the lead in sup­
plying capital, whereas 10 years earlier they
were only one-third as large.
Thus, in projecting credit demands it is
not enough to cite the capital flows antici­
pated. It appears equally important to pro­
ject the cash flow and also the proportion of
that flow that farmers will be willing or
forced to apply to satisfaction of the pro­
jected capital needs. In so doing, additional
uncertainties are obvious. Is a major change
in net income probable? Has the postwar
trend toward less internal financing reached
its lowest point? How probable is a higher
savings rate in the near future?
Current factors affecting credit use. In the
last period of markedly increased participa­
tion of creditors in the financing of agricul­
ture, that of 1900-20, Tostlebe found two
primary factors in operation. One was the
pressure of financing farm transfers at the
newly inflated prices.28 Physical farm en­
largement was not a major factor, but the
average dollar value of assets per farm rose
27 D. G ale Johnson, op. cit., p. 377.
28 Tostlebe, op. cit., pp. 140 and 145-147.

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

by 79 per cent between 1900 and 1910 and
by 91 per cent between 1910 and 1920.29
Tostlebe also speculates that family living
offered stiff competition for available
funds:30
First, and m ost im portant, inflated expenditures
for fam ily living probably m ade heavy inroads on
the incomes of m any farm ers. The rise in prices of
that period m ade necessary m uch greater outlays
to m aintain the prew ar level of living. But m ore
than that, the prosperity of the times encouraged
farm ers to spend freely, so that the level of living
for m any farm ers was substantially higher during
this period than before.

These elements appear in the current
situation, although they do not seem to
dominate it. Typical farms are now so large
that an average person seeking to enter
farming through purchase necessarily has to
borrow a large portion of the funds re­
quired. Also, family farms approaching op­
timum size increasingly represent a quan­
tity of assets that a typical farmer is not
expected to save during a lifetime, and so
farmers are more likely to remain indebted
throughout their career. On the other hand,
in these circumstances, alternatives to the
use of credit— leasing of land and equip­
ment from nonfarm investors, vertical inte­
gration, or corporate ownership— are
spreading and lessening the credit demands
made directly by farmers, although prob­
ably increasing credit demands of these
other entities of the farm production sector.
The desire to raise family living levels
may also be a powerful factor in current
borrowing. National television networks
have exposed farmers more to consumer
amenities. Among landowners, income after
depreciation and expansion allowances
might not permit a significant rise in living
conditions, but paper capital gains may
have imparted a sense of financial prosperity
29 I b id ., p. 85.
30 I b id ., p. 145.




131

reflected in spending. Several authors have
noted that short of selling their land, farm­
ers can tap these gains only by offering them
as collateral for increased debt. This proc­
ess has probably occurred in subtle ways.
Perhaps depreciation allowances, which
after all look just like net income, are con­
sumed in current living, and the tractors
that were purchased for cash 10 years ago
are today bought on the instalment plan. Or,
instead of saving toward a downpayment
on the adjacent “80,” a farmer simply plans
to use his inflated equity in his present hold­
ings to effect a completely debt-financed
purchase.
The attitudes of farmers and lenders to­
ward the future of farming and toward what
constitutes appropriate uses and terms of
farm credit are obviously important deter­
minants of the proportion of capital needs
financed by debt. Farmers must be willing
to borrow and lenders to lend if outstanding
credit is to increase— and both were ob­
viously willing over the last 20 years. The
outlook for product and land prices must be
important in the determination of these
attitudes. In recent years, lenders that iden­
tify their interests most closely with those
of agriculture— retiring farmers and the co­
operative credit system— have provided a
larger share of credit, and other lenders have
employed more agriculturally trained loan
officers. Thus, it is not surprising that the
outlook and attitudes of borrowers and
lenders have apparently tended to coincide.
The question of attitudes leads into the
dominant feature of the present situation—
farm enlargement— that was largely absent
in the previous period. According to Tost­
lebe, average physical assets per farm na­
tionwide remained almost unchanged be­
tween 1870 and 1940, although their
composition was altered.31 A slow decline
in the size of Southern farms concealed a
31 Ibid., p. 85.

132

slow increase in the size of Midwest and
Western enterprises, but nowhere did ex­
pansion match that started in the 1940’s.
Since then, the benefits of, or competitive
necessity for, enlargement became more ob­
vious to farm lenders. In fact, numerous
educational efforts attempted not only to
instruct lenders in these matters, but also to
advise them to tell farmers about the need
to expand in order to raise income and
about how credit could assist this endeavor.
Greater appreciation of the leverage that
could be attained through credit was in­
stilled in lender and farmer alike.
The importance of these considerations
emerged in the 1960 Sample Survey of Agri­
culture, in which a large national sample of
farmers for the first time was asked to
enumerate debts owed to various sources.
About 58 per cent of all farmers were in­
debted to varying degrees. When Garlock
compared indebted operators to those with­
out debt, he found that:32
Regardless of w hether the farm ers were clas­
sified by age, years on the farm , tenure, or type of
farm they operated, the indebted farm ers, on the
average, conducted larger-scale operations than
the debt-free farm ers. The value of the land and
buildings they operated was greater, they leased
m ore land, and they owned m ore land. Also they
sold products of greater value, earned m ore net
cash income from farm ing, and had larger offfarm incomes and m ore net incom e from all
sources than did the debt-free farm ers.
A lthough credit was indispensable to indebted
farm ers in building up and operating large farm
businesses, it is questionable w hether use of credit
was fundam entally responsible for their larger,
m ore profitable operations. W hat the data p rob­
ably m ean is th at the farm ers who used credit
were m ore energetic and aggressive, m ore willing
to take risks, and less willing to w ork only with
the assets they owned outright than were the debtfree farm ers. This is indicated by their m ore
extensive use of leased land as well as by their use
of credit.
32 Fred L. G arlock, F arm ers and T heir D e b ts . . .
The role o f credit in the farm econ om y, A gricultural
Economic R eport No. 93, USDA (W ashington: Govt.
Printing Office, June 1966), pp. 8 and 9.




These expansionist characteristics of the credit
users— particularly the heavy credit users— are
pointed up m ore sharply w hen farm ers are clas­
sified according to the extent of their indebtedness.
. . . D espite their small equities, the m ost heavily
indebted farm ers ow ned farm s of nearly as high
value as those owned by the debt-free farm ers. But
the m ost significant point is the extent to w hich
the indebted farm ers used their equities as a ful­
crum for developing larger operations than their
own financial resources would support. T he m ost
heavily indebted farm ers ow ned 3 Vi tim es as
m uch land, and operated 6 times as m uch land, as
they could have ow ned or operated w ithout b o r­
rowing and leasing. By using these m ethods of
expanding operations, they raised their net cash
farm incomes to levels approxim ating those of the
other groups whose equities were m uch greater.

In the past, these expansionary desires,
grounded in the economics cited by G ar­
lock, might have been financed in large
part by saving. But in view of the fact that
many farmers have come to regard credit as
an appropriate tool for achieving these ends,
that lenders encourage this use of credit,
and that both young farmers and holders of
paper gains are probably disinclined to post­
pone attainment of family living goals, a
continued high or perhaps even increased
use of credit relative to required capital flow
seems probable as long as the factors forc­
ing farm enlargement continue operative.
These have been found to be rooted in tech­
nological innovation and seem in no danger
of expiring before 1980. They have already
been found responsible for higher capital
requirements and now are also found re­
sponsible for greater relative use of credit
in meeting these requirements, given the
farm income situation since 1950. Barring
a drastic rise in net farm income, it seems
reasonable to expect a savings rate no higher
than that of the 1960’s. On the other hand,
if real net income per farm rises at a rea­
sonable pace, there would be no great
pressure to reduce the savings rate. The
credit projections that follow incorporate
this reasoning.

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

Projected credit requirem ents, 1 9 7 0 -7 9

The analytical framework outlined above
and exemplified by Table 9 can be used to
project credit requirements to 1980 under
the various capital models that have been
developed. For each past period shown in
Table 9, capital flow, capital consumption,
net income, and increase in debt were all
known, and thus the amount of cash flow
that was used to meet capital requirements
could be obtained by subtraction. For the
projections, however, only the capital flows
and the capital consumption allowances that
are consistent with these flows are initially
given. But if the course of net farm and non­
farm income is projected, the total cash
flow becomes known. Then, if a further
projection is made about how much of their
cash flow farmers will devote to meeting
capital requirements, the amount of increase
in borrowing— the credit requirement— can
be determined as the residual.
Internal financing in the 1970fs. To project
internal financing, the course of net farm
income, nonfarm income of farmers, and the
savings rate must first be estimated.
Instinctively, one wants to project total
net farm income by projecting gross farm
income and production expenses and cal­
culating the difference. But a different ap­
proach is taken here, based on the belief
that over a period of years (1) advances in
real per-farm income will parallel gains in
per capita income achieved in the nonfarm
economy; (2) technological advances will
cause farm numbers to decline indepen­
dently of the course of farm income; and
(3) the general price level will tend to rise.
These trends have been in evidence over
the postwar period. Between 1958 and
1968, for example, operators’ real net farm
income per farm (income adjusted for
changes in the index of prices paid by farm­
ers) rose by 3.3 per cent annually, while




133

national per capita real personal income
rose at a yearly rate of 3.4 per cent. How­
ever, the number of farms decreased by 3.2
per cent annually, and so total real opera­
tors’ net farm income was unchanged. On
the other hand, prices paid by farmers rose
at an average annual rate of 1.6 per cent,
and so total net farm income in current
dollars increased at the same rate.
For the 1970’s the National Planning
Association projects an annual advance of
3.25 per cent in national per capita real
personal income.33 In the long run, the inter­
play of competitive and political forces will
tend to ensure that farmers participate to
roughly the same extent in this advance in
the national level of living. At the same
time, as farm enlargement continues and
farm numbers therefore decline, this rate
of gain in real income per farm may be
achieved by a merely stable total real net
income. However, if prices paid by farmers
tend to rise by an average of 2 per cent
annually, as is projected in Models HT and
HM, total net farm income would also have
to rise by 2 per cent annually to yield the
projected real gains.
Note that this projection of net farm
income implicitly requires that gross income
rise sufficiently not only to provide the in­
crease in net income, but also to cover any
rise in production expenses (including in­
terest payments on projected increases in
debt) and in projected depreciation allow­
ances.
Total nonfarm income of the farm popu­
lation has been rising rapidly and the trend
is expected to continue as nonfarm employ­
ment and investment opportunities become
increasingly available to rural residents.
33 Ahmad Al-Samarrie, Morris Cobern, and Take­
shi Hari, National Economic Projections to 1978/79
(Washington: National Planning Association, Jan.
1969), p. 117.

134

Between 1958 and 1968, nonfarm income
rose at an annual rate of 5.8 per cent in
spite of an average yearly drop of 4.8 per
cent in the farm population. For the 1970’s,
total nonfarm income is projected to in­
crease by 5 per cent annually, with twofifths of the gain reflecting projected price
inflation.
To summarize the cash flow projections,
net farm income is projected to increase
from $16.1 billion in 1968 to an annual
average of $17.4 billion in 1970-74 and
$19.3 billion in 1975-79. Annual nonfarm
income is projected to rise from $11.8 bil­
lion in 1968 to an average of $14.3 billion
in 1970-74 and $18.3 billion in 1975-79.
Capital consumption allowances, which vary
among the capital models according to the

growth of the machine stock foreseen, are
projected at annual levels of $7 billion to
$8 billion in 1970-74 and $7 billion to $10
billion in 1975-79. Total cash flow, which
was $34 billion in 1968, is therefore pro­
jected to rise to about $39 billion per year
in 1970-74, and about $45 billion in 197579, with some variation among models as
shown in Table 10.
Of this cash flow, 21 per cent is projected
to be allocated to meeting capital require­
ments— the same proportion that was so
allocated on average during 1960-68. In­
ternal financing of capital flow is thus ex­
pected to average about $8 billion per year
in 1970-74 and $9 billion to $10 billion in
1975-79, up from the average of $6.9 bil­
lion in 1965-68.

TABLE 10
PROJECTED FINANCING OF ALTERNATIVE CAPITAL FLOWS
In billions of dollars unless otherwise indicated
1970-74
Sources of —

Model
NC

Model
HT

Model
B

1975;-79
Model
HM

Model
NC

Model
HT

Model
B

M odel
HM

5-year total
Capital financing
From cash flow (21 per cent of cash flow) ...............
Increase in debt ...................................................................
Total capital flow ......................................................
Cash flow
Capital consumption allowances ................................
N et farm income .................................................................
Nonfarm income .................................................................
Total cash flow ...........................................................

40.4
15.8
56.2

40.8
22.9
63.7

40.5
18.5
59.0

41.5
34.4
75.9

46.7
10.0
56.8

47.6
29.3
76.8

47.0
17.0
64.0

49.9
44.5
94.4

33.6
87.1
71.7
192.4

35.5
87.1
71.7
194.3

34.3
87.1
71.7
193.1

38.9
87.1
71.7
197.7

34.5
96.5
91.5
222.5

38.4
96.5
91.5
226.4

35.8
96.5
91.5
223.9

49.6
96.5
91.5
237.6

Annual average
Capital financing
From cash flow (21 per cent of cash flow) ...............
Increase in debt .................................................................
Total capital flow ......................................................
Cash flow
Capital consumption allowances ...................................
N et farm income .................................................................
Nonfarm in c o m e ...................................................................
Total cash flow ..........................................................

8.1
3.2
11.2

8.2
4.6
12.7

8.1
3.7
11.8

8.3
6.9
15.2

9.3
2.0
11.4

9.5
5.9
15.4

9.4
3.4
12.8

10.0
8.9
"1^9

6.7
17.4
14.3
38.5

7.1
17.4
14.3
38.9

6.9
17.4
14.3
38.6

7.8
17.4
14.3
39.5

6.9
19.3
18.3
44.5

7.7
19.3
18.3
45.3

7.2
19.3
18.3
44.8

9.9
19.3
18.3
47.5

490.1
108.1

358.9
91.3

409.7
136.8

End of period
Assets and debt
Selected assets .......................................................................
Outstanding debt .................................................................

281.1
71.5

378.6
78.9

320.5
74.3

344.2
92.3

281.1
81.6

Per cent
Analytical ratios
Capital flow /cash flow ......................................................
Increase in debt/capital flow .........................................
Average annual change during period:
Selected assets ...........................................................
Outstanding debt ........................................................
Debt/assets, end of p e r io d ................................................




29
28

33
36

31
31

38
45

26
18

34
38

29
27

40
47

5.1
25.4

5.1
7.1
20.8

2.2
5.9
23.2

3.4
9.8
26.8

2.7
29.0

5.3
6.5
22.1

2.3
4.2
25.4

3.5
8.2
33.4

135

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

Projected debt expansion under alternative
capital models. For each capital model, the

projected increase in outstanding farm debt
consists of the difference between the capital
flow and the internal financing projected by
that model. These calculations are shown
in Table 10, and the resulting debt projec­
tions are summarized in Table 11.
Under Model NC, in which farm assets
remain unchanged in value, substantial but
decreasing annual additions to debt would
still be required, and outstanding debt would
reach $81.6 billion in 1980, up from $52.0
billion in 1969. Thus it appears that farm­
ers would for some time tend to incur siz­
able amounts of new debt simply in the
course of replacement and transfer of to­
day’s capital plant at today’s prices. In
Model B, in which capital flows advance
moderately, outstanding farm debt would
reach $91.3 billion in 1980. The rate of
debt expansion would fall to an annual rate
of about 4 per cent by 1980, compared with
the actual rate of 9.6 per cent in 1965-68.
However, debt would grow more than twice
as rapidly as assets and in 1980 would con­
stitute 25 per cent of assets, compared with
19 per cent in 1968.
The relatively greater land price increases
projected in Model HT would lead to an
outstanding farm debt of $108.1 billion in
1980. Annual gains in debt would average
about 7 per cent; in dollars, the annual in­
crease during 1975-79 would average $5.9
billion. However, because of the large rise
in farm real estate values projected by this
model, the ratio of debt to assets would
rise only slowly, to perhaps 22 per cent in
1980.
Model HM represents the greatest in­
crease in capital flows, resulting mainly
from large real additions to farm machine
stocks. Outstanding debt would continue to
grow almost as fast as in recent years and




TABLE 11
ALTERNATIVE PROJECTED CREDIT
REQUIREMENTS
In billions of dollars unless otherwise indicated
Projection

1950-54 1955-59 1960-64 1965-69 1970-74 1975-79
Debt: increase during period

Actual
Model NC
HT

4.7

8.2

12.4

20.0*
15.8
22.9
18.5
34.4

B

HM

10.0
29.3
17.0
44.5

Debt: average annual increase
Actual
Model NC
HT

.9

1.6

2.5

4.0*

B

HM

3.2
4.6
3.7
6.9

2.0
5.9
3.4
8.9

Outstanding debt:: end of period
Actual
Model NC
HT

15.4

23.6

36.0

56.0*
71.5
78.9
74.3
92.3

B

HM

81.6
108.1
91.3
136.8

Outstanding debt: annual growth rate (per cent)
Actual
Model NC
HT

7.6

8.9

8.8

9.2*
2.7
6.5
4.2

5.1
7.1
5.9
9.8

B
HM

8.2

D ebt/asset ratio: end of period (per cent)
Actual
Model NC
HT

10

12

16

B
HM

191*

25
21
23
27

29
22

25
33

* Estimate based on data in Table 9.
f As of Jan. 1, 1968.

would reach $136.8 billion in 1980. In
1975-79, annual additions to debt would
average $8.9 billion. The rise in debt would
far outpace growth in the value of farm
assets, so that the debt/asset ratio would
rise to 33 per cent by 1980.
In comparison with the experience of
recent years, these projected credit demands
represent somewhat slower rates of expan­
sion in debt. However, no model represents
continuation of the combination of capital
growth that has actually prevailed in 196368— significant real additions to machine
stocks plus relatively rapid increases in land
values. If this experience were to continue
through all the years to 1980, credit de­
mands would probably prove larger than
any of those projected. But the historical
perspective on capital flows provided in Sec­
tion III indicates this to be a somewhat ex­
treme expectation.

136

Sizable increases in debt and in the debt/
asset ratio are projected by each model. The
levels reached in each by 1980 are not so
large as to be impossible, but neither can
the process continue indefinitely, especially
at the rate represented by Model HM. At
some point, capital flows may recede and/or

farmers’ savings may increase. Or nonfarm­
ers may supply significantly more of the
capital needed. A watch should be main­
tained for the occurrence of such structural
changes on a significant scale, as these
events would lead to changes in demands
for credit.

V. SOURCES OF CREDIT, 1950-79
From 1950 through 1968, $41.3 billion of
additional credit was supplied to farmers
by a great many individual and institutional
lenders. As will be shown, the share sup­
plied by some lender groups increased over
this period, whereas other groups became
less important sources. Commercial banks,
however, maintained about the same rela­
tive role over the entire period.
In the preceding section, further sizable
increases in total farm debt were projected
for the 1970’s. To continue to provide their
recent historical share of such expansion,
banks would have to continue to expand
their farm lending substantially. The amount
of increase necessary to achieve this target
varies among models, as it depends on the
projected size of total credit requirements
and also on how much of the credit is in­
curred to support non-real-estate rather than
real estate spending. These projections of
required bank credit growth are made here
for Models HT, B, and HM.
Attention then turns to the supply of
funds at rural banks— to examine how banks
have been able to increase farm lending
rapidly since 1950 and whether they will
be able to continue the pace. Future deposit
growth is projected and then compared with
the various projections of future farm loan
demands, to provide an indication of the
degree to which internal growui of rural
banks is or is not likely to be adequate to
meet farm credit demands arising in a




variety of possible future farm capital situa­
tions.
Sources of outstanding credit, 1 9 5 0 -6 8

Credit to farmers is provided by a large
number of individuals, dealers, and institu­
tions. Estimates of the amount outstanding
from each of several classes of lenders are
published annually by USDA. For the major
institutional lenders, these estimates are
based on lender reports submitted at least
annually. Commercial banks hold the larg­
est outstanding farm loan total among these
reporting lenders. Other institutions in this
group are insurance companies, the Farmers
Home Administration, and the agencies
(Federal land banks, Federal intermediate
credit banks, and production credit associa­
tions) that comprise the cooperative credit
system supervised by the Farm Credit Ad­
ministration.
Many other lending institutions make
small amounts of loans to farmers, but in
general they do not report their volume of
farm loans. In the USDA estimates of farm
lending, such loans are grouped with credit
provided by individuals.
Taken together, individuals, dealers, and
these nonreporting institutions are the most
important source of farm, credit. Retiring
farmers and other sellers of farms, in par­
ticular, provide large amounts of credit to
the purchasers by taking mortgages or land
contracts. Merchants, dealers, and individ­

137

C A PITAL AN D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

uals such as farm landlords also supply
large amounts of non-real-estate credit to
finance purchases of production inputs,
machinery, and livestock. In this group,
national farm supply and machinery cor­
porations have emerged as a major source
of financing. In general, these creditors do
not report their loan volume annually, and
so USDA estimates of the debt they hold
may contain relatively large errors. This
is particularly true of recent yearly changes,
as census surveys of farm debt made in
1960 and 1965 have permitted improved
evaluation of the relative longer-term role
of these lenders.
Holders of outstanding debt. Outstanding
farm debt on January 1, 1969, totaled $52.0
billion, up from $23.6 billion at the start of
the decade and $10.7 billion in 1950 (Table
12). Individuals, dealers, and nonreporting
institutions held about two-fifths of the out­
standing debt throughout this period.
OUTSTANDING FARM DEBT, 1950-69
By major lender groups excluding CCC

T o t a l .........................................

1950 1955

1960 1965 1969

3.0
4.9

4.1
7.2

6.5
11.5

9.7
17.5

13.6
26.2

1.4
1.2

1.9
2.1

3.8
2.8

6.1
4.3

10.1
5.8

2.3

3.2

4.9

7.1

10.3

2.3
.5

3.4
.7

4.9
.8

7.6
1.3

10.9
1.3

15.4

23.6

36.0

52.0

10.7

Per cent of total
Banks ................................................
Money market lenders ...............
Cooperative credit system . . .
Life insurance companies . . .
Dealers and individuals
(non-real-estate)* ...............
Individuals (real estate) * .........
Farmers Home Administration.
T o t a l.........................................

28
46

27
46

27
49

27
49

26
50

13
11

12
13

16
12

17
12

19
11

22

21

21

22
5

21
4

20
21
4

20

22
5
100

100

100

100

100

21
3

Per cent of bank and
money market total
Banks ................................................
Money market lenders ...............

38
62

37
63

36
64

36
64

34
66

T o t a l .........................................

100

100

100

100

100

* Includes other nonreporting lenders.
S o u r c e . — A gricu ltu ral F in an ce R e v ie w , U SD A , Apr. 1969,
pp. 2, and 22 and 23. Th e B alan ce S h e et o f A g ricu ltu re, 1968,
U SD A , Jan. 1969, pp. 13 and 15. Data are as of January 1
of each year.




AVERAGE ANNUAL GROWTH RATE OF
OUTSTANDING FARM DEBT, 1950-68
By major lender groups excluding CCC
Lender group

Billions of dollars
Banks ................................................
Money market lenders ...............
Cooperative credit system . . .
Life insurance companies . . .
Dealers and individuals
(non-real-estate)* ...............
Individuals (real estate)* .........
Farmers Home Administration.

TABLE 13

In per cent

TABLE 12

Lender group

Among the major lending institutions, com­
mercial banks ranked first with $13.6 bil­
lion in 1969, about one-fourth of the total
farm debt. Outstanding loans at banks had
also increased markedly from $6.5 billion
in 1960 and $3.0 billion in 1950.
The cooperative credit system held nearly
one-fifth of outstanding farm debt in 1969.
Its volume of $10.1 billion represented a
rapid rise from $3.8 billion in 1960 and
$1.4 billion in 1950. Life insurance com­
panies held $5.8 billion of farm mortgage
loans in 1969, representing 11 per cent of
total farm debt. Finally, the Farmers Home
Administration held 3 per cent of the total
debt.
Farm debt has been rising by about 9 per
cent yearly since the mid-1950’s (Table
13). During 1965-68, total debt rose at an

1950-54 1955-59 1960-64 1965-68

6.8
8.0
Money market lenders . . . .
Cooperative credit system 6.4
Life insurance companies 11.8
Dealers and individuals
6.6
(non-real-estate) * . . . .
Individuals (real estate) * ..
8.1
Farmers Home
Administration .................. 5.5

9.3
9.8

8.4
8.8

8.9
10.6

14.6
6.6

10.0
8.7

13.5
7.7

8.7

7.9

9.8

7.3

9.5

9.4

3.5

8.6

1.0

8.9

8.8

9.6

7.6
* Includes other nonreporting lenders.

annual rate of 9.6 per cent, paced by an­
nual gains of 13.5 per cent in outstanding
debt held by the cooperative credit system
and assisted by rapid expansion of farm
loans at each of the other principal lenders.
Expansion at banks averaged 8.9 per cent
annually during 1965-68 and 8.4 per cent
during 1960-64, in each case only slightly
below the growth rate of total farm debt.
Sources of additions to debt. Another per­
spective on farm credit is provided by ex­
amination of the sources of net additions
to outstanding debt, which are shown in

138
TABLE 14
SOURCES OF ADDITIONS TO FARM DEBT, 1950-69
Excluding CCC
In billions of dollars unless otherwise indicated
Lender group

1950-54 1955-59 1960-64 1965-69*

Relative role of banks, 1 9 5 0 -6 8

5-year total
Banks .......................................
Money market lenders . . . .
Cooperative credit system
Life insurance companies.
Dealers and individuals
(non-real-estate) f . . . .
Individuals (real estate)f ..
Farmers Home
A dm inistration....................

1.2
2.3
.5
.9

2.3
4.3

3.2
6.0

4.9
10.9

1.9
.8

2.3
1.5

5.0
1.8

.9
1.1

1.7

2.2

4.0

1.4

2.8

4.1

.2

.1

.4

.1

Total .................................

4.7

8.2

12.4

20.0

Banks .......................................
Money market lenders
Cooperative credit system
Life insurance companies.
Dealers and individuals
(non-real-estate) f . . . .
Individuals (real estate) f . .
Farmers Home
A dm inistration....................

.2
.7
.7

Annual average
.5
.9

.2

.4
.2

.2

.3

.2

.3

.6
1.2
.5

1.0
2.2
1.0
.4

.3

.5
.6

.8

.8

.1

Total .................................

.9

Banks .......................................
Money market lenders
Cooperative credit system
Life insurance companies.
Dealers and individuals
(non-real-estate) f . . . .
Individuals (real estate) f ..
Farmers Home
A dm inistration....................

25
48

1.6

4.0

28
52

26
48

25
54

11
19

23
9

19
12

25
9

19

20

18

20

24

18

22

21

3

2

3

100

100

2.5

Per cent of total

Total .................................

100

100

Percentage of bank and
money market total
Banks .......................................
Money market lenders

34
66

35
65

35
65

31
69

Total .................................

100

100

100

100

* Data shown for 1965-69 are actual values for 1965-68
multiplied by 1.25 to facilitate comparison with previous 5-year
periods.
f Includes other nonreporting lenders.

Table 14 for 5-year intervals since 1950. In
each 5-year period, dealers and individuals
provided about two-fifths of the increase,
while banks provided about one-fourth. The
increase at the cooperative credit system was
low in 1950-54, when real estate lending
by the Federal land banks was restrained
by appraisal methods that proved outmoded.
More recently, the cooperative credit sys­
tem has been supplying around 20 to 25
per cent of the additions to farm credit. In
1965-68, banks and the cooperative credit
system each supplied 25 per cent of the total
increase. After providing 19 per cent of the




gain in farm credit in 1950-54, the share
of life insurance companies dropped to
about 10 per cent in subsequent periods.

New insights into the relative role of vari­
ous lenders, as well as a better basis for
projection of future roles, may be secured
by further aggregation of lenders into
groups with key common characteristics.
Thus, it is useful to group three lender
classes— the cooperative credit system, life
insurance companies, and the nonreporting
creditors who supply non-real-estate credit
— into one category called “money market
lenders” because the supply and the real or
opportunity cost of the credit provided by
each is influenced by conditions in the na­
tional money market. The cooperative credit
system obtains its funds by selling money
market instruments. Such instruments also
comprise a major alternative investment for
funds of life insurance companies. And, the
non-real-estate-lending volume of non­
reporting creditors is dominated by national
corporations that supply production inputs
to farmers, and such concerns are likely to
have obtained funds for these loans in the
money market or by borrowing from money
market banks. Local merchant credit re­
mains in this category as separate data are
not available, but the amount of this misclassification is relatively small.
After this consolidation, four groups of
farm lenders remain: (1) the money market
lenders, (2) individuals who hold real estate
debt, (3) banks, and (4) the Farmers
Home Administration.
Individual holders of real estate debt are
sellers of farms who took mortgages or sold
by land contract for tax reasons, in order to
make the sale, to obtain a higher price, or
to retain a continuing investment in their
farm. Their volume of lending depends on

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

the strength of these considerations and on
prices and activity in the farm real estate
market.
Banks are set apart as a third major
lender group because their farm lending is
significantly affected by factors different
from either the sellers of farms or the money
market lenders. Loans for real estate pur­
chases constitute only 15 per cent of banks’
farm lending, and so land market considera­
tions are less important in determining loan
volume than in the case of sellers of farms.
Also, the bulk of banks active in farm lend­
ing find it difficult to participate effectively
in national money markets under present
conditions and so are dependent on local
sources of funds. Thus, whereas money mar­
ket participants active in farm lending face
a very elastic supply function, in that their
demands on the money market constitute
only a small portion of total national de­
mands for funds, most rural banks face a
relatively inelastic supply. In seeking to en­
hance the growth of their lending resources,
they are limited both by legal ceilings on
interest rates they can offer on deposits and
by the over-all economic growth being
achieved by their community. In the long
run, therefore, constraints are thereby
placed on growth of farm lending at most
rural banks, given present institutional ar­
rangements that exclude such banks from
effective participation in the money market.
The Farmers Home Administration com­
pletes the four lender groups. In its direct
farm lending program, this agency makes
supervised loans to farmers unable to obtain
credit from the other lenders. The outstand­
ing volume of these loans failed to increase
during the 1965-68 period and conse­
quently declined to 3 per cent of total out­
standing farm debt. In the projections that
follow, it is assumed that the volume of farm
lending by the Farmers Home Administra­




139

tion will remain unchanged over the next
decade.
Share of outstanding debt. As outstanding
farm debt rose from $10.7 billion in 1950
to $52.0 billion in 1969, the share con­
sisting of real estate debt held by individ­
uals fluctuated narrowly between 20 and 22
per cent of the total. The share held by
banks declined slowly from 30 per cent in
1952 to 26 per cent in 1969. Conversely,
the portion held by money market lenders
rose from 46 per cent in 1950 to 50 per
cent in 1969 (Table 12).
Of the total debt held only by banks and
money market lenders, the share held by
banks declined from 39 per cent in 1952 to
34 per cent by 1969. In eight of the years
from 1950 to 1968, bank credit grew faster
than credit from money market lenders, but
on average the latter tended to expand more
rapidly throughout the period. In the 4
years 1965-68, debt at banks rose by 8.9
per cent annually, whereas debt held by
money market lenders grew at a rate of
10.6 percent (Table 13).
Share of additions to debt. While the share
of outstanding debt held by banks eroded
slowly over the entire period since 1950,
banks’ share of additions to farm credit
showed no downward trend during 195064. Although year-to-year fluctuations were
large, banks on average provided slightly
over one-fourth of the total increase in farm
credit and slightly over one-third of the
total gain at banks and money market lend­
ers. These shares of new credit were slightly
below the shares of outstanding credit with
which banks entered the period. This differ­
ence explains the erosion observed in the
shares of outstanding credit.
In 1965-68, banks’ share of additions to
credit dropped to 25 per cent of the grand
total and to 31 per cent of the sum provided
by banks and money market lenders. The

140

share provided by money market lenders in­
creased (Table 14).
Projected credit expansion by
major lenders, 1 9 7 0 -7 9

The preceding section presented three al­
ternative projections of increases in farm
debt to 1980, based on three different capi­
tal models and a single farm income and
savings rate projection. Given these pro­
jected additions to total farm credit, esti­
mates are here made of the corresponding
increases in farm lending by banks that
would be necessary for banks to maintain
their recent share— about one-third— of the
total credit expansion projected for banks
and money market lenders together.
Credit from sellers of farms. As a prelim­
inary step, it is necessary to estimate the
amount of additional real estate credit that
may be provided by individuals, particularly
sellers of farms. Credit from this source is
virtually certain to be related to the value
of farms transferred by sale; thus more
would be expected if land prices rise rapidly,
as projected by Model HT, than if they
rise more moderately, as projected by
Models B and HM. In addition, credit pro­
vided by sellers has recently been increas­
ing relative to the value of transfers. It is
estimated that such credit may have equaled
18 per cent of the value of real estate sales
in 1955, 22 per cent in 1960, 24 per cent

in 1965, and 29 per cent in 1968. Several
factors have contributed to this increase,
chief among them being substantial capital
gains tax advantages to sellers who provide
credit under a land contract and the ability
of sellers to offer lower downpayments than
most institutional lenders. Again, the future
trend of this ratio seems likely to be posi­
tively related to the rate of gain in real
estate values.
With these considerations in mind, past
increases in real estate credit provided by
individuals were related to estimated capital
flows required by real estate transfers. This
ratio was estimated at 11 per cent in 1955—
59, 17 per cent in 1960-64, and 20 per cent
in 1965-67. For Models B and HM, the
ratio was projected to average 22 per cent
in 1970-74 and 24 per cent in 1975-79.
For Model HT, in view of its more rapid
rise in land prices, the ratio was projected
at 25 and 29 per cent, respectively. These
relationships were applied to the value of
real estate capital flows projected by these
models (Table 7) to obtain the estimated
amounts of additional real estate credit that
may be supplied by individuals and other
nonreporting lenders. The estimates are
shown in Table 15.
Projected loan demands on banks. Subtrac­
tion of the projected seller-supplied credit
from the total credit requirements shown in
Table 15 (from Table 10) yields projections

TABLE 15
ALTERNATIVE PROJECTED FARM LOAN EXPANSION AT MAJOR LENDER GROUPS, 1970-79
In billions of dollars

Projection, and period

Total

Individuals
(real estate)

Banks and
At banks
money
to maintain
market relative
share
lenders

Total

5-year total
Model HT
1970-74 ...................................
1975-79 ...................................
Model B
1970-74 ...................................
1975-79 ...................................
Model HM
1970-74 ...................................
1975-79 ...................................




Individuals
(real estate)

Banks and A t banks
money
to maintain
market
lenders relative share

Annual average

22.9
29.3

7.0
11.0

15.9
18.3

5.4
6.3

4.6
5.9

1.4
2.2

3.2
3.7

1.1
1.3

18.5
17.0

5.5
6.7

13.0
10.3

4.4
3.5

3.7
3.4

1.1
1.3

2.6
2.1

.9
.7

34.4
44.5

5.6
7.0

28.8
37.5

9.8
12.8

6.9
8.9

1.1
1.4

5.8
7.5

2.0
2.6

141

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

This pace would be significantly below ac­
tual rates of farm loan expansion at banks
since 1955. But with the much greater
capital flows represented by Model HM,
farm loans at banks have to expand at an
annual rate of 10 per cent, or even faster
than they have been growing since 1955.

of the amounts to be supplied by banks and
money market lenders together. If banks are
to supply one-third of the latter totals, they
would have to increase their farm loans by
the amounts shown in Table 15.
In Table 16, the required additions to
farm lending by banks are shown in a more
familiar context, as the sum that outstanding
farm loans would reach in 1975 and 1980
and as the average annual rate of increase
in outstanding loans in each 5-year interval.
Outstanding loan volume required in 1980
ranges from $22.5 billion (Model B) to
$37.9 billion (Model H M ). These sums
may be compared with estimated outstand­
ing volume of $14.6 billion at the end of
1969. The projections show that credit de­
mands on banks would be very large if the
high rate of machinery investment projected
by Model HM should materialize. Rapidly
rising land prices, as represented by Model
HT, would have a more moderate effect on
credit demands on banks, because the pro­
jected increase in seller-financing of real
estate transfers meets a significant portion
of credit demands arising from that source.
Under the moderately greater capital
flows of Models B and HT, and given the
projected internal financing, annual rates
of farm loan expansion averaging 6 per cent
would suffice to maintain the relative role
of banks in farm lending during 1970-74.

Supply of funds at rural banks

Would it be easy or difficult for banks to
expand farm lending at the various rates
projected above and thereby to maintain
their share of the farm credit market? At
present, rural banks depend primarily on
growth in their deposits, most of which
originate locally, for expansion of their
lending resources.
Farmers' deposits. To some extent, banks
act as financial intermediaries among
farmers. In the early 1950’s, the outstanding
loans to farmers represented about one-half
of farmers’ deposits, and at that time over­
all farm lending activity at banks could be
viewed as being on average sustained com­
pletely from the deposits of farmers them­
selves. By 1960, however, the volume of
farm loans was almost equal to that of
deposits, and in 1968 it was 43 per cent
larger (Table 17). It is evident that banks
have been making farm loans from funds
received from sources other than farmers
alone.

TABLE 16
ALTERNATIVE PROJECTED FARM LOAN EXPANSION REQUIRED AT BANKS TO
MAINTAIN BANKS' RELATIVE ROLE IN FARM LENDING, 1970-79
In billions of dollars unless indicated otherwise
Outstanding loans
Projection

195054

195559

196064

196569

1970-74

197579

195054

195559

4.1

6.5

Increase during period
Actual ..............................................
Model HT .....................................
B .........................................
H M .....................................

1.2

Actual ...........................................
Model HT .....................................
B ............................ ..
HM ...................................

.2

2.3
3.2
4.9*
.....................................
.....................................
.....................................

5.4
4.4
9.8

* Estimate based on data shown in Tables 12 and 14.




9.7

197074

197579

20.0
19.0
25.1

26.3
22.5
37.9

14.6*

6.3
3.5
12.8

Annual growth rate during period (per cent)
6.8

1.1
.9
2.0

196569

End of period

Average annual increase
.5
.6
1.0*
.....................................
.....................................
.....................................

1960-64

1.3
.7
2.6

9.3

8.4

8.5*
6.5
5.5
10.5

5.6
3.4
8.6

142

TABLE 17
COMMERCIAL BANK FARM LOANS COMPARED
WITH FARM ERS’ DEPOSITS, 1950-69
In billions of dollars unless otherwise indicated

Year

Bank loans
to farmers

Demand and
time deposits
of farmers

Farmers’ loans
as percentage
of farmers’
deposits

1950...............
1955...............
1960...............
1965...............
1969...............

3.0
4.1
6.5
9.7
13.6

6.6
7.2
7.2
7.7
9.5

45
57
90
126
143

S o u r c e . — A g ricu ltu ra l F inance R e v ie w , U SD A , Apr. 1969,
pp. 2, and 22 and 23. The B alan ce S h eet o f A g ricu ltu re, 1968,
U SD A , Jan. 1969, pp. 10, 13, and 15.

The discussion of farmers’ cash assets in
Section III turned up conflicting views on
the extent of the growth that banks can ex­
pect in farmers’ deposits during the next
decade. As farmers purchase more inputs,
cash working capital has become more im­
portant in farm operation, but farmers have
also learned how to economize on these
balances. If these offsetting trends continue,
farmers’ demand deposits may show only
moderate growth. It is possible, however,
that banks could achieve more significant
expansion in time deposits of farmers by
attracting current and past savings away
from alternative investments.
Total deposit growth, 1950-68. Fortunately,
total deposits at rural banks increased at a
faster pace than farmers’ deposits alone. An
indication of this is provided by the USDA’s
index of deposits of country banks, which
measures changes in deposits at banks in
towns with population under 15,000 in 20
agricultural States. These primarily rural
banks achieved annual growth in total de­
posits averaging 3.4 per cent in the 1950’s,
5.8 per cent in 1960-64, and 8.5 per cent
in 1965-68 (Table 18).
The very significant recent acceleration in
the growth of total deposits at these banks
can be traced primarily to the expansion of
time deposits. Since 1950, demand deposits
have increased slowly, with annual expan­
sion averaging less than 3 per cent. Time
deposits, however, rose at an average annual




rate of about 10 per cent in the 1950’s and
15 per cent in 1960-68. At first, these rapid
rates of expansion did not contribute much
to total deposit growth, because time de­
posits represented only a small fraction— 13
per cent in 1950—of total deposits at these
banks. But as the rapid pace continued, time
deposits became more important, reaching
44 per cent of total deposits in January
1969. With this sizable component growing
at 15 per cent annually, total deposits rose
by 8.5 per cent a year in 1965-68 even
though annual demand deposit growth aver­
aged only 4.2 per cent during these years.
TABLE 18
DEPOSITS OF SELECTED COUNTRY BANKS,
1950-69*
Period

Total

Demand

Index of volume (1947-49 1950....................
1955....................
1960....................
1965....................
1969....................

102
124
142
188
261

103
122
127
144
170

Time
100)
103
152
260
502
883

Average annual growth rate (per cent)
1950-54.............
1955-59.............
1960-64.............
1965-68.............

4.0
2.7
5.8
8.5

3.4
.8
2.5
4.2

8.1
11.3
14.1
15.2

* Data are for banks in towns with population under 15,000
in 20 agricultural States, as compiled and published by U SD A .
Data for 1950-65 are averages for January of each year. Data
for 1969 are as of January 1.
S o u r c e . — Agricultural Finance Branch, U SD A .

Deposit and farm loan growth compared,
1950-68. Data on farm loan growth at the

universe of banks used in compiling the
USDA index of country bank deposits are
not available. It is likely, however, that they
parallel the course of farm loans at all banks
and that impressions obtained from a com­
parison of the deposit index with total farm
loan growth will not be misleading. Such
comparison shows that farm loans have
tended to increase faster than rural bank
deposits (Table 19). The gap was espe­
cially large in 1955-59, was reduced some­
what by faster deposit growth in 196064, and then almost closed by still faster
deposit growth in 1965-68. In 1965-68

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

TABLE 19
COMPARISON OF DEPOSIT AND FARM LOAN
GROWTH, 1950-68
Average annual rate of growth, per cent
Period

Total deposits
of selected
country banks

1950-54.......................... .....................4.0
1955-59.......................... .....................2.7
1960-64.......................... .................... 5.8
1965-68.......................... .....................8.5

Total farm
loans at
all banks
6.8
9.2
8.4
8.9

deposits rose by 8.5 per cent annually
while farm loans expanded at a rate of 8.9
per cent.
Confirmation of these recent relationships
between loans and deposits is afforded by
data from surveys of banks active in agri­
cultural lending, made annually since 1962
by The American Bankers Association
(ABA). From 1962 to 1965, loan/deposit
ratios at these banks tended to move up­
ward. In 1968, however, the distribution of
banks by loan/deposit ratio was still much
the same as in 1965 (Table 20). At the naTABLE 20
PERCENTAGE DISTRIBUTION OF ABA
AGRICULTURAL BANKS, MIDYEAR 1962-68
By loan/deposit ratio
Loans as percentage of deposits
Year
1962........................
1963........................
1964........................
1965........................
1966........................
1967........................
1968........................

Under 50
41
38
31
27
27
21
25

50 to 59
34
33
35
32
31
33
33

60 and over
25
29
34
41
42
46
42

N o t e . —Data are for banks designated as “agricultural” banks
by The American Bankers Association and thereby covered by
the midyear agricultural credit situation survey. Approximately
two-thirds of all insured commercial banks qualify as agricul­
tural banks under the criteria used. See footnote 39.
S o u r c e . — T ren ds in A g ricu ltu ra l B an kin g: R e p o r t o f M id ye a r
1968 A g ricu ltu ra l C r e d it S itu ation S u rve y, The American Bank­

ers A ssociation, N ew York, 1968, p. 8.

tional “median” bank covered by the ABA
surveys, the 58 per cent gain in farm loans
in 1963-68 was virtually identical to the
59 per cent increase in total deposits. At
banks in the Plains States, however, deposits
had risen by only 26 per cent compared to
farm loan growth of 67 per cent.34
34 Trends in A gricultural Banking: R ep o rt of M id ­
yea r 1968 A gricultural C redit Situation Survey (New
Y ork: The A m erican Bankers Association, 1968), p. 8.




143

Projected deposit growth, 1970-79. It seems
reasonable to believe that demand deposit
growth at rural banks in 1970-79 may
resemble postwar expansion to date, aver­
aging perhaps 3 per cent annually. This pro­
jection reflects the growing money needs
of an expanding rural economy. However,
the rate of money expansion is somewhat
below the anticipated rate of economic
growth, as persons and businesses continue
to reduce the money balances that they
hold in relation to their volume of trans­
actions.
Projection of time deposit growth seems
more speculative. To some extent, the large
recent gains represent an adjustment by the
public to increased attractiveness of time
deposits relative to both demand deposits
and nonbank investments. First, ceiling in­
terest rates prescribed by regulatory authori­
ties on passbook and other time deposits
were raised to a level more competitive with
those paid by nonbank financial intermedi­
aries, such as savings and loan associations,
and with returns available from U.S. sav­
ings bonds and marketable securities.
Second, in response to their increased loan
requests and reduced liquidity, many banks
began to offer time certificates of deposit
on which they were permitted to pay higher
rates of interest than on passbook savings
accounts. Small banks, while unable to par­
ticipate in the sale of large-denomination
certificates that have become a popular
short-term investment for businesses with
surplus cash, have been quite successful in
marketing small-denomination certificates
and passbook-notice accounts to the public.
From one point of view, further realloca­
tion of personal savings to time deposits
could occur, if time deposits continue to be
attractive. Nationally, time deposits at banks
still constitute a relatively small share of
the total financial assets of consumers—in

144

1968, less than 10 per cent of the total.
Thus, even relatively small shifts of funds
from other assets into time deposits would
enable the latter to increase at a very rapid
rate, and this process conceivably could
continue for many years.
However, there is a second and prob­
ably dominant consideration that militates
against such expectations. The rate of time
deposit growth is obviously an important
influence on the rate at which total bank
credit can expand— and expansion of total
bank credit will continue to be greatly in­
fluenced by national economic policies seek­
ing full employment without price inflation.
Thus, policies of the Federal Reserve Sys­
tem can be expected to result in rates of
bank credit expansion consistent with po­
tential real economic growth, while taking
into account trends toward greater relative
use of credit. In this environment, total de­
posit growth at banks will at times be en­
couraged and at other times restrained, as
appropriate in the light of national economic
goals and current business conditions. The
relative attractiveness of time deposit rates
is likely to be regulated accordingly. On

average, an annual increase of 6.5 per cent
in total deposits may represent a reasonable
projection.
This reasoning implies that a slowdown
from recent rates of time deposit growth
must be projected, with the estimated future
gains dependent on the growth actually ex­
perienced in demand deposits. If the latter
do increase at an average rate of 3 per
cent annually at rural banks covered by the
USDA index, the following annual rates of
time deposit growth at these banks would
yield the projected 6.5 per cent increase in
total deposits in the 1970’s: 11 per cent in
1969, 10 per cent between 1970 and 1974,
and 9 per cent between 1975 and 1979.
Projected deposit and farm loan growth com­
pared, 1970-79. If farm credit demands on

banks were to increase at the same rate as
deposits, it may be assumed that on aver­
age banks would be able to meet these de­
mands without excessive difficulty; that is,
on the average, banks could increase farm
loans at this rate without (1) increasing the
proportion of farm loans in their loan port­
folios, or (2) increasing their over-all loan/
deposit ratio in order to make the addi­
tional farm loans. Farm loan expansion at a

TABLE 21
PROJECTED FARM LOAN EXPANSION AT BANKS COMPARED WITH BANKS'
INTERNAL RESOURCE GROWTH, 1970-79
In billions of dollars unless otherwise indicated
Banks’ percentage share
of total farm loan
expansion if bank
expansion is—

Increase in outstanding loans

Projection,
and
period

Needed to
maintain
banks’
relative
role in
farm
lending

Supported
by annual
deposit
growth
of 6.5
per cent

Excess of
needed
amount
over
expansion
supported
by internal
growth

Needed to
maintain
banks’
relative
role in
farm
lending




Excess of
needed
amount
over
expansion
supported
by internal
growth

Enough to
maintain
relative
role

6.5
per cent
annually

Annual average

5-year total
Model HT
1 9 7 0 -7 4 ...
1 9 7 5 -7 9 ...
Model B
1 9 7 0 -7 4 ...
1 9 7 5 -7 9 ...
M odel HM
1 9 7 0 -7 4 ...
1 9 7 5 -7 9 ...

Supported
by annual
deposit
growth
of 6.5
per cent

5.4
6.3

5.4
7.3

.1
—1.1

1.1
1.3

1.1
1.5

“ .2

24
21

23
25

4.4
3.5

5.4
7.3

-.9
—3.8

.9
.7

1.1
1.5

-.2
—.8

24
21

29
43

9.8
12.8

5.4
7.3

4.5
5.5

2.0
2.6

1.1
1.5

.9
1.1

29
29

16
16

C A PITA L A N D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

yearly rate of 6.5 per cent during the 1970’s
would increase outstanding farm loans at
banks by about $5.4 billion in 1970-74
and $7.3 billion in 1975-79. Table 21
shows how these amounts compare with ex­
pansion that would have to take place under
the various capital models in order that
banks maintain their relative share of farm
lending.
In only one of the model situations would
this rate of increase in farm credit avail­
ability at banks exceed the credit demand
projected. This result occurs in Model B,
which combined a stable real stock of farm
machinery with a moderate 3 per cent yearly
increase in land prices.
In the other situations projected, in
which one of these capital projections is
different— either real machinery stocks in­
crease (Model HM) or land prices rise
faster (Model H T )— expansion of deposits
and loans at 6.5 per cent yearly would at
best just permit banks to maintain their
one-third share of total bank and money
market lending (Model HT) or funds would
fall substantially short of this goal (Model

145

H M ). As these capital trends may easily
continue, the projections on balance point
toward probable difficulty for banks as they
try to meet the farm loan demands of their
present customers. If, as in Model HT, pro­
jected national supply and demand for bank
credit are roughly in balance, a significant
proportion of banks can still be expected to
be out of balance because of differing local
conditions. In the situation projected by
Model HM, a majority of rural banks would
experience farm lending difficulty.
On balance, the analysis and projections
indicate a fairly high probability that rural
banks may be unable to maintain their usual
share of farm lending on the basis of growth
in their deposits. True, low farm capital
requirements would reduce credit demands
to a rate that could be met by probable de­
posit growth. Or a continued very high rate
of increase in time deposits would enable
higher credit demands to be met. But more
probable events appear likely to result in
a shortage of internally originated loanable
funds relative to farm credit demands on
rural banks.

VI. SEASONAL PRODUCTION CREDIT
In addition to using credit to maintain, add
to, and transfer capital assets, farmers de­
mand seasonal credit to carry on produc­
tion processes not financed from their stock
of cash and liquid assets. Seasonal credit
extensions particularly require recognition
here because the preceding analysis em­
ployed capital stocks and debt measured as
of January 1, whereas the national seasonal
peak in the demand for farm working capital
occurs in the spring and summer.
Unfortunately, seasonality of total ex­
penses and working capital has not been
measured. Only annual estimates of farm
expenditures and capital are available.




Data on seasonal credit extensions are
also incomplete. Such credit is provided
mainly by three lender groups: merchants
and dealers, commercial banks, and produc­
tion credit associations (PCA ’s). Advances
and outstanding debt at PCA’s are reported
monthly, but PCA’s hold only about onesixth of total non-real-estate debt. Loans
from commercial banks, which represent
two-fifths of the total, have been reported
only semiannually in recent years. Debt out­
standing at merchants, dealers, and other
individuals is estimated only as of January 1.
Although the magnitude of seasonal capi­
tal and credit requirements is not known,

146

the rate at which such demands have been
expanding can be estimated with the help of
some plausible assumptions. For instance,
the growth rate of operating expenses that
clearly have a significant seasonal com­
ponent can be computed. If the relative
seasonality of these expenses is assumed to
have remained roughly unchanged, that
growth rate becomes an estimate of the rate
at which seasonal capital requirements have
been rising.
On the credit extension side of the puz­
zle, the January-July variation in loans out­
standing at PCA ’s and banks, after adjust­
ment for trend, can serve as an index of
seasonal credit extensions by these lenders.
The assumption here is that a change in the
amount of seasonal lending would change
the difference between January and July
outstanding loans by about the same propor­
tion. Thus, the growth rate of that difference
becomes an estimate of the growth rate of
total seasonal lending by these institutions.
The validity of this estimate may be helped
by the fact that January is the low month
and July the high month in outstanding farm
debt nationally, as indicated by data for
PCA’s.
Seasonal capital requirem ents

Operating expenditures with major seasonal
elements include purchases of seed, fertil­
izer, and lime; operation and repair of motor
vehicles and machinery; and wages and per­
quisites paid to hired workers who do not
reside on the farm by which they are em­
ployed. These expenses are tabulated in
Table 22. Purchases of feed and livestock
are omitted from this table both because
additions to these inventories have been in­
cluded in capital requirements previously
considered and because the national sea­
sonal peak in credit extended for these items
likely occurs near the January 1 date on




T ABLE 22

SELECTED CURRENT FARM OPERATING EXPENSES
In per cent unless otherwise indicated

Item and
period

Expenditures in
1968 (millions
of dollars) .........

Total

Seed
pur­
chases

Operation
and
Wages
to
Fertilizer repair
non­
of
and lime vehicles resident
workers
and
machinery

8,788

668

2,095

3,916

2,109

Annual rate ..

38.2
3.3

28.3
2.5

74.2
5.7

19.8
1.8

53.3
4.4

Average annual
rate of change in
specified period:
1950-54 .........
1955-59 .........
1960-64
1965-68 .........

3.2
3.4
2.2
4.6

- .7
—1.4
2.9
4.2

6.2
1.3
5.7
5.3

4.1
3.7
—.3
4.5

.1
6.6
4.0
4.0

Increase from
1956-58 to
1966-68:

S o u r c e . — F arm In c o m e S itu a tio n , U SD A , July 1969, pp. 56,

58, and 59.

which capital stocks and debt were meas­
ured for the preceding analysis. Repairs
and maintenance of buildings and land im­
provements are omitted on the conjecture
that they did not have a strong seasonal
element. For the same reason, wages paid to
hired workers who reside on the farm are
also excluded.
The selected expenses totaled $8.8 billion
in 1968 and over the previous decade had
risen at an average annual rate of about 3.3
per cent. An exponential least-squares trend
for 1950-68 rises by 3.1 per cent yearly.
Data for each component, as shown in
Table 22, reveal that these longer-term
averages are depressed by the relative stabil­
ity in vehicle and machinery expenses during
the early 1960’s. With such expenses ad­
vancing more rapidly in the last few years,
the total selected costs rose by 4.6 per cent
annually during 1965-68.
If the degree of seasonality in these ex­
penditures has not changed in recent years,
the seasonal capital requirement that under­
lies demand for seasonal production credit
has also been advancing at these rates— less
than half as fast as total outstanding farm
debt. However, seasonal credit demands

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

may also have increased because farmers
wanted to finance a higher proportion of
their seasonal costs by borrowing. Further
evidence is provided by examination of
the seasonality in non-real-estate debt.

147

found more useful in showing average an­
nual growth rates, along with the longerterm changes presented in the last section of
Table 24.
TABLE 24

Seasonal credit extensions

Semiannual variation in outstanding nonreal-estate farm debt held by reporting lend­
ing institutions was calculated by averaging
the amounts outstanding at the beginning
and end of each year and subtracting this
average from the amount outstanding on
July 1, with results as shown in Table 23.
The seasonal credit increase thus obtained
has an upward trend both in total and at
banks and PCA’s separately; however, the
year-to-year fluctuations have been so large
that the trend is not properly revealed by
use of the 5-year periods that this study has
employed in analysis of other data. Ex­
ponential trend curves fitted by the leastsquares technique to data for 1950-68 were
TABLE 23
SEMIANNUAL VARIATION IN INSTITUTIONAL
NON-REAL-ESTATE DEBT OWED BY FARMERS,
1949-68
Debt on July 1 exceeded average of debt at
beginning and end of year by—
Year

Millions of dollars

Per cent

Total i

Bank

PCA

Total

Bank

PCA

1 9 4 9 ....
1 9 5 0 ....
1951___
1952___
1 9 5 3 ....

437
269
464
680
634

271
127
247
418
400

146
108
171
211
191

11.6
8.7
12.5
16.4
15.9

13.6
5.6
8.8
13.2
13.4

38.7
25.8
33.8
36.4
33.5

1 9 5 4 ....
1 9 5 5 ....
1 9 5 6 ....
1957___
1 9 5 8 ....

609
664
640
473
530

354
385
363
222
255

171
185
183
161
178

15.8
15.8
14.4
10.0
9.9

12.4
12.3
11.0
6.4
6.6

30.5
30.3
27.2
20.3
17.8

1 9 5 9 ....
I 9 6 0 .. ..
1 9 6 1 ....
1 9 6 2 ... .
1 9 6 3 ....

686
650
626
627
872

336
329
311
278
425

262
241
244
243
313

11.0
9.5
8.6
7.8
9.7

7.5
6.7
6.0
4.9
6.7

21.2
17.0
15.6
14.0
15.9

1 9 6 4 ....
1 9 6 5 ....
1 9 6 6 ....
1 9 6 7 ....
1 9 6 8 ....

956
781
855
940
1,030

500
326
385
433
485

324
299
324
356
393

9.8
7.4
7.3
7.2
7.3

7.3
4.4
4.8
4.9
5.1

14.8
12.3
11.6
10.9
10.7

i Total non-real-estate loans to farmers held by all operating
banks, production credit associations, Federal intermediate
credit banks, and the Farmers Home Administration, excluding
loans guaranteed by the CCC.
S o u r c e . — A g ricu ltu ra l F in an ce R e v ie w , U SD A , Oct. 1957, pp.
30 and 31; Apr. 1969, pp. 22 and 23.




SELECTED CURRENT EXPENSES AND SEASONAL
COMPONENT OF DEBT: AMOUNT AND
RELATIVE CHANGE, 1950-68
In uer cent unless otherwise indicated

Period

Selected
current
expenses

Seasonal component of institu­
tional non-real-estate debt
Total

Bank

PCA

Annual average (millions of dollars)
1950-54
1955-59
1960-64
1965-68

5,332
6,182
6,998
8,328

531
599
746
902

309
312
369
407

170
194
273
343

Change from previous period
1950-54
1955-59
1960-64
1965-68

15.9
13.2
19.0

12.8
12.5
20.9

1.0
18.3
10.3

14.1
40.7
25.6

Change from specified period to 1965-68
1950-54
1955-59 .
1960-64.. ..

56.2
34.7
19.0

69.9
50.6
20.9

31.7
30.4
10.3

101.8
76.8
25.6

The estimated seasonal component of
total institutional non-real-estate debt
reached $1,030 million in 1968 and ex­
hibited an average annual growth of 4.4 per
cent over 1950-68. The upward trend thus
exceeded the annual average growth of 3.1
per cent estimated for seasonal production
expenses. The excess may be explained by
a seasonal element in intermediate-term
credit that has been captured in the cal­
culated seasonal component of debt— farm­
ers tend to buy machinery in the spring, and
debt incurred for this purpose would be
paid down somewhat by year-end. However,
farmers may also have been increasing the
proportion of their seasonal production ex­
penses financed by debt.
The increase in the seasonal component
of outstanding debt fell far short of keeping
pace with the rise in total non-real-estate
debt at institutional lenders. In the late
1950’s debt in July was about 10 per cent
higher than the January-December average,

148

but by the late 1960’s the average difference
was reduced to 7 per cent.
Given the expectation that farm produc­
tion will continue to rise at the modest rates
that prim arily reflect domestic population
growth and higher consumer living levels,
seasonal farm operating costs can reason­
ably be expected to continue to increase at
rates approxim ating those of the recent past,
in which the same influences were dominant.
The historical record indicates that seasonal
credit demands can be expected to reflect
this increase, and thus to rise by perhaps 3
to 5 per cent annually. A t this rate, the
trend-adjusted January-July increase in
non-real-estate farm debt might range from
$1.3 billion to $1.7 billion around 1980.
But if total non-real-estate debt should
meanwhile increase in line with projections
for total farm debt, this seasonal fluctuation
would represent only about 4 to 5 per cent
of outstandings.
This analysis and projection indicates that
provision of quantities of seasonal credit
desired by farmers as a whole will not be a
m ajor or growing problem. However, this
prognosis is not likely to apply to each farm ­
ing region. As will be shown, there is great
regional variation in relative seasonal farm
credit demands, and in some regions the
seasonal factor can only be classified as
huge. In these areas, any shortfall in total
credit supply is synonymous with a short­
age of seasonal credit. Also, changes in re­
gional production patterns— particularly
increasing specialization in a seasonal com­
modity— will continue to place at least
tem porary strains on seasonal credit re­
sources in some areas from time to time.
Institutional sources of seasonal credit

As estimated seasonal lending at banks and
PC A ’s together has recently been rising
somewhat faster than estimated seasonal




capital requirements, one might reason that
these institutional lenders have been respon­
sive to farm ers’ seasonal demands. However,
the increased credit demands have been met
more vigorously by PC A ’s than banks. The
large year-to-year fluctuations in the cal­
culated seasonal component, particularly in
the bank debt series, precludes explicit judg­
ments, but it appears that during the last
two decades P C A ’s may have provided ad­
ditional seasonal credit that surpassed the
volume supplied by banks, in spite of the
P C A ’s lesser role in total non-real-estate
lending (Table 2 4 ). The 1950-68 leastsquares trend shows that the seasonal com ­
ponent of non-real-estate loans at banks
rose at an average annual rate of only 3.0
per cent, whereas that at PC A ’s rose by 5.5
per cent annually.
A t both PC A ’s and banks, seasonal credit
extensions have become a substantially
smaller proportion of outstanding credit.
The semiannual variation at P C A ’s fell from
18 per cent of outstanding loans in 1958 to
11 per cent in 1968, while at banks it de­
creased from 7 per cent to 5 per cent (T able
2 3 ). As already noted, however, the am ount
of seasonal funds provided by both lenders
actually increased and the seasonal role of
P C A ’s rose in relation to that of banks. The
ratios give the wrong impression because
total farm lending (1 ) increased greatly at
both lenders and (2 ) grew faster at P C A ’s
than at banks.
PC A credit exhibits greater seasonality
than bank non-real-estate credit in all m ajor
production areas except the A ppalachian
and Southeastern States (Table 2 5 ). The
same relationship is found in m any im por­
tant farm States— in 1968, P C A ’s showred
larger relative seasonal variation in 18 of
the 29 States in which bank non-real-estate
farm loans exceeded $100 million, while in
1966 the proportion was 20 of 28 States.

CAPITAL AND CREDIT R E Q U IR E M EN T S OF AG RICU LTURE

TABLE 25
SEMIANNUAL VARIATION IN BANK AND
PCA NON-REAL-ESTATE DEBT
OWED BY FARMERS, 1968
By farm production areas
Debt on July 1 exceeded average of debt
at beginning and end of year by—
Per cent

United States .................
Northeast ......................
Lake States .................
Corn Belt ......................
Northern Plains .........
Appalachian ...............
Southeast ......................
Delta States . ..............
Southern Plains .........
Mountain ......................
Pacific ..........................

Millions of dollars

Bank

PCA

Bank

PCA

5.1
.8
4.3
1.4
—.3
14.6
9.9
26.3
4.1
6.4
12.8

10.7
—1.5
4.9
7.0
3.3
9.3
6.0
53.8
13.4
13.7
16.3

485
3
37
35
4
66
29
74
40
65
140

393
4
20
51
13
39
20
117
40
50
40

S o u r c e . — A g ricu ltu ra l F in an ce R e v ie w , U SD A , Apr. 1969, pp.

24 and 25.




149

Seasonality in farm loans is greatest in
Southern, Plains, and W estern States. In the
Mississippi River Delta States, for example,
the semiannual variation in 1968 was 26
per cent of outstanding loans at banks and
54 per cent at P C A ’s.
These regional data indicate the con­
tinued great im portance of seasonal credit
in some farming areas. From the historical
trends previously noted, it appears that
PC A ’s have been better able than banks to
meet seasonal credit demands in areas
where such demands have been large and
increasing.

Part 2. PROPOSALS TO INCREASE AVAILABILITY OF BANK CREDIT

Part 1 outlined two important projections:
(1) the agricultural sector is likely to con­
tinue to seek significantly larger amounts of
credit, and (2) the ability of rural banks to
provide their historical share of such in­
creases and adequately finance their com­
munities from their own resources is likely
to be further impaired.
To maintain their role as a leading farm
lender, commercial banks will therefore in­
creasingly have to assume the role of inter­
mediaries who channel nonlocal— urban
and money market— capital into agricul­
tural loans of either a term or a seasonal
character. The avenues for securing such
funds fall into two general categories: (1)
discount or sale of assets— in particular, of
loans; and (2) borrowing, such as by pur­
chase of Federal funds or sale of time cer­
tificates of deposit.
These avenues for obtaining reserves to
support additional lending have been partly
or totally closed to many banks that are
extensively engaged in rural lending.
Whereas secondary markets have been de­
veloped for some bank paper, such as ac­
ceptances and mortgages, there is virtually
no market for many rural loans. Thus, most
banks that make a high percentage of their
loans to agriculture and for other rural pur­
poses are unable to obtain any significant
volume of reserves through rediscount or
sale of notes. Their volume of lending is re­
duced by this imperfection in financial
markets.




Borrowing— the second route by which
additional reserves can be secured— has
been employed in significant proportions by
large banks but is much less available to
small institutions. Present markets in such
instruments as Federal funds, time certifi­
cates of deposit, and Euro-dollars are largely
designed to meet efficiently the needs of
large banks. Thus small banks, including
most banks engaged primarily in rural lend­
ing, are in many cases virtually precluded
from participation or can participate only as
effectively as the interest of their city cor­
respondent permits. The ability of small or
isolated banks to employ these sources of
funds is further restricted by lack of man­
agerial skills in this area, lack or relatively
high cost of market information, and the
relative lack of geographical and economic
diversification of their resources, which out­
side investors tend to view as prima-facie
evidence of higher risk.
These imperfections in financial markets
prevent an optimum allocation of money
market resources, with attendant social cost.
Economic sectors that must deal with the
disadvantaged banks— industries such as
agriculture, with large numbers of small
firms located in isolated areas— are placed
at a relative disadvantage in obtaining funds
to finance expansion, new technology, or
seasonal production processes.
In the next three sections, imperfections
in specific banking mechanisms and finan­
cial markets are considered in somewhat
150

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

greater detail to determine whether the flow
of funds into rural areas is obstructed. Some
thoughts are offered on how procedures
might be changed or new mechanisms estab­
lished to improve the mobility of funds and
thereby to increase the potential lending
ability of rural banks.
First, the efficacy of correspondent bank­
ing— the present mechanism by which funds
are moved within the commercial banking
system— is reviewed and appraised. Evi­
dence from Federal Reserve studies is
presented to question whether correspond­
ent banking makes a net contribution to
the flow of funds into rural areas, and to
examine whether its contribution could be
improved by altering the manner in which
most correspondents are compensated for
their services.
To complement the evaluation of cor­
respondent banking, which is most highly
developed in States with unit banking, the
rural lending performance of branch bank­
ing is also examined. While the conversion
of small rural banks into arms of larger in­
stitutions is shown to present important
advantages, several offsetting conditions and
circumstances are also noted.
The second question raised is whether

151

present central banking mechanisms— the
open market and discount operations of the
Federal Reserve System— succeed in pro­
viding an equitable proportion of reserves to
rural sectors. An optimum distribution of
reserves provided either for seasonal fluctua­
tions or for long-term growth is thought un­
likely given the present state of financial
markets, with funds reaching small and iso­
lated banks after considerable lag, if at all.
Therefore, a number of suggestions for im­
proving present markets or compensating
for their deficiencies are offered.
Third, as a fundamental means for mov­
ing money market funds into rural lending
via the banking system, development of sec­
ondary markets in rural bank portfolio items
is proposed. Organizational considerations
and operational methods are briefly out­
lined for new regional agencies— unified
markets— that would make trading in such
items feasible by neutralizing certain dis­
advantages that rural banks face in current
money markets. Regional unified markets
would provide rural banks with information
and trading facilities for all financial instru­
ments, and thereby place rural banks on a
more nearly equal footing with other institu­
tions in the financial arena of the Nation.

VII. CORRESPONDENT AND BRANCH BANKING
In the context of this study, correspondent
and branch banking constitute existing
mechanisms by which the advantages of
large banks can potentially be enjoyed in
rural areas. These mechanisms are in­
herently capable of improving the flow of
funds, both between the money market and
rural banks and among rural banks. In this
process the net flow of funds can be either
into or away from rural areas. Unfortu­
nately, national evidence on the net effect
is meager. Relevant considerations and




some recent research findings are discussed
here.
One other aspect of correspondent and
branch banking deserves special mention:
among the mechanisms considered, these
arrangements alone provide a means to cope
with the problem of farm loans that exceed
the legal lending limits of rural banks.
C orrespondent banking

The correspondent-banking mechanism helps
to provide more effective financial serv­

152

ices to rural areas. City banks may handle
overline loans, provide seasonal credit, ad­
vise on investment policies, help with ac­
counting and management problems, execute
security transactions, and clear checks. In
exchange for such services, country banks
maintain deposits with their city correspond­
ents. This traditional method of payment
drains funds from rural areas by tending to
offset, or in many cases exceed, funds pro­
vided through credit services.
Our interest in correspondent banking
centers on the effectiveness and cost of the
credit services rendered to rural areas. In­
sofar as available information and data
permit, the following questions will be in­
vestigated: (1) Are the credit services re­
sponsive to rural needs? (2) What is the
ratio between funds provided to and drawn
from rural areas? (3) Should credit services
be paid for by deposit balances?
Correspondent-credit services. Intensive in­
terviews about correspondent relationships
were conducted with a number of rural
banks in 1966.35 These banks regarded the
handling of overline loans as the most im­
portant credit service rendered by their city
correspondents, and nearly all were using or
had used their correspondents in this way.
In a few instances, a customer had been re­
ferred to a correspondent, and in some
cases the banks had also obtained loans
from the city banks. But on the whole, most
of the credit was obtained in the form of
participations in loans originated by the
country bank, and most participations were
sought because the loan exceeded the legal
lending limit of the country bank.
Two earlier but broader surveys confirm
this finding. A national survey of correspond­
ent banking conducted in 1963 found that
35 A total of 29 country bankers in Iowa, Illinois,
Colorado, Kansas, and O klahom a were interviewed
by personnel of the Federal Reserve Banks of C hi­
cago and Kansas City.




the bulk of correspondent credit was pro­
vided through participation loans.36 In the
1963 midyear farm credit survey by The
American Bankers Association, 84 per cent
of country bankers and 74 per cent of city
bankers rated participation in overline loans
as the most important correspondent bank­
ing service to agriculture.37
Participations are also used to obtain
correspondent credit even when overlines
are not involved. For example, one banker
has described how his bank obtains sea­
sonal credit through sale of participation
certificates in a block of farm loans. This
procedure was found more convenient than
the sale of individual notes.38
Extent of overline loan problem. Legal lend­
ing limits fix the maximum outstanding
credit that a bank may extend to an in­
dividual and are intended to avoid serious
financial difficulty should one borrower de­
fault. For national banks, the legal limit is
10 per cent of the bank’s capital and sur­
plus, except that loans secured by livestock
may go to 25 per cent. Laws governing
banks chartered by State governments gen­
erally also impose lending limits based on
similar criteria, although they vary among
States.
Rapid postwar growth in the size of in­
dividual farms has resulted in numerous
farm loan requests that exceed the legal
lending limit of the bank at which they are
made. The market value of average assets
per farm in the United States, for instance,
more than doubled both in 1946-56 and
36 U.S. Congress, House, Subcommittee on D om es­
tic Finance of the Comm ittee on Banking and C ur­
rency, A R ep o rt on the C orrespondent Banking
System , 88th Cong., 2d Sess., 1964, pp. 2-4.
37 T. P. Axton, “Introductory Rem arks,” C or­
respondent Agribanking: P roceedings o f the C or­
respondent A griban kin g Forum (New Y ork: The

A m erican Bankers Association, 1963), pp. 5 and 6.
38 R obert L. W alton, “Overcoming Pressure of
Seasonal Loan D em and,” A gricultu ral Banking and
Finance (N ov.-D ee. 1967), pp. 28-31.

CAPITAL AND CREDIT R E Q U IR E M EN T S OF AG RICU LTURE

1956-66. The average amount of credit
used per farm more than tripled during each
of these periods. The assets and capital of
most rural banks did not grow so rapidly.
Thus in many areas, a significant proportion
of farms grew much faster than the banks
by which they were being financed.
Therefore, overline loan requests persist
even though lending limits of rural banks
have been moving upward. Between 1962
and 1968, ABA surveys found that the pro­
portion of agricultural banks with loan
limits under $50,000 declined from 43 to
23 per cent and the proportion with limits
of $150,000 and above increased from 25 to
37 per cent. However, the proportion of
agricultural banks that received one or more
overline requests in the first half of the year
increased from about 25 per cent in 1962 to
29 per cent in 1968. In surveys made each
year since 1962, this proportion has ranged
between 26 and 34 per cent.39
Overline loans are particularly common
at rural banks in Western States that pro­
hibit or severely restrict branch banking.
Farms in these States tend to be large, and
the rural banks tend to be small. In the
1968 ABA survey, 41 per cent of agricultural
banks in the Plains States had received at
least one excess farm loan application.
The Federal Reserve’s 1966 survey of
farm lending confirmed both the widespread
occurrence and the geographical concen­
tration of overline farm loan requests. Of
all insured commercial banks, 14 per cent
39 T rends in A gricultu ral Banking: R e p o rt of M id ­
year 1968 A gricultu ral C redit Situation Survey (New
Y ork: The A merican Bankers Association, 1968), pp.
11-13, and similar publications for earlier years. The
ABA defines agricultural banks as banks with under
$5 million in assets having 5 per cent or m ore of
their assets outstanding in farm loans, and larger
banks with 1 per cent or m ore of their assets in farm
loans. In 1968, 840 of these banks participated in the
sample survey.




153

had received at least one overline request
during the 12 months ending in June 1966.
Among banks with capital and surplus be­
low $300,000, one-fourth had received
overline requests.
Nationally, there were about 12,000 re­
quests totaling $330 million. They equaled
0.3 per cent of the number and 3 per cent
of the volume of all farm loans outstanding
on the day of the survey. At the banks that
received the requests, however, the overline
requests equaled 1.9 per cent of the number
and 15 per cent of the dollar volume of
outstanding farm loans. In both relative
volume and number, overline requests were
about five times more important at small
than at large banks.40
In the Northern Plains States— Kansas,
Nebraska, and the Dakotas— the dollar
volume or overline requests received dur­
ing the year totaled 7 per cent of farm loans
outstanding on the survey date, compared
with the national average of 3 per cent.
Overline requests also occurred with aboveaverage frequency in the Southern Plains
and Mountain States.41
Responsiveness to rural credit needs. The
ABA midyear survey of agricultural banks
has consistently shown that a high percent­
age of overline requests has been handled
through the correspondent system. In 1968,
for instance, 86 per cent of the dollar vol­
ume of excess loan applications was han­
dled on a participation basis with correspond­
ent banks. Another 5 per cent was referred
entirely to a correspondent, so that only 9
per cent was lost to other lenders. During
1962-68, the proportion of dollar value
handled through the banking system has
40 Em anuel M elichar, “Bank Financing of A gri­
culture,” Federal Reserve Bulletin (June 1967), pp.
929 and 930.
41 Ibid., p. 943.

154

ranged from 88 to 97 per cent, and has most
generally been at 94 to 95 per cent.42
The 1966 Federal Reserve survey did
not ask about the disposition of overline
requests, but did show a relationship be­
tween these requests and outstanding par­
ticipation loans. Of the banks with over­
line requests during the year ending in June
1966, one-half had at least one participation
loan outstanding on June 30. At banks that
had overline requests, participation loans
represented a tenth of the outstanding farm
loan business, about double the proportion
found at all banks. Participation loans were
relatively most important in those areas—
the Plains and Mountain States— where
overline requests were most frequent.
The survey found $574 million of farm
participation loans outstanding on June 30,
1966, of which the participating banks’
share was $304 million. Participation activ­
ity was widespread, as 2,500 banks had
originated at least one of these outstanding
loans, and 1,100 banks were participating
in them. Since a similar survey in 1956, the
number of originating and participating
banks had tripled, and the dollar volume of
participation credit had increased by 607
per cent.43
In general, the 29 rural bankers inter­
viewed in 1966 were pleased with their cor­
respondent relationships, which echoed at­
titudes generally expressed by bankers in
the 1963 national survey of correspondent
banking.44 Several bankers indicated that
42 A gricultu ral Banking D evelo p m en t, 196 2 -1 9 6 7
(New Y ork: The A m erican Bankers Association,
1967), pp. 13 and 14.
43 M elichar, op. c i t p. 937. For another discussion
of overlines and participations, see “Lending Limits
of Comm ercial Banks,” in Gene L. Swackhamer and
Raym ond J. Doll, Financing M odern A gricultu re:
Banking's P roblem s and Challenges (Federal Reserve
Bank of Kansas City, 1969), pp. 40-53.
44 U.S. Congress, House, Subcommittee on Dom es­
tic Finance of the Comm ittee on Banking and C ur­
rency, C orrespondent R elations: A Survey o f B anker
Opinion, 88th Cong., 2d Sess., 1964, pp. 6 and 7.




their correspondent had always responded
favorably when asked to take overlines.
However, there were indications that correspondent-credit services may suffer as city
banks reach less liquid positions. Several
rural bankers had been told to hold credit
extensions requiring overline participations
to a minimum. Further questioning revealed
that the banks that were asked to restrict
credit in 1966— a year of general credit
tightness— had generally tended to use their
correspondents extensively, whereas those re­
porting no restrictions had never asked their
correspondent to take more in overlines or
other loans than the amount of their demand
balance with the correspondent.
The Federal Reserve’s 1966 national
survey of farm lending provided additional
insights into the resource pressures on city
banks that might adversely affect their credit
services to country banks. An estimated 83
per cent of participation funds came from
banks with loan/deposit ratios of 60 per
cent or higher. Also, 27 per cent of these
funds were extended by banks that reported
difficulty in financing their own farm cus­
tomers.45
Cost of correspondent-credit services. City
correspondent banks are usually “paid” for
their correspondent services by having the
use of demand deposits that rural banks
keep with them. This flow of funds from
country to city counters the flow of cor­
respondent credit from city to country.
How do the two flows compare in vol­
ume? Some indication is provided by com­
paring farm loan participations and demand
balances outstanding on June 30, 1966. Be­
cause only data on farm loan participations
were obtained in this survey, this compari­
son must be restricted to banks whose lend­
ing business consists primarily of loans to
farmers. Banks with more than one-half of
45 Melichar, op. cit., pp. 940 and 941.

155

CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE

their total loans in loans to farmers were
chosen. The analysis also concentrates on
member banks, thereby avoiding the com­
plicating factor that nonmember banks hold
balances in other banks to meet reserve re­
quirements. (Table 26 provides data for
both member and nonmember banks.)
At the 855 member banks meeting the
farm loan criterion, farm participations
averaged 22 per cent of demand balances
with other banks, whereas at the 2,069 non­
member banks, the ratio was 16 per cent.
Thus, the balances exceeded the credit re­
ceived by more than four times, which
agrees with other impressions that the net
flow of funds is from the country to the city.
For the heavily agricultural banks in this
analysis, a reasonable allowance for non­
farm participations and for nonparticipa­
tion credit would still leave correspondent
balances far ahead of correspondent credit.
A more detailed analysis of these data
reveals wide variation in the ratio of par­
ticipations to balances among individual
banks, indicating that managerial inertia at
country banks may be an important factor
contributing to the unfavorable direction of
the net fund flow.

If a country banker is operating at a low
loan/deposit ratio, city banks can hardly
be faulted for attempting to obtain rela­
tively large balances from him even though
they are not called upon for proportionately
large credit services. A distribution of the
heavily agricultural member banks by loan/
deposit ratio is particularly revealing. Those
banks with loan/deposit ratios under 50
per cent had outstanding participations
averaging less than 10 per cent of the bal­
ances they held in correspondent banks. The
ratio of participations to balances rose
with higher loan/deposit ratios until it
reached 97 per cent at banks with loan/
deposit ratios of 70 per cent and over. These
banks kept correspondent balances averag­
ing only 5.4 per cent of their deposits, com­
pared with an average of 7.3 per cent for all
the member banks in this analysis. A similar
though less marked relationship was found
at nonmember banks.
It is evident that some banks can obtain
a relatively high volume of correspondent
credit relative to balances. A further break­
down of the data cited shows that the larger
banks among those with high loan/deposit
ratios had the higher ratio of participations

TABLE 26
COMPARISON OF FARM LOAN PARTICIPATIONS RECEIVED FROM AND DEPOSIT BALANCES
HELD IN OTHER BANKS, JUNE 30, 1966

Capital and
liquidity status
of bank

M illions of
dollars

Farm loan
participations as
percentage of—

Farm
loan
partici­
pations

Bal­
ances

58

262

22

7
16
17
18

51
63
82
66

2
1
4
14
16
21

20
36
59
69
56
22

Balances as
percentage of—

M illions of
dollars

Deposits

Farm
loans

Farm
loan
partici­
pations

Bal­
ances

4.6

7.3

21

91

574

16

13
26
21
27

3.1
5.7
4.4
4.8

8.5
7.5
7.3
6.4

24
22
21
18

52
15
18
6

264
130
123
58

8
3
7
20
29
97

5.9
1.1
1.8
3.9
4.7
10.4

11.5
7.9
7.6
7.3
6.7
5.4

72
33
26
20
16
11

1
1
11
10
44
23

31
80
126
161
116
61

Bal­
ances

Farm
loans

Member banks
Total ..........................
Capital and surplus
(thousands of
d o lla rs):
Under 200 .
200-299 .................
300-499 .................
500 and over
Loan/deposit ratio
(per c e n t):
Under 3 0 ...............
30-39 ......................
40-49 ......................
50-59 ......................
60-69 ......................
70 and over .........

Farm loan
participations as
percentage of—
Bal­
ances

Deposits

Farm
loans

4.7

10.7

30

20
12
15
10

6.3
3.3
4.1
3.0

11.5
9.9
10.3
10.7

32
35
28
29

4
1
9
6
38
38

3.9
.4
3.1
1.8
9.0
7.4

15.2
11.7
10.9
10.3
10.2
10.3

89
49
36
28
24
19

Nonmember banks

N ote.— D ata shown are for banks at which farm loans comprised 50 per cent or more of total loans.




Farm
loans

Balances as
percentage of—

156

to balances (Table 27). Better managerial
skills at larger banks may have played a
part in this result, along with the greater
power that larger banks presumably have
to encourage their correspondents to pro­
vide more credit service.
TABLE 27
FARM LOAN PARTICIPATIONS RECEIVED AS
PERCENTAGE OF DEPOSIT BALANCES HELD
IN OTHER BANKS, JUNE 30, 1966
L oan/deposit ratio
(per cent)
Under 50 ............................
50-69 .....................................
70 and over ........................

Capital and surplus
(thousands of dollars)
Under
200

200 to
499

500 and
over

18
3
32

3
38
73

1
11
146

N ote.—D ata shown are for member banks at which farm
loans comprised 50 per cent or more of total loans.

To some extent, fund outflow from rural
communities is accentuated by complemen­
tary deposit accounts that rural bankers
keep with city banks that are not called
upon for correspondent credit and that in
many cases are rarely called upon for serv­
ices of any kind. Each of the 29 rural banks
in the 1966 survey, for instance, was main­
taining accounts with from 2 to 12 city
banks; however, in no case did a bank have
more than three active accounts. Some of
these banks did report that they were re­
ducing their number of inactive accounts.
However, there is ample evidence that
provision of correspondent credit is directly
dependent upon maintenance of deposit
balances and is related to the amount of
such balances. For instance, one Illinois
bank, in return for use of an anticipated
$300,000 of seasonal participation credit
(maximum $800,000), agreed to “keep with
the correspondent an average of $150,000
in excess deposits above and beyond that
needed to break even on a normal cor­
respondent relationship.”46 In a normal year,
the city bank would apparently provide
46 Walton, op. cit., p. 30.




$300,000 for perhaps 6 months, on which it
would receive interest “at XA per cent above
the prime rate.” In effect, the country bank
gave the city bank a yearly average of
$150,000 interest-free in return for the priv­
ilege of borrowing $300,000 at slightly above
the prime rate for perhaps 6 months. On a
yearly average basis, the city bank’s average
commitment of its own funds was zero. If
it could invest the balances at the prime
rate, its annual earnings from the arrange­
ment were equal to the prime rate times
$300,000. Nevertheless, this country banker
was pleased with this correspondent arrange­
ment. With his bank fully invested, he found
it necessary to pay this relatively high price
for seasonal credit.
City bankers traditionally have viewed
deposit balances as additional compensation
for provision of participation credit. For
example, one banker with a large farm
participation business, whose bank was
therefore presumably offering participations
on terms competitive with other city banks,
made this statement in 1963:47
We will not accept an overline from a country
bank unless we have a deposit relationship with
that bank. W e expect some correlation between
the amount of deposit relationship and the amount
of overline accommodation. . . . We want the
country banker to participate substantially in any
loan he asks us to carry.

Apparently, farm loans obtained through
correspondents were not viewed as a suffi­
ciently profitable investment, even though
the country banks were incurring most of
the cost of originating the loans and were
sharing the risks involved. Another city
banker has more recently affirmed this
view:48
47 M orris F. M iller, “O ur Bank’s A gricultural P ro ­
gram ,” C orrespondent A gribanking (New Y ork: The
Am erican Bankers Association, 1963), p. 36.
48 R obert E. H am ilton, “F arm Credit— It Should
Be Supplied by Bankers, but A griculture M ust C om ­
pete fo r Funds on the Same Basis as Any O ther In­
dustry,” M id-C ontinent B anker (Nov. 1968), p. 49.

CAPITAL AND CREDIT REQ U IR E M EN T S OF AG RICU LTURE

W here lies the glam our for M r. City Banker to
send funds to F arm er Smith through his banker
in w estern Illinois at the prim e rate, w ith no
deposit balance? If, on the other hand, the same
funds can be placed locally at the same rate with
20% com pensating balances and some good
trust business in prospect, w here w ould your
stockholders expect the money to go?

Similar attitudes on the part of city banks
are likely to become even more common as
more city banks encounter tighter liquidity
conditions, with inherent conflict between
the loan demands of their own customers
and the credit needs of their country cor­
respondents. If the latter needs are met, it
seems evident that the correspondent system
will exact a considerable toll for this service.
A proposal to minimize drains on rural funds.

Although the use of deposit balances to pay
for correspondent services drains funds from
rural areas, in a number of common circum­
stances this means of payment constitutes
an efficient use of rural banking resources.
For many nonmember banks, correspondent
balances also serve to meet State reserve re­
quirements, and thus the funds would be
unavailable for lending anyway. Also, at
banks with funds in excess of loan demands,
no immediate diminution of lending ca­
pability results when balances are used to pay
for overline participations and other services.
Or if a city bank is content to be paid for
seasonal credit extensions by balances re­
ceived only in the rural bank’s off-season,
and the rural bank would not be fully in­
vested at that time in any event, payment
through balances may not adversely affect
the local credit service of the rural bank.
These circumstances are present in many
correspondent relationships and may help to
explain why a majority of country bankers
surveyed in 1963 expressed a preference for
balances over fees as means of payment for
correspondent services.49 Also, it is natural
49 U.S. Congress, House,
op. cit., pp. 10-12.




C orrespondent R elations,

157

for these bankers to favor a traditional tech­
nique to which they are accustomed. But
with the increasing shortage of loanable
funds and with more sophisticated manage­
ment, more country banks may question the
use of correspondent balances to pay for
overline or seasonal participations. In many
instances, community needs might be better
served if rural banks made additional local
loans with the funds they now are using to
maintain correspondent balances and used
the returns on these loans to pay for cor­
respondent services on a fee basis. Fees for
credit accommodation should prove reason­
able, as interest rates charged by city banks
on participations and other farm loans
should be high enough to make them a
profitable investment in their own right.
If city correspondents are able to adapt
to the changed liquidity position of rural
banks, and at the same time maintain or ex­
pand credit services provided to rural areas,
they will continue to constitute a useful
farm credit mechanism. However, an in­
evitable conflict may arise as both country
and city banks simultaneously approach less
liquid positions. Thus at the same time that
country banks are interested in reducing
correspondent balances and increasing credit
services, city banks probably have more in­
terest in increasing balances and less interest
in providing credit. Given these circum­
stances, it seems unlikely that the traditional
correspondent banking system can become
the means whereby substantially larger
quantities of urban funds are channeled into
agriculture.50 However, correspondent bank­
ing could contribute materially to this flow
if city banks prove interested in becoming
50 Further evidence and evaluation of credit flows
through the correspondent-banking system have been
provided by a Federal Reserve staff task force headed
by Ernest Baughman and Dorothy Nichols, Federal
Reserve Bank of Chicago. Some data and conclusions
from this study are presented by Bernard Shull in
R eport on Research U ndertaken in C onnection w ith
a System Study, vol. 1 of this series, pp. 60-62.

158

brokers for funds that country banks need
to maintain their role in rural finance.
Branch banking

In the heart of the Nation’s agricultural
areas— the western Com Belt, Plains, and
eastern Rocky Mountain States— branch
banking is prohibited or severely restricted.
One-half of the banking system’s farm loans
are in this region. Farm loan demands in
the area have increased rapidly as crop farm
acreages have been enlarged and livestock
production increased. In consequence, many
agricultural banks have reached high loan/
deposit ratios and some have expressed con­
cern over their future capacity to finance
agriculture. Also, large farming operations
are common in this area, so that overline
loan requests are frequently received. Con­
tinued availability of participation credit
from larger correspondent banks is essen­
tial in this environment.
In contrast, the 1966 survey of farm lend­
ing found that overline requests and general
farm financing present markedly smaller
problems in rural areas served by large
branch-banking systems. The most striking
evidence was contained in reports from the
Pacific States, where very large farms pre­
dominate. But because the banks there were
also relatively large, overline requests were
virtually nonexistent, and few banks thought
that farm loan demands pressed unduly
against their resources.
In addition to being less likely to receive
farm loan requests exceeding their legal
lending limit, large branch banks are po­
tentially able to improve rural credit serv­
ices in several other ways. Their greater
lending volume can support employment of
specialists in farming and farm lending.
Their lending practices and terms can there­
fore stay abreast of modern developments.
Over-all management of the bank’s re­




sources is also likely to be better than that
achieved by many small banks. A typical
branch system is likely to operate at a higher
loan/deposit ratio than the average of an
equivalent group of unit banks, partly be­
cause its geographically diversified lending
reduces the over-all risk. More loans can
therefore be made from the same banking
resources. Within a branch system, funds
can be shifted to offices facing the greater
loan demand. Consequently, in communi­
ties where credit needs are greatest loans
may easily exceed deposits. Finally, the
larger banks are more likely to be able to
tap national money markets for additional
funds.51
On the other hand, there are reasons to
question whether branch banking can be
relied upon to improve the flow of bank credit
to agriculture. To be most effective, a sys­
tem should cover an area sufficiently broad
and diversified to include both capital sur­
plus and deficit regions between which funds
can be moved. With branching limited to
statewide systems at best, it is doubtful that
this condition is met in some agricultural
States. A more meaningful contribution
could be expected if branching were per­
mitted over a larger economic area or were
delineated by national or regional economic
sectors rather than State lines.
A second major concern is that the man­
agement of branch systems, because of un­
familiarity with rural finance, may not
implement the policies that would lead to
the potential lending improvements cited
above. In a branch system covering a di­
versified area, rural lending may be a less

51 As p art of the over-all discount study, Federal
Reserve staff studies of fund flows within branchbanking systems were undertaken by Verle Johnson,
H arm on Haymes, and M argaret Beekel. A brief state­
m ent of the findings is presented by Bernard Shull,
op. cit., p. 62.

C A PITAL AN D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

important activity than in a unit bank in a
rural community. Top managers will prop­
erly allocate less of their time to this phase
of their bank’s business. Nevertheless, such
a bank can perform an outstanding rural
credit job if top management is interested
in developing its rural business along with
its other endeavors and employs capable
technical staff to work in rural credits. But
if such lending is neglected by a large
branch system, many rural communities
may be adversely affected. The potential

159

limitations should be recognized along with
the advantages.
Finally, a realistic appraisal must note
that State legislation now prohibiting branch
banking seems likely to be changed quite
slowly, if at all. While a gradual nationwide
trend toward reduction of restrictions can
be detected, it has made little or no progress
in many nonmetropolitan States. Meanwhile,
it may prove desirable to implement other
measures to improve the ability of the bank­
ing system to finance agriculture.

VIII. FEDERAL RESERVE CREDIT
Since the early 1930’s, the Federal Reserve
System has relied mainly on open market
operations to provide reserves to support a
growing volume of money and bank credit,
as well as to offset seasonal and other fluc­
tuations affecting bank reserves. Recently,
only about 2 per cent on average of total
Reserve Bank credit has been supplied
through the discount window.
Making Reserve Bank credit available
through open market operations and letting
market forces determine its allocation has
much appeal, should distributive mechan­
isms in the financial markets enable a near­
optimum allocation to be achieved. Imper­
fection in present mechanisms, however,
may lead to less-than-optimum distribution
of new reserves among different economic
and geographic sectors or may cause long
lags before an optimum allocation is at­
tained. Empirical evidence tends to verify
these fears.52
52 A fter empirical work th at included comparisons
of portfolio behavior at reserve city and country
banks, Goldfeld concluded th at in operations pro­
viding for reserve growth, “There is . . . no assurance
that reserves generated by open-m arket purchases will
find their way to banks in need of funds . . . openm arket operations are likely to affect country banks
only indirectly” (p. 52). Similarly, in operations off-




To compensate for inequities that thus
arise from the present structure of banking
and of financial markets, more Reserve
Bank credit could be provided directly to
rural banks. Through the discount mechan­
ism, member banks in need of reserves have
had access to credit for short periods of
time— too short in most cases to provide
effective support for farm lending.
Data on intrayear flows of loans and de­
posits show that many rural banks could
each year use adjustment credit provided for
the entire length of a farm production sea­
son. Such credit could be supplied through
a discount mechanism redesigned to incor­
porate a seasonal borrowing privilege. The
extent to which alternative types of such
privileges might improve farm credit avail­
ability at banks is examined in this section.
The analysis also reveals that more than
half of member banks in relatively tight
setting reserve losses, “there is no assurance th at the
reserves created by open-m arket purchases will be
distributed am ong m em ber banks in proportion to
the reserve losses which they are intended to re­
place” (p. 183). A dditional evidence is presented on
pp. 149 and 150. See Stephan M. Goldfeld, C o m ­
m ercial Bank B ehavior and E conom ic A c tiv ity : A
Structural Study of M on etary P olicy in the P ostw ar
U n ited States (A m sterdam : N orth-H olland Publish­

ing Company, 1966).

160

liquidity positions face a year-round rather
than seasonal strain on their lending re­
sources. Furthermore, many rural banks
are not members of the Federal Reserve
System, and if they do not belong to the
System, they would not be eligible for sea­
sonal discount credit. Two possible Fed­
eral Reserve actions to assist both groups of
banks are examined: (1) longer-term credit
through the discount or open market mech­
anisms and (2) improvement of markets for
assets and liabilities of rural banks.
Seasonal discount credit

Banks in nonmetropolitan areas frequently
experience a seasonal squeeze on funds
through simultaneous withdrawal of deposits
and expansion of loan demands. Because of
their small size and geographic isolation,
rural banks frequently are ill equipped to
utilize their resources effectively in a highly
seasonal environment. During the off-peak
season of the year, funds that might other­
wise have been committed to financing in­
termediate-term rural needs instead tend to
be maintained in short-term Government
securities, city bank accounts, or other forms
that provide a high degree of liquidity, but
that represent inefficient use of the financial
resources of the community. Twenty, or per­
haps even 10, years ago, when most banks
had ample stocks of liquid assets even at
seasonal peaks, this situation caused little
concern. Now, however, many banks are
hard pressed to meet the loan demands of
their area. With discount policy revised to
allow rural banks to borrow a substantial
portion of the funds required to meet sea­
sonal outflows, these banks would have
more funds for meeting community needs
and would be able to handle their invest­
ment portfolios more satisfactorily.
The existing regulation permits exten­
sion of short-term discount credit for sea­




sonal requirements “. . . beyond those which
can reasonably be met by use of the bank’s
own resources.” This regulation has usually
been interpreted to mean that a bank is ex­
pected to meet seasonal outflows of his­
torically average amplitude through its own
portfolio adjustments. And when borrowing
for seasonal needs has been permitted, the
assistance has usually been of shorter term
than the period of the bank’s need. A help­
ful revision of the rule would permit Federal
Reserve Banks to establish seasonal borrow­
ing privileges for their member banks for
meeting a portion of normal seasonal needs,
with maturities geared to the length of need.
This recommendation again seeks to remedy
partially the inability of small and isolated
rural banks to tap national money markets
effectively for short- and intermediate-term
funds. The following discussion demon­
strates the scope of the seasonal lending
problem at such banks and the extent to
which assistance through the discount win­
dow might be helpful.
Example of seasonal fund flows at rural banks.

Not all rural banks experience seasonal loan
demand and deposit withdrawals that are
large in relation to the size of the bank. But
at some banks, principally those in crop
production areas, such fund outflows can
be violent. To illustrate a situation of this
kind, actual data for three small banks in
Nebraska, each with large seasonal flows
relative to its size, were averaged to obtain
data for a composite rural bank (Table
28).
More than three-fourths of the loans at
this bank consisted of loans to farmers,
both in December and in June. But farm
loans increased by 64 per cent between De­
cember 1965 and June 1966. In the same
interval, deposits of individuals, partner­
ships, and corporations (IPC ) decreased by
17 per cent. Even after adjustment for an

CA PITA L A N D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

Community consequences of large seasonal
flows. The composite rural bank described

TABLE 28
SEASONAL FUND FLOWS AT A COMPOSITE
RURAL BANK 1
Amounts in thousands of dollars
Amount outstanding
Bank’s
portfolio of —
Farm loans ............
Total l o a n s ..............
Deposits, IPC ........
Balances at other
banks ....................
U.S. Govt, securities
Loans as per cent of
total deposits . . . .

June
1965

Dec.
1965

June
1966

1,867
2,414
2,684

1,295
1,664
3,549

2,124
2,485
2,952

324
687

555
1,847

398
611

77.8

40.4

74.9

Trend-adjusted
January-June
change as
percentage of
December
total deposits
22
25
—23
-6
-3 8

i Average of data for three rural banks experiencing relatively
large seasonal flows of funds.

upward growth trend in deposits and loans,
the combined semiannual fund outflow from
increases in all loans and withdrawal of IPC
deposits was equal to 48 per cent of the
December level of total deposits.
Other data in Table 28 indicate that as
this bank received an inflow of deposits in
the second half of the year, the money was
placed primarily in U.S. Government securi­
ties and to a lesser extent was held as bal­
ances at other banks. In the spring, deposits
flowed out of the community, and in addi­
tion farmers borrowed for production pur­
poses. To accommodate these seasonal de­
mands, the bank sold the securities that had
been purchased the previous fall and also
drew down its balances with other banks.
The combined trend-adjusted semiannual
change in these two assets totaled 44 per
cent of total December deposits, almost
equal to the relative semiannual outflow of
48 per cent.
This bank thus financed the seasonal
demands of its community from its own
resources; that is, from the resources of the
community. Funds deposited in the fall were
merely stored in anticipation of the certain
outflow of the following spring. The bank
had a loan/deposit ratio of 75 per cent in
June, at which time its resources were al­
most fully employed. In December, however,
its loan/deposit ratio was only 40 per cent.




161

above had nearly a maximum year-round
level of loans consistent with meeting the
indicated seasonal outflow from its own re­
sources. If it had additional year-round loan
demand, such as for farm machinery and
equipment purchases or from nonfarm busi­
nesses, it could in theory operate in a dif­
ferent fashion and still meet the same sea­
sonal outflow: it could commit its own funds
to the additional year-round loans and bor­
row an equivalent sum during the spring
and summer to meet the seasonal demand.
However, with the present structure of
money markets, this could be difficult for
a small bank in Nebraska.
On the other hand, if this bank were able
to obtain seasonal funds from its Reserve
Bank in sufficient quantity to cover a signif­
icant portion of its seasonal outflow for the
entire period of the outflow, it could operate
in just that fashion. It could increase its
year-round lending for legitimate commu­
nity needs with complete assurance that
funds would be available for the vital sea­
sonal demands.
In addition, this bank, in spite of the
large seasonal outflow, is possibly not meet­
ing the full seasonal loan requirements of its
customers. Faced with increasing demand
for both year-round and seasonal credit,
perhaps the latter is being curtailed instead
of, or in addition to, the former. In this
event, seasonal borrowing from the Federal
Reserve Bank would enable the bank to
meet more adequately the complete sea­
sonal needs of the community. After several
years the real seasonal pattern would be
evident, and the bank could obtain still
greater seasonal sums from the Federal Re­
serve, thereby releasing the community’s
own resources for additional year-round
loans.

162

Community benefits from a seasonal dis­
count privilege can thus be expected in situ­
ations where banks (1) are experiencing a
significant seasonal outflow of funds rela­
tive to their size, and (2) are operating at a
relatively loaned-up position at the peak of
the seasonal outflow. The latter condition
indicates that term an d /o r seasonal loan de­
mands are not being fully met or that such a
situation may soon develop. The following
discussion attempts to measure the preva­
lence of these circumstances among rural
member banks and to estimate the impact
that seasonal discount arrangements might
have on farm lending at these banks.
Prevalence of large relative seasonal outflows.

Fund flow data for all banks, similar to
those shown for the composite rural bank,
indicate that banks involved in financing
agriculture to the extent of at least 25 per
cent of their total loan volume (hereinafter
referred to as agricultural banks) are more
likely than other banks to have semiannual
TABLE 29
DISTRIBUTION OF M EMBER BANKS BY RELATIVE
SEMIANNUAL FUND OUTFLOW AND
BY IMPORTANCE OF FARM LENDING, 1965-66
Relative semiannual
fund outflow
(per cent)

Total

All banks ..............
Under 5 ..............
5 to 9 ..................
10 and o v e r ........

6,151
3,398
1,784
969

Farm loans as percentage
of total loans
Under 1

1 to 24

25 and
over

Number of banks
1,388
867
344
177

2,713
1,665
786
262

2,050
866
654
530

Percentage distribution
(by relative outflow)
All b a n k s ................
Under 5 ..............
5 to 9 ..................
10 and o v e r ........

100
55
29
16

All b a n k s ................
Under 5 ..............
5 to 9 ..................
10 and over ........

100
100
100
100

100
62
25
13

100
61
29
10

100
42
32
26

(by farm loan ratio)
23
26
19
18

44
49
44
27

33
25
37
55

fund outflows. As Table 29 indicates, 26
per cent of agricultural banks experienced
a semiannual fund outflow equal to at least
one-tenth of deposit volume. Only 11 per




cent of other banks had relative outflow of
this magnitude. Also, an additional 32 per
cent of agricultural banks had semiannual
fund outflows of from 5 to 9 per cent of
deposits, still a slightly higher proportion
than found among other banks.
As of June 1966, agricultural banks com­
prised one-third of all member banks. But
of member banks with relative semiannual
outflow equal to 10 per cent or more of
deposits, 55 per cent were agricultural
banks. Of banks at which outflow com­
prised 5 to 9 per cent of deposits, 37 per
cent were agricultural banks. Thus, rela­
tively large seasonal fund outflows were
more prevalent among agricultural banks—
many of which were precisely the banks
unable to cope with such seasonal flows ex­
cept by keeping their own resources avail­
able for this use.
Potential impact of specific seasonal discount
proposals. In any arrangement that permits

banks to borrow from Federal Reserve
Banks to meet part or all of seasonal out­
flows, specific rules would be needed to guide
the definition and measurement of seasonal
outflows, and to indicate the proportion of
outflows that could be met by borrowing.
Formulation and execution of such rules
could, and undoubtedly would, employ more
detailed banking data than the semiannual
statistics shown thus far. The particular
regulations adopted would influence the
total amount of seasonal credit extended by
the Federal Reserve System, as well as the
amount that could be obtained by agricul­
tural banks.
An indication of the proportion and
amount of borrowing that might be done
by agricultural banks, however, can be ob­
tained from the semiannual data that is now
readily available for all banks. Suppose,
therefore, that seasonal outflow is defined
as in the example involving the composite
rural bank and that banks are allowed to

C A PITA L A N D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

borrow funds equal to all outflow exceeding
either 5 or 10 per cent of average de­
posits. The extent to which agricultural
banks could participate in seasonal borrow­
ing and the relationship between their po­
tential borrowings and their volume of farm
lending can be calculated to show the poten­
tial impact of the seasonal discount credit
on farm lending. Selected data of this kind
are shown in Table 30.
TABLE 30
ESTIMATED MAXIMUM SEASONAL BORROWING AT
AGRICULTURAL AND OTHER BANKS UNDER
ALTERNATIVE DISCOUNT PLANS, 1965-66
Seasonal discount
plan (level of
deductible)

Total

Farm loans as percentage
of total loans
Under 1

1 to 24

2^

d

Number of banks eligible
10 per cent ........
5 per c e n t ........

969
2,753

177
521

262
1,048

530
1,184

Distribution of banks
eligible (per cent)
10 per cent ........
5 per cent ........

100
100

18
19

27
38

55
43

Borrowings (millions
of dollars)
10 per cent ........
5 per cent ........

461
2,130

157
1,022

185
801

120
307

Distribution of
borrowings (per cent)
10 per cent ........
5 per cent ........

100
100

34
48

40
38

26
14

Borrowings as per cent of
deposits at eligible banks
10 per cent ........
5 per cent ........

4.1
3.0

3.0
2.6

4.8
3.1

5.5
5.3

Borrowings as per cent of
farm loans at
eligible banks
10 per cent ........
5 per cent ........

59.4
87.3

97.0
82.4

20.5
21.9

Farm loans at eligible banks
as per cent of farm loans
at all insured banks
10 per cent ........
5 per cent ........

7.0
22.3

4.0
20.1

9.9
23.8

Borrowings as per cent of
farm loans at all insured banks
10 per cent ........
5 per cent ........

4.2
19.5

3.8
16.6

2.0
5.2

Under the 10 per cent plan, 16 per cent
of member banks could borrow, and 55
per cent of these would be agricultural
banks. The 5 per cent plan would broaden
potential borrowing to 45 per cent of mem­




163

ber banks, of which 43 per cent would still
be agricultural banks.
Although dominant in numbers, the agri­
cultural borrowing banks would tend to be
smaller than other borrowing banks. Thus,
of total potential seasonal borrowings of
$461 million under the 10 per cent plan,
agricultural banks would obtain 26 per
cent; under the 5 per cent plan they would
obtain 14 per cent of total borrowings of
$2,130 million. Although agricultural banks
would get a smaller portion of the total
credit extended under the latter plan, they
would obtain a much larger sum than under
the 10 per cent plan— $307 million versus
only $120 million.
Under either plan, however, the potential
borrowings would have more impact on
the agricultural banks than on the other
banks, reflecting the fact that seasonal
outflows are proportionately greater at agri­
cultural banks. Borrowings by agricultural
banks under the 10 per cent plan could po­
tentially equal 5.5 per cent of deposits at the
eligible banks, against only 3.0 per cent at
eligible banks with few or no farm loans.
The 5 per cent plan yields the same differ­
ence in potential impact. Thus, seasonal bor­
rowing arrangements would not only benefit
a greater proportion of agricultural banks
than other banks, but would also be of
relatively greater importance to the agricul­
tural banks among the banks eligible to
borrow.
At the eligible agricultural banks, poten­
tial borrowings under either plan would
equal about one-fifth of present farm loan
volume. The proposal could thus have a
significant impact on farm lending at these
banks.
The impact on total farm lending by all
insured commercial banks would be much
smaller, but still potentially significant, es­
pecially under the 5 per cent plan. Mem­
ber banks eligible to borrow under the 10

164

per cent plan hold 7.0 per cent of the
total farm loans outstanding at all insured
banks, whereas under the 5 per cent plan
the proportion rises to 22.3 per cent. Mem­
ber agricultural banks eligible to borrow
under the alternative plans hold 9.9 per
cent and 23.8 per cent, respectively, of
total farm loan volume at all insured agri­
cultural banks. Potential borrowings are
equal to 2.0 per cent and 5.2 per cent,
respectively, of the total farm loan volume
at all insured agricultural banks. The po­
tential impact on total farm lending is re­
strained because (1) agricultural banks with
large seasonal outflows tend to be small
banks, and (2) two-thirds of all agricul­
tural banks, as well as of agricultural banks
with large seasonal outflows, are nonmem­
ber banks that would not be eligible for
seasonal discount credit from the Federal
Reserve System unless they became mem­
bers, or unless a basic legislative change per­
mitted borrowing by nonmembers.
Impact of bank liquidity on potential borrow­
ing. It seems reasonable that banks with

little liquidity, particularly at the peak of
seasonal outflows, would be most likely to
utilize a seasonal borrowing arangement to
advantage. The 1966 farm loan survey indi­
cated that banks began to experience sig­
nificantly increased difficulty in financing
their farm borrowers when loan/deposit
ratios exceeded 60 per cent. Table 31 in­
dicates that about 34 per cent of agricul­

tural banks eligible to borrow under the 10
per cent plan, and a slightly smaller portion
of those eligible under the 5 per cent plan,
were illiquid to this degree at their seasonal
peak. Another 30 per cent had loan/deposit
ratios in the 50 to 59 per cent range, indi­
cating that they might soon be more seri­
ously concerned with liquidity, and perhaps
might already be able to benefit from some
seasonal borrowing.
At more than one-third of agricultural
member banks with large relative seasonal
outflows, however, loan/deposit ratios are
apparently under 50 per cent— at some
banks, under 40 per cent— even at the sea­
sonal peak. Although some of these banks
might exercise a seasonal borrowing priv­
ilege and perhaps thereby improve their
farm lending service, their present liquidity
would permit them to do so even in the ab­
sence of such arrangements. An analysis
performed by the Federal Reserve Bank of
Kansas City showed that many such banks
do not seem to lack farm lending opportuni­
ties in their communities. Many had neigh­
boring banks in the same or adjacent towns
with much higher loan/deposit ratios, some
of which were expressing concern about
their inability to meet the legitimate loan
demands of the area. Greater educational
and other efforts to overcome the apparent
managerial inertia at the banks with low
loan/deposit ratios would be of service to
the communities affected.

TABLE 31
DISTRIBUTION OF AGRICULTURAL MEMBER BANKS WITH FUND OUTFLOW IN
JANUARY-JUNE 1966
By relative size of outflow and by loan deposit ratio on June 30, 1966
Loan/deposit ratio (per cent)
Relative fund
outflow (per cent)

Total

Under
40

40-49

50-59

60-69

70 and
over

Total




1,663
602
568
493

304
118
102
84

376
143
138
95

472
156
170
146

40-49

50-59

60-69

70 and
over

Percentage distribution of banks

Number of banks
All banks ..........................
Under 5 ..........................
5 to 9 ..............................
10 and over ..................

U ^ er

355
125
116
114

156
60
42
54

100
100
100
100

18
20
18
17

23
24
24
19

28
26
30
30

21
21
20
23

9
10
7
11

CA PITA L A N D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

Latent seasonal demands. The preceding
evidence on the potential assistance of sea­
sonal discount credit to farm lending neces­
sarily shows only how it could help banks
to cope with the seasonal loan demands that
they have actually filled in the past. It is
probable, however, that some— perhaps
many— banks have seasonal loan demands
in their communities that have not been met
because of lack of funds. Again, at progres­
sive banks this situation is likely to occur
more often as liquidity is exhausted.
Although banking statistics alone cannot
reveal latent seasonal demands, some indica­
tions of their existence and relative signifi­
cance have already been noted in Section
VI, where the trend in the amount of sea­
sonal credit provided by banks was com­
pared with trends in seasonal operating
expenses (Table 22) and in seasonal credit
provided by PCA’s (Table 24).
Expenditures for current farm operating
expenses with significant seasonal compo­
nents increased by 3.3 per cent annually
during 1950-68. Over the same period, the
semiannual variation in total institutional
non-real-estate debt rose at an average
yearly rate of 4.4 per cent. Although this
comparison is far from complete, the evi­
dence is nevertheless consistent with the
hypothesis that increased farm seasonal
credit demands are being met by institu­
tional lenders.
During the same period, however, the
amount of the semiannual variation in bank
non-real-estate loans rose at an average an­
nual rate of 3.0 per cent, whereas at PCA ’s
the average annual gain was 5.5 per cent.
PCA’s probably provided more additional
seasonal credit than did banks over this
period. In 1950-54, for instance, the aver­
age January-June loan increase at banks
amounted to $309 million, whereas at
PCA ’s the amount was $170 million. By




165

1965-68, the amount at banks had risen to
$407 million, or by 32 per cent, whereas
the amount at PCA’s had doubled to $343
million.
These data are consistent with the hy­
pothesis that banks have encountered
greater difficulty in financing seasonal credit
demands of farmers, presumably because
increased year-round loan demands have re­
duced liquidity from which seasonal de­
mands could be met. Increased seasonal de­
mands upon PCA’s were readily financed
by short-term borrowings in the central
money market, whereas rural banks could
not easily tap this source for significant
amounts. It is conceivable that some farm
borrowers switched from banks to PCA ’s
primarily because PCA ’s were more inclined
to meet their seasonal requests— not be­
cause PCA’s had a more favorable attitude
toward the wisdom of such borrowing, but
simply because they were much better able
to cope with these demands. A seasonal dis­
count arrangement for member banks would
restore their ability to compete with PCA’s
in seasonal lending.
Supplemental adjustment credit. To encour­
age rural banks to take advantage of their
eligibility for seasonal discount credit under
any plan that is implemented, such a plan
should clearly indicate that banks using
seasonal credit remain equally eligible for
additional short-term adjustment credit
should circumstances make use of the latter
advisable. Otherwise, at least until other
financial mechanisms are improved, rural
banks might be reluctant to make full use of
the seasonal privilege for fear of unex­
pectedly finding themselves in an illiquid
position.
Rural banks on the whole have not made
effective use of present short-term adjust­
ment credit available through the discount
window. Clarification and simplification of

166

the terms of and Federal Reserve attitudes
toward this privilege would be desirable to
promote such use, as conditions that present
no problem to sophisticated money market
banks may have deterred many rural bank­
ers. Similarly, any new regulations to gov­
ern seasonal credit extensions should be
comprehensible and suitable to the rural
bankers that these arrangements are in­
tended to serve.
Longer-term credit

Many rural banks face year-round rather
than only seasonal strains on their lending
resources, according to loan/deposit ratios
that have been examined (Table 31). Struc­
tural factors at present limit the access of
these banks to financial markets in which
larger and less isolated banks in the same
circumstances are able to obtain funds by
selling their assets and liabilities. To com­
pensate for the market imperfections, the
Federal Reserve System conceivably could
provide reserves directly to the rural banks
on a long-term basis. One might propose
that particular rural banks be allowed to
borrow at the discount window for indefi­
nite periods, or that the Federal Reserve
purchase certain assets or liabilities of these
banks, such as farm loans, debentures se­
cured by farm loans, or certificates of de­
posit.
However, in contrast to seasonal or other
temporary assistance, provision of long­
term Federal Reserve credit directly to spe­
cific banks presents severe operational and
conceptual difficulties. In principle, given
the situation outlined above, the Federal
Reserve could try to provide the quantities
of funds that rural banks might obtain if
they had better access to financial markets
and could try to charge the rate of interest
they would have to pay in the market. But
what these quantities and rates might be




and how they might be altered from time to
time by changes in general monetary con­
ditions and other factors would not be easy
to determine within acceptable limits.
Nevertheless, if implemented, a program
of direct compensatory assistance would
undoubtedly improve the availability of
bank credit to farmers, obviously a goal of
its proponents. Paradoxically, this effect, al­
though it might be in the public interest,
creates a fatal conceptual difficulty. As a
principle of sound monetary policy, the Fed­
eral Reserve will not knowingly enter upon
programs in which its credit-creating powers
are used for the special benefit of a particu­
lar sector of the economy or in which it is
called upon to allocate credit among specific
uses. Through the years, Congress has rein­
forced this view of the proper role of the
Federal Reserve by turning to or creating
nonbank financial institutions to augment
credit supplies for specific economic sectors
judged to be in need thereof, rather than by
asking the Federal Reserve to deliberately
influence the allocation of credit to these
uses. Because it would be difficult to deter­
mine the point at which compensation for
market imperfections ends and favoritism
toward farm credit begins, it is also difficult
to visualize the Federal Reserve adopting
a program of direct long-term assistance.
This conclusion about direct long-term
credit, however, does not negate the fact
that a central bank can obtain equitable
and satisfactory results in supplying reserves
mainly through open market operations
only if financial markets are well developed,
as they generally are in the United States.
Thus, the Federal Reserve has an implicit
stake in the development and maintenance
of financial markets that serve all sectors
of the economy. It should work toward per­
fection of markets on which the fairness and
success of its procedures depend, and it has

C A PITA L A N D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

done so on numerous occasions. In the face
of decreased rural bank liquidity, and given
that unit banking is required in many pri­
marily agricultural States, the Federal Re­
serve should now undertake to secure im­
provement of secondary markets for assets
and liabilities of rural banks, including
agricultural paper and debentures secured
by agricultural paper. The Federal Reserve
has the knowledge and resources to take
an active role in the development of secon­
dary markets such as those outlined in the
next section. If necessary, for example, the
Federal Open Market Committee could ex­
tend material support to an embryonic mar­
ket through a controlled volume of trading
in its instruments, similar to the manner in
which the FOMC has helped to establish
the market for bankers’ acceptances.53 The
53 M uch of the Federal Reserve System’s rationale
for purchases of bankers’ acceptances and its pro­
cedures and experience in this m arket appear trans­
ferable to the proposed dealings in rural bank paper
or an instrum ent secured by such paper. F or instance,
in describing operations in bankers’ acceptances,
Roosa states “the Federal Open M arket Committee,
in recognition of the potentialities fo r further use of

167

Federal Reserve System and its FOMC
should not ignore the structural imperfec­
tions in financial markets and instruments
that discriminate against small and isolated
banks.
bankers’ acceptances that m ay be inherent in the
expanding role of the U nited States in financing
world trade, and for other reasons, decided to re­
sume the acquisitions of a portfolio in bankers’ ac­
ceptances for the System itself. . . . The Federal
Reserve has not, as a m atter of practice, sold accept­
ances out of its portfolio. . . . there are alm ost al­
ways some acceptances m aturing every day, and in
a relatively short time m aturities alone can run the
holdings down as far as might be appropriate in
conform ing to the direction of other credit policy
action. . . . the job of the acceptance clerks is . . .
one of . . . verifying the negotiability . . . as well
as inquiring, under some circumstances, into the
credit standing of the business concern drawing the
acceptance. Because of the nature of this paper,
however, the principal reliance as to its soundness is
placed upon the nam e of the accepting bank and the
added endorsem ent which the acceptance carries. C ur­
rent lists are m aintained of all banks in the U nited
States engaged in extending acceptance credits, and
the condition of each such bank is periodically re­
viewed.” See R obert V. Roosa, F ederal R eserve O p ­
erations in the M on ey and G overn m en t Securities
M arkets (Federal Reserve Bank of New Y ork, 1956),

pp. 87-90. Recent year-end Federal Reserve holdings
of bankers’ acceptances have approached $200 mil­
lion.

IX. UNIFIED MARKETS TO SERVE RURAL BANKS
Unified markets— in which small and rural
banks could obtain market information and
conduct trading in a wide variety of port­
folio items in units that correspond to their
needs— would improve the flow of funds to
rural areas. These institutions could provide
rural banks with both market information
and trading facilities for purchases and sales
of Federal funds and Government securi­
ties, placement and secondary marketing of
certificates of deposit, and secondary mar­
keting of loan paper. With these services
centralized in one location, rural bank man­
agers would have the market options now
effectively available only to larger banks,




as well as the information necessary for
proper decisions— for example, whether to
raise funds by selling bonds, discounting
loan paper, or participating in a certificate
of deposit issue. More transactions would
become profitable— some are not now
economical because of the small amounts
involved and the numerous telephone calls
to different markets required— and rural
banks would have an enhanced ability to
respond to changing loan demands and
other conditions.
Structural and operational aspects of a
unified market are considered in this sec­
tion. First, some ideas for its basic organi­

168

zation are advanced. Next, the approach
the agency might use in providing a second­
ary market for rural bank paper is analyzed
in some detail. Although the unified mar­
ket would be most effective if all major
types of commercial bank loan paper
were traded, only non-real-estate agricul­
tural loan paper is covered herein, because
the primary concern is with availability of
credit to farmers. However, much of the
analysis also applies to trading in other
types of paper. Finally, the prospective role
of the unified market in trading in other
instruments— Federal funds, certificates of
deposit, and bonds— is briefly discussed.54
Organization

The cardinal principle in organization of a
unified market should be to provide rural
bankers with a maximum amount of infor­
mation and service for a minimum of ex­
pense and effort on their part, just as present
money markets are organized to invite and
expedite trading by large institutions. Rea­
sonably convenient facilities, adequate
capital, and a knowledgeable operating staff
are essential, as are a competent research
staff and appropriate facilities for gathering
and disseminating information.
To attain these goals in the most effec­
tive and efficient way, operations of regional
unified markets should be coordinated and
supervised by a national agency. Given
present and foreseeable developments in
communications and computer technology,
a national network of unified markets can
constitute a practical and desirable addition
to the Nation’s financial mechanisms.
54 F or additional discussion of the unified m arket
concept, see Raym ond J. Doll, “Unified M arkets for
R ural Banks,” Banking, Journal o f the A m erican
Bankers A ssociation (Jan. 1969), pp. 63-65; and
“Unified M arkets to Facilitate Exchange of Bank
Assets and Liabilities,” Bank N e w s M agazine (June
1969), pp. 13-18.




A secondary m arket for rural bank loans

Successful secondary markets for loans
made by rural banks would materially in­
crease the banks’ ability to finance rural com­
munities. Development of such outlets
would be a primary goal of unified markets.
There are two basic ways in which a mar­
ket for such paper could be provided. First,
the unified market could simply bring to­
gether buyers and sellers of the notes. Or
the market, acting as an agency, could sell
debentures and use the proceeds to purchase
rural bank paper. By either method, if the
market is effective, a bank that is loaned up
could obtain funds by selling notes from its
portfolio. It could then use these funds to
make additional loans.
Trading in loan paper. Direct sale of loan
paper to investors avoids the more com­
plicated process of issuing debentures, with
the market itself becoming directly in­
volved with questions of risk. However, the
market for such paper might prove quite
thin, as most of the notes are small and fre­
quently in odd amounts and maturities. But
even if direct sales were restricted to the
larger farm notes of borrowers for whom
financial and credit ratings are readily avail­
able, significant sums might be obtained and
rural banks would be especially encouraged
to provide adequate financing for the larger
farms and other firms located in their com­
munity.
To increase the marketability of loan
paper, the unified markets could provide or
arrange for some form of insurance that
would reduce or eliminate the risk of loss to
the purchaser of an individual note (altern­
ative insurance plans are discussed later).
In so doing, however, the markets would
probably become involved in risk determina­
tion to about the same extent that they would
if they had bought the paper themselves in
a debenture operation.

CA PITA L A ND C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

Sale of debentures. The alternative method
— sale of debentures secured by loans—
would resemble the present operations of
the cooperative farm credit system, par­
ticularly those of the Federal intermediate
credit banks. These banks have been able
to raise funds in national capital markets
and use the proceeds to discount agricultural
paper of the production credit associations.
This process has proved efficient, and much
of the experience would be transferable to
the operations of unified markets. Also,
favorable investor experience with these is­
sues should improve initial marketability of
unified market debentures.
The unified markets could logically use
both approaches. They could act as direct
brokers, where feasible, in bringing together
buyers and sellers of rural bank paper, and
in addition could issue debentures to raise
funds for purchase of such paper from com­
mercial banks. These debentures should be
joint obligations of all unified markets—
with only the paper purchased by these uni­
fied markets being used as security.
The primary advantage of debentures is
that they would enjoy a much broader mar­
ket than individual notes because they
would be issued in standard sizes, have more
diversified security than individual notes,
and would not require a new investigation
by the potential investor for each purchase.
Thus, they could undoubtedly be sold in
larger volume and at lower interest rates
than individual notes.
Insurance mechanisms. The attitudes of
bankers and bank examiners make it un­
likely that significant amounts of discount­
ing can be done if bankers must retain the
risk on the paper sold. It seems desirable,
therefore, that all sales be made on a non­
recourse basis, with controls established to
prevent bankers from ignoring the credit
risks. One such control is insurance. Sellers




169

could be required to buy insurance on each
note sold to the markets, with the rate de­
pending on the note’s risk classification, but
high enough to build up an adequate re­
serve.55 Such insurance could be funded by
the markets themselves or handled by pri­
vate insurance companies. The markets
could underwrite the insurance by acting
through a central body to achieve geo­
graphical diversification. While the princi­
ple of insurance is applicable whether loan
paper is traded or debentures are issued, in­
surance would be of particular benefit— or
be virtually required— in the former case,
where it would reduce risk differentials and
greatly increase the probable number of
market participants.
Alternatively, the markets could provide
for risk differences by varying the offering
price according to the risk classification of
each note. Prices could be adjusted so that,
after allowance for probable losses, the rate
of return on all notes would be the same.
Over the long run, the price differences
would exactly compensate for losses. Ad­
ministrative costs of insurance would be
saved, but the risk classification process
would entail some costs and difficulties.
The insurance problem might be better
handled by a third alternative, the establish­
ment of a reserve account for each bank.
For instance, if a bank’s actual losses aver­
age 0.5 per cent, payment into its reserve
account might proceed at the rate of 1 per
cent of new loans sold until the reserve
equaled 2.5 per cent of total loans sold and
still outstanding. Payments into the account
would then cease until there was either a
net increase in the bank’s activity or a loss
55 Available evidence indicates th at default losses
on bank agricultural loans average less than 0.5 per
cent. Average insurance rates would, of course, have
to be slightly higher to cover other insurance costs,
although the insurance rate charged for high-quality
loans might still be less than 0.5 per cent.

170

on one of its notes— in which case, they
would be resumed at a rate of 1 per cent of
new sales. The relative size of the reserve
would be varied according to losses experi­
enced over an appropriate period.
Losses larger than the reserve account
would be borne by the markets, so the pro­
cedure would be equivalent to sales on a
limited-liability basis. Bankers who sold
very high-quality paper would be rewarded
by very low insurance costs once the reserve
was established. Among the possible dis­
advantages is the likelihood that some bank­
ers might be reluctant to change an estab­
lished volume of loan sales because this
would require additional payments into
their reserve accounts. The accounts also
would require continual supervision, but
total administrative costs might well be
lower than in the preceding alternatives be­
cause individual notes would not have to be
evaluated for risk.
Education. To realize the full potential of
secondary marketing of loan paper, a major
educational program would initially be de­
sirable to demonstrate the need for and
benefits of secondary markets to bankers
and their customers. Such mutual under­
standing would help preclude damage to
customer relationships when banks market
loan paper.
Unfortunately, the mere existence of a
secondary market for rural bank paper would
not eliminate the managerial inertia that
exists in some rural banks. However, these
banks would be placed under more pressure
than at present, from their competitors and
customers, to improve their credit services to
their communities.
Other services of unified m arkets
Federal funds. Inclusion of Federal funds
activity in the unified markets would assure
rural banks of greater access to the funds




market, particularly on the buying side. At
present, participation by small banks is
largely dependent on the willingness of city
correspondent banks to act as brokers or
dealers in Federal funds. Accommodation
hinges on whether the correspondent has
complementary reserve needs or can match
the wishes of two country correspondents.
Under other circumstances, correspondent
banks appear much less willing to accommo­
date small transactions in Federal funds. By
acting as a dealer, a unified market could
give small banks access to the Federal funds
market on a basis that is continuous, cer­
tain, and independent of a correspondent.
Unified markets probably could provide
most effective service in Federal funds by
taking dealer positions. This operation
would enable banks to accommodate trans­
actions of differing size and would allow
them to offset net buying or selling by their
customers through trading in the national
market— in effect, by acting as wholesalers
of Federal funds. In addition, a dealer op­
eration would stimulate trading because a
selling bank would not have to concern it­
self with the solvency of a different small
bank each time it sold or to establish re­
strictive lists of banks to which it would
sell.
The minimum trading unit needs to be
relatively small if banks serving rural areas
are to be able to participate effectively
Also, small banks might arrange to have thv
markets buy or sell funds for them for
specified periods of time on some automatic
basis. For example, a bank might place a
standing order for purchases or sales when­
ever its excess reserves vary by one trading
unit from a specified amount. Another more
sophisticated approach would rely on daily
computer analysis by the unified market of
each bank’s reserve account, with decisions
about whether and how much to trade being

CAPITAL A N D C R E D IT R E Q U IR E M E N T S OF A G R IC U LT U R E

based on recent patterns of its reserves and
of Federal funds rates, the stage in the settle­
ment period, and the existing Federal funds
rate, as well as the bank’s current reserve
position. The unified market would need
ready access to the most recent information
about each bank’s position for this approach
to be most effective. Arrangements could
probably be made, with authorization from
the commercial banks concerned, for uni­
fied markets to obtain current reserve status
data directly from Federal Reserve Banks at
which these accounts are kept.56
Certificates of deposit. Unified markets
could further improve the geographical dis­
tribution of credit by facilitating the issue of
certificates of deposit by rural banks. Rural
commercial banks have been excluded from
the market for negotiable CD’s primarily be­
cause the standard size of those traded is so
large. For a bank with $5 million to $10
million in deposits, a $1 million CD— for
that matter, even one for $100,000— simply
is not a satisfactory instrument; it is too
large, relative to the bank’s needs and re­
sources, to be attractive either to the bank
or to potential investors.57
A unified market could enable smaller
banks to compete for time deposit money
by offering certificates in which a number of
affiliated banks participate. Such certificates,
of course, would be only partly insured by
the Federal Deposit Insurance Corporation
under existing regulations, and so a prospec­
tive purchaser might need to investigate a
number of banks in order to evaluate the
56 F or more inform ation on the present structure
of the Federal funds m arket and some other sugges­
tions for improvement, see Parker B. Willis, A Study
of the M arket fo r Federal Funds, vol. 3 of this series.
57 Description and evaluation of the present sec­
ondary m arket for negotiable certificates of deposit
and review of num erous suggestions for im prove­
m ent are provided by Parker B. Willis in The Sec­
ondary M arket fo r N egotiable Certificates o f D eposit,

vol. 3 of this series.




171

total risk inherent in a given certificate. To
make such certificates marketable, it might
be necessary for the unified market to accept
liability for them. With proper supervision,
unified markets should be able to guarantee
such instruments with minimum, risk. If in­
surance or guarantees were secured, the
certificates almost certainly could be traded
in the existing market.
But if the unified markets cannot guaran­
tee certificates issued jointly by small banks,
it might still be possible to establish a new
market for such issues. The certificates
would be classified as nonprime and thus
expected to carry a slightly higher rate of
interest than prime-name certificates. Also,
many relatively small certificates would
likely be sold to allow issuing banks to ob­
tain maturities of desired length and diver­
sity. With sufficient effort, a new group of
investors might be attracted to these higheryielding small issues, including smaller cor­
porations, banks, other financial institutions,
and even individuals.
The volatility of demand for small certifi­
cates could prove less than that experienced
in the present large-certificate market, thus
making these instruments a more appro­
priate source of funds for small banks. And
in particular, banks with well-established
seasonal patterns in local deposits and/or
loans could meet seasonal outflows by tim­
ing the maturity of certificates to coincide
with periods of loan repayment or deposit
inflows.
The development of a strong demand for
these small, joint-issue CD’s will be depend­
ent on a good secondary market for them,
thus making it important for the unified
markets to act as brokers in resales as well
as in original issues. The Federal Reserve
System could contribute to market develop­
ment by making its wire facilities available
for transfer of certificates. If offices of the

172

unified market also stored and redeemed
certificates, costly mail transfers would be
avoided and marketability thereby en­
hanced.
Bond services. Another activity valuable
to participating banks would be information
and brokerage services in U.S. Government
securities and municipal bonds. Unified mar-

kets could provide up-to-the-minute bond
quotations along with analysis of bond mar­
ket trends and conditions. Using this and
other information provided by the markets,
bankers could choose the alternative for
raising or investing funds that is best
suited to their specific situation in each
instance.

X. CONCLUDING COMMENTS
If rural banks are to finance rural capital
investment effectively in the future, they
must increasingly assume the role of inter­
mediaries that facilitate flows of funds from
money market centers. But present banking
and money market mechanisms are ill-suited
to the needs of progressive rural bankers
who undertake this task.
With many rural banks encountering
liquidity problems today— and such situa­
tions likely to intensify as well as multiply
in the future— the Federal Reserve System
should act promptly to provide more re­
serves directly to such banks, while simul­
taneously seeking to perfect market mechan­
isms. Rediscount procedures should be im­
mediately revised to provide a greater vol­
ume of seasonal credit on a more appro­
priate basis than heretofore. Discount proce­
dures in general should be revised as neces­
sary to encourage and facilitate use of this
source of funds by rural banks.
These measures, promptly instituted,
would buy time during which financial m ar­
ket mechanisms could be improved to ac­
commodate the needs of small and isolated
banks. The Federal Reserve System, and
particularly its Federal Open M arket Com­
mittee, should face up to indications that
such banks are unable to compete for funds
with money market banks and other agen­
cies. Federal Reserve distaste for providing




long-term discounts to disadvantaged banks,
or for purchasing their securities in the
open market, is justified only if financial
markets are structured to permit such banks
to compete for available funds. The Federal
Reserve System thus has both an obligation
and a stake in securing market perfections
that make more significant and equitable
participation by small banks possible.
One of the more effective ways to over­
come present deficiencies might be through
establishment of a network of unified mar­
kets to handle transactions in the assets and
liabilities of small banks. A device to per­
mit these banks to market farm and other
notes should constitute a vital part of the
services provided by such markets. In this
and other financial instruments, unified mar­
kets could provide one-stop information and
service to small banks.
As these various measures are taken, a
considerable number of rural bankers would,
as judged from present liquidity levels and
trends, be waiting to utilize them. However,
perhaps an equal number, judging from the
same banking statistics, are not now serving
the loan demands of their communities as
well as their present liquidity status would
permit. Federal Reserve Banks could render
valuable service by conducting educational
programs aimed at overcoming or minimiz­
ing managerial inertia at such banks, both

C A PITA L A N D C R ED IT R E Q U IR E M E N T S OF A G R IC U LT U R E

now and especially as improved sources of
funds are established. As knowledge of the
improved sources spreads, more community
pressure on inert banks could also be ex­
pected.
The Federal Reserve System can make a
real contribution to rural finance by helping
to achieve the legislative, regulatory, and
market changes required by these recom­
mendations, as well as by arousing private




173

individuals and institutions to face the chal­
lenges presented. The proposals are revolu­
tionary in their implications for city cor­
respondent banks, for rural banks char­
acterized by managerial inertia, and for the
discount officers and the Federal Open
Market Committee of the Federal Reserve
System, but no more so than the sweeping
changes in rural economies that have made
them necessary.