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SPRAGUE, 0. M. W.
Foreign exchange*
Lecture
January
1 2 , 1912
The subject of my lecture today is "Foreign Exchange,"
3?oreigli-i^0hari^# deems' couiino-nly to be regarded an u very
Biy«t€riouB subject, one beset with innumerable conp3 ications.
Th.e general principles of the subject are* however, by no
means fib^truee*
To conduct a Foreign .Exchange Department
does reouire a special training and a certain natural aptitude,
but any intelligent person can, 1 think, readily secure a
general understanding of the subject taken as a whole, and
such a general understanding is of much value, 2 think, to
persons engaged in other "branches of banking.
First let me define Foreign Kxohange*
It is the
business which is concerned with the buying and selling in
one- country of • righto to .money in other countries, either
immediate- or 'in':Vthe • future*
Much of our Foreign Exchange business i& cloB^ly
parallelled with certain kinds of domestic tueiness carried
on in all tanks*
I refer to the-business of making payments
between different parts of the country.
In particular, the
domotic exchange ,are eloeely 'Analogous to the Foreign K-xohiuige
b-usiness9
Dozoeotic Exchange rates riee and fall within oeytain
limits, which are aet by the cost of shipping currency between
any two placed*
The quotations are usually expressed in a
• 2 •
premium or discount on one thousand dollars•
If it costs, for
B%amplm9 fifty cent© to ship ont thousand dollars between two
places, the rate of exchange laay be anywhere up to fifty cents
above or below par.
Now, Foreign Exchange "Irate© fluctuate in exactly the
-A
way,
fhey fluctuate above and below par to the export or
import points, and these export and iraport points are determined
by the cost of shipping, not currency, but gold,
the quotations
are, however, expressed in a somewhat different manner, and
neoesearily so, "because of differences in currency betv/een
different countries.
It would be a moist roundabout fashion
to express Foreign Exchange rate© in the terms used in Boaestic
Exchange, although it would be possible.
If it costs, for example, $2*50 to send one thousand
dollars in gold to Bngland, then that |2»50 sets the limit to
V
the possible fluctuation in «cchange#
in that way.
The rate i® not expressed
The par of exchange between the United States and
England is f4*86-2/3, because the araount of gold in a sovereign
makes, when coined into United States dollars, $4.86-2/3, and
exchange rates fluctuate above and below $4.86~2/3 by the cost
of shipping gold to England*
In the case of France, the quotation is expressed in
a slightly different fashion.
Instead of being expressed in
United State® isoney, it is. expressed in francs * in the number
of francs which the gold in a dollar will make*
How, the gold
in a dollar will mak© 5 francs, 18 and a fraction centimes/^ A " 1
- 3 ~
Ixohang© on Paris, therefore, fluctuates above and below by the
cost of shipping gold to Paris*
Exchange on Berlin is*like that on London, expressed
in United States money, but 3HB-' not erep*MM»g«H>Hh^
of taking the mark, 4 marks are made the basis of
the quotation*
low, the gold in 4 marks, coined into dollars,
makes 95 and a fraction cents*
Consequently, exchange on
Berlin may rise and fall by the amount that it cost© to send
gold to Berlin.
When exchange is expressed in your own currency, a
rising quotation indicates an approach toward the export point*
It indicates that there is a demand for remittance to Burope say, Bngland «* which is in excess of the supply•
gold export point to London is about |4.88.
Thus, the
When, however,
quotations are expressed in the currency of a foreign country,
just the opposite is the case.
A fall in the quotation then
indicates an approach toward the export point.
That Mwi34H»e"*
Suppose you have to make a payment of a thousand
pounds in London*
If exchange is toward the export point,
you will m&te&**4m pay more, a£$$#*$S^, than if it were toward
the Import point, because at the ©xport point you have to pay
tht gold value of Jft sovereign plus the cost of shipping the
sovereigns, andJ&Qj^JL&^^
If the rate were |4*88 you obviously would hav©
~ 4 -
to pay more to get your thousand pound© than you would if the
rate were |4*86*
Suppose, however, you have to pay a thousand francs
in Paris, and the quotation is expressed in francs*,
Clearly
you have to pay more to get your thousand francs in Paris if
you can only get 5 francs 16 centimes for a dollar than if you
could get 5 francs 18 centimes for a dollar*
How a few words B,B to what determines the export and
the import poin%&»
gold?
What are the expenses incurred in shipping
fhe very obvious expenses are, freight, insurance, and
the cost of packing the gold*
These element© of expense,
however, are somewhat variable; the freight charges inay not
be uniform, and it makes a good deal of difference what sort
of gold you are shipping*
purpose is gold in bars*
The moat inexpensive, form for the
-ftifft cnn be packed more handily, end
there is less loss froia abrasion than there is if you ship
coin*
Gold bars are secured from the United States treasury,
a nominal charge being exacted.
In the past it has not alv/ays
been possible to get an adequate supply of gold bars, but in
the future that difficulty will probably not present itself,
because the Government has recently been empowered to hold
gold in the form of bars against gold certificates in circulation*
Formerly all the gold against the gold certificates
had to be coined*
Therefore, the export point will be in the
future, cm the average, a little less than in the paett because
now it will always be po>lble tn get gold bars*
A irery important elegant of expense is time*
If one
of the faat express eteamern is sailing* the MIiUaitaniaf< for
instance, the otqxrot point is lo^er than during a week when
no faet sship is sailing.
OJQ^M^^^
The interest, however, counts only in one direotion|^rt only
in eaee you are importing* ryi|Siaafc«^
If you export a million dollars1 worth of gold,, you can
sell sight exchange at once to an equivalent amount.
quently, you are not out of your money at all*
it is a cace of importing gold#
Conse-
Suppose, however,
Tnmi you are out of the interest
while the ^old ia in transit,v.and for ta?t reanon the goldi import
point is somewhat further laiiaMi par than the gold export point#
If we assume, for exa&ple, that the gold export point is about
1-1/2 ctsnts abf>ve par, then we will probably fin<l that the gold
import point ia oomathing like 2 oento<rbelov/.
Q^S&®^^
There has been a alow but pretty steady reduction in
the possible range of exchange fluctuations iii^jy&s**^
J!ULjtfMM^
20 or 30 years ago the export point was about $4*90*
It is now in the neighborhood of (lAA^Us The import point
then in the vicinity of £4.82,
i t is now^pt g4,84.
So far I have only spoken of sight exchange. A glance
in the newspaper will show that there are various other rates
regularly quoted, ~ hankers 1 hills a^isUsommwoial -toi"3fire- and
various kinds of commercial bills, drawn for varying periods
of time.
Now t these rates are always below the sight rates.
They vary with eight rates in a perfectly definite fashion,
but they also vary for certain other reasons.
If you should
find that the sight rate was $4*86, you might find that the
rate on bankers* sixty day bills was 14.83, and you might find
that the rate on a certain class of commercial bills was $4.82-1/2,
and on anotherkkind, perhaps, $4•82,
The quotation on time bills is lea® than that for Bight
exchange by the ^ont'of discounting theue lime bills in the
foreign country on which they are drawn* * If the rate of discouni
on a sixty day bankers 1 bill ie Z% in London, then the quotation
for a bill of that sort in Hew York will Tje the sight rate of
exchange in Hew York lees the discount on that bill in I^
-f
If the discount rate in London advance© on that particular
sort of bill, then the quotation oiuthat "frtifrl will move somewhat
further away from the Bight quotations mr*t i&he reason that there
are these different prices or quotations for various kinds of
time bills is that there are a variety of discount rates in the
London market, depending upon the character of the bill. The
lowemt rate is secured by bills drawn on*and accepted by, a
London banker.
Then there are various other rates, running all
the way up to the M bank rate; 11 that is, the rate of the Bank of
England, whatever that may b#.
A little description of the more important kinds of
time bills will, perhaps, not be unnecessary*
Most of the goods
exported from this country to Europe give rise to documentary
bills of exchange.
The seller draws upon the purchaser, or upon
the bank of the purchaser, and the various document© are attached
to the bill of exchange, the moat important being the bill of
lading, without which it will be impossible to secure possession
of the goods.
1
Documentary bills are of various kinds,
fhey
may be documentary for payment, or documentary accept ance bills•
If they are documentary payment bills, the purchaser of the good®
cannot get possession of them until he has paid the bill of
exchange„
Now, theee documentary payment bill© are of two
general classes, first, those on perishable goods and othergoods
which the purchaser is pretty certain to want iiamediately on
arrival, and, second, those in connection with goods which the
purchaser is not likely to want until the maturity of the b&ll*
If the purchaser wants the goods and makes the payment, he is
allowed a rebate, which is \% below the Bank of England rate,
whatever that may be*
Therefore, the price of such bills in this
country is readily figured by taking the eight rate of exchange,
determining what the Bank of England rate i@, deducting 1^,
computing that rate of discount and deducting it from the sight
I
-
8
-;
/-•
/
<4*
oonfident of the solvtnoy or the credit of the drawer of the
bill.
If th@ goods are of a kind which are not likely to
wanted by the purchaser until maturity, then you
»-4k^^
London"/
4S^#au^%*t2T'ft^'tt^&^f^ymk. or your agent in London may be obliged
to hold it until it matures.
But perhaps you would like the
money, perhaps you do not care to finance this business during
the life of the bill.
You may in that caee use aucja bills
as collateral with your London correspondent^ppjBaiy^'Wtnnet bo
t they may be used a^ ^aa-l-larta^arl-'r-^awi you may
draw your own #bi11 on ynrr Londnn correBpondent, the London
correspondent afoceptl«ffr ti^^t bill, | W N i t can then be discounted*
-1
itttxiB your balance will be built up.
acceptance bi 11 s .^JSZvm^ are of
two kinds^-thoae which are drawn for acceptance "by & merchant
and those which are drawn for acceptance by a bank or accepting
house.
Naturally, the latter get the better rate in the London
market, because Jfb»{f will be universally known andjrssU&fc-Hr^
of»«J&ittwr«^^
The documentary acceptance bills on
merchants will be discounted at a slightly higher rate in London,
and, consequently, the price of BUCII a bill in this country will
be slightly lower than documentary acceptance bills on banker©.
When goods are sold to other parts of the world than
Buropt, the arrangements are somewhat different.
We do not draw
« 9 ~
bills ©n South Asierioan cities, for instance, to any appreciable
extent,
There is not a sufficiently broad
market in bills of exchange to isa&e that a feasible arrangement*
Th^re are a number of possible arrangements, but I shall only
mention cm© of them*
A commission house exporting goods to South America
will, very likely, be paid in 90 day drafts on some London bank*
which will be drawn by the Oouth American purchaser of the good®
Well* this cleans that the
commission house will be a long time out of its money*
The
time that the floods are going to South America, the time that
is taken in sending the bill of exchange to Londonf- and 90 days
thereafter..- something 3 ike six months will be absorbed before
the maturity of this bill*
wants its money.
The commission house in Kew York
It may itself draw a bill - a 90 day bill «•
upon a 'London bank •» coswifff-!^^
.»J*isw^^
w h i c h the C&fflK""™*
- an4 by selling its own 90 day
bill in the Hew York market the co&aiBsion hou^a will get the
ready cash*
The 90 day bill will be sent to London and die--
counted on the London market*
Thun t you. see that London realy
finances, in such an instance* the shipment of goods from Hew
York to £outh .America.
When the 90 day bill falla due f the
Hew York house nust', of course, provide payment^ an4-«iaaftl;
js^TtWTffiy the South American bill is not yet due. It may pwr~
chase sight exchange in Hew York.! in order to meet its 90 day
draft, and also draw another one to oover another 90 days,
• 10 -
the time-JtaJ* second draft reaches maturity the proceeds of
the South
American draft will be at hand.
Thus, by drawing
two bills, each for 90 days, the Hew YorS: commission house >
will throughout the period have secured the funds, 4 ^ ^ ^ f e ^ ^
the London discount market*
J^4J**^^
How let us take a case of imports to this country.
The most common method of arranging payment is through a commercial
letter of credit.
Let us suppose that a Boston wool house is
going to purchase a quantity of wool in Australia.
a&#*2fHt±ti»^
It will %«•*
secure, through some foreign exchange banker here,
a credit with some London bank.
Under the terms of this credit
the agent in Australia of the Boston wool house will be empowered
to draw documentary bill© of exchange up to a certain amount*
The purchase of wool is made, the bill on the London bank ia
drawn, the documents attached, and it is disposed of to some
Australian bank.
Thus the fund si are provided for the wool.
The
Australian bank sends this bill t0^S*aii^m with documents to its
correspondent 3$gmm**> and at the same time, very likely, will ©ell
an equivalent amount of eight exchange in Australia against the
credits which'will be given it in London throughvthis long bill.
_
*\A
^
'
-1
0 one
1
«HBDB# Hi
i^ Australia has any further connection with this
transaction.
The correspondent of the Australian bank in London
takes the bill, with its documents, to the London bank on which
it is drawn for acceptance, Hpvinff been accepted by the London
takes the documents, %M
the bill is discounted
~ 11 -
in the open market and the funds provided with which to meet the
sight exchange which we assume the Australian bank had sold.
The London bank which accepted and took the documents then
n#€% .f( i< ix *v..*-^Ki^
sends ifamm on to this cmrntry, presumably to a shipping broker,
according to instructions, or to the foreign exchange banker
here through whoin the arrangements were made,
fhe wool house
cannot get possession of the wool until it can get these
documents, and the foreign exchange banker need not give up
these documents until he is provided with funds sufficient to
pay the si^ht exchange on London necessary to meet the payment
of ttmrt time bill accepted by the London bank*
Thus everehody
is secured at every point in the transaction, in B O far as the
.wo«>l itself may be regarded as security.
It is a natural 'query* I suppose, at this point*
why we do not finance any of this business.
It is largely
because the demand for capital In this country is such that
rates for loans are higher, ordinarily, here than they are in
European cities, and particularly in London.
'
rl
Of course,
commissions have to be paid alonft the line in connection with
this transaction that I have outlined in the case of the wool,
but even with the commissions added to the London rates of
discount the cost is, ordinarily, not what it would be at our
prevailing rates for loans.
If a lower average rate for loans
csmeB in this country, then we may presumably finance not a
little of our foreign trade, though it is doubtful whether we
shall at any time in the immediate future displace London*
It
- 12 -
in of confix arable advantage to have souse one city in the world
which ie a center for payment© for all of the other countries.
Juet as in this country Hew York is the center for the payrn.fln.ti.
of QJM&sdbs^ between different parts of the eoimtry, London
occupies that position for the world at large$ largely for
historical reasons, largely because of the extent of the
English Empire, and even more because of the extent of English
trade and investment©«
It seems to me extremely unlikely
that the position of London will, in any time that is worth
while considering, be seriously threatened by Hew York, or
by any other financial center*
In the actual practice of exchange, bills are drawn
on London; London jteelf draws very few bills indeed,
In the
case of our exports, for instance, commercial bills are at
once drawn, and ordinarily those bills are discounted in the
London market, and, as you have seen in the case of imports
&&mmt while the goods are in transit the business is financed
in London•
The commercial bills of exchange drawn largely
supply or feed the balances in London against which sight
exchange ie sold.
Our merchandise export© amount to something
like SS,000,000,000.(|§ annually.
That provides an enormous
amount of bills of exchange, mostly time bills, drawn chiefly
on London,and to a lesser extent upon other foreign financial
centers.
a year
Our importa amount to something over 01,000,000,000.
toefoggfiiLJt^^
They do not give
- 13 ~
to any considerable quantity of time bills.
They are paid,
very largely, in sight exchange, and the possibility of providing
sight exchange comas through the proceeds of the billn drawn
againet exports.
But merchandise paymenta do not make up, by any
means, all of the foreign exchange material.
whether they make up even half of it,
of invisible exports and imports.
It may be doubted
There are a great variety
Shipping charges, tourists1
expenditures, remittance© of home of foreign residents* are all
very large items.
Then there Is the interest upon foreign
capital, and on the other side of the account there i© n w
capital - additional capital - invested in thin country#
there a»e^*i4i^
Then
due to dealings in securities - resale
to this country of securities held abroad*
All these operations
give rise to foreign exchange *• create foreign exchange *
juet ae'zmch as merchandise dealings.
of such dealings may be no one can say#
What the total amount
Bu/ there can be no
question that we owe, year after year, prgmahly some thing like
15,QoSu 000.00 or $6,000,000.00, ana for/Vnat reason we must
export nN%r.ehan«3ize to a greater value Ahan we import merchaii&iBe#
In addition to all of these exchange creating factors,
there is the matter of temporary loans made by one foreign
market in another foreign market*
variety of different ways,
They may be made in a
A foreign exchange hou^e enjoying
good credit abroad may, for example, draw bills upon a London
correspondent payable ©ay in three months*
Those bills, if
accepted by the London correspondent, may t>& readily discounted
- 14 *
thus giving the American exchange aouee credit to that extent
in London, and enabling it to sell here an equivalent quantity
of Eight exchange«
That is what happens when you read about
foreign borrowing.
There is no money, ordinarily, sent acrooa.
What actually happens is that a time bill is drawn on and
accepted by a London bank, discounted in London and. sight
exchange to an equivalent amount sold hers, thus giving the
exchange house the money here, but no money lias passed between
the two countries,
this is done, maybe, by an exchange banker
for one of his clients who nay deposit collateral securityh ere*
Sometimes the initiative may be taken by a foreign bank which
desires to loan ir* thi& market,.
In that case it may or xs&y not
assume the risk of a change in the Bight rate of exchange, for
the profit in foreign loans in Tary largely determined by the
course of the sight exchange rato.
If, for example* trie
sight rate of exchange ie #4»85 and a long bill is drawn, ©ay
at $4*82, reflecting the discount rate in Loddoru
Ko%f if
you borrow in that way, when the long bill matures you irsust
supply enough sight exchange to meet it.
If the si^ht exchange
rate remains at $4.8bf then you have only paid tra 3 cents on
each pound for tae use of the money during the period, Suppose
the Bi;:ht rate %M gone to &4»87 then^MJibMi h4v& to pay a good
deal more - yru Uave to pay 5 centb for each pound*
Xhio will
explain largelyf I think, why Qjui^f^^^y these foreign loais
do not involve' any lavement of money.
Tney usually sJHKt when
trie rate of exchange is high ~ toward the export point,
"hen
• 15 -
we are approaching the export point aQji^j^
^i^t**, and rates for loans, in Hew York, ^N^^^mm^e^^
are
likely to be high, is the time that it may he desirable to
borrow in foreign markets.
For example, if you would have to pay 5^> on eollater&l
loans in New York, and the rate in London is 3£J, than it may
be worth your while to borrow in the way 1 have mentioned, and
partieularly uo if the eight rate is around $4.87, or a littH
higher, because then it can 1 1 get away from you very much.
It
canft go above £4.88 anyway, and it nay go much lower before
you nave \o make the payment, and if it goes down that reduce©
>*f®o much what you are actually paying for the money during the
three months.
If, however, you Bhould enter upon this transaction
when the si^ht exchange rate wan |4.85, you would toe, ordinarily,
very ill advised indeed, because the possibilities are that the
ekchange rate might go up to $4*07 or &4.88f and then the cost
of your loan would "be very heavy,
what this borrowing does is to provide, "by rricuns of
the loans, additional si^ht exchange, and it thu*"*, ]M£fhhff4hLff,
prevents gold exports and brings down the sight rate of exchange
but it does not involve - ij^4n&-w^r^^
- a positiTe xooyeisent of
money.
The foreign lender, as I intimated a moment ago, may
be willing tn take the risk of a fluctuation in the 8-i^ht
exchange rate, or he may not.
If he in will in?:; to take the
risk, he loans in currency.
Suppose, for example, that the quotation on bankers1
time "bills is $4.83, and thai uomeone in !few York winhes to
"borrow ?SQO,OQO*OO.
A bill in drawn for, say, a hundred
thousand pounds, on London, by the a^ent of the London bank,
acting on instructions,
That bill is eold for |4*83, and the
proceeds are turned over to the wouldte borrower in Hew York;
that is, he gets $483,000.00.
Vhen the bill matures the
borrower must return $483,000.00 plus whatever rate of interest
han been agreed upon, let us say 5J->#
The borrower has not been
affected at all by fluctuations in sight exchange. "How, the
foreign banker may desire to get back his money in London.
He
inBtructs his Hew "fork correspondent to buy Bi^ht exchange on
London ^ttfp^BT^
If the rate has ^onn down, then the
London bank go ins from having ansumed the risk.
If the sight
exchange rate is down to £4.05, for invfcfince, and it can buy
a oi?ht draft on London for & hundred thousand pounds for
t485t000.00, it gets, obvious]y>*father return than if the
f
rate ware #4 # 87 and it had to p&y g407f 000*00 in o n e r
to get its money back to London,
vr
hen, therefore, the foreign banker is inclined to
think that the rate for eight exchange i« going down, he will
be rather willing to loan in currency in this market,
if hi a
- 17 -
opinion is the other way, then the rink will h%%® to be
p.noumed by the borrower here.
He will \uz~u£sL£j£LJ&*i>i 11i)
^
but at the maturity of the
'bill he rrap.t provide the means for its liquidation, paying
whatever the si^ht rate may be.
You will thus see that interest rates have a
profound influence upon the current or short time fluotuatione
in exchange rates.
If we should have an enormously large
balance of p<^/fflentet for one reason or another - because of
the falling off of merchandise emortn,
because of the resale
to this country of American securities held abroadf and so
on,-no poraible temporary borrowing wouldt for any great
length of time, prevent the exchange rate from moving tow^srtF^
the 1ja@fp point*
But within very considerable limits it is
ponsibie to postpone f?old moveraeiits, if in thie maricet interest
rates reach a higher lAvel than those in the foreign countries
to which it is to Kake payiaents.
Under euoh cirouio^tanGei^^ if
tVie credit of the isarivet remain a good in the foreign, country,
yft^nfaii?*^^
#
then very oonBiderable teaspor-*
nry loano may ba !nadet and that provides, for the time being,
si^ht exchange, but, of course, if youtfrav/a lot of three
month bill£ now and ma-ke loans in that way, tit the end of thQ
three months it it? neceseary to make payments, or saeura
renewals, and renewals cannot be continued indefinitely*
1 :roay mention one instance:
In the active markets
• 18 -
of 1906, enormous quantities of temporary indebtedness were
incurred "by means of
MIIB
other European markets.
of exchange drawn on London and
In fact, the amount of such bills
in that year wjuaJLJU>---4?ittc^
as to involve gold imports,
rather an exceptional result of temporary borrowing.
The
jfr "C 4* "0' ^'*V
a n o u n t o f s u c h b i l l n w a s so l a r g e t h a t lMW¥f*irth*thfi e n d o f t h e
•*&i4$e they *;ere discriminated against in the London market,
and then it became necessary to remit in payment, and that
caused, very serious strain in our financial markets in the
early part of 1907.
Within moderate limits these bankers1 bills serve
a very useful/ purpose, because they tend to greater steaciness
of the oi&ht rate of exchange,-prevent its «oinu to m e
export point when there is a very slight excess of demand
for payment over the amount of London balances. ^vi^<.
w
AAticipatory Bills11 ^W^W^^^fff^
-c v
Bunker a' bills drawn
1
'S
in the Bummer becaune it is known that in the I?ajn , on account
of cotlon exports, there will be a ^reat quantity of comrieroial
paper coming into the market.
Anticipatory bill8 are in no
senr^e different fron any other bankers1 bills; it ie ©imply
that, when used in moderate amounts and with that in view
they really are anticipatory*
The terra "Finance Bills11 is also used.
a technical exureBsion.
That is not
It r«frt»&p»Tnea&8 that a large number
of bankers1 billa are beinp: drawn in order to finance financial
5/28/54
Original memo in posession of
Theodore Sprague, 13 Follin St.
Cambridge, Mass.
This document contains internal or confidential information and has
been removed.
Author(s): O. M. W. Sprague
Title: Memorandum for the Council of National Defense: Gold and Credit Policies and
Reconstruction
Date:
Page Numbers:
5/28/54
Original memo in posession of
Theodore Sprague, 13 Follin St.
Cambridge, Mass.
MEMORANDUM ON THE GLASS-OWEN BANKING BILL
0. M. W. Sprague
Converse Professor of Banking in Harvard University.
In forming an opinion regarding the merits of the GlassOwen Bill for the reform of our banking system, the measure must
be considered from three points of view.
In addition to some
changes in the powers of the national banks, the bill provides for
the establishment of entirely new banking machinery— at least
twelve regional reserve banks under the supervision tfed in the exercise of some of their powers under the control of a Federal
Reserve Board.
Whether these new powers granted the national banks
and whether the new banking mechanism, if properly handled, will
remove the recognized defects in our banking system, are matters
to be judged in the light of sound banking principles and praq*
tice.
Equally and indeed more important in estimating tjie wis-
dom of this legislation are the provisions regarding the choice
of the management of the regional banks and the membership of thf
Federal Board.
They must be such as may give reasonable
that a wise and conservative body of men will be secured,
the likelihood of securing the general acceptance of the plan
the banks must be considered, since they are to provide the necessary capital, and without their very general co-operation the plan
could not be carried out.
While there are many and often fundamental differences
between the Glass-Owen Bill and the measure proposed by the National Monetary Commission, the two plans contain a number of identical
provisions and are in general sufficiently Bimilar in purpose and
method to make a somewhat detailed comparison advisable*
The changes proposed in the powers of the national banks
require little comment.
To take care of foreign business, the
Glass-Owen Bill allows banks with a capital of one million dollars
to establish branches in foreign countries; while the Monetary Commission Bill permitted the banks to invest in the stock of a new
kind of bank, foreign national banks, to an amount not exceeding
ten per cent of their own capital•
Both measures authorize country banks to make real estate
loans— the Glass Bill to an amount not exceeding fifty per cent of
capital or of time deposits;
the bill of the Commission only to
thirty per cent of time deposits•
The possible danger from the
higher limit is, however, perhaps offset by a provision that loans
secured by real estate must mature within nine months*
A more considerable difference is to be noted with reference to acceptances, regarding which a general power was granted by
the Monetary Commission Bill;
while the Glass Bill, restricts their
i
use to foreign business.
It is here that the acceptance is chief-
ly needed, and it may be reasonably argued that its use may well at
the outset be restricted in this way*
Some changes in methods of bank examination are found in
both bills but are of no great importance, though a clause in the
- 2
Glass Bill, that no two successive examinations shall be made by
the same examiner, should most certainly be eliminated*
One of the
administrative clauses of the bill designed to prohibit the taking
of gratuities from borrowers by officials and directors is so drawn
as practically to exclude note brokers and Investment bankers from
national bank directorates.
This clause should be re-drawn*
The two measures contain identical provisions regarding
capital and the disposition of profits in the new banking organization.
Each national bank is to subscribe an amount equal to
twenty per cent of its capital, one-half of which is to be paid int
the other half remaining a liability subject to call. After the
payment of a five per cent cumulative dividend, half of the profits
are to go to the Government, the other half to surplus} bat after
the surplus reaches twenty per cent of capital, all profits In
excess of the dividend requirement are to go to the Government#
If one could be sure that practically all the banks, stats as well
as national, would become members of the association, the payment
of a smaller part of the subscription to the capital by each bank
would probably be entirely adequate*
A higher dividend rate, at
least six per cent, would be a desirable change,, especially in
the case of the Glass Bill which, as we shall see, takes away
from the banks some of their sources of income.
Both measures confine the deposits of the new institutions to be established to those made by the Government and by
member banks. On bank deposits no interest is to be paid, but a
provision in the Glass-Owen Bill requires such payment on Govern-
- S -
ment deposits— a difference from the Commission Bill of no particular significance.
The general character of the discounting operations as
determined "by the two bills is very similar.
Only under unusual
circumstances is anything but commercial paper to be accepted for
re-discount, except that the Glass Bill does place state and municipal bonds on the same footing*
Some objection has been raised
against this provision but it would not seem to be well taken.
There is no strong banking reason for eliminating any class of securities;
it is a matter that might well be left to the management,
as is the case with the European central banks.
Political consid-
erations and the existing preference for collateral loans resulting
from our faulty banking system make it, upon the whole, desirable
to discriminate against security loans.
ceptable paper into two classes:
The Glass Bill divides ac-
one maturing in forty-five days,
the other within one hundred and twenty days;
thirty and one hun-
dred and twenty days were the corresponding periods in the bill of
the Monetary Commission.
The amount of re-discounts which might
be granted to a bank was subject to some limitations in the Commission bill.
Whether the absence of similar restrictions in the
Glass Bill is a defect should be given careful consideration.
We now come to differences of a fundamental character
between the Glass-Owen Bill and that prepared by the Monetary Commission.
These fundamental differences are in organization and
in matters relating to discount rates, note issue, and reserves.
A simpler form of organization and a simpler method for
- 4 -
selecting the management characterize the new plan.
Under provi-
sions in the Monetary Commission Bill, the "banks were to be grouped
into local associations, for electoral purposes and in order to
guarantee the paper of members which was to be re-discounted.
associations are eliminated in the new measure.
Local
Bach bank is to
deal directly with its regional association in securing re-discounts
and in no case is its paper to be guaranteed by other banks.
The
Commission measure provided for fifteen branches which were to be
directly operated by a national board.
This board was to be direct-
ly engaged in the banking business, fixing a uniform rate of discount, appointing the managers of the branches, and determining to
what extent authority should be delegated to the local directorate
of each branch.
The feature in the new bill analogous to these
branches is the regional associations, of which there are to be at
least twelve, but these regional associations are given a far more
independent status and more important functions. While subject to
control by the Federal Reserve Board in some matterst the directorate of each regional association is in most respects entirely
independent.
It is, for example, to take the initiative in fixing
the rate of discount and is to act altogether independently in determining the amount of paper to be re-discounted for member banks 9
and in passing upon its quality.
The only direct power over loans
possessed by the central board is that of requiring one regional
association to discount for other associations, and even in such
cases the Board of the lending association would pass upon the
security offered by the borrower.
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The other functions of the Central Board are strictly
supervisory, with the exception of its power over note issue and
over the rates of discount charged by the various regional associations which, in the phraseology of the bill, are ••subject to the
review and determination of the Federal Reserve Board••
In prac-
tice it is probable that in this matter and also in that regarding
inter-regional association loans, the Federal Reserve Board would
exercise its authority but seldom.
The purpose of these provisions
presumably is, and certainly should be, simply to enable the Board
to exercise a restraining influence upon the regional associations
and to enable it to prevent any working at cross purposes among
them.
The circumstances are quite inconceivable under which it
would ever be desirable that the Central Eoard should require a
regional association to discount at a lower rate than that deemed
wise by its own directors.
It is, however, not unlikely that, in
some periods of active business and especially in those parts of
the country where there is a relative scarcity of capital, the management of a regional association might fail to exhibit all the caution that the situation of affairs required.
Every purpose to be
served by giving the Central Board authority over discount rates
would be secured through a provision granting it the power to require a regional association to advance its rates of discount.
It is a more difficult matter to include within the provisions of a statute just those situations in which it might become
expedient for the Federal Board to require co-operation among the
regional associations through inter-regional loans.
- 6 -
After all,
the danger from an unrestricted power of this sort would seem to
be slight.
The Federal Board, however constituted, is most un-
likely to force the management of a regional association to extend
loans to other associations except on occasions of most serious
emergencies.
If it "becomes clearly recognized that the primary
function of the Federal Reserve Board is the exercise of a restraining influence over the regional associations, there is little
danger to be feared from the wrong exercise of this power*
This
general understanding of the true function of the Federal Board is
certainly quite as important as the method of its selection.
It
should also be noted that the Federal Board is not to take the initiative in this matter.
It can only act upon requests for accommo-
dation made by the Board of a regional association.
A provision
might well be inserted in the bill that no inter-regional loans
can be required by the Federal Board at a lower rate than six or
even seven per cent.
Such a provision would largely remove the
danger of frequent recourse to this means of securing funds by any
regional association.
The very great differences in the powers and functions
of the Federal Reserve Board of the Glass Bill and the Board of
Directors of the National Reserve Association of the Monetary Commission Bill afford some ground for the distinctly different method
of constituting these boards found in the two measures.
Under the
Monetary Commission Bill, the Board of Directors was to consist of
five Government appointees and thirty-nine others chosen in various
ways by the banks.
According to the Glass Bill, there is to be a
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board of only seven, three of whom are Government officials, the
Secretary of the Treasury, the Secretary of Agriculture, and the
Comptroller of the Currency, and four others to be appointed by
the President with the advice and consent of the Senate.
As the
term of one of these four members would expire every two years,
each President at the very beginning of his term would have occasion to appoint a majority of this board.
It is further provided
that one of the four members must be a banker.
That this board
must be appointed by the President, if popular support is to be
found for a measure of banking reform similar to either the Glass
or the Monetary Commission Bills, seems certain.
It does notf
however, seem wise or necessary that each President should at the
very beginning of his term re-constitute a majority of the board.
If all of the three Government officials^ are to remain on the board,
it would require a board of eleven, one retiring every two yearsf
to provide a body, the majority of which would outlast a single
presidential term.
The only apparent objection to a modification
of the bill of this sort is the long term of sixteen years1 service
for each member which this arrangement would involve.
Certainly
some change should be made In the bill designed to remove the very
real fear that the board might be directly subject to political
influence.
In securing satisfactory results from the working of the
new banking machinery to be set up under the provisions of the
Glass-Owen Bill, the character of the management of the regional
associations is quite, if not more, important than that of the
- 8 -
central "board.
These regional boards will "be in most respects
entirely independent of the central board;
they alone will deter-
mine the amount to "be loaned to member banks and will pass upon
the merits of the paper offered for re-discount and upon the purchase of foreign bills.
These boards will also have the power to
raise or lower their rates of discount, subject only to review by
the central board.
The disposition to be made of the resources
of each of the regional associations is entirely within the control of its own board of directors, except that it may be required
to re-discount for other associations, but even here the board of
the lending association would pass upon the security offered for
such loans.
Even if the central board were unwise and incompe-
tent, there would seem to be no consequent danger that the funds
entrusted to the regional associations by the banks would be endangered.
They could only be lost through unsound banking on the
part of the local boards.
The functions of the management of the regional associations are distinctly and even technically banking functions.
It
is essential, therefore, that the boards of directors of these
associations should be chosen in such a manner as to insure the
selection of men of wide banking and business experience.
The
provisions in the bill regarding this matter are simple and ingenious and if slightly modified seem altogether likely to yield good
results.
The member banks of each regional association are to be
divided into three groups, as nearly as may be equal in number and
of the same capitalization.
Each group is to select one banker
- 9 -
and one person not an officer or director of a tank as members of
the directorate of the regional association.
This second group of
three directors is to represent fairly the commercial, agricultural, and industrial interests of the locality.
Finally, three
additional directors are to be designated by the Federal Reserve
Board, one of whom is to be the chairman of the board of the regional association.
The selection of two-thirds of these boards
by the banks might seem to guard sufficiently the resources invested by them in the regional associations, but, as their functions are strictly banking functions, at least the six directors
selected by the banks and of course the Chairman should be persons
who possess banking experience.
The method of dividing the banks
into groups fcr electoral purposes minimizes the influence of the
large banks, but they are in a measure protected, since the right
of withdrawal from the system is always open.
The resources of the regional associations cannot be estimated with any degree of certainty.
If all of the national banks
should subscribe to the arrangement, the regional associations would
have a paid in capital of more than one hundred million dollars.
The deposits of the United States Government will also generally
amount to rather more than one hundred million dollars.
These
deposits are to be distributed among the regional associations by
the Secretary of the Treasury, though doubtless in this matter the
opinion of the Federal Reserve Eoard would have great weight.
As
in the Bill of the Monetary Commission, deposits of member banks
are the sole remaining resource.
Provisions regarding this matter
- 10 -
in the Glass-Owen Bill are, however, in every respect fundamentally different from those found in the Bill of the Commission.
According to the latter, that part of the required reserve which
may be deposited with reserve agents was left undisturbed.
The
banks were to be permitted to transfer to the national reserve
association such part of their cash holdings as they deemed advisable and were to be allowed to count the deposit thus created as
a part of their required cash reserve•
It will thus be seen that
the deposits secured by the National Reserve Association at the
outset would not have involved any reduction in the reserves of
the banks and consequently would not have made necessary any contraction of credit on their part.
Any loans made by the reserve
association would, therefore, have been a net addition to the
available supply of credit.
This was a serious defect in the
bill of the Monetary Commission.
If the National Reserve Asso-
ciation had been established four years ago, such loans as it
might have made would not have strengthened the business situation;
they would merely have strengthened the tendency to rely upon short
time credit for purposes which properly should be met by means of
investment capital.
The Glass-Owen Bill provides for a radical change in reserve requirements.
Country banks are to hold a reserve of five
per cent in cash in vault, instead of six as at present; are to
establish a reserve of three per cent with their regional association at once, and at the end of a year increase it to five per cent;
and may further keep the remaining one-third of their required
- 11 -
reserve with reserve agents for a period of two years more;
there-
after this portion of their reserve may be left with reserve agents
or transferred to the regional association, as the Federal Reserve
Board may determine.
The distinction between reserve cities and
central reserve cities is to disappear at the end of three years.
These banks are to maintain a reserve of twenty-five per cent for
two years, then twenty-two and one-half per cent for a year, and
thereafter a reserve of twenty per cent.
An amount of cash equal
to ten per cent of deposit liabilities must be retained in the
vaults of the banks.
Three per cent, and after a year five per
cent, must be deposited with regional associations.
The remaining
five per cent may be held either in cash or with the association.
A somewhat elaborate calculation is required to form an
estimate of the effect of these changes.
On the basis of present
liabilities and reserves if all the banks enter, the initial changes
involving the deposit of three per cent of their deposit liabilities
with the regional associations, together with the subscription to
the capital of these associations, would make it necessary for the
banks to re-discount with the associations to the extent of something like one hundred and fifty million dollars.
The further
change at the end of the first year, increasing balances with reserve associations to five per cent, would involve additional rediscounts of perhaps one hundred million dollars.
And finally,
if the Federal Reserve Eoard were to transfer from reserve agents
remaining reserve balances, still another one hundred and fifty
million of re-discounts would be required.
- 12 -
The first and perhaps the second step in this complicated
rearrangement of reserves would seem to be wise and also entirely
feasible.
The one hundred and fifty millions of re-discountst and
even the two hundred and fifty millions, would give the reserve
associations a moderate amount of business at the outset without
involving any danger of credit expansion.
Some business the re-
serve associations must have, if they are to exercise any influence over the banking situation.
But the further transfer of
all reserve balances from agents not only would seem to be unnecessary but also almost certain to endanger the success of this
plan of banking reform.
It would give the reserve associations
an unnecessarily large amount of business and render the banks
unnecessarily dependent upon them for accommodation.
Further,
there is every reason to believe that a very large number of banks
would decline to become members of the associations on these terms.
Country bankers would resent the loss of the interest which they
receive from reserve agents, and reserve agents would lose virtually the only advantage which they possess over their neighbors
operating under state charters.
General and hearty co-operation
of the banks is essential to any scheme of banking reform;
but
since the advantages from a better system are far more important
to the community generally than they are to bankers or to the
investor in bank shares, unnecessarily burdensome requirements
should not be imposed upon the banks.
Some slight inducement to enter the system is indeed held
out to the banks, since those who do not, will cease to be national
- 15 -
"banks and must at once relinquish their right of note issue and
either hold their two per cent bonds to maturity or incur certain
loss in marketing them.
Banks entering the system continue to
issue notes, subject to a provision in the bill for their gradual
retirement and the coincident exchange of their bonds for an issue
yielding a higher rate of return.
This privilege should also be
extended to other United States bonds held by the banks, in particular to those which serve to secure United States deposits,
inasmuch as these deposits are to be transferred to the regional
associations.
It is doubtful, however, whether the loss in con-
nection with their holdings of Government bonds will be sufficient
to induce by any means all of the national banks to accept the new
arrangements provided for in the bill.
It is even less likely
that any considerable number of state banks will be converted into
the national system, unless the bill is so modified as to make its
provisions distinctly more attractive.
Something in this direc-
tion would be accomplished if the capital of the reserve associations to be paid in were reduced to five per cent of the capital
of the banks if the dividend rate were advanced to six per cent;
and if part, at least five per cent, of the required reserve of
country banks is left with reserve agent3.
None of these changes
would in the slightest degree diminish the effectiveness of this
plan of banking reform.
Another matter regarding which the new bill goes beyond
its predecessor is with reference to the handling of checks.
Ac-
cording to the Bill of the Monetary Commission, the branches of
- 14 -
the National Reserve Association might undertake clearing-house
functions and transfer funds "between branches at rates to be fixed
by the managers of the branches.
Under the Glass Bill, collection
of checks and drafts on member banks is to be made free of cost
for members by each regional association, and transfers of funds
between associations are to be made at par.
Under this provision
of the bill, it will be necessary for each regional association
to set up machinery for the handling of checks within its own region, machinery analogous to that of the foreign department of the
Boston Clearing House.
Further, all places in which there is a
regional association will become par points for the entire country^
It may be expected that, as a consequence, exchange charges on all
checks will disappear.
A Boston bank, for example, while unable
to collect checks on Illinois points through the Chicago Regional
Association, will be able to do so through some Chicago bank; and
the Chicago bank, through its reserve association, will be enabled
to remit to Eoston at par.
Transfers on the books of the reserve
associations will vastly lessen the shipments of currency between
banks in different parts of the country.
Requirements for the
use of cash will become more regular than at present and machinery
for making settlements between different parts of the country
which will not break down in future emergencies will have been
provided.
On the other hand, it must be admitted that the taking
over by regional associations of this function takes away business
which has been profitable to many banks, lessening the Inducements
for accepting the system.
- 15 -
Much more attention than the importance of the subject
warrants has been given to the provisions in the Glass-Oweil Bill
regarding the issue of notes.
Assuming that the reserve associa-
tions had been established four years ago and that their affairs
had been handled conservatively, it is probable that no notes
whatever would have been issued up to the present time. Throughout this period there has been in general an entirely adequate supply of banking credit;
and even on the few occasions characterized
by some strain, the cash and credit of the reserve associations
would have been ample for every purpose without resort to the power
of note issue.
The bill provides for new issue of notes amount-
ing to five hundred million dollars, together with such amounts in
addition as will take the place of the existing note issues of the
banks as they are gradually retired under provisions included in the
bill.
A limited issue is eminently wise, and the particular limit
which has been set will permit quite as much increase in the currency as can possibly be needed for many years to come*
These notes
are to be a direct obligation of the Government and are to be issued to the reserve associations on the deposit of security and at
rates to be determined by the Federal Reserve Board, if that board
is convinced that there is a real need for the notes*
of notes is not to be subjected to any special tax.
This issue
Reliance is
placed upon the wisdom of the management of the reserve associations
in applying for notes and upon the policy of the central board.
A
valuable safeguard, however, is found in the separate interests of
the various reserve associations.
Those managed with a high degree
- 16 -
of conservatism would doubtless oppose any considerable use of the
limited right of issue by other associations, unless the need was
evident.
The criticism which would be directed against liberal
issues to a recklessly managed reserve association should prove a
far more potent safeguard than legislative taxation devices through
taxation.
The limited right of issue serves another useful pur-
p o s e — it will prevent the substitution of notes for gold certificates now in circulation, a substitution which would have provided
the National Reserve Associations proposed by the Monetary Commission with the basis for an enormously and dangerously large lending power*
Taken as a whole, the Glass-Owen Bill seems to provide
the mean3 for very great improvement in our banking system*
It
is superior in a number of respects to the bill proposed by the
National Monetary Commission, notably so in the provision that
reserve requirements may be temporarily suspended by the Federal
Board and in the absence of the requirement of a uniform rate of
discount throughout the country, a most unsound and dangerous
feature of the Commission bill.
Unless some of the provisions of
the Glass-Owen bill are modified, however, it does not seem probable that it would prove effective, because of the probability that
large numbers of banks would not enter the system.
Fortunately,
the changes which are needed to make the bill more attractive to
the banks do not involve concessions on principle.
Surely it must
be possible to formulate conditions regarding qualifications for
membership on the Federal Reserve Board which will cive bankers
- 17 -
confidence in its competence and freedom from political influence*
Surely also sound banking under national charters does not require
burdensome restrictions which will enhance the attractiveness of
organization under state laws and jeopardize the very existence of
the national banking system.
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eJ/'
•
u/U,c*v>utx-
/
This document contains internal or confidential information and has
been removed.
Author(s): O. M. W. Sprague
Title: Memorandum for the Council of National Defense: Reconstruction Policies and
the Maintenance of Peace
Date:
Page Numbers:
@FedFRASER