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December 12, 19U7#
A S E S T QUESTIONS SUBMITTED TO CHAIRMAN ECCLES
NWR O
B SENATE BANKING AND C R E C SUBCOMMITTEE O THE RFC
Y
URNY
N
1®

To what extent does the Federal Reserve
System have oversight and supervision' of
the nation's credit, with particular
reference to its control over bank credit?

The power of the Federal Reserve System to influence the volume
of the nation's credit arises primarily out of i t s authority to require
member banks to keep prescribed proportions of their demand and time deposits
in the form of balances with the Federal Reserve Banks®

Thus member banks

can lend, and thereby create deposits, on the basis of balances held with
the Federal Reserve Banks to meet legal requirements®

The Reserve System,

insofar as i t can influence bank credit conditions, does so by affecting
the amount and cost of reserves available to these banks®

Such influence

in the past has been exerted by the use of the System's open market, rediscount,
and reserve requirement policies®
Federal Reserve influence over the composition, as contrasted to
the volume, of bank credit is at present very limited, being restricted
primarily to i t s power over margin requirements in the case of loans on
listed securities®

Under this power the Board can determine the amount of

collateral required on loans made by banks and other lenders for the purpose
of purchasing or carrying listed securities®
Under current conditions, the Federal Reserve System's effective
control of the nation's credit is seriously handicapped both by the divided
character of our banking and credit structure and by the changed banking
situation brought about by war finance®

Even the System's authority to

influence the credit expansion of i t s member banks is limited at present
because of the banks' large holdings of Government securities*



» 2 -

On numerous occasions the Board of Governors has pointed out to
the Congress that the Federal Reserve System is only one part of a complicated banking and credit structure which has evolved over time in
response to specific competitive situations and emergencies•

I t has

frequently recommended a comprehensive review of our banking credit,
and monetary system to discover how our banking laws and bank supervision
could be simplified and coordinated more effectively®

The Reserve Board

is now engaged in e^>laining to the appropriate committees of the Congress
the limitations of its powers in the present inflationary situation and
is requesting temporary authority to overcome these limitations by the
imposition of a special reserve requirement against the demand and time
deposits of a l l commercial banks.
Concerning the divided character of our banking and credit
structure and its limiting effect on the Federal Reserve System's control
of bank credit, the supervision of the country's approximately 1^,000
commercial banks is now shared by 3 major agencies of the Federal Government and the 1 8 States®
*

Ihile the System is one of the important Federal

agencies, its examination responsibilities reach only a part of the banks
and immediately only those member banks that are chartered under State
law*

Approximately k9 per cent of a l l commercial banks in the country

are members of the Federal Reserve System, although these member banks
hold 85 per cent of the nation's total commercial bank deposits.
Although the System actively cooperates with other Federal and
State supervisory agencies in working out and applying consistent and
constructive supervisory policy, the System has no control over the




- 3 -

activities of these agencies*

Nor can i t exert an influence, except

indirectly and through influence on its members, over the reserves and
credit creation activities of nonmember banks.

Reserve requirements for

these banks, which are determined by State law, vary considerably from
State to State and are generally lower than those prescribed for member
banks.

As a result, nonmember banks are reluctant to join the Federal

Reserve System, and the problem of controlling the over-all volume of bank
credit is made more complex and d i f f i c u l t .
The System likewise has no control over the direct lending or
loan guaranteeing activities of the Federal agencies in the farm credit,
home mortgage, or business loan fields®

Authority for such activities has

usually been superimposed upon our existing credit system in response to
special needs and interests.

There is much to be said for the provision

of some mechanism through which the programs of these agencies can be
coordinated into a national credit policy.
Concerning the Reserve System's current lack of power to control
the economy's bank credit expansion, such control could not be exercised
under present powers without running the risk of seriously disrupting the Government bond market®

Therefore, in order to reestablish effective control over

the total volume of bank credit, which i t was the intent of Congress that
the Federal Reserve System should exercise, the Board has proposed that the
Congress pass legislation granting the System's Open Market Committee temporary
authority to impose a requirement that a l l commercial banks hold a special
reserve, i n addition to reserve requirements under existing Federal and State
laws*

This reserve would be imposed gradually as conditions warrant, and




-

U -

i t would be calculated, within limits fixed by law, as a percentage of
demand and time deposits and consist of short-term Government securities
or cash, at the option of the individual bank*

Information relating

to the detailed specifications of the plan has already been made available
at the recent Congressional hearings®




- 5 2.

In the light of such oversight and supervision as th© Federal Reserve System has
over credit, what are the advantages and
disadvantages in granting powers to the
Federal Reserve System and to the Federal
Reserve Banks to guarantee banks loans to
business enterprise as provided in S. 08?

In assessing the desirability of granting the Federal Reserve
System powers to guarantee bank loans to business enterprises, as provided
for in Senate B i l l I4.O8, two basic credit requirements of the smaller business concerns should be considered.

One is the need for a standby credit

authority that can be used in time of economic uncertainty to support the
extension of bank credit to business*

This need was recognized in 1 3 4
9^-

when the Federal Reserve Act was amended to include section 13b.

I t is

generally agreed that at a time when the individual bank!s primary concern
is the liquidation of a l l slow or doubtful credits and caution in the
extension of any additional credits, some arrangement should be available
to ensure a continued flow of bank credit into worthy business enterprises.
Such a standby credit authority, however, should be held inactive in an
inflationary period*

Businesses generally should be discouraged from

seeking additional bank loans at a time like the present.
The second basic credit need is for some means of facilitating
the extension of intermediate and longer-term bank credit to finance out
of future earnings the longer-term working and fixed capital needs of
smaller businesses*

While the customary money and capital market channels

are available as the most satisfactory means of financing the intermediate
and longer-term credit needs of the larger concerns, smaller concerns—
particularly those needing a million dollars or less of outside financing—




- 6 -

are either unable to obtain capital funds from this source or find that
the cost is prohibitive.

The smaller businesses face serious difficulties

of obtaining long-term borrowed capital through the capital market, and
there is a pronounced reluctance on the part of most owner-operators of
smaller businesses either to dilute or lose their control by bringing
in outside equity or to pay the price that is necessary to interest such
equity capital*

Accordingly, i t is essential that smaller businesses

have some assured source of long-term credit.

Such a source is essential

during periods idien banks are unwilling to make such credits available at
and
their own risk,(especially during periods when longer-term credits are
necessary to maintain production and would not have inflationary effects.
Senate B i l l lj.08 constitutes a long step forward in f u l f i l l i n g
both of these credit requirements of the smaller businesses.

By liberalizing

the terms and conditions of loans eligible for guarantee by the Federal
Reserve Banks, i t increases their effectiveness as a standby credit source
in periods of economic and credit contraction.

By broadening the e l i g i b i l i t y

requirements to include new as well as established businesses, by dropping
the working capital limitation and by extending the maturity period from
5 to 10 years, i t facilitates the financing of intermediate and longerterm credit requirements of smaller businesses during periods when such
financing is most urgently needed.
The principal advantages of S 1 0 may be summarized, as follows:
# ^8
1.

The b i l l eliminates any possibility of Reserve Bank com-

petition with private banks by discontinuing the direct lending authority
of the Reserve Banks and authorizing them only to guarantee, or make commitments to purchase, loans extended by private banks.



- 7 -

2.

The b i l l would provide a standby insurance arrangement

which would give the private banks the support they need for credit
extension to an important sector of business, the smaller enterprises,
at times when the risk factor might otherwise unduly deter credit extension.
3»

By removing existing provisions of section 13b, which limit

Federal Reserve Bank loans and participations to loans which provide
working capital only and have maturities of not over 5 years, the b i l l
would facilitate the granting of longer-term leans for working or fixed
capital purposes to business, particularly in periods of slackened business activity when banks might be less willing to extend credits entirely
at their own risk.

In so doing the b i l l would help to f i l l a recognized

gap in the financing sources available to smaller businesses unable to
raise funds through customary money market channels*
ij.*

The extension of capital leans to smaller businesses could

be readily coordinated with national credit policies under the provisions
of S* I4.O8, inasmuch as primary responsibility for both would be lodged
with the same authority—the Federal Reserve System*
5«

By restricting the aggregate of guarantees on individual

loans in excess of $100,000 to

per cent of the combined surplus of

the Federal Reserve Banks, S* J O ensures that at least half of such
48
credit assistance would go to small businesses*
6*

The proposed b i l l does not require the appropriation of

Federal funds for the purpose of establishing insurance reserves, nor does
i t involve any provision in the Federal budget to cover the expenses of




- 8 -

its administration.

Should losses be sustained on guaranteed loans, they

would f i r s t c m out of the fund created by the guarantee fees charged «
o e
I f the latter were inadequate, losses would be met out of the Reserve
Banks1 net earnings or surplus.
7.

By restricting the System1 s authority to the guarantee of,

or commitment to purchase, a loan made by a commercial bank, this b i l l
would place the primary responsibility for extending credit on the institution best fitted to judge the needs and capabilities of loan applicants—
the local bank.
8«
to business.

The b i l l would not encourage extension of undue risk credit
In the f i r s t place, i t provides that the loan originate

with a commercial bank.

This assures careful appraisal by those most familiar

with the needs and circumstances of the applicant.

In the second place,

no loan would be guaranteed except upon request of the lending bank, and
each loan would be subject to individual appraisal by the Reserve Bank
prior to the granting of a guarantee or purchase commitment.

In the

third place, a steeply graduated scale of guarantee fees would curb any
tendency to grant loans promiscuously on the basis that these loans could
be guaranteed at a nominal cost to the lending bank.

Finally, the b i l l

provides that the lending bank itself would be liable for at least 10 per
cent of any realized loss; therefore, a l l lending banks would continue to
exercise caution in originally granting these credits.
%

In selecting the Federal Reserve System to operate a loan-

guarantee program, the b i l l would be utilizing established banking channels
and the services of an organization that has had long experience in the




- 9 -

business credit f i e l d as well as substantial experience with guarantee
operations both under its section 13b and the regulation V wartime lending
program*

Under regulation Y, the Reserve System processed loan applica-

tions aggregating more than 10 b i l l i o n dollars, and at the conclusion
of this program, the amount collected in guarantee fees exceeded a l l
losses by more than 20 million dollars.
Each loan would be passed on by the Reserve Bank of the local
bank's Federal Reserve District.

I f approved by that Reserve Bank, the

guarantee would be promptly available without reference to the Reserve
Board in l^ashington.

To use another agency for this purpose would mean

unnecessary duplication of effort and operating facilities, and less
efficient utilization of the Reserve System's past experience and existing
regional facilities.
The principal disadvantages of S. I4O8 are contingent upon its
administration.
1*

Even with a loan guarantee* individual banks may be unduly

reluctant to extend longer-term credit under certain circumstances*

It

must be assumed, however, that given this assurance of assistance in case
of unusual losses, enterprising bankers w i l l extend the long-term credit
needed by small businesses to the extent that dictates of sound banking
and economic policy will permit.
2m

I t may be argued that S. J O would foster further expansion
48

of bank credit under inflationary conditions and that its enactment at this
time would therefore be inadvisable.




Since the guarantee program would be

- 10 -

coordinated with national credit policy, use of loan guarantees
discouraged under inflationary conditions such as now exist.

would be

However, the

establishment of a standby credit authority should precede any change in
the general credit situation that would require its use.




- 11 -

3*

Does the contemplated use of the combined
surplus of the Federal Reserve Banks to
support loan guarantees conflict -with the
uses of this surplus as provided in Section
7 of the Federal Reserve Act?

The surplus fund of each Federal Reserve Bank is accumulated,
in accordance with section 7 of the Federal Reserve Act, by annual payments
into that fund of net earnings available after payment of 6 per cent
dividends to stockholders*

With respect to the use of the surplus fund,

the law provides only that, upon the liquidation of any Federal Reserve
Bank, any surplus remaining after payment of debts and dividends would
become the property of the United States•

Ihile there is no express pro-

vision as to other uses of the surplus of the Federal Reserve Banks as
going concerns, the surplus fund of each Bank is intended to provide a
fund which w i l l be available for meeting losses in excess of earnings in
extraordinary contingencies without causing any impairment of capital*
The b i l l S# Uo8 provides that the aggregate amount of a l l
outstanding guarantees and commitments of the Federal Reserve Banks at
any one time shall not exceed the combined surplus of the Reserve Banks
at such time.

It is very unlikely, however, that i t would ever be

necessary for any Federal Reserve Bank to use any portion of its surplus®
Loans guaranteed would originate with local banks which would
be f u l l y acquainted with the character, financial ability, and solvency
of their customers*

They would be required to carry some portion of the

loans without guarantee and this would act as a deterrent on their making
undesirable loans*




Moreover, the steeply graduated guarantee fees, which

- 12 -

they wouJ.d be required to pay to the Reserve Banks, would induce the
lending banks to carry as much of the risk as possible and thus cause
them to exercise careful judgment and prudence i n passing upon credits.
These considerations serve to limit the risk of loss to the Reserve Banks
in making guarantees under the b i l l .
It is to be expected, of course, that the Federal Reserve Banks
would incur some losses i n carrying out the provisions of the b i l l i f
they are to guarantee any large volume of loans, since the purpose of
the legislation is to guarantee long-term loans the quality of which is
such that commercial banks would not make them without a partial guarantee.
However, the guarantee fees paid to the Reserve Banks by the lending banks
would constitute a fund out of which any such losses could be absorbed,
and normally that fund would be adequate to cover a l l losses®

I f the

fund should not be adequate, losses would be met from current earnings
of the Reserve Banks before any charges were made against surplus#
Current earnings of the Federal Reserve Banks have been at
relatively high levels i n recent years and on the basis of present estimates
i t is expected that their net earnings for 19i*7> after payment of dividends,
w i l l aggregate more than $80,,000,000®

Their combined surplus at the end

of 19U6 was approximately $14*0,000,000®

In view of their large earnings,

the Board of Governors, in April 19li7> acting under authority coaferred
upon i t by section 16 of the Federal Reserve Act, levied an interest charge
on Federal Reserve notes issued by the Reserve Banks for the purpose of
providing for payment into the Treasury of approximately 90 per cent of the
net earnings of the Reserve Banks for l$hl+



Even after making such payments

- 13 -

to the Treasury the combined surplus of the Reserve Banks at the end
of the current year w i l l approximate $h$0$000,000*

This amount is

ample to take care of a l l needs of the Federal Reserve Banks, including
any losses which might be sustained in carrying out the proposed
authority.
For these foregoing reasons, the use of Reserve Bank funds
i n making guarantees under the b i l l S* 1|08 would in no way affect the
adequacy of their surplus funds for use i n meeting requirements incident
to their other operations under Section 7 of the Federal Reserve Act*




-lu-

ll*

Is loan insurance a sound practice for either
RFC or the Federal Reserve Banks? I f so,
which is the best agency to guarantee bank
loans to business enterprise?

I t is a sound practice for Government agencies such as the
Federal Reserve Banks and the Reconstruction Finance Corporation to
have stand by authority f o r , and to engage i n , the insurance of business
loans*

The use of such authority should of course vary with general

business and credit conditions*
To insure against risk in this type of lending activity is
as appropriate as the insurance against loss of l i f e or loss by f i r e by
private companies, against loss of bank dep&sits by the Federal Deposit
Insurance Corporation, or against loss on home mortgage loans by the
Federal Housing Administration*

In each illustration a premium or fee

is paid to cover the risk of loss in the individual case, and the receipts
from premiums or fees provide a pool to meet such losses as occur*

In

this way, the incidence of loss i n the individual case is spread over the
group*

In the case of the long-term capital loans to small business, the

type of credit contemplated by Senate b i l l lj.08, a bank making a loan of,
say, $50,000 may wish to insure as much as $1*0,000 or $U5,000 against loss.
To obtain such insurance, i t would pay a fee which is determined as a
percentage of i t s interest income and increases as the proportion of the
loan insured increases*

The bank ?rould reduce the earnings on the loan

by the cost of the insurance i n order to eliminate the risk of loss on a
part of the principal*




-15 -

An outstanding example of the application of the insurance
principle i n the lending f i e l d is the insurance of home mortgage loans •
Under the FHA, as provided by law, private mortgage agencies may take
out insurance against loss on home mortgage loans that conform with
the regulations of the FHA*

Under this type of insurance, the financing

services which lending agencies, including banks, can give to home owners
have been greatly improved*
The type of credit tinder discussion i s an appropriate one
for application of the insurance principle* Small businesses which do
not have access to the capital markets need long-term credit to meet
their capital needs and need better terms for long-term credit*

However,

the risk involved in financing the smaller enterprises is greater than for
the larger ones because the future of these enterprises depends to a large
extent on the ability of the owner-manager*

Such risks are also greater

because the loans are extended for a longer period*

Banks usually are

unwilling to make long-term loans unless they have some way of reducing or
limiting the risk*
There are a number of reasons why the Federal Reserve System is a
more appropriate agency than the RFC for insuring loans to small business.
1*

The Federal Reserve System has a long-established regional

organization which provides direct contacts with banks, large and small,
throughout the country*
banking system*

The System is an integrated part of the commercial

A Federal Reserve Bank is located in each of the twelve

Federal Reserve Districts into which the country is divided*




In most of

~ 16 -

the districts, branches have also been established to facilitate
business regularly conducted by the Banks*
such branches*

There are twenty-four

Thus, the twelve Banks and the twenty-four branches

provide convenient access for insurance to any bank large or small that
may seek i t *
2*

In carrying out the regular functions given by law to the

Federal Reserve System, such as those of holding reserves, or providing
currency, or acting as a clearing house for checks, the Federal Reserve
Banks have an intimate knowledge of bank conditions throughout the
country*
3*

The extension of this type of credit should be made with

due regard for broad credit policies*

I f the insurance is extended

through the Federal Reserve System, which has the responsibility for
formulating and carrying out national credit policies, uniform credit
policies can more easily and directly be brought about*
li*

The Federal Reserve System in recent years has added con- •

siderably to i t s experience with loan insurance*

Before the war the

Reconstruction Finance Corporation and the Federal Reserve System were
both gaining some experience as a result of their authorization by
legislation in 193k to make commitments or deferred participations to
take over bank loans*

During the war, however, the Federal Reserve System

was the agent for the war procurement agencies in a widespread application
of the insurance principle to bank loans to numerous manufacturers,
large and small, to facilitate war production and, later, contract settlement*

Over 10 b i l l i o n dollars of guaranteed loans were authorized under




- 17

this program, and the staff of the Federal Reserve Banks and branches
and of the Board of Governors in Washington played an essential role
in marking out with the commercial banks and the procurement agencies
the loan terms on which guarantee agreements were based®

Results of the

entire operation after a l l expenses and losses show a profit of more
than 20 million dollars.
Loan insurance i f administered by the Federal Reserve
System, would be based not on government appropriation but on the
cumulative earnings of the Federal Reserve Banks®

Thus, i t would not

involve any money from public funds®
On the contrary, passage of the b i l l would carry out a
recommendation of the President i n his budget message for 19it8 which
would release about $139,000,000 of public funds to the Treasury for other
uses®

I t would require the return by the Federal Reserve Banks of a l l

funds heretofore received by them from the Treasury in connection with
their industrial loan operations, about $27,^00,000, and would eliminate
any further claim upon the Treasury for any part of the $112,000,000 which
was appropriated by Congress and i s now set aside in the books of the
Treasury for this purpose®




- 18 -

f>*

3f RFC is authorized to continue its
lending activities, vrould i t be an improvement in organization to have an advisoryboard of directors, and to be administered
by a Fresident or general manager responsible
to the board of directors? I f so, in the
interest of establishing more uniform credit
policies, would i t be advisable to have the
Chairman of the Federal Reserve Bank and
the Secretary of the Treasury members of the
RFC board of directors?

The proposal on which the questions are based is not clear*
The comments below assume that the advisory board of directors would
replace the present board of directors of the Reconstruction Finance
Corporation, that i t would include in i t s membership the Chairman of
the Board of Governors and the Secretary of the Treasury, and that a
Fresident or general manager would be responsible to this newly constituted
board of directors*

The proposal is apparently intended to solve the f o l -

lowing two problems that have arisen in the operation of government corporations such as the RFC.
First, how can the responsibility for operations be most
effectively placed?

The proposed form of organization would not differ

greatly from the present one*

The Reconstruction finance Corporation now

operates with a board of directors appointed by the President by and with
the consent of the Senate, and an executive committee composed of the
chairman and two other directors*

With such an organization the responsibility

for operation is definitely placed upon the appointed directors of the
Reconstruction Finance Corporation*




- 19 I t really makes very l i t t l e difference whether the organizational setup provides for an administrator with a few deputy
administrators, as with the Farm Credit Administration, or for a
small board of directors*

A small top organization more definitely

places responsibility; i t also reduces trading, compromise, and red
tape, and thus raises efficiency*
Second, how can Reconstruction Finance Corporation activities
best be coordinated with the broad f i s c a l , credit, and monetary
policies of the Government?

An effective way of doing this would

be to provide for an advisory committee of possibly 5 persons representing appropriate Government agencies and headed by a representative
of the Treasury*

Such a setup would oonform to that of the National

Advisory Council, which was established by Congress to operate in
the international field*

There are five Council members and they

operate through a permanent staff committee composed of technical
personnel of the agencies represented — the Treasury, the Department
of State, the Department of Commerce, the Federal Reserve System,
and the Export-Import Bank*

The Council not only advises the

Government agencies operating in the international financial f i e l d
but also reports to Congress on its activities.

The establishment

of a similar inter-departmental organization in the domestic credit
f i e l d would meet one of the objectives which the Committee apparently
has in mind in framing its proposal*