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July 12, 1945


Draft of policy record regarding
elimination of preferential discount rate
The preferential discount rate of 1/2 pmr cent was established at
all of the Federal Keserve Banks in October 1942. It was recognized at that
time that the war financing program would require substantial purchases of
Government securities by member banks, and it was the belief of the Board of
Governors that the existence of a preferential rate would encourage member
banks, particularly those outside of the financial centers, to invest la
short-term Government securities store of their excess reserves, which at that
time were 3 billion dollars, the Board also felt that such a rate should not
be established in ordinary circumstances and should be eliminated when the
need for it had passed.
Shortly before the elimination of the preferential rate, the Board
had considered this question informally and had discussed it with the President a of the Federal Reserve Banks* The Board felt that the reason for
establishing this rate no longer existed, that its eliiaination would not
interfere with the war financing program, that the continuance of the rate
would encourage a further unnecessary and dangerous expansion of bank credit,
and that the privilege was becoming increasingly subject to abuse.
There was no longer the same need for encouraging banks to increase
their holdings of Government securities that existed at the time of the
establishment of the preferential rmte. Both Treasury financing practices and
Federal Reserve policies have been directed toward selling as large a proportion of Government securities as possible to investors other than banks and
to keep bank purchases to the ainimuta necessary to assure the success of
Treasury financing. Bank holdings of Government securities had increased

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by larger amounts than were needed.


The tremendous investment of nonbank

funds in Government securities in the drives, the large remaining uninvested
nonbank funds, and the sharply declining level of Treasury cash reqairesaeats,
with the reduction In the scale of war expenditures, indicated that bank
investment in Government securities l a & amount even approaching the previn
ous scale no longer was necees&ry.

It was, therefore, necessary no longer

to give banks any special encouragement, but rather to discourage them,
In adding to their holdings.
Hot only were banks increasing their total holdings of Government
securities by larger amount® than necese&ry, they were purch&alng more
longer-term, higher-rate issues and fewer short-term low-rate Issues than
they had previously,

the lower preferential discount rates on advances

secured by short-term obligations was, therefore, not having the intended
effect of encouraging purchases of short-term Issues* there were, in fact,
evidences that some banks were borrowing at the preferential rate for the
purpose of increasing their holdings of securities bearing higher rates.
Member bank borrowings had reached a high level in June and at the same time
banks were increasing their holdings of Government securities, particularly
their holdings of medium-term bonds. They were encouraged to do this by the
fact that the rate of 1/2 per cent was considerably below the rate that
could be earned on most Issues of Government securities.

The only rate that

i t exceeded was the rate of Treasury b i l l s , and member banks since 1942 had
reduced their holdings of b i l l s and had Increased enormously their holdings
of longer-term higher-id elding securities.

The preferential rate, moreover,

by encouraging a low rate on loans on Government securities that banks make

-3to dealers and to others, had encouraged speculative buying of Government
securities on bank credit, which had reached a large amount in the immediately
preceding drive* There was evidence also that some banks borrowed in order
to reduce their excess profits tax Utilities.
The purpose of the lower discount rate was not to encourage banks
to borrow in order to purchase securities but to assure them that if they
used available excess reserves to purchase securities they could borrow at
low rates in case they should later need additional reserves for temporary
period*. Under the circumstances that developed, it was felt that the
continuance of the preferential rate would encourage a farther unnecessary
and dangerous expansion of bank credit at a time when Inflationary pressures
were increasing*
The time chosen for the elimination of the preferential rate was
one when it would cause no disturbance to the banking system and to Treasury
financing. Member bank borrowings were small and excess reserves large,
and the Treasury needed to borrow no additional funds for several aonths.