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Form No. 131
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Orrice C o r r e s p o n d e n c e
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From

Governor Eccles
Mr. Goldenweiser^y ^\Q

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FEDERAL RESERVE

BA D
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Aprn

22.1935

Subject: Collateral requirements as a
limit on Reserve bank purchases of
Government obligations

The Federal Reserve Act requires that when a Reserve bank obtains
currency from the Federal Reserve agent it shall pledge with him an equal
amount of collateral consisting of gold or eligible paper, and, under the
Glass-Steagall Act of 1932, Government securities are also eligible and
will continue to be, under the President's Proclamation, until March 4>
1937* To extend the operation of the Glass-Steagall Act beyond that date,
legislation will be required.
In practice the way the issue function operates is that when a member
bankfs customers apply to it for Federal Reserve notes, either because of
seasonal requirements or because of an increase in the volume of trade, or
because of a lack of confidence in the banks, the member bank first pays
out cash from its vault, but since it never has more cash than it requires
from day to day, it soon finds it necessary to obtain additional cash from
the Reserve bank. In order to obtain it, the member bank usually has to
borrow from the Federal Reserve bank, unless it has excess reserves, which
is not the case under ordinary conditions. Ordinarily the Federal Reserve
bank can pass the paper received from the member bank to the Reserve agent
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and obtain the required notes in exchange. In aperiod of expansion, therefore, collateral requirements do not constitute a restricting influence,
because at such a time the banks are likely to be heavily in debt and the
evidences of that indebtedness are eligible as collateral for notes^




Governor E c d e s , - #2

April 22, 1935

It should be mentioned that eligible paper includes the member banks1
collateral notes secured by Government obligations, so that it is not in
any way directly related to tradej it is merely a matter of indebtedness of
member banks* The times when collateral requirements become undesirable are
when there is a depression and the Federal Reserve System wishes to meet
currency demands without necessitating borrowing from the Reserve banks, since
heavy indebtedness of banks exerts a deflationary influence. When banks are
in debt they become reluctant to make new loans to their customers and, in
fact, are inclined to contract credit by calling loans and selling investments•
This is what happened in 1932. There was a heavy demand for currency for
hoarding and a heavy drain of gold from abroad. There were still large foreign balances in the United States that were subject to withdrawal in gold on
demand* It was a period of terrible deflation and the Reserve banks had purchased up to #800,000,000 of Government securities in an effort to ease conditions* As a consequence, member bank indebtedness was small in relation to the
volume of Federal Reserve notes outstanding and the amount of eligible paper
available as collateral for notes was limited. The Reserve banks during that
period had $1,400,000,000 of reserves in excess of legal requirements. Eligible
paper available for collateral, however, was smaller by about #1,000,000,000
than the amount necessary to cover the Federal Reserve notes outstanding. As
a consequence, the Federal Reserve banks had to pledge with the Federal Reserve
agent $1,000,000,000 of gold, over and above the 4-0 per cent required as reserves against the notes, and they had only #4.00,000,000 of so-called "free11
gold.




Governor Eccles, - #3

April 22, 1935

The situation was, therefore, that the Federal Reserve banks had plenty
of excess reserves but owing to shortage of collateral could nevertheless not
pursue a policy of easing thentarket and thus arresting deflation* If the
banks had bought more Government securities, this would have resulted in an
equivalent decrease of member bank indebtedness, in a further reduction of
eligible paper, and, therefore, in the necessity of pledging more gold against
Federal Reserve notes* The 1400,000,000 of free gold afforded only a very
narrow margin and would have been used up in a short time* The Reserve banks
were, therefore, in a position that made it necessary to meet any further outflow of gold or of currency by increasing member bank indebtedness and thus
aggravating the deflationary process* It is from this condition that the Reserve banks and the country were saved through the passage of the GlassSteagall Act, which permitted temporarily the use of United States Government
obligations as collateral for Federal Reserve notes*
This is what is meant by the statement that collateral requirements limit
the amount of Government securities that a^Reserve bank may buy* It 11 ml fcg
It limits them, furthermore, at the very time when the Reserve banks should
pursue a policy of liberal purchases in the open market because of the existence of a deflationary situation. Collateral requirements, therefore,
which add nothing to the safety of Federal Reserve notes, as has been explained in other connections, have a perverse influence on Federal Reserve
policy* They do not in any way restrain credit expansion at a time when
restraint might be desirable, but they do prevent an easing policy at a
time when such a policy is necessary in the public interest*




Governor l o d e s , - #4-

April 22, 193$

At the present time the Federal Reserve banks have total reserves of
$5,900,000,000 and excess reserves, allowing 4-0 percent against Federal Reserve notes and 35 percent against deposits, of #2,900,000,000^ In these
circumstances they have enough gold to meet collateral requirements t*y the
use of gold certificates even though there is practically no eligible paper•
They can at present cover their entire note issue by gold certificates, and
have enough reserves left for the 35 percent required against deposits, and
over and above that have 1700,000,000 of w free w gold available for the purchase of Government securities or as a basis for expansion• On the basis
of this #700,000,000 the Reserve banks couM buy about #2,000,000,000 of
Government securities so long as the deposits created by the purchases remained as balances with the Reserve banks• This is for the reason that
only a 35 percent reserve is required against deposits* Consequently, at
the present time, if the Reserve banks were not permitted to use United
States Government obligations as collateral against Federal Reserve notes,
they could purchase about #2,000,000,000 of additional United States Government obligations and meet the additional reserves necessitated by the
creation of additional deposits by using the #700,000,000 of "free11 gold.
If, however, a demand for currency should develop and the Reserve
banks were not permitted to use United States Government obligations as
collateral, they would have to use the #700,000,000 of ttfreen gold, dollar
for dollar, to cover the Federal Reserve notes*
The situation at the present time, therefore, is that the Reserve
banks, if they did not have authority to count Government securities as
collateral, could buy #2,000,000,000 of additional Government securities,
if there were no demand for additional currency, and could buy #700,000,000




Governor Ecdes, - #5

April 22, 1935

of additional Government securities, if there were a demand for additional
currency*
The Federal Advisory Council has recommended that under special conditions the Board could authorize the use of a billion dollars of Government
securities as collateral on the payment of a 3 percent tax* This would add
an additional billion dollars that the Reserve banks could buy in case there
was a currency demand, but only upon payment of a penalty tax at the rate of
$30,000,000 a year, a larger amount that the System1s entire expenditure in a
year*
One of the illogical features of the proposal is that it would limit purchases of Government securities much more radically when there is a demand for
currency than at a time when the demand is for deposits* This is entirely
contrary to what should be, because, when inflation develops, it develops
through the creation of deposits, while a currency demand comes much later*
When the stage of currency demand has been reached, it is too late to exert
a restraining influence, because at that time the Reserve banks srust be in a
condition to meet the member banks1 demand for currency; otherwise the Reserve
banks would be declared insolvent* A situation might also arise, at it did in
1932, when the Reserve banks would be confronted with the necessity of selling
Government securities in order to put the banks into debt for the purpose of
having that debt available as collateral, at a time when indebtedness of member
b&nks might be highly undesirable*
This is a technical matter and fairly complicated in its actual operation*
The significance of it, however, may be summarized very simply* Collateral requirements against Federal Reserve notes, which add nothing to the safety of




Governor Ecdes, - #6

April 22, 1935

the notes, have a practical significance only to the extent that they limit
the volume of United States Government securities that the Reserve banks may
buy* The limitation arising from the collateral requirements, furthermore,
is very much more drastic when there is a demand for currency than when there
is a demand for deposits. Therefore, the limitation comes too late to restrain
an inflation, and at a time when the choice is between deflation or modification of the law* It is safe to assume that in these circumstances the law will
always be modified, but probabilities are that the modification will be delayed
enough to prevent a timely policy of ease lay the Reserve banks.
If it were decided to limit the participation of the Federal Reserve banks
in Government financing, this should be accomplished by a direct limit of the
amountof Government securities that the Reserve banks may own, possibly in some
ratio to the Governments revenue, as is done in certain central banks* A
round-about limitation through collateral requirements, which operates only at
the wrong time and is at all times an expensive and complicated piece of
machinery, is not the proper way to limit Government security holdings by the
Reserve banks even though such a limitation be considered desirable*