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July 9# Benrv Mergers thau, Jr», of the £re**nry, , t ! . C* ecretary* I am writiag tc a«3vi«« you that the Board of ^overnors and the Federal Kes<&rve Hacks are tsjiitiAsjriUtg the d is sentimuars.ee at an earl^- date of the preferential discount rate of l / 2 per ceut on Government securities maturing or callable in one yemr or l e s s . The r e f e r e n t i a l rate waa established at a l l of the* neservs Baraks iti October |f|gt. At that tiase bsmks wore b^icr called upo« to take a larger proportion of %h* debt tnaa MM is MHWHNQry^ S)M prefere??t*al r^^t© was d«si^n©<j t© MMNNONftfi banke t» partioipa'te In the financing procram by borrowing t«soporarily when iitcesiary and to avcid holdl^r an '.asrea^OBftbly lar^e iMlrt of excese reserves. We felt at th© time that the privilege of btnMViag a t t h e preferejiti&l rate ^ouldfee*-*.sed to 9tk%J * llmiteci extent and that such u«e as «ai rade of i t would fe© larg^lv bgr banks that did *9% hold Treasury tills. the principal reason for eatabHthSr.r; th1.« rate no since the rroblem now i« to retard the growth in l*ak holding of aeiat •#e«rlti«l« Xi fttet the fitBfrwrtf#• of the preferential rate i« overdue* The 'hnmr i t i« Hi»lr*t*iRe<2 the saore i t tends to become froaeirt ihn s of the preferential rate M*M result in iurfeher iodireot bank fineseing ar;d ie further speculation. JJoresoveTj, the preferential rate has beecno subject to abuse. It affords a substantial profit to banks, whioh ean borrow at l/2 per aeiit aud thereby c^an obtain a profit of l/U per cent on most laii—i of certificates and a lar-er ^rofit OB lonp-er-tena seouritioi. Hetaber bank borrowings in June reached a peak of about 900 million dollars* and practically a l l of this amotmt was at the prefer«ntial r a t e . About 600 million dollars of the borrowings «ere at Sew York City, where earnlags already ar«s Utirgt and where speculation is most prevalent, although to Botm extent these borravingp were incurred for the purpose ©f obtaining reserves Wtwoen drives, there is evidence also that V-anks borrowed in order to increase their holdings of •Ooveniment securities and particularly ©f • 2 - medium-term bonds* Another purpose of borrowing was to reduce excess profits tax liabilities. It is likely that these abuses of the preferential rate will continue to fffpm as banks become sore and ntore willing t« borrow* la addition this low rate, by sustaining a low rate on loans that banks make to dealers and to others* has encouraged speculative buying of Government securities on bank credit* In June loans on Government securities to dealers and brokers reached a peak of 1*3 billion dollars, and sueh loans to others reached a peak of 2.2 billion* a total ef h billion. Discontinuance of the preferential rate would eliminate the profit that can be made by borrowing and using the funds to purchase certificates and would reduce the profit that can be made by borrowing in order to purchase longer-term securities* This change would serve thereby to retard the growth in bank credit at a time when inflationary tendencies are strong* In addition* it probably would result in an increase in the rate on bank loans to dealers and others, which would discourage such loans and thereby would reduce speculation and indirect bank financing* The existence of the preferential rate has had no effect on the cost ©f Treasury borrowing, which has been influenced rather by Federal Reserve open market operations* Discontinuance of the preferential rate, therefore, would have B O influence on the cost of Treasury borrowing. The present is the best tiae to make this change* '£he large expansion of bank credit in the recent drive indicates that continuance of the preferential rate is undesirable* the Treasury will need te berrew no additional funds for several months* Member bank borrowings are now at a low level* and excess reserves are large* Accordingly the change probably would have little or no effect on the Government security market* Any effect that it might have could be handled easily by open market operations The Treasury would be assured, therefore, of a ready market for any refunding or any cash offering of certificates that the Treasury say desire, at the present rate of j/S per cent* Sincerely yours. H. S. Secies, Chairman* UfFtij
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