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PRESIDENT
H. W. KOENEKE, PRESIDENT
. ,^THE SECURITY BANK OF PONCA CITY
* ">ONCA CITY. OKLAHOMA
. ^ ^ I R S T VICE PRESIDENT
W. L. HEMINGWAY, PRESIDENT
MERCANTILE-COMMERCE BANK & TRUST CO.
ST. LOUIS, MISSOURI
SECOND VICE PRESIDENT
A. L. M. W I G G I N S , P R E S I D E N T
BANK
OF
HARTSVILLE
H ARTSVILLE, SOUTH C A R O L I N A

AMERICAN BANKERS
ASSOCIATION

DEPUTY MANAGERS
W. ESPEY ALBIG, SECRETARY
SAVINGS DIVISION
JAMES E. BAUM, MANAGER
INSURANCE AND PROTECTIVE DEPARTMEI
A. G. BROWN, MANAGER
AGRICULTURAL CREDIT DEPARTMENT
WALTER B. FRENCH, MANAGER
CONSUMER CREDIT DEPARTMENT

22 East 40 Street, NewYork,N.Y.

TREASURER
W. F. AUGUSTINE, VICE PRESIDENT
NATIONAL SHAWMUT BANK
BOSTON, MASSACHUSETTS
EXECUTIVE MANAGER
HAROLD STONIER

BRANCH

EDGAR E. MOUNTJOY, SECRETARY
NATIONAL BANK DIVISION
MERLE E. SELECMAN, SECRETARY
TRUST DIVISION

OFFICE

ECONOMIST
DR. PAUL F. CADMAN

W A S H I N G T O N B U I LD I NG , W A S H I N G T O N , D. C .

GENERAL COUNSEL
D. J. NEEDHAM
SECRETARY
RICHARD W. HILL

DR. ERNEST M. FISHER, DIRECTOR
RESEARCH IN MORTGAGE AND
REAL ESTATE FINANCE

March 21, 1942

COMPTROLLER
J. J. ROONEY




SENIOR DEPUTY MANAGER
FRANK W. SIMMONDS, SECRETARY
STATE BANK DIVISION

THE

WILLIAM POWERS, DIRECTOR
CUSTOMER RELATIONS

Mr. Marriner S. Eccles, Chairman
Board of Governors of the
Federal Reserve System
Washington, D. C.
Dear Marriner:
Here is the draft report which I mentioned
yesterday which has been mailed to about 150 leading
bankers. It is our hope that it will facilitate the
kind of program on which you and I are both agreed
and I think we have succeeded in taking out bias for
or against specific methods.
We should be very glad to have your suggestions before giving it any wider circulation.
I am sending a separate copy to Ronald.
IOUBS

sincerely,

Randolph Burgess
Chairman
Economic Policy Commission
FJB:TB
Enc.




TREASURY WAR BORROWING AND THE BANKS

Draft Report by the Economic
Policy Commission of the American Bankers Association and the
Fiscal Policy Committee of the
Reserve City Bankers Association

*

*

*

March 19*42

Confidential

TREASURY WAR BORROWING AND THE BANES

The "banks of the United States are eager to do their full share in
financing the war. This is their special area* Their responsibility lies
not simply in doing what they are asked by the agencies of government, but
in understanding the problem and themselves initiating plans and cooperative
efforts for carrying out so vast a project. The 15,000 commercial banks, —
savings banks and 1,200 investment bankers of the country have the capacity
and mechanism to meet this responsibility.
The decisions made now as to methods of financing and the energy
with which they are pursued will influence the success of the Nation's war
effort and will react upon the well being of the people for many years to
come.
The two ways of financing war are by taxation and by borrowing.
Broadly speaking, the more the taxation and the less the borrowing, the
less will be the danger of inflation. A country at war must tax to the
maximum extent consistent with the maintenance of morale and incentive.
Borrowing must be kept at a minimum.
With this preliminary comment this memorandum will not discuss
taxation but is limited to presenting facts and principles as to the
Treasury war borrowing program and the place of the banks in that program,
No attempt will be made to suggest a specific financing pattern but rather
the broad principles which underlie detailed methods.
Amount of Borrowing
In the fiscal year 19^1 Treasury public financing totaled 5 l/2
billion dollars. In the fiscal year 19^2 the amount will be close to 19
billion dollars, and present estimates place the amount in the fiscal



2.
year 19k$ at about 33 1/2 billion dollars. These estimates are shown in
the following table, based upon the President's budget message of January
It:
th
TABLE I
RECEIPTS - EXPENDITURES - PUBLIC FINANCING
(In Millions of Dollars)
Fiscal
19M
Actual

Fiscal
19^2
Budget

Fiscal
19^3
Budget

Total expenditures
(excluding debt retirement)

$12,711

$30,576

$58,928

Total net receipts
(excluding social security)

7,607

11,9^

5,103
1.3*9
X252
1,385

18,632

Budget deficit
Add* govt. corp. - net outlays
Total cash requirements
Less trust funds receipts - net
Net cash requirements
Change in cash balance
Total public financing

X m

2?220
20,852

2,018

187333

/708
5,575

18,818

23,^87*
35,M*1
2,9^1
387382
H.76U**
33^18
- 3
33,615

* Includes proposed $7 billions increase in taxes •
** Includes proposed $2 billions increase in social security taxes.
These figures are staggering compared with anything ever done before in this
country or in any other country. The largest amount of public financing by
the United States in any one year of World War I was the 1919 figure of
13 l/k billion dollars.
The estimates of expenditure for the fiscal year 19^3 call for the
devotion of about half of our national productive effort to war, as compared
with a maximum of about one quarter in the last year of World War I.
However, other nations have been carrying a burden as great or
greater than this in relation to their productive capacity, national income,
and financial resources. Germany and England are devoting over 60 per cent
of their capacities to war, and Canada approximately 50 per cent. Our



3
resources of Industry, labor and wealth are vastly larger and were not fully
employed when the war began* thus greatly easing the shift to a war basis.
War has found us also with a sound banking position and enormous gold reserves.
While the expenditures and borrowing contemplated are huge, they are within
our capacity.
We can finance this vast undertaking, but the choice of methods, -the way it is done — will affect directly the efficiency of our war effort,
the extent to which that effort disorganizes our economic and social structure,
and our capacity to recover prosperity after the war.
Before discussing the borrowing program it should be noted that
its size, as estimated above, is dependent on a number of variables. The
first is the actual expenditure, and the second, the amount of taxes collected.
The table above assumes expenditures and the collection of taxes in accordance with the President's budget message of January k, 19^2. For the avoidance of inflation it is most desirable that at least these amounts of taxes
be raised and that the amount of borrowing be kept to a minimum, but fot
the purpose of this memorandum we start with the amount of borrowing estimated
by the President.
Sources of Funds
The problem of inflation has been summarized as follows by tfe
lc
Secretary of the Treasury: "Our economy today resembles an overloaded steam
boiler. The fire under the boiler is being fed by billions of additional
purchasing power in the hands of the public. The fire is growing hotter and
is generating more steam than the boiler can safely hold. If we are to
prevent the boiler from bursting, we must damp down the fires by diverting
spending away from those articles or commodities in which there is a shortage,
actual or pobenti al.H




k.

In the application of this principle to war borrowing, the first
rule is that the Treasury should borrow as much as it can from the current
income of the people which might otherwise be spent < The great danger of
inflation arises from spending power in excess of the amount of goods available to be bought, and when the Treasury taps this spending power' through
tax collections or through the sale of government securities it reduces the
inflationary forces. The sale of defense bonds through payroll deductions
does exactly this. The greatest increase in purchasing power in this war
effort is arising from swelling industrial payrolls. The more of these funds
which can be drawn off in taxes and bond purchases, the less will be the
danger of inflation.
A second source of funds is idle money in the hands of individuals
tod corporations • The use of this money is not as anti-inflationary as the
tapping of current income, but it is less positively inflationary than the
purchase of bonds by banks. The use of idle money by the Government gives
this money greater activity; the purchase of securities by banks tends to
create new money. Both of these steps are somewhat inflationary, but the
second is more so than the first.
The worst way to finance a war is by the Treasury's borrowing at
the central bank, -- the Federal Reserve System. This adds both to bank
deposits and to bank reserves and has potentialities for inflationary credit
expansion several times the amount of money actually borrowed. Borrowing
at central banks was the mechanism of inflation in Germany and France after
World War I.
The underlying principle may be summarized by saying that the
desirable sources for Treasury borrowing are in order:




First, and best, From the current income of the people which
would otherwise be spent;

5
Second, From idle money in the hands of non-bank holders;
Third, From the commercial banks;
Fourth, and worst, From the Federal Reserve System*
It is in the interest of the banks, the enterprises, the worker,
the farmer and everybody else that every possible dollar be borrowed from the
first source.
The following table shows the sources of funds for Treasury borrowing in the fiscal year 19^1, estimates for fiscal year 19*+2, and projected
for 19^3 if the present trends should be continued.
TABLE II
ESTIMATED CHANGES IN HOLDINGS OF
PUBLICLY HELD DIRECT & GTD. DEBT
IF PRESENT TRENDS SHOULD BE
CONTINUED. _ _
(In Millions of Dollars)
Fiscal
19bl

Defense savings bonds
Tax anticipation notes
Insurance companies
Mutual savings banks
Federal Reserve banks
Govt, corps. (FDIC, etc.)
Indiv., corps., trustees,etc.
Subtotal
Commercial banks
Total

Actual
/ 1,1*09
/ 600
/ 312
- 266
/
b6
80
/ 2,021
/ 3,55**
/ 5,5?5

Fiscal
19^2
Estimated
6,500
2,500
1,700
bOO
570

100
1,700
W+70

Fiscal
19U3
Projected

/ 12,000
/ 1,000

I 1,500
/
200
/
100
I ?rOOQ

/ 17,800
/ 15,800
/ 35,600

These various sources of funds will be discussed in more detail later
on, but they show in general that defense savings bonds constitute the major
channel now open for drawing off the current income of individuals into the
Treasury, though purchases by life insurance companies and mutual savings banks
do so indirectly, but just as effectively. A substantial part of the defense
bond sales, however, represent putting idle money to work rather than savings
from income*



6.
A rough inspection of these sources of funds indicates rather
•learly that far too small a part of the total, perhaps one third, represents a diversion of current income which could otherwise " e spentf Perb
haps two thirds represent either the use of idle money or the extension of
bank credit. In fact, unless new methods and efforts are introduced into
the borrowing program, half the new money in fiscal year 19^5 is likely to
come from bank credit expansion. While the banks are prepared to lend
the Treasury the amounts it needs, not raised elsewhere, it is in the
national interest that these amounts should be as small as possible#
An additional point may be made here that may seem theoretical but
is of real importance. Any form of additional saving, refraining from spending, is as effective in avoiding inflation as specific graving through defense
bond purchases* Such saving tends to offset war spending in its effect on
prices* Our program should be broad enough to recognize and encourage varied
forms of saving*
Reaching Current Income - Defense Bonds
The first step in reaching current income is to promote vigorously
the sale of defense bonds and stamps. There is, of course, ground for debate
whether their terras are the best possible for drawing into the Treasury current income which would otherwise be spent. The important facts, however,
are, first, that these bonds have demonstrated real effectiveness and, second,
that they have back of them an educational campaign of several years1 duration so that we fortunately come into the war period with a program already
well under way* Wo substitute plan could be inaugurated and put into active
operation without many months1 loss of time. So regardless of theories, the
wise course is to use with our utmost vigor this instrument which we have*
The results achieved in December, January and February make it clear that




7.
the potentialities for the sale of these "bonds are only beginning to be
tapped, and vigorous sales efforts will bring results. The banks have had
a large share in the success of this program thus far and have the contacts
and machinery to carry it much further •
It should again be noted that only part of the purchases of defense
bonds have been made out of current income. It may be assumed that purchases
of F and G bonds represent largely the employment of idle balances rather than
of new income, but on the other hand, that a substantial part of the purchases
of E bonds are out of current income. Sales divided between the three types
are shown in the following table *
SALES OF DEFENSE SAYINGS BONDS, BY MOUTHS
(000 omitted)
May* 19kl
June
July
August
September
October
November
December
January, 19^2
February
Total

Series E
$100,581
102,517
1*,7*
152*
117,603
105,21+1
122,916
109,1+75
3*+l,085
667,1+11
298,000
2,210,103

Series F & G
$21+9,237
212,010
196,857
11+8,003
127,086
11+7,798
12l+,013
187,51!+
393,136
305 >200

Total
$3^9,8l8
3 * , 527
1+
31+2,131
265,606
232,327
270,71*+
233,^88
528,599
1,060,5^7
703,200

2,090,85^

!+,300,957

It is encouraging that the volume of sales of E bonds is steadily
rising as payroll deduction plans are getting under way more vigorously, and
as individuals respond to actual war. It is still true, however, that the
amounts of current income absorbed by these bonds are small compared with the
additional income created by defense activities, largely in the fom of
industrial payrolls, and available for consumer spending. The active promotion
of purchases of these bonds out of current income is a first duty of bankers
and others interested in avoiding inflation.




8.
For the foregoing reason sales efforts up to now have been largely
concentrated on the E bonds and properly so. While purchases of Series F
and G have been substantial for trust funds and large accounts, there has
been no vigorous selling campaign for these series. Such a program could
now be undertaken without confusion or interference with E bond sales, and
the banks are in much the best position to do it. It should bring forth
substantial subscriptions, not so much out of current income, but out of
idle balances, and reduce by that much the amount of borrowing from banks.
One feature of the defense bonds which has caused some concern to
many people is the fact that holders of these bonds may present them to the
Treasury for redemption. This constitutes in effect a floating debt or
demand liability for the Treasury which might conceivably prove embarrassing.
Our experience with this type of obligation is limited. The bonds have been
carefully designed, however, to discourage redemption, and a large portion
is evidently being bought with the intention of holding to maturity. The
total amount of this liability does not yet seem to justify serious concern,
or offer a serious obstacle to pressing the program vigorously. It is one
of the questions which should be reviewed from time to time as the amount
outstanding increases, and as experience accumulates.
Other Ways of Reaching Savings Funds of Individuals
The most obvious sources of savings funds of individuals aside from
those reached by defense savings bonds are the insurance companies and savings banks. Insurance companies provide an indirect means for gathering up
savings from current Income and making them available for the Government.
Under present conditions few other means of employing their funds are available to insurance companies. Private building, aside from defense plant
and defense housing, has practically ceased, and there is relatively little




9.
financing in the market except for reftindings* Insurance companies look forward to some borrowing by policy holders to pay taxes, but are likely to have
in the coming year something between 1 billion and 1 l/2 billion dollars
available for the purchase of government securities« Insurance companies are
among the few willing buyers of bonds of long maturity. They are more interested in the rate and will take the longest bonds offered*
As noted earlier, the savings banks have been sizable buyers of
government securities, but it seems unlikely that they can be counted upon
for much this year* The savings banks as a whole have not been gaining
deposits, partly because their customers have been buying defense bonds.
There is no advantage in depositors vitfadrawing money from savings banks
to buy defense bonds if the savings banks themselves find it necessary as a
result to sell some of their own holdings, A recent tendency in this direction further emphasizes the desirability of directing the campaign for the
sale of defense bonds primarily to the absorption of current income*
The objective is to gather up the savings of the people out of
current income through every available channel* In the long run it would
impair the program if the defense bond drive were so narrow as to damage
such savings agencies as savings banks, building and loan associations and
insurance companies. To avoid this the publicity program should be a
coordinated effort reorganizing the place of these collecting agencies
as the medium through which large amounts of savings will reach the
Government*
Tax anticipation notes for individuals have not produced any substantial amount of money. There must be large amounts of funds held by individuals
for the payment of taxes which might be reached by some modification of the
program. It might, for example, be wise to raise the limit on the A Series




of notes from $1,200 to $10,000 or to remove the limit altogether or perhaps
accept other issues of Governments in payment of taxes. Since taxpayers
will return to the Government a substantial part of interest received, the
net interest paid even at 2 per cent would not be large after deduction of
taxes. The present plan furnishes little incentive for the individual taxpayer, and there are large amounts of funds available which should be reached.
In recent years there has been a remarkable increase in bank deposits
which will continue. To the extent that these deposits can be made available
for the purchase of government securities the amounts which banks themselves
must buy directly are reduced. While withdrawals from these deposits may
compel adjustments of position for the bank concerned, the funds later
reenter the banking system so there is no net loss of deposits.
The banker who has been constantly engaged in trying to build up
his deposits naturally hesitates to suggest to a depositor the use of that
deposit to buy government bonds, especially if large amounts are involved.
It is cold comfort to know that the deposit will return to some bank when
the Government spends the money.
To leap this hurdle the banker will need a somewhat new point of
view —* which indeed the new situation justifies. The banker's problem in
the coming months will be not to keep his deposits up -- but to restrain
overextension. It may be noted also that if the banks generally follow a
practice of selling government bonds to their depositors their relative
deposit position will be little changed. Such a policy is to the long
time interest of the banks and the whole country.
From the point of view of the Treasury it would be highly desirable
to spread out the Treasury debt over a longer number of yeara by finding
investors who are willing to take longer maturities« The principal diffi-




culty is perhaps that few investors outside the insurance companies have "been
so eager for rate of return as to venture the greater risk of depreciation
involved in longer-tern obligations, at very low yields after taxes. Various
modified sorts of bonds to reach this investment market and various sorts of
special sales campaigns such as have been successful in other countries have
been suggested. This is a subject which requires special examination.
A further substantial source of funds of individuals that remains
untapped is hoarded currency. The present amount of money in circulation
is l j billion dollars, as compared with around k ? billion dollars at the
l?
j
peak of the 1929 prosperity. A part of this is accounted for by higher wage
rates and larger incomes of lower income groups not accustomed to having bank
accounts. A substantial amount represents hoarding. It should be possible
to devise some appeal which would bring forth some of these funds for the use
of the Government. This again is a special problem requiring individual
analysis.
In this whole program of reaching current savings and idle investment funds it should again be emphasized that the banks and investment
bankers of the country constitute the agencies best qualified to aid the
Treasury in the distribution of its obligations.
Reaching Corporation Funds
In the past year the Treasury tried successfully an experiment in
reaching the current income of corporations, in the form of tax anticipation
notes. These performed the valuable service of bringing over 2| billion
dollars into the Treasury perhaps a year earlier than its normal payment in
taxes. This is of course an anticipation of future receipts rather than a
new source of funds, and any further increase depends on future increases
in corporate income and its taxation.




In addition to tax reserves corporations hold substantial amounts
of cash, part of which might be reached in some way. While doing so is not
as useful as tapping current income otherwise expendable, funds from this
source at least reduce the amount to be borrowed from banks.
There are differences of opinion as to the amount of corporation
cash which might be tapped. Industries doing defense work will need most
of their cash and some will have to borrow. On the other hand, in nondefense industries inventories will be liquidated and depreciation reserves
cannot be fully employed in plant improvements because of priorities. Without dogmatism as to amounts available, they are at least substantial and
should be reached. In Canada corporations are heavy buyers of War Loan Bonds
partly as temporary underwriters and partly to hold.
Most corporations consider it necessary that securities which they
purchase should be liquid and not subject to substantial fluctuation in
price, since colorations generally are not in the investment business.
This means that they are ordinarily interested in obligations with maturities
up to two years, though some corporations might go longer than that if they
can always realize on the securities promptly.
The Treasury has not recently been offering any securities, aside
from tax anticipation notes, of this sort that are attractive to corporations.
Treasury bills have been sold at such a low yield basis that after taxes they
are only worth while for someone who has a special requirement for them. But
whenever the Treasury bill rate has gone above l/k per cent, corporations
have begun to buy. An immediate logical step in reaching corporations would
be to supply the market with enough bills and other short maturities so that
this market will no longer be starved and corporations can fill their needs.
The banks also need a broader market of short-term securities to facilitate
adjustments of position between banks.



k/

Distribution of. Maturities
Another principle to be considered in determining a borrowing program should perhaps be stated at this point, and that relates to the distribution of maturities of the public debt. By June, 191*3, the national
debt is likely to be well over $100,000,000,000. It is desirable that the
maturities of this debt should be spread out over a sufficient number of
years so that the Treasury would not have to refund too large an amount in
any one year, particularly during the period when large amounts of new money
have to be raised. The following table shows the distribution of the
present Treasury debt in terms of maturities, (Page 1^).
It must be recognized that there is here a conflict in interest.
All lenders would like to avoid the risk of fluctuations in the market values
of holdings, a protection they ordinarily obtain by holding short maturities.
On the other hand, both from the point of view of the Treasury and the
effect on the money market, security markets, and the whole economy, it
is undesirable for the Treasury to face too large maturities in nearby years.
It is the old problem of a floating debt which proved so disastrous to
France after World War I. This conflict of interest between what most
borrowers want and the Treasury1s position is always one of the puzzling
problems for Treasury financing.
Fortunately, the Treasury for some years has been following a policy
of selling long term bonds whenever possible with the recognition that it was
desirable to leave the nearby years reasonably available for financing in an
emergency. This policy leaves the Treasury much more free at this time to
meet the needs of investors than would otherwise be true, though it is still
desirable to spread out new financing as much as possible without sacrificing
other objectives, and especially the objective of putting the debt into the
hands of investors rather than banks.



Ik.

MATURITY SCHEDULE
United States Direct and Guaranteed, Marketable and
Non-marketable Securities Outstanding as of December 31» 19^1
(Esalusive of "Special Issues11 sold
to various Federal Trust Funds)
(In Millions of Dollars)

Year

Classified by year
in which issues are
first callable *

1942
1943
1944
1945
19H6

$5,123
6,336
6,798
4,575
3,175

)
)
)
)
)

1947
1948
1949
1950
1951

1,879
3,849
3,084
2,185
7,017

)
)
)
)
)

1952
1953
1954
1955
1956

1,043
816
707
2,632
2,431

)
)
)
)
)

1957
1958
1959
1960
1961

919 )
)
1,485 )
50 )

Classified " y year
b
in vhich issues
mature

5-Year
Average

$5,201

$3>908
4,481
3,410
4,008
2,350

)
)
)
)
)

$3,631

3,603

3,884
1,975
2,460
2,686
4,206

)
)
)
)
)

3,042

1,526

3,233
2,995
3,713
2,034
1,170

)
)
)
)
)

2,629

1,449
982
2,611
50

)
)
)
)

)

)

491

1,018

)

1962
1963
1964
1965
1966

919 )
95 )
1,485 )

500

2,666

1967
1968
1969
1970
1971

2,666

1972
Total

5-Year
Average

$56,770

$56,770

* Fixed maturity issues are classified by year in which due * Those nonmarketable Issues that are redeemable at any time at option of owner
are classified by years in which due.

Source:


Daily Treasury Statement - Dec* 31* 19^1•

15*
General Place, of Commercial Banks
In this whole program the "banks have a large funotion as distributors of securities to investors. Banks are willingly doing millions of
dollars1 worth of work in connection with the Defense Bond campaign for which
they receive no reimbursement. This is in conformity with the practice
established for many years in this country by which the banks have performed
for the Treasury a substantial number of free services in connection with
the Treasury financing operations,
The banks have also acted in a sense (though not technically) as
underwriters of government security issues. Their subscriptions have
insured the success of every issue and they have later distributed over a
period a considerable number of the securities so purchased to investors
and institutions. There has usually been some profit on this undertaking
which may be balanced against the services performed.
Banks1 Own Purchases
In the fiscal year ended June 50, 19^1, holdings of government
securities by cornraarclal banks were increased by 3 l/2 billion dollars.
In the current fiscal year this increase is likely to be over 5 billion
dollars, and in the fiscal year 19^5 it may be three times that amount if
amounts of purchases by other buyers continue at about the present rate,
a development which every effort should be made to avoid.
The following table is designed to show the effect of any such
large additional purchases on the general condition of the banks. The data
used are for member banks only, for which current reports are available, and
the table assumes for illustrative purposes that recent trends continue as
in Table II; that bank loans will remain practically stable in 19^3 and bank
deposits will increase along with holdings of government securities, except
to the extent that deposits are withdrawn in currency. The estimated figures
are as follows; (Page 16).




16.
ESTIMATED POSITION OF
ALL MEMBER BANKS IN THE UNITED STATES,
ASSUMING CONTINUANCE OF PRESENT TRENDS*
(In Billions of Dollars)
June 30

Dec* 31
19^1

June 30

June 30
113
9+

$13.0

$12.1+

$12.1

$10.0

Required Reserves

7.8

91
.+

10.1

Excess Reserves

5.2

3.0

2.0

2.0

Loans

16.7

18.0

18.8

18.8

Governments

18.1

19.5

22.6

36.0

5.8

6.0

6.0

6.0

^0.6

*35
+.

58.5

59,6

63.0

7^.3

5.8

5.9

6.0

6k2

9.9$

9.9$

9.5$

B.3#

ll+.3#

13.6$

12,6$

10.2$

19kl

ASSETS:
Actual Reserves

Other Investments
Total Loans & Investments

8.0 **

60.8

LIABILITIES:
Deposits
Capital Funds

CAPITAL FUNDS RATIOS;
To Deposits
To Loans & Investments
*

Assumes also an estimated increase of $800,000,000 in Federal Reserve holdings of government securities "between December 31, 19**1 and June 30, 19^2,

** Reserve requirements of $12.k billions under existing rates reduced by 35
per cent to maintain an excess reserve of about $2 billion. This will be
commented on later.




It has been assumed in this table as a working hypothesis that the
Federal Reserve System would replenish bank reserves by open market operations
or by reducing reserve requirements when the excess is reduced to about 2
billion dollars, a status which is likely to be reached before the middle of
19k2.

This assumption will be discussed later.
An Inflationary Trend. A first observation from these facts is

that they indicate a highly inflationary tendency. They show an increase
of about 25 per cent in bank deposits and an even larger percentage increase
in total loans and investments from December 31, 19^1 to June 30, 19^3, a
period of 18 months, and the war may well last years beyond that time.
With such a huge addition to purchasing power at a time of great activity, the
maintenance of stable prices would be most difficult. It would certainly
call for very detailed and unwelcome economic controls. Even if inflationary
effects were resisted in the war period, post-war stability would be
endangered.
The conclusion is that ways must be found to finance the war more
largely from taxes and bond sales to the people.
Capital Position and Government Holdings. It will be seen that
under conditions assumed in the foregoing table the ration of bank capital
to deposits and to loans and investments would be considerably reduced.
There does not seem to be any reasonable way by which capital could be
increased as rapidly as government security holdings, since the banks must
be expected to pay their share of the added tax bill. The table, therefore,
assumes that bank capital will only increase at slightly moie than the rate
of the last two or three years, namely, about 200 million dollars a year.
This will be discussed later.
A good many bankers have been concerned about the recent continuing reduction in their capital ratios, and supervisory authorities have also



18;
"been giving the question attention* As the banks are called on to d&rry
through their considerable responsibility in the huge war program they must
be so strong that no doubt about their position will arise in the public mind.
Since the increase in the assets of the banks is likely to be wholly
in cash and in government securities, their ultimate soundness is not seriously
impaired by even the changes contemplated above • The principal immediate
question aside from inflationary dangers is with respect to fluctuations in
market value of the securities which might cause concern on the part of
depositors or others or, if these securities had to be liquidated, might
raise question of a potential loss*
It is difficult now to anticipate circumstances under which such
liquidation would be necessary. The Federal Reserve System is ready to
discount notes secured by governments at their par value and it may safely
be assumed that this practice will oontinue during the war period. Moreover,
the Treasury and the Reserve System have ample power to keep the banks
supplied with cash so that there need be no occasion in the banking system
as a whole for liquidation of securities*
However, it is clear that if a major part of the estimated increase
in government securities were in long bonds and the market were to fluctuate
five to ten points the capital of the banks would at least on paper be impaired. Such a situation might be expected to cause concern among some
depositors and bank officers and directors* Again it may be said that the
Treasury and the Reserve System would be active in attempting to avoid such
a decline in the market. But conditions change rapidly; unforeseen post-war
conditions will succeed the war; and it seems doubtful whether the Treasury
and the central bank can underwrite fully against such fluctuations.




19 4
One proposal to safeguard this situation is that the securities
offered the bank& should " e wholly of very short maturities of perhaps one
b
to five years and hence subject to only modest fluctuations even with a considerable change in the market. The difficulty with this proposal is that
under it the Treasury would have a huge floating debt which has to be renewed
embarrassingly often, at the same time that large additional issues for new
money are being floated<
A more realistic suggestion would be the sale to the banks of maturities
ranging from one year to about ten years. This would have the effect of
spreading out Treasury maturities and would give the banks well distributed
portfolios with a fair yield and some market outside the banksf With obligations up to ten years and an average maturity of five years or less the
banks would not be exposed to serious fluctuations in values.
Interest Bates and the Market, The foregoing shows the need for
financing the war on a fairly steady level of interest rates. Any serious
fluctuations in rates would cause concern and interfere with the maintenance
Of a broad and active market, which is desirable as a means for effecting
adjustments between individual banks and other institutions and taking care
of the flow of funds through the market incident to the enormous transactions
of the war period* The Treasury moreover would be greatly handicapped in
its financing program if succeeding issues of bonds appeared at sharply
rising interest rates. Investors would be tempted to wait for better rates.
Such a tendency is natural in view of the fact that the present interest rates
are the lowest in the history of this or any other country.
The experience of England and Canada, however, has shown that it
has been possible to finance their war effort at fairly steady rates * For
this purpose the fundamental necessity is the general ofcAerstanding on the




part of the market, the "banks, and the Government that rates will be maintained at a fairly steady level within a moderate range of fluctuations.
To attest to peg a rate firmly would defeat the purpose for it would take
away freedom of trading in the market, which is essential both to confidence
and to the usefulness of the market for adjustments between investors and
institutions•
This general statement of principle does not mean that there should
be no moderate change in rate level. If, for example, it is found that real
investors can be induced into the market at slightly higher rates for short
money or for very long money, there seems no inherent reason why those rates
should not be allowed to adjust themselves to the more desirable level without fear of a general market collapse.
For the maintenance of a brofsd and dependable market for government
securities, the prime necessity is cooperative understanding between the
Treasury and the Reserve System on the one hand and the banks on the other.
Reserve Position* Closely related to the question of the maintenance
of steady interest rates is the reserve position of the banks, For a
number of years the banks have held huge amounts of excess reserves and this
excess has been largely responsible for a continuous decline in interest
rates. It has made Treasury financing very easy, for as rates fell, bank
earnings fell also, and the banks were under pressure to use excess funds
to buy more government securities.
Now this situation needs to be reexamined for it is necessary that
securities be distributed widely among investors and the banks take only
what cannot be sold to others, The banks ought to have less inducement to invest; others should have more* This object would probably be
achieved more easily if excess reserves declined somewhat. But they should




not " e allowed to decrease enough to place pressure on the market at a time
b
when it is facing large additional amounts of financing.
The current increase in deposits together with currency withdrawals
will normally lead to some decrease in excess reserves. In the table on page
16 it has been assumed asftworking hypothesis that the Treasury and the
Reserve System might consider 2 billion dollars as a point where they might
maintain excess reserves by open market operations or decreases in reserve
requirements. That level should be adequate to maintain interest rates at
about their present level especially if we assume, first, some redistribution
of reserves as between banks, resulting from a larger supply of short term
securities in the market, and second, mutual cooperation with respect to the
market between the Treasury and the Reserve System, and the banks.
However, it is clearly Impossible to be dogmatic as to the most
desirable amount of excess reserves. That must be worked out from experience,
having in mind, however, the desirability of selling the maximum amount of
government securities to investors rather than banks.
Bank Capital and Earnings. The recent history of the banks with
respect to their capital and earnings is shown in the following diagram
(page 22) for member banks.
These data may be summarized by saying that in the period from 1929
through 1933 the banks absorbed very large losses so that their capital funds
were reduced by about 1,750 million dollars, or 26 per cent. Since that
time they have restored out of earnings and recoveries about half of this
loss, but their capital funds, even including about 300 million dollars of
R. F 4 C. contributed funds, are still 12 per cent less than in 1929 and
their loans and investments 17 per cent larger. Their earnings in this
recent period have not been sufficient to build their capital as rapidly as



22

DEPOSITS, LOAMS & INVESTMENTS
CAPITAL FUNDS AND EARNINGS
OF ALL .MEMBER BANKS
(Billions of dollars)

8

90,

7
Capital Funds
6

Total
Deposits

5
1
+

20

10

C » J 1 1 1 jl 1 J 1
L—-—
,L,K
29 30 3 1 32 33 3b 35 36 37 33 39
hi




Net Earnings

Loans ~ T
8
Investments
m.

ra ^ E3 n gi P3
tttt. t B
t
Deficit
29' 30' 31' 32' 33' 34' 35' 36' 37 38 39' W \ l
II L M

* " «•

« 1 I II

*Net earnings are before taxes

23
their assets and liabilities have increased. Neither their earnings nor
their earning prospects have been good enough to enable them to sell additional capital stock to the market. The typical bank has been paying
dividends equal to only about 3 per cent of its capital funds. So this
emergency finds the banks with clean assets but with reduced capital. As
indicated above, this capital is probably sufficient for the need, but in
order to maintain unquestioned public confidence in the face of great increases
in assets and liabilities some further steady increase in capital seems
desirable. With the increase in security holdings, increased earnings are
normally to be expected, and it is suggested that enough of these earnings
remain in the banks after taxation to allow a moderate but steady increase in
capital funds. Similarly it would seem a wise policy for the banks themselves to strengthen their positions by a thoroughly conservative policy
as to building up reserves and as to the payment of dividends. This is
not a long-term solution but adequate for the present emergency.
Summary
1* The present budget program calls for public financing of $18,800,000,000
in fiscal 19^2 and $33,600,000,000 in fiscal 19^3•
2. The way this huge sum is raised will influence our whole economic and
social structure.
3. To avoid inflation the greatest part of this sum should be borrowed from
the current income of people who would otherwise spend it, - and next
best from funds now idle.
k. Banks and bankers are offered the opportunity of assisting the Treasury
in the sale of Defense Savings Bonds and other government securities
to investors, of acting in effect as underwriters of government
issues, and providing themselves what additional funds may be required, all with the support of the Federal Reserve System as the
lender



of last resort.

2+
1
5#

To avoid disturbed markets and uncertainties a fairly steady level of
interest rates is desirable, and it can be maintained with the cooperative effort of the banks, the Treasury, and the Reserve System,

6. The sale of government securities to investors rather than banks might
be encouraged if excess bank reserves were allowed to decrease as
deposits expand, to perhaps 2 billion dollars and maintained there
instead of at the present

billion* The smaller amount should be

adequate to maintain reasonable stability of money rates at low
levels,
7, During this period banks cannot expect to maintain as high capital
ratios as in the past nor is this necessary as their expansion of
assets will be in cash and government securities. Banks should
be allowed to earn enough, however, to increase their capital at a
moderate rate so that the increase in their deposits will be
protected by an adequate capital cushion.

March 19, 19^2