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Form WR. 1 1










Office Correspondence

Chairman Eccles


D t Sp me 2 , 9 7
ae et br 31 3

Mr. Oolaenweisei

The attached a r t i c l e on "The Nature of Federal Reserve Banks"
was written f o r the purpose of giving a more complete l i s t of d i f ferences between Federal Reserve banks and other banks than i s now

I have not given any thought to the question as to the

d e s i r a b i l i t y of i t s publication nor to the form such publication
might take.

September 20, 1937
E. A. Goldenweiser

Federal Reserve banks were established and are operated for the advancement of the public interest.

They are not ordinary business undertakings l i k e

other banks, which are operated with a view to making the maximum amount of
returns on the c a p i t a l investment, consistent with the safety of the funds
entrusted to them by t h e i r depositors.
Purpose of Federal Reserve banks
The public purposes for which Federal Reserve banks aro operated have
been variously defined at different times.

In tho preamble to the Federal

Roservo Act i t i s stated that thoy wore established for tho purpose of providing an e l a s t i c currency, t o offer opportunities to discount paper, and for
bettor supervision of banking.

In other sections of the law the guiding

principle for Federal Reserve policy is statod as "the accommodation of commerce and business with due regard to general crodit conditions. 11

On the basis

of oxporience the Foderal Reservo Systom has gradually developed a broador
conception of i t s purposes.i/

B r i e f l y stated, those objectives aro to use tho

powers of the Systom i n such a way as to contribute to the continuous employment
of the nation 1 s productive rosourcos and to diminish undesirable fluctuations
i n the volume of business a c t i v i t y .


Soo: Objectives of Monetary Policy, issued by tho Board of Governors.
Foderal Reserve B u l l o t i n , September 1937.

I t i s clear, therefore, that the purposes of the Reserve banks are
r a d i c a l l y different from those of other banks.

In the following pages are

outlined the structural and functional differences between the Reserve banks
and other banks, with a view to indicating i n what ways these differences jare
adapted to the furtherance of the public purposes which the Federal Reserve
banks must serve.
Ntgnber and location of Federal Reserve hanks
Perhaps the f i r s t difference i s the fundamental one that a Reserve bank
cannot be organized or dissolved, except by the action of Congress®


determined that there s h a l l be no less than eight and not more than twelve
Federal Reserve banks, and once twelve banks were established upon the decision
of the Federal Reserve Board t h e i r number cannot be changod, except by Congress.
The c i t i e s i n which tho Federal Reserve banks are located wore also determined
by a public body, an o f f i c i a l cammittoc appointed for that purpose.


of the Reserve banks can bo established and discontinued, but t h i s can be done not by privato individuals or by directors of the Reserve banks — but only by
the Board of Governors of the Federal Reserve System, a public body appointed
by the President with the advice and consent of tho United States Senate.
Reserve banks, therefore, are the creation of Congress, and not of privato
enterprise, and t h e i r numbor and location are determined by a public body.


- 3 -

Ovmorshig of Foderal Re serve banks
Ownership of tho Foderal Rosorvo banks i s l e g a l l y vostod i n i t s member

But the manner of t h e i r ownership i s also very different from the usual

arrangement followed i n the case of a private enterprise.
ownership i s not optional.

Participation i n the

No bank or other i n s t i t u t i o n can purchase Federal

Reserve bank stock simply because i t believes that the stock i s a good investment, or that a voice i n the management of the Reserve banks would be desirable
to obtain.

Who s h a l l be the owners of the stock of the Federal Reserve banks

i s stated i n the law:

a l l national banks, that i s banks operating under

charters granted by the Federal Government, must be members of the Federal
Reserve System and purchase stock i n the Federal Reserve banks•

They can avoid

i t only by abandoning t h e i r national charters and obtaining State charters•
National banks are the principal owners of the Federal Reserve banks,-- they
constitute 5,293 out of a t o t a l membership of 6,357.
Banks chartered by States have an option about joining or not joining
the Federal Reserve System.

Out of a t o t a l of approximately 10,000 State banks

only 1,064 are members of the System.

They can j o i n , however, only i f they

have the required amount of capital and i f tho nature of t h e i r business and
the character of t h e i r management i s such as to convince the Board of Governors
that they are e l i g i b l e .

Their purchase of Foderal Reserve bank stock, thero-

foro, i s not at a l l l i k e any other kind of investment.

Not only must they bo

granted permission by a public body to make tho investment, but they can acquire
tho stock only i n a determined amount and as a part of tho process of becoming
mombor banks subject to examinations, rules and regulations, reserve requirements, and general supervision by the Board of Governors.

- 4 -

Amount of Fedora 1 Rosorve bank stock
Every member of the Federal Reserve Systom, national and State * must
subscribe to the stock of tho Foderal Reservo bank of i t s d i s t r i c t an amount
equal to 6 porcent of i t s capital and surplus •

I t has no option i n the

I t cannot buy more i f i t thinks the investment i s good or for the

purpose of increasing i t s influence; i t cannot buy less i f i t finds a more
profitable use for i t s funds.

The momber bank's investment i n the stock of

the Foderal Reserve bank changes only when changes occur i n i t s own capital
and surplus.

I t has to subscribe 6 percent of these capital funds:

3 percont

have been paid i n and the remainder i s subject to c a l l by the Board of Governors®
In theso circumstances stock i n the Federal Reservo banks i s not so much an
investmont from the point of view of a momber bank as a compulsory participat i o n i n a public onterpriso.
Returns on Federal Reserrc bank stock
I t i s true that t h i s participation has yielded a good return to the member
banks — i t has yielded them 6 percent on their investment, no more, no less.
The rate of return on the c a p i t a l has not been l e f t to the determination of
the directors of the Reserve banks.

I t has been determined by Congress, and

can at any time be changed by that body.

In t h i s , as i n other respects, the

arrangement under which the Federal Reserve banks function i s entirely d i f f e r ent from the arrangements customary for private undertakings.

Distribution of Federal Reserve bank earnings





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.. ft .. . - T . -

I- • • •


The question arises what becomes of the earnings of the Federal Reserve
banks over and above the 6 percent dividend paid to the member banks•
also i s prescribed by law.
expenses have been met.


The dividends are paid out of earnings after

The amount earned by the Reserve banks and the volume

of t h e i r expenses are determined by considerations different from those that
would prevail i n a private undertaking, and the disposition of such funds as
the Reserve banks may have a f t e r meeting expenses and dividends i s
prescribed by law.


U n t i l 1933 i t was divided i n fixed proportions between

the Reserve banks1 surplus and the franchise tax paid t o tho United States

At that time Congress appropriated $140,000,000 of the surplus

to be contributed to the capital of the Federal Deposit Insurance Corporation,
and at the same time abolished the franchise tax, presumably i n order to
enable the Reserve banks to rebuild t h e i r surplus.

This surplus, so long as

i t belongs to the Reserve banks, enables them to absorb losses and to meet
expenses when earnings are low.

In case of l i q u i d a t i o n the surplus belongs

to the United States Government.
The volume of earnings of the Reserve banks i s not the result of deliberate
policy; i t i s i n the main an incidental result of decisions with regard to
discount rates and open-market operations.

These decisions are made, not by

the owners of the banks, but by public bodies, and f o r purposes having to do
with influencing the volume and cost of the nation's supply of money, rather
than with the returns on Federal Reserve bank stock.

Expenses of the Reserve

banks are also subject t o regulation, supervision, and scrutiny by public


To a large extent they arise out of the performance of services

to the community i n supplying i t with cash and i n cloaring and c o l l e c t i n g
Since t h e i r establishment the Reserve banks have earned about $1,000,000,000.

Of t h i s amount about one-half was disbursed i n meeting expenses.


the other h a l f , one-fourth was paid as franchise tax to the Government,
p r i n c i p a l l y during 1920 and 1921, when the volume of discounts was large and
the discount rates high; another fourth was paid out i n dividends to member
banks; one-fourth was contributed to the capital of the Federal Deposit Insurance Corporation; and one-fourth was added to surplus.

In other words, while

one-eighth of the Reserve banks1 earnings has been paid out to i t s proprietors,
the member banks, seven-eighths has been used d i r e c t l y or i n d i r e c t l y for a
public purpose.
Sources of Federal Reserve franks' lending power
Another difference between the Reserve banks and other banks i s i n the
source of their lending power.

A commercial bank derives the funds for making

loans and investments from three sources:
expenses, and i t s deposits.
from these sources.

i t s c a p i t a l , i t s earnings above

No bank can lend or invest more than i t derives

An exception to this rule existed while national banks

had authority to issue notes, but t h i s power has now been abrogated.


Reserve bank, on the other hand, derives the funds available for i t s loans
and investments from powers conferred upon i t by Congress.

The capital i t

has i s prescribed by Congress and constitutes a small part of the funds at
i t s disposal.

The other source of funds of the Reserve banks i s i t s power to

issue notes and to accept and create deposits.

- 7 -

The note issuing power makes i t possible for the Reserve banks to create

I t i s limited only by the requirement that they must keep a reserve

of 40 percent i n gold c e r t i f i c a t e s against their notes i n c i r c u l a t i o n .


Reserve banks, thorofore, can acquire gold, pay for i t by Federal Reservo
notes, exchange i t at the Treasury for c e r t i f i c a t e s , and then have authority
to issue additional notes on tho basis of reserves thus acquired.
i n figures:

To i l l u s t r a t e

A Reserve bank may issue $1,000,000 of Federal Reserve notes i n

exchange f o r that much gold purchased from a bank that has imported i t from

The gold can then be deposited i n the Treasury i n exchange for gold

c e r t i f i c a t e s or gold c e r t i f i c a t e credit on the Treasury's books®

Forty per-

cent or $400,000 of these c e r t i f i c a t e s would be required as reserves against
the Federal Reserve notes issued i n payment for tho gold, and $600,000 would
be available as reserves against a further issue of nates.

This issue could

amount to $1,500,000, sinco $600,000 i s 40 percent of that amount, and 40 percent
i s the required reserve.
The power t o issue notes, therefore, conferred by Congress on tho Federal
Reserve banks i s a power to create funds when they are noeded by the public.
In our f i n a n c i a l systom, howevor, Federal Reserve notes and othor currency
aro used only to a limited extent, nine-tenths of a l l the payments being made
by check.

Tho Reserve banks can issue notes, but they can keep i n c i r c u l a -

t i o n only enough to moot tho requirements of tho public, which i n normal times
vary with tho volume of payrolls, r e t a i l trade, and r e t a i l prices®


above that amount finds i t s way back into the banks and i s deposited by thom
with tho Reservo banks®

This i s what i s meant whon wc say that wo have an

e l a s t i c currency.

I t s volume i s attuned to the nation 1 s business.

This very

f a c t , however, places an important l i m i t a t i o n on the Federal Reserve banks1
note issuing power, i n practice a more important l i m i t a t i o n than the 40 percent
reserve requirement.
The other source of the Federal Reserve banks1 funds i s i n t h e i r power to
accept and to create deposits.

So f a r as deposits by member banks consist of

gold imported from abroad, the deposits increase the funds at the disposal of
the Reserve banks.

A more important source of deposits, however, i s their

creation through loans or investments made by the Reserve banks.

TWien a member

bank borrows from a Reserve bank,this bank gives the member i n s t i t u t i o n a
deposit credit on i t s books.

Such a deposit i s not made by the member bank

but i s created by the transaction.

I t has not added to the Reserve bank*s

lending power, but, on the contrary, has arisen out of the use of that power
and has used up a corresponding amount of i t .

For the Reserve banks are

required to keep a 35 percent reserve i n cash against t h e i r deposits, and
that i s the only l i m i t a t i o n on the amount of deposits they can create.
Difference from member bank deposits
The creation of deposits by a Reserve bank i s similar to the creation of
deposits by other banks.
to t h e i r customers.

These banks also create deposits by lending funds

There i s a great difference, however, i n that a commercial

bank can only lend funds that i t has, because the borrower is almost certain
to withdraw a large part of the proceeds i n cash or by drawing a chock, and the
bank has no way of t e l l i n g whether the money w i l l be redepositcd with i t or
with another bank.

I t must be prepared to lose tho funds before i t can make

- 9 -

a loan.

A Reserve bank i s under no such obligation, and that for two reasons:

f i r s t , the member banks cannot withdraw their deposits permanently from a
Reserve bank because the law requires them to keep a specified reserve on
deposit with the Reserve banks•

In fact, a member bank usually borrows from

a Reserve bank only for the purpose of bringing i t s reserve deposit to the
level required by law.

In the second place, a member bank frequently keeps

i t s deposits,even above the legal amount,with the Reserve bank when i t has no
other use for the funds•
Withdrawals from a Reserve bank are different from withdrawals from
other banks:— i f they are i n cash,they are met by the issuance of Federal
Reserve notes, a mere substitution of one kind of l i a b i l i t y of the Reserve
bank for another; i f they are made by check i n favor of a bank i n the same
d i s t r i c t , t h e r e i s no withdrawal at a l l , but merely a transfer of funds from
the account of one bank on the Reserve bankfs books to that of another bank.
Only when a member bank withdraws funds to send to another d i s t r i c t does the
Reserve bank lose funds®

"When that occurs,the funds go to another Reserve

bank, but s t i l l remain i n the System.
Summary of sources of funds
To sum up, the Reserve banks obtain funds with which to make loans and
investments through: ( l ) capital contribution made by member banks i n accordance with legal requirements; (2) issuance of Federal Reserve notes limited
by a 40 percent resorvo requirement and by the need of the public for currency;
(3) authority to receive deposits from member banks; and (4) the power to
create deposits, combined with the logal obligation of member banks to hold

- 10 -

t h e i r reserves with the Reserve banks.

In a word, the Reserve banks1 power to

make loans and investments arises e n t i r e l y out of powers and privileges given
these banks by tho Government, and not out of voluntary deposit of funds by
stockholders or depositors, as i s the case with non-Reserve banks.

This i s

an important d i s t i n c t i o n which should be particularly recognized i n connection
with discussions of the part that tho Government, from which the Reserve banks
dorive a l l thoir power to create funds, has i n the management of these banks
and i n the determination of t h o i r p o l i c i e s .
Management of Federal Reserve banks
In accordance with the differences i n t h e i r purposes and the sources of
their funds, the management of the Reserve banks i s also very different from
that of other banks.

The Reserve banks are managed i n the f i r s t instance by

t h e i r directors, as are other banks.

But the manner of electing these directors

and the persons e l i g i b l e to be directors are prescribed by law.

Of the nine

directors, s i x are elected by member banks and three are appointed by the Board
of Governors.

Of the s i x , three are bankers and three must not be bankers.

Also of the s i x , two must represent small banks, two medium size banks, and two
large banks.

The chairman and deputy chairman are appointed by the Board of

Governors i n Washington.

F i n a l l y , a l l of the directors are subject to removal

for cause by that Board.

This organization creates a pattern under which the

Board i n Washington, a governmental body, has a considerable voice i n the
management of a Reserve bank.

- 11

Nor i s this a l l of tho participation of the Government i n the management
of a Reserve bank.

I t s two chief executive o f f i c e r s , the President and F i r s t

Vico President,are appointed by tho directors (for fivo-year terms) subject
to the approval of the Board of Governors.

In addition, a l l salaries and

expenses of the Reserve banks are subject to review by the Board of Governors,
and a l l i t s officers and employees are subject to removal for cause by that

I t i s clear, therefore, that tho Government, which gives the Reserve

banks a l l their powers, retains a close control over t h e i r management.
Determination of credit policies
This describes the differences between Federal Reserve banks and other
banks i n organization and management.
public regulation goes even farther.

In the determination of national policies
Of the instruments of policy possessed

by the Reserve banks, discount rates are subject to review and determination
of tho Board of Governors, which has been construed to mean that the Board
not only must pass on rates proposed by tho banks before they become effective,
but has power also to establish rates on i t s own i n i t i a t i v e .

Reserve require-

ments of member banks are proscribed by law, subject to changes within certain
l i m i t s that can be made by tho Board of Governors.

Foreign relations of the

Reserve banks are made subject to special supervision of th'e Board of Govornors.
This Board has also authority over maximum rates of interest to be paid by
member banks on time deposits and over the amount of loans member banks may make
on a given volume of security.

F i n a l l y , purchases and sales of the Federal

Reserve banks i n the open market are determined by a Fodoral Open Market
Committee which consists of tho seven members of tho Board of Governors and

- 12 -

fivo roprosontativos of tho Reserve banks, oloctod regionally by those banks*
In t h i s way a l l tho policies that havo an influence on monetary conditions
throughout tho country are determined by governmental authorities, and tho
independent a c t i v i t i o s of tho twelve Federal Reservo banks arc largely confined
to curront day-to-day relationships with their member banks®

To sum up, tho difforonco between Fedoral Reservo banks and othor banks i s
that the Reservo banks aro operated i n tho public intorost, and not for private
p r o f i t , that they derivo tho funds for their operations from powers granted to
them by Congress, that the disposition of their earnings i s prescribed and can
at any timo be changed by law, that tho Government has an important participat i o n i n t h e i r management, and that those of t h e i r operations that exercise
an influence on national monetary conditions are determined by governmental
agencies established f o r that purpose by Congress*

Federal Reservo banks,

thereforo, though t h e i r stock i s owned by momber banks, aro i n effect public
institutions operated i n such a manner as to leave l o c a l matters to l o c a l
management, under Government supervision, and to havo national monetary policies
determined by national public authorities®