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Form WR. 1 1 3 h^ N—^ / BDARD DF \ FEDERAL GDVERN•RS DFTHE RESERVE SYSTEM Office Correspondence To Chairman Eccles l^i. D t Sp me 2 , 9 7 ae et br 31 3 e Subject: 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 available. 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 THE NATURE OF FEDERAL RESERVE BANKS by 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 . l/ 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® 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. Branches 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. The - 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 banks• 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 • matter® 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 u. • 1 . , • - . .. 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. This 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. strictly 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 Government. 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 authorities. 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 checks. 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. Of 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. A 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 funds. 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 . The 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 abroad. 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® Currency 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 Board. 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® Summary 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®