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EXHIBIT B November 6, 1940 TO* Mr, E, A, Goldenweiser FROIIj Viotor M. Long street SUBJECT« A plan to stabilize prioes of bank-held Government bonds It has been proposed that (1) commercial banks be required to hold a "bond reserve” of Government bonds in an amount not below a fixed percentage of their deposits and (2 ) suoh bonds held in excess of the required amounts cannot be sold in the market but oan in the future be redeemed at the Federal Reserve banks or Treasury for ap proximately amortized oost price. This proposal is aimed at (1) pro tecting banks from losses due to a decline in bond prioes and (2 ) pro tecting the bond market from the effects of bank selling. Summary of proposal Bonds eligible as bond reserves could be defined as Govern ment bonds maturing after a oertain period, say 12 or 15 years. There is no advantage in inoluding short-term Governments in the plan be cause banks run little risk of loss on them and because bank selling of short-term securities is not likely to be disturbing. Another idea is to make use of a consol, or some speoial type of Government security, which oould be held only by banks and would not have a mar ket, This speoial type of Government bond would be obtained by the oommeroial banks in exohange for some of their present Governments. To insure maintenance of bank earnings the consols would have to bear about the same interest iate as the banks' holdings of Government bonds that they replaoed. Consols held in exoess of the required amounts oould always be redeemed at the Federal Reserve banks or the Treasury, The percentage of deposits required as bond reserve would not have to be identical for every class of bank. Different percent ages could be established for each class of bank, at levels that would cause the least disturbance in inaugurating the plan. If ohanging conditions caused banks to need more oonsols for the required bond reserve, the Reserve banks and Treasury oould always be prepared to issue new ones for oash. Or it might be de sirable to lower the percentage bond reserve requirements from time to time. Aims of the proposal A plan of this sort would unquestionably reduce the risk of prioe declines in Government securities» If banks oould always redeem the reserve bonds at approximately amortized oost prioe banks would never have to sustain any losses on these securities regardless - 2 * Tot Mr, E. A« Goldenweiser of how far market prioes had fallen. Also, if banks oould not sell such bonds in the market, the banks to that extent oould not depress prioes in the Government bond market. Presumably the aims of the proposal would be most fully achieved if it embraoed all bank holdings of Government bonds. If banks are still pormitted to hold some Government bonds that are not redeemable but oan be sold in the market, banks oould continue to go in and out of the market and sustain heavy losses if prioes decline. In the following discussion tho questions raised about the proposal are of a general charaoter and are designed to apply to all of the various forms that the plan might assume if actually adopted. Possible objections to the proposal Two prinoipal difficulties appear to be inherent in the plani (1 ) it permits a high long-term interest rate to be paid on what is in effect a short-term or demand investment and (2) it benefits a particular class of bondholder. As regards the first point, a bond on whioh the holder runs practically no risk of loss if he wants his principal before maturity has the charaoteristio that distinguishes a short-term obligation from a bond. Justification for the Government’s paying a high coupon on bonds is that bonds relieve the Government of the necessity of frequent refinancing at whatever may be the current rate. Therefore- the Govern ment pays a coupon high enough to encourage investors to accept the risk of any losses they may have to take if they should have to sell on a weak market before maturity. If the Government provides, through the Federal Reserve banks or otherwise, for oash redemption of .bonds before maturity, so that banks will not assume any risk of loss, then the bank, or to be more speoifio the holder of bank stook, is only entitled to a short-term interest rate and not a bond rate. And the Government would be raising funds at a higher cost than the bill rate without obtaining any of the advantages whioh it pays for when it raises money through a bond issue* As regards the second point, clearly a proposal that singles out banks for preferred treatment is open to a charge of favoritism. It oan be said, of course, that banks are giving up something under the proposal since they would be required to maintain a Government bond reserve requirement. At times this might prevent some banks from shifting into loans or other securities. In view of the large volume of exoess reserves of most banks, however, these requirements are not likely to present much hardship. To» 3 - Mr. E, A • Goldenweiser Other similar proposals Similar considerations apply to other proposals for the achievement of the same end. It is sometimes proposed, for example, that the Reserve banks peg the prioe of Government bonds, offering to buy and sell unlimited amounts at fixed rates with a small spread. This spread would have to be about as small as the one that occurs in the short-term market, otherwise large losses oould still fall on investors buying at the top of the spread and selling at the low,. Let us assume that this were the policy and that the Reserve authorities had oonvinoed the market that they were able and deter mined to pursue it. To be able to liquidate bonds always at not more than a slight disoount from a predetermined, fixed prioe, would make suoh bonds the equivalent of short-term investments, both for the Government, which would always be subjeot to demands for redeeming or buying the bonds, aid to the investor, who could always get his principal. Under these conditions large new demands would come into the bond market* Many holders of idle bank deposits would then be willing to hold bonds. For the Reserve banks to prevent these demands from pushing up bond prices, the Open Market Committee would have to sell bonds. In faot the Committee might sell all its bonds without successfully keeping prioes from rising, Those that bought early, before prioes rose appreciably above the pegged prioe, would be obtaining in effect a short-term investment with no risk but bringing a long-term return, It would be undesirable to plaoe suoh holders in a favored position. If the Government or some agency thereof is willing always to buy a Government investment at a stated prioe it would seem proper to put a low rate on the investment oommensurate with the absence of risk to the investor*
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