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CREDIT CONTROL BY THE FEDERAL RESERVE SYSTEM
ADDRESS BY
M. S. SZ"YMCZAK, MEMBER,
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
DELIVERED BEFORE
T'rlE RICHMOND CHAPTF..R OF
THE AMERICAN INSTITUTE OF BANKING
March 25, 1956,
8:00 P• m.
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There are five principal means·by which credit control may be exercised in the Federal Reserve System.
These are:
Discount Rates
Open Market Operations
Direct Action
Reserve Requirements
Margin Requiremcmts
Discount Rates
Under the original terms of the Federal Reserve Act two principal
instruments of credit control were used.
One of these was the discount
rate; the other was the rate on bills, or as they are called in the Act,
"Acceptances".
The Act specifically provided that each Federal Roserve
bank "establish from time to time, subject to review and determination
of the Board of Governors of the Federal Reserve System, rates of discount to be charged by the Federa.l Reserve bank for each class of paper,
which shall be fixed with a view of accommodating commerce and business".
To this the Banking Act of 1955 added the provision that such rates shall
be established "every fourteen days, or oftener if deemed necessary by
the Board 11 •
This does not mean that the rates have to be changed every
time, but that they must be regularly and frequently reviewed.
The Re-
serve banks usually take the initiative in any action on rates.
The discount rates of the Federal Reserve banks are usually somewhere between bill rates, which are usually lower, and other short-term
rates in the open market, which are usually higher.
They are also lower
than rates which banks charge their customers for loans.
They differ,
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therefore, from the discount rate of foreign central banks, such as the
Bank of England, for example, whose discount rate is higher than the
market rate.
Since the Federal Reserve bank discount rate is lower than
the rates charged by member banks it has usually been possible for member
banks to borrow from the Reserve bank and relend at a profit.
It has
not been tho practice for them to do so, however, probably because they
are averse to having borrowings show up in their published statements.
Consequently, member banks as a usual thing borrow of the Reserve bank
only when they have to in order to
~eplenish
their reserves and avoid the
penalty for deficiencies in their reserve accounts.
Although each Federal Reserve bank's rate is determined largely with
reference to local conditions, it is importru1t, of course, not to fix
rates at any one Reserve bank without reference to the conditions to
which other Reserve banks are subject.
The member banks in one district
cannot go to the Federal Reserve bank of anoth.Jr district, but nevertheless if rediscount rates in one district were noticeably lower than in
another it would be possible for funds to find their way through indirect
channels (such as correspondent banks, for example) from the district
where rates were low to the district where rates were high.
Consequently,
general conditions as well as local have to be taken into account in determining what the rediscount rate will be and what changes should be
made.
The Federal Reserve Act formerly limited the classes of paper whj_ch
Federal Reserve banks could discount for member banks, on the principle
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that a definite preference should be maintained for short-term credit
based on self-liquidating commercial transactions.
The Reserve banks
we1·e, therefore, given the power to discount only short-term selfliquidating commercial paper, that is notes, drafts, bills of exchange
and bankers• acceptancGs arising out of commercial, industrial and agricultural transactions, and to make advt..nces to member banks on their
promissory notes backed
~~
paper eligible for discount or purchase or
backed by United States Government obligations.
fined classification.
It was a narrowly de-
Advances on a wlde range of other assets which
made up an important part of the total earning assets of banks were not
authorized.
These included advances on securities other than those of
the United States Government, on real estate loans, and on other loans
of considerable importance in the portfolios of banks.
As a result of many developments in our financial organization,
paper which qualified for borrovdng from the Reserve banks has constituted a constantly decreasing proportion of the total assets of member
banks ever since the System was established.
In 1929 it was only about
twelve percent of total loans and investments of such banks, and in
1954 it was but eight percent.
Consequently, in 1931 and 1952 when the
great liquidation occurred, many banks with assets which were good but
technically ineligible for borrowing at Reserve banks, were obliged to
dump them on a falling market, suffering severe loss thereby and contributing to the deflation in values, or to close their doors.
The new banking act increases the powers of the Federal Reserve
banks so that they may meet this situation.
It authorizes tho Reserve
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banks to make advances to member banks for periods not exceeding four
months on any security satisfactory to the Reserve bank, at a rate of
interest at least one-half of one percBnt above the highest discount
rate in effect at the particular Reserve bank.
This amendment modifies
and ma'kes permanent tho emergency legislation which was passed in 1952.
In addition to the foregoing general powers of dl.scount and purchase the Federal Roserve banks have special powers with respect to
loans to commerce and industry for working capital purposes.
powers are granted by Section 15b of the Act.
These
Under this section the
Reserve banks are authorized to discount loans made by member banks and
other financing institutions to establ1shed industrial and commercial
businesses for the purpose of supplying working capital.
These changes made by recent legislation enlarge very greatly the
kind of credit which the Federal Reserve banks may deal in directly,
and give the Reserve banks greater freedom of action in meeting requirements of the money me.rket.
Open Market Operations
In addition to the discount rate and the bill rate, two other important means of credit control have been developed from Reserve System
experience, although they were not specifically contemplated in the
original Federal Reserve Act.
direct action.
These are open market operations and
Open market operations consist of the purchase and sale
by Reserve banks of certain classes of securities, chiefly Government
obligations.
They have the effect of increasing or decreasing the
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supply of credit available in the money market as a whole.
.
They do not
leave control of the money market dependent upon the voluntary action
of member banks in seeking funds for the
repl~nishment
of their reserves,
but give to the Federal Reserve banks the initiative in influencing the
market.
By selling securities the Reserve banks withdraw funds from thu
market and less credit becomes available.
By purchasing securities they
put funds into the market and tend to ease credit conditions.
If sccuri-
ties are sold they must be paid for, and in the process of paying for
them the reserves of member banks arc diminished, for
eve~J
payment
means a debit sooner or later to some member bunk's reserve account.
If the program is carried far enough the member
ba~~s
will be forced to
restrict their extensions of credit or dispose of some of their assets
to the Federal Reserve banks either b,y sale or rediscount in order to
replenish their reserves.
When this happens, the member banks have been
forced by the initiative of the Reserve banks to take action which they
would otherwise not have had to take.
If, on the contrary, market condi-
tions are such that member banks have gone into debt to the Federal Reserve banks in order to replenish depleted reserves, the Federal Reserve
banks may relieve the situation and the tightness which exists in the
money market generally by buying securities on a large scale.
The funds
which they release in payment for the securities which they buy flow one
way or another into the reserve accounts of the member banks and enable
the latter to pay off their obligations.
If the purchases continue
beyond this point, they create excess reserves which it is likely the
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-6member banks will try to put to some use.
By selling securities, therefore, the Federal Reserve banks may enable themselves to give an effectiveness to a discount rate which it
would not have otherwise until such time as market conditions had stiffened and individual banks were forced by those conditions to go to the
Reserve banks for funds.
Open market operations, therefore, enable the
Reserve banks to accelerate corrective action.
They are especially
useful in view of the tradition which makes banks refrain as much as
possible from borrowing from the Federal Reserve banks.
If member banks
felt no inhibitions about being in de.bt, and built up their reserves by
borrowings so th13 t they might make more loans, they would more generally
be amenable to control through the discount rate.
As it is, however,
the discount rate must depend for much of its effectiveness upon open
m<:trket opera tlons.
The powers of the Reserve banks to buy and sell·securities in the
open market were granted in general terms in the original Federal Reserve
Act, but at the time were not generally considered to be of very great
importance.
It was not until 1922 that open market operations were con-
ducted on a large enough scale to affect tha money market.
The first
operations were carried on by tl1e Federal Reserve banks independently of
one another, but it was soon found that action had to be coordinated,
for otherwise the banks would be buying or selling in competition with
one another and following different, and perhaps conflicting, policies.
Consequently, a committee representing several of the reserve banks was
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formed for the purpose of coordinating their operations.
same time the purpose of the operations was clarified.
About the
For some time
there had been a tendency to allow purchases and sales to be influenced
by the objectiv·e of profit, but it was eventually realized that such an
objective was in conflict with that of moderating a given condition of
the money market, and must, therofore, be subordinated or even abandoned.
This is in line with the general policy of central banks in conducting
open market operations; they do so quite definitely with the idea of
correcting credit conditions and not for the purpose of making earnings.
The Banking Act of 1935 gave specific recognition to open market
operations and established a Federal Open Market Committee of twelve
members, one representing each Federal Reserve bank, .to take the place
of the former non-statutory committee.
At the same time the law adopted
substantially the statement of purpose which had already governed open
market operations.
The statute provides that open market operations
"shall be governed with a view to accommodating commerce and business
and with regard to their bearing upon the general credit situation of
the country."
The Banking Act of 1955 made further change by providing that the
Federal Open Market Committee should comprise the members of the Board
of Governors of the Federal Reserve System and five representatives
chosen by the twelve Federal Reserve banks.
The law also makes the deci-
sions of this committee obligatory upon the Federal Reserve banks and
provides that the record of the committee's actions shall be included
in the annual report of the Board submitted to Congress.
Thus an
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activity which was barely
reco~1ized
in the original Federal Reserve
Act, and which was gradually developed in the process of administration
of the System, has come to be emphasized in the law as one of the System's most important activities.
Direct Action
I also mentioned direct action as a means of credit control.
Di-
rect action means individual effort by the Federal Reserve banks to
discourage credit policies of given member banks in given circumstancGs.
For the correction of specific conditions, it is to be regularly resorted
to by the H.eserve banks in their relations with member banks.
Opportun-
ity for it occurs on various occasions, but particularly when the member
bank is being examined, and when it is seeking to rediscount some of its
paper.
In this sense, direct action is largely an individual matter and
the form taken by it in any case may have little or no reference to general credit conditions.
It may also have reference either to regional
or country wide conditions, however, and may then be resorted to for
the purpose of enforcing general credit policy.
The power to exercise
direct action against member banks lies partly v!i th the Federal Reserve
banks and partly with the Board of Governors,
The effectiveness of direct action was specifically strengthened
by the Banking Act of 1955 in several particulars.
that undue use of
bar~
When it appears
credit is being made for the purpose of specula-
tion in securities, real estate, or conm10di ties, or for any other purpose inconsistent with sound credit conditions, the facts should be
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reported by the Federal Reserve banks to the Board of Governors of the
Federal Reserve System.
The Board may in its discretion suspend any
member bank making such use of credit from recourse to credit facilities
of the System.
Furthermore, authority has been given to the Board to
remove from office any officer or director of a member bank who has violated the law governing the bank's operation or who has persisted in
unsafe and unsound practices in conducting the bank's business.
The
Board also has power to limit for each Federal Reserve district the individual bank capital and surplus which may be represented by loans
secured by stock or bond collateral.
It is to be presumed that these special powers will not often have
to be used, in view of other broad powers designed for control of credit
conditions, but in principle they are nevertheless significant, for
they indicate that the law definitely contemplates the exercise of considerable responsibility by the Federal Reserve banks and the Board.
Power to Change Reserve Requirements
Recent legislation has also established two other new forms of
general credit control which previously did not exist.
The first of
these is the power given the Board to change the reserve requirements
imposed upon member banks by the statute.
For most banks the require-
ment is and has been for years that they have reserves on deposit with
the Federal Reserve bank equal to at least 7 percent of their demand
deposits, and 5 percent of their time deposits.
The power to alter
these reserve requirements was first given the Board by an amendment
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to the Federal Reserve Act May 12, 1955, but under limitations which
were later removed by the Banking Act of 1955.
ized to change the reserve requirements
11
The Board is now author-
in order to prevent injurious
credit expansion or contraction", but it is not permitted to lower them
below the present requirements nor increase them to more than twice the
present requirements.
The effect of raising them, which is the only
action that could now be taken, because the reserves are now at the
point of legal requirement, would be to decrease the lending power of
member banks and consequently the available credit.
The effect of sub-
sequently lowering them would be, of course, to enlarge the lending
power nnd the amount of available credit.
This means of credit control
is one of the most powerful and direct that the law has bestowed.
Margin Requirements
The second new form of general credit control recently authorized
pertains to margin accounts and loans made for the purpose of purchasing
or carrying listed securities.
Authority for the Board to issue regula-
tions in this field was granted by the Securities Exchange Act of 1954.
This grant of authority was in line with various provisions of the Federal Reserve Act, such as I have already referred to, aimed at restricting the use of credit for speculative purposes.
In the language of the
Securities EXchange Act, the authority it bestows is to be ex·ercised
with the object of preventing "the excessive use of credit for the purchase or carrying of securities".
The standard established in the Act
and adopted by the Board as an initial regulation limits the loans which
a broker or dealer may make on a security to whichever is higher of the
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X-9529
two following ratios:
Fifty-five
{.1.)
percent of the current market price of the
security, or
(b)
One hundred percent of the lowest market price of the secur-
ity since July 1, 1955, but not more than seventy-five percent of the
current market price.
This standard permitted the extension of eredit up to seventy-five
per cent of' current market value on securities that he..d made little or
no advance from the lows of recent years, and up to fifty-five percent
on securities that had made considerable advance.
The Board, howevor,
was given authority to alter this initial standard, making it either
higher or lower as conditions might warrant, and it has recently changed
the fifty-five per cent
limit~tion
to forty-five per cent.
The reason
for this action was realization of the possibility that recent increases
of stock market values might lead to such excesses as the law sought to
prevent.
The determination of margin requirements is designed to exert a
restraining influence on speculative trading.
By imposing higher margin
requirements on securities that have had a rapid rise, credit is made
less freely available for trading in speculative stocks.
A limitation
is also imposed on the extent to which speculative profits on securities
can be used as margins for further speculation, a practice that is known
as pyramiding.
The power of the Board to raise margin requirements provides an
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instrument for controlling the demand for cre:dit from speculators in
the stock market without restricting the suppljr available for other borrowers.
It differs from oth.:::r r:J.eans of c:redi t control in that it af-
fects diri.:;Ctly the demand for credit rather than the available supply
or cost.
Through the use of this instrument it may be possible for the
Board to exert a restraining influGnce on the use of credit for speculation in the stock market before it has reached
.:t
stage at which the
general business and credit situation is unfavorably affected.
The use
of the instrument exercises a restraint on speculation without limiting
the supply or raising the cost of credit to agriculture, trade, and
industry.
The Securities Exchange Act specifically exempts from its provisions all obligations of the United States Government, of any state,
municipal, or other political subdivision, and of agencies or instrumentalities of a State or local government.
Additional exemptions of
a similar nature are provided for.
Brokers and securities dealers subject to the Act are not permitted
by the Act to borrow from banks which are not members of the Federal Reserv3 System, unless such banks agree to comply with the same conditions
relating to the usa of credit to finance transactions in securities as
are imposed on member banks.
The foregoing provisions .governing the credit actlvities of brokers
and dealers are covered in Regulation T of the Board of Governors.
Insofar as banks are concerned, the Board's authority relates to
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loans made for the purpose of purchasing or carrying securities registered on national securities exchanges.
It does not apply, therefore,
to loans made solely for industrial, agricultural, or commercial purposes, regardless of the question whether these loans are secured or
unsecured, and, if secured, regardless of the character of the collateral.
Th0 determining factor is the purpose of the loan and not the nature of
the security offered.
If a loan is made for the purpose of purchasing
or carrying securities registered on a national securities exchange, it
comes under this section of the act; if it is made for any other purpose -- industrial, agricultural, or commercial -- then it is exempt.
It is also exempt if it is secured by certain types of collateral other
than stocks, such as bonds and government obligations.
In general, the
law, insofar as it applies to control over banks, is intended to prevent
the banks from being used for the purpose of circumventing the margin
rGquirements prescribed for loans extended by brokers to their customers, and to prevent undue expansion of bank credit in the securities
markets.
The law imposes upon the Board no duties in connection with supervision of stock exchanges or prevention of undesirable practices among
members of such exchanges.
Responsibility for these matters rests upon
the Securities and Exchange Commission.
Conclusion - Limitation on Means of Credit Control
Although the five means I have discussed by which credit control
may be exercised - discount rates, open market operations, direct action,
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reserve requirements, and margin requirements - appear to be very comprehensive and powerful, it would be a mistake to convey the impression
that a perfect control of credit will be effected through them.
In the
first place, their application cannot be mechanical nor governed by
simple unvarying rules.
Credit and economic relationships are extremely
intricate, and the circmnstances under which the need for action arises
are always to some extent different and special.
Let me mention a few
things that complicate the task of credit control.
In the first place, if there were a clear connection between given
extensions of credit and the uses· to which the credit is ultimately put,
the control of credit would be simplified.
This connection was formerly
assumed to exist and to afford an important means of control.
The
thought was that the Reserve bank could shut off speculation by refusing to discount the notes of speculators.
the facts.
That, of course, is far from
A bank may borrow from the reserve bank on biJ.ls of lading
covering the sale of merchandise and at the same moment it may buy the
mortgage of a man who is speculating in industrial stocks.
The exten-
sion of credl t on bills of lading was specifically fr..vored by the original Federal Reserve Act, yet in such an instance as I mention, it might
make possible a speculative activity directly opposed to the purposes
of the Act.
Another important faet is that more than half the banks of the
United States are not members of the Federal Reserve System.
The sys-
tem has consequently only a purtio.l and ind1rect influence on their
credit activities.
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For another thing, there is always the importar1t consideration
that United States Treasury activities must be taken into account.
These have to do in part with the operations of the Exchange Stabilization Fund and the issue of circulating media, e.g., coins, silver certificates, and United States notes; and in part with the public debt,
and the government's receipts and expenditures.
These operations in-
volve such large sums and so intimately affect the banking and credit
situation that Federal Reserve poliQY and Treasury policy must always
be coordinated with one another.
Finally there are conditions that arise not only outside the System, but outside the country, and yet affect the domestic banking situation powerfully.
There is, for example, the recent great movement of
gold to the United States from abroad- a movement that in the last two
years has added over three billion dollars to the reserves of member
banks.
These factors, among others, necessarily limit and modify the exercise of credit control.
@FedFRASER