The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
R-163 BOARD OF' GOVERNORS 15 OF" THE FEDERAL RESERVE SYSTEM WASHINGTON ADDRESS OF"F"ICIAL CORRESPONDENCE TO THE BOARD January 15, 1938. Dear Sir: There are being sent you under separate cover today copies of an address made by Mr. Szymczak on this date before the Pittsburgh Chapter of the American Institute of Banking, Pittsburgh, Pennsylvania, on the subject: "The Federal Reserve System as a Central Banking Organization". Copies of the address are being forwarded to you for the purpose of making them available to the officers and directors of your bank and branches, if any, and to any member banks which may desire them. tional copies will be furnished upon request. Very truly yours, L. P. Bethea, Assistant Secretary. TO THE PRESIDENTS OF ALL FEDERAL HESERVE BANKS Addi- Z-6? ,. 16 "THE FEDERAL RESERVE SYSTEM AS A CENTRAl. BANKING ORGPJHZA'l'!ON" ADDRESS BY M. S. SZYMCZ.tlli, :i1IE:rv1BER, BOARD OF GOVERNORS OF THE :B'EDERAL RESERVE SYSTEi\JI, before the PITTSB"lJRGH CHAP'rER, .AI1~l!."'RICAN INSTITUTE OF B.Al"'iKING William Penn Eo tel, Pittsburgh, Pennsylvania, 'f:'hu!'sday, January 13, 1938, 6:30 P.M. Not for publication before 6:30 P.M., Thursday, January 1~'3, 1938. Z-6? 17 THE FEDERAL RESERVE SYS'I'EM .AS A CENTRAL BANKING ORGANIZA'I'ION Because the Federal Reserve System is distinctly Ar.terican, and, unlike the central banks of Europe, is organized on a regional plan, the term "central banking" has not been vory commonly applied to i.t. But it is an extremely useful term, for it emphasizes the essential fact that the functions of the Federal Reserve Banks are different from those of privately managed banks operated for profit. Too often, it seems to me, consideration of the purposes and activities of the Federal Reserve Systern is approached from the point of view of resemblances, real and imaginary, between the Faderal Reserve Banks and privately managed banks. would be more instructive to emphasize the differences. is a matter of regulating the supply and cost of credit. Central It b~nking The Federal Re- serve Banks are engaged in central banking, and privately managed banks are not. The term central banking, which does not appear in the Federal Reserve Act, is a relatively new expression. 't It relates to certain spe- cific functions directed at the money market and performed by the Fc:Jderal Reserve System under the authority of the Federal Reserve Act. In other countries, similar functions are performed by the Bank of Canada, T the Bank of England, the Bank of France, and the GermAn Reichsbank, to use only a few of the many possible examples. In discussions by students, it is especially important that the thing which is being discussed be called by a name which clearly and definitely distinguishes it. I !'eel that recognition of the fact the.t the Federal Reserve System performs 18 Z-67 -2eertatn cent~_·al banking functions is properly the first ster) to be taken toward an understanding of its essential purposes and activities. Central banking is a public function. Either by statute or cus- tom, every central bank is subject to a certain amount of control by the government of the country in which it is situated, though not every cent:eal bank is government owned. The twelve Federal Reserv:,; Banks, for exalnple, operate under the control of the Board of Governors in Washington, but their capital is supplied by the banks which are members of the Jl'cderal Reserve Sy1ctem and is not supplied by the government. The capi- tal of the Bank of England, the Bank of France, and the German Reichsbank is furnished wholly by private interests. In Russia, Finland, Sweden, Australia, and New Zealand the governJnent furnishes the entire ca-pital of the central bank and in numerous countries - Canadr~, Mexico, Argentina, Guatemala, Bolivia, and others - the government furnishes an important part of the capital. There ts a central banking institution in practically every civilized country. The Bank of England and the Bank of Sweden have been in existence more than two centuries; other central banks are more than a century old; still others have been established only in recent years. The older institutions have evolved into their present position as the result of long cxp~ricnce and custom; the newer ones hove been expressly established as central banks by law. The ret1son for this difference is that the function of central bn.nking has only gradually emerged over a long period of time. Under the economic conditions that prevailed several centuries ago there was no 19 -3~llnc:e Z-67 for a central banking organization as we know it. The modern bank- ing and credit system itself had not developed. The economy under which nr,tions existed was by our present dey Rtandards & sc.;mt-j thing is still true in many countries. very simple one. 'I'he Their inaustrial and fimm- clnl development is such that they have little or no OCCflSior;. for tne + s•;rvices of a central banking institution. It is only where there is a diverse and highly developed economy, as in the United States and C<mada, to name only two such countries, thst a full and active use of c<mtral bank facilities becomes desirable and, indeed, necessary. The Bank of Engl::md, which is n·Emrly two hundred and fifty years old, was established before the need for central banking in the modern sense had arisen. It was originally regarded as o private institution, opernted for profit, and in competition with other banlcs. It ~rvas distinguished by thE, feet that it enjoyed certnin privileges, made loans to the government, and acted as the fiscal agent of the government. In process of time it as•.. surned in some cases, and i!l other cases h11d thrust upon it, the oblj.gation to perform those services for other banks and fa~ the money market as a whole which we now recognize as centrnl banJ(ing services. In 1848 a Com- mittee of the House of Commons describ8d it as follows: "The Bank is a public institution, possessed of special ~ld exclusive p~ivileges, standing in a peculiar relation to the Gove~nrr:ent and exercising, from the magnitude of its resources, great influence over the general mercantile and monetary transactions of the country. These circumstances impose upon the Bank the duty of a consideration of the public interest, not indeed enacted or defined by law, but whj_ch Parliament in its various transactions with the Bank hc,s always recognized and which the Bank has never disclaimed." Z-67 -4- This statement indicates, as I said, that the present position of the Bank of England as a central bank was not determined by law, but gradually developed out of experience and custom. tory has been different. In this country his- Here, as in many other countries, the need for central banking operr1tions was met not by the adaptation of institutions already existing, but by establishment of institutions specially created for the purpose. Yet it might have been otherwise in this country. If the Bank of the United States, which was established in 1791 when Washington was President and Hamil ton was Secretary of the Treasury, had had its exist-· ence continued, it would be by now one of the oldest central banks in the world. The Bank of the United States was the fiscal agent for the government; its notes provided a circulating medium amencble to central control; it exorcised restraint upon the note issues of the State banks. In these respects it had the beginnings of r;1 central bank. But condi- tions did not then call for a central bank in the modern sense. In the modern sense, the central bank holds the reserves of the banking system and offers rediscount facilities for the replenishment of reserve balances. There were at that time, however, only a few other banks in the United States and the present day practice of maintaining reserve balances had not developed; with minor exceptions, each bank kept its reserves in its own portfolio and vault. By the same token the Bank of the United States was not generally recognized as an institution to which other banks might send their paper for discount when they needed reserve funds, The Bank was e.n important buyer of bills, of which there was a 20 Z-&!'? -5- relatively large supply, incidental first to foreign trade and later to inland trade, but its purchases were not made, apparently, for the purpose of regulating the money or exchange market. Like those of other nanks, they were made for investment and profit. The Bank's acquisition of government obligations, the supply of which was relatively small, were also made primarily for investment and profit. ever, In process of time, how- its operations in bills and government obligations, like those of the Federal Reserve Banks and other modern contral banking institutions, would undoubtedly have come to be governed not by the profit motive but by the motive of adjusting the supply of funds in the money market to the needs of sound business. That the characteristics of a modern central bank were not developed by the Bank of the Unl.ted States is logical, therefore, in view of the rather primitive economic situation then pr.:;vailing in the united States. There wnre few banks, no large scale 9roduction, only rudimen- tary transportation, and little cash capital. Because there was no oc- casion in such a situation for a modern central bank, the Bank of the United States was very li ttlo dH'fcrentiated from othor bankG. LU:e them, it not only acquired investments for profit, but made loans to private individuals and held their deposit accounts. In theso respects, there- fore, it was like the Bank of Englnnd and others of the older central banks and unlike our present day Federal Reserve B2.nks. The charter of the Bank of the United States was not renewed and in 1811 its existence came to an end. for a fiscal agency ~res The need of the federal government pressing, however, and five years later in 1816 a 21 22 -6- second Bank of the United States was chartered. Z-6? As in the case of the first Bank, this institution was not confined to banking services for .., the government. It cultivated commercial banking business in competi- tion with other institutions, and this fact was to a considerable extent responsible for the political hostility which eventually brought its career to an end. Because the life of the second Bank extended into a period when national development brought about quite different economic conditions from those that had obtained in the first years of the republic, the second Bank came to perform more prominently those services which we now recognize as central banking services. Like the first Bank, it was fiscal agent of the government, it sought to exercise a corrective influence upon American banking practice as a whole, it furnished a uniform circulating medium, it put pressure upon local banks to meet their obligations. During the period the second Bank was in operation under its federal charter, namely, from 1817 to 183?, intense and revolution,. ary changes came about. The population of the country greatly increased, a large number of new states were added to the union, transportation was immensely improved, the corporate form of enterprise with its requirement of a large supply of capital funds, such as could be available only in a money market, became common. In spite of the great services the Bank performed and the prospects that it might in time have performed still greater ones, it became involved in a bitter political controversy wi.th the President of the United States. Andrew Jackson ordered the federal government's deposits withdrawn and curtailed the Bank's services as fiscal agent. The Bank's Z-6'7 -7- charter as a federal institution v:as not renewed. 23 From that time till 1914, a period of approximately eighty years, this country was without a central banking orge.nization. I need not remind you how important wGre thG developments within the span of those eight decndes separnting the second Bank of the United StL;tes from the Fede.r•al Reserve Syst8m. The population increr..:sed from 15,000,000 to 100,000,000, the number of states from 25 to 48. tled area expanded from the Mississippi to the Pacific. covered in California. 'l'he Civil War was fought. elr:~ctric Gold was dis- Railway transportation had its beginning and spread over the whole country. telegraph, the The set- The telephone and motor, the electric light, and the automobile were originated and became powerful factors in Arlerican life. scale production methods were vmrked out. prise became dominant in business. I. arge The corporate form of enter- Cash capital accumulated o.nd a great money market developed. It was changes such as these, with their profound effects upon monetary requirements, that made the need of a tion imperative. ~entral banking organiza- Without such an organization, there was no one recog- nized custodian of bank reserves, there was no one recognized lender of last resort capable of cushioning the effect of crodit stringency, there was no one recognized authority watchful of untoward tendencies in the field of credit and empowered to put corrective measures into effect. In the absence of any central banking i::lstitution to hold reserves, and in the absence of a system of widesprec•d branch banking, the custom of the correspondent relationship had become established. Under this re- lationship, which of course still continues though modified in significance Z-67 -8- since the Federal Reserve Banks were established, banks throughout the country maintained their reserve balances with metropolitan correspondents. These correspondents, relatively few in number and situated mostly in New York City, performed indispensable functions for the banking system as a whole. They supplied currency, they cleared and collected checks, they rediscounted the paper of country banks. But these were not their primary functions as privately managed banks, and there was no public obligation to perform them. As much as they could, the city cor- respondents met the needs of the rest of the banking system, but they were under four very serious limitations. 'l'he first was that they were operated for profit and not as public institutions. The second was that they had the needs of their local non-bank customers to meet, and the needs of these customers were often in conflict with the needs of country banks. The third was that they were under inflexible reserve requirements, which diminished their rediscount powers at the very moment those powers were most needed. 'l'he fourth and perhaps most important was that they had no ready source of reserve credit available to them outside their m~ vaults; there was no central banking institution to which they could transfer some of their earning assets in exchange for additional reserve funds, and such relief as they could get had to be sought in a feverish and exhausted market. They stood at the end of the line, with their backs to the wall and with the credit noeds of the whole country converging upon them. This was a decidedly unsatisfactory situation. It not only meant, as I have already said, that there was no authority charged with responsibility for maintaining an orderly money market, and that there was no Z-67 -9- 25 lender of last resort with po·wers flexible enough to meet both indi vidual and general demands for additional reserve funds; it meant that in fact the public interest involved was left largely in the hands of certain metropolitan banks, whose responsibilitl.es were divided and whose powers were incommensurate with the burden placed on them. In establishing a central banking organization through the provisions of' the Federal Reserve Act, Congress departed in important respects from the example of previously existing central banks. The rnost striking departure lay in creating not a single institution, such as the Bank of England, the Bank of France, the German Reichsbank, or the two former Banks of the United States, but a system of tv;elve regional institutions, or Federal Reserve Banks, each serving a particular district and coordinated in nation-wide policies through a governing Board in Washington. Another departure lay in the means of providing capital for the Federal Reserve Banks. Other central banking institutions then in exist- ence usually had their capital provided by the sale of shares to the public. This had also been the case with the two former Banks of the United States, and when the second Bank's existence as a federal institution ce.me to an end, the government had had great difficulty in realizing upon its ·shares. Congress provided that the capital of the twelve Federal Reserve Banks should be supplied wholly by the banks that became membe1rs of the Federal Reserve System. But it did not thereby put the member banks in control of the .Federal Reserve Banks, in the sense in which ownership of a corporation's stock ordinarily gives control. Congress predetermined 26 Z-67 -10- the amount of capital to be supplied by the member banks, and forbade the sale, transfer or hypothecation by any member bank of the shares of Federal Reserve Bank stock owned by it. of ownership by purchase of stock. This prevented concentration Congress limited the dividends to 6 percent per annum, and reserved the Federal Reserve Bank surplus, in the event of liquidation, to the United States. It allowed the member banks to elect six out of nine directors, but required that three of the six directors elected by them represent other lines of business than banking. It authorized the governing Board in Washington to appoint the remaining three directors, Qesignating one as Chairman and another as DGputy Chairman of the bank. It also reserved to the Board a large meas- ure of authority over the management and activities of the twelve regional institutions. Thus it retained control of the twelve Federal Reserve Banks as governmental instrumentalities, but relieved the United States Treasury of the burden of supplying their necessary capital. Another departure from foreign central banking organization lay in providing that privately managed banks become members of the Federal Reserve System and that as such they be required to maintain their entire legal reserves in the form of a credit on the books of the Federal Reserve Banks. In other countries, reserves were kept with the central bank as a matter of option or custom rather than law and the la.w did not stipulate so specifically what constituted reserves. Still another departure lay in specifying the proportion of customers' deposits which member banks must maintain in their reserve accounts. This too was mainly a matter of custom and discretion in other countries. 27 Z-67 -11- In the m8tter of powers and functions, however, as distingui.slled from form of organization, Congress made little if any departure from the essentials of central banking as elsewhere exercised. rirst, the Federal Reserve Banks were given the power to rediscount and to 9urchase obligations. ·~ion This enables them to perform the primary func- of a central banking organization, namely, to release funds to the money market and take in exchange the obligations which are already being carried by privately managed banks and others. This may be done by re- discounting for particular banks whieh need reserve funds, or by purchasjng government securities in the open market and thereby supplying funds to the market in general. This power of the Federal Reserve Banks to act as lenders of last resort is not under such limitations as circun1scribe the lending operations of privately managed banks. A privately managed bank is bound to lose reserves in the process of making extensions of credit. If its extension of credit takes the form of purchases of bonds, the funds with which it pays for the bonds come out of its reserves and find their way at least in part to other banks. If its extension of credit takes the form of loans, the borrowed money will sooner or later be checked out, with the result that funds are transferred from its reserves to those of other banks. This must be the case so long as the banking business is divided up a:rliong different banks. But a central bank- ing organization does not lose reserves when it makes loans or purchases securities except if the funds it giv-es in exchange for the obligations it acquires are taken out of the country. Otbenvise when the central banking organization - in this case the Federal Reserve System - acquires Z-67 -12an obligation, it is paid for by of some member bank. B credit entry to the reserve balance Unless gold is withdrawn for export against that reserve balance, the Federal Reserve Banks, in such a transaction, part with nothing. They have acquired certain assets and in exchange there- for have increased their liabilities. This ability to exercise the lending function to a degree far beyond what competitive, privately managed banks can do is a peculiar and essential feature of central banks. for the existence of central banks. It is the principal occasion Because of it, privately managed banks and the money market as a whole do not find the sources of additional credit running dry just when funds are needed most. They may find the cost of credit rising, but so long as banks have assets that are discountable or salable the additional credit they require will be provided. In this connection, it is desirable to comment on the supposed • relation between the amount of reserve deposits and the ability of the Federal Reserve Banks to make loans and purchase securities. The idea that the ability of the Reserve Banks to extend credit depends upon the amount of their deposits appears to be based on a fallacious analogy between central banking organizations and privately managed competitive banks. The thought seems to be that a central banking institution is en- abled to extend more credit when its deposits increase, because a commercial bank is enabled to extend more credit when its deposits increase. Such considerations are beside the point. The Federal Reserve Banks do not have their power to extend credit enlarged by an increase in reserve 28 Z-67 -13- 29 requirements, because they already have statutory powers to extend credit independently of the volume of reserve deposits on their books. The purpose of legal reserve requirements is not to give lending power to the Reserve Banks, but to facilitate credit regulation; and the Reserve Banks could have built up their present volume of earning assets without any reserve requirements for member banks at all. Their lending power depends upon the amount of their gold certificates and lawful money, which rnust be sufficient to provide a reserve of at least 35 percent of their deposits. A Federal Reserve bank, in other words, can expand its deposits by the extension of credit so long as its gold certificate and lawful money reserves are 35 percent or more of its deposits. The gold certificate holdings of the Federal Reserve Banks have long been ample to support credit extensions far beyond what there is any reason to expect will be called for. Accordingly, since the Federal Reserve Banks, as central banking institutions, already have ample powers to buy securities and make loans, there is no occasion to seek an increase in those powers, and if such an occasion existed, the object would not be sought by increasing member bank reserve requirements. I have discussed the fact th::tt a central banking organization supplies funds to the money market by the processes of rediscount and of securities purchases. I bave also indicated that though the central bank- ing organization may advance additional credit as required, it may do so at a higher and higher rediscount rate. In other words, without abandon- ing its role as lender of last resort, the central banking organization may nevertheless restrain the use of credit by the device of raising its Z-67 -14cost. It may also restrain it uy the device of selling securities in the open market; for just as central bank purchases of securities put funds in tho money market, central bank sales of securities draw funds from the market. 'l'he central banking org.•mization, accordingly, has an active and responsible duty to perform no matter what the situation of the money market may be. It throws its weight in thA direction calculated to maintai.n on adequate supply of credit and an orderly market. at times to encourage and at times to restr~in. It seuks For several years now the Federal Reserve System has consistently followed a course of encourcgement; and to that end it has lowered discount rates and made large purchases of securities. That is, it has employed the primary and cus- tomary means available to a central banking organization in maintaining ~ policy of monetary ease. Congress gave two other important functions to the Federal He- serve Eanks besides the essential central banking functions - rediscount and open market operations - which I have just O.iscussed. These two others are the currency function and the fiscal agency function. They 'A-ere originally the primary functions of central banks, and so far as I know they are still performed by the central banks of all countries. Cur- rency issue, in process of time, has become of less relative importance because so large a portion of monetary credit transferred by check. ~ayments is now mcde with deposit Fiscal agency, however, has become a more important function, with the great growth in the volume of government receipts and expendi tur·es and in the size and complexity of the public debt structure. 30 31· , -15!\.. central bun.king j Z-67 nsti tution is only one of the various instr'11- ncAllt'llities and agencies which a wise government will provide for the wcHm'e of its people. It is an important in3trumentnli ty, but it can contritute no more than its share in a concentrated effort of all agencies of the government toward the maintenance of economic stebiljty.
@FedFRASER