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F E D E R A L R E S E R V E B O A R D WASHINGTON X-2091 December 17, 1920. SUBJECT: Proposed L e g i s l a t i o n E s t a b l i s h i n g a Maxiaujn Federal Reserve Bank Discount Rate. Dear S i r : There i e enclosed herewith f o r your information copy of a l e t t e r i n reply t o a communication from the Chairman of the Senate Committee on Banking and Currency, r e q u e s t i n g an expression of the views of the Federal Reserve Board with regard t o a b i l l r e c e n t l y introduced i n the Senate which, if enacted, would f i x the maximum r a t e of i n t e r e s t or discount which Federal reserve banks could charge member banks i n any c o n t r a c t , agreement or any other f i n a n c i a l t r a n s a c t i o n had with them a t f i v e per centum p e r annum. Very t r u l y yours, G O V E R N O R . To t h e Chairmen and Governors of a l l F.R.Bs. 1188 X-2091a December 3.6, 1920; Dear Mr. Chairman Tou have requested the views of the Federal Reserve Board with regard t o Senate B i l l No. 4$60, which, i f enacted, would f i x the maximum r a t e of i n t e r e s t or discount which Federal Reserve Banks could charge member hanks i n any c o n t r a c t , agreement, or any o t h e r f i n a n c i a l t r a n s a c t i o n had with them at f i v e p e r centum p e r annum. The Federal Reserve Board d e s i r e s t o put i t s e l f on record as u n a l t e r a b l y opposed to t h i s b i l l or to any other b i l l which in any way attempts to l i m i t the power now vested in. i t and i n the Federal reserve hanks to r e g u l a t e the r a t e s of discount which those banks may charge. I t i s e s s e n t i a l t o the proper f u n c t i o n i n g of any c e n t r a l banking system t h a t the c e n t r a l bank or banks of discount s h a l l hslve complete c o n t r o l over t h e i r r a t e s . This c o n t r o l over r a t e s i n normal times i s the u s u a l and most e f f e c t i v e means of p r o t e c t i n g the gold r e s e r v e s of a country a g a i n s t withdrawals f o r f o r e i g n account, and i n domestic t r a n s a c t i o n s i t i n s u r e s the accummulation i n normal tiroes of a reserve s u f f i c i e n t t o meet the seasonal and emergency demands of the c e n t r a l hank or banks. I t i s the general p r a c t i c e of c e n t r a l banks t o f i x t h e i r r a t e s s l i g h t l y above the market r a t e s . This i s p a r t i c u l a r l y t r u e of the Bank of England and i n view of the f r e q u e n t r e f e r e n c e s which are made t o t h i s i n s t i t u t i o n i n public d i s c u s s i o n s i t may be of i n t e r e s t to review i t s experience in the matter of discount r a t e s s i n c e the passage of the Bank Act of 1844, as shown by the t a b l e on page 33 in a book e n t i t l e d "Bank Rate and the Money Market" by R. H. 2 n g l i s Palgrave, F.R.S. The ahnual average bank r a t e of the Bank of England d u r i n g the years 1845 t o 1871, i n c l u s i v e , was h i g h e r than the annual average market r a t e in s i x t e e n of the twenty-six years and was lower than the annual average market r a t e in the other t e n y e a r s , b u t from the year 1872 t o the end of the period covered by the t a b l e , 1900, the average Bank r a t e was h i g h e r than the average market r a t e in every y e a r . From 1900 down t o the p r e s e n t time the average Bank r a t e has continued to be h i g h e r than the average market r a t e . Up to the y e a r 1833 the Bank of England whs s u b j e c t to the usury laws. In h i s book e n t i t l e d "Essai Sur La Fondation Et L ' H i s t o i r e de l a Banque D 'Angleterre, 169U - 1844" Dr. A. Andreades, of the U n i v e r s i t y of P a r i s , r e f e r s , on page 3Si, to the r e l e a s e of the Bank from the a p p l i c a t i o n of the usury laws and d e s c r i b e s the c o n d i t i o n s which led to t h i s a c t i o n by "Parliament. The c o n d i t i o n s then e x i s t i n g in England were n ° t a l t o g e t h e r u n l i k e p r e s e n t c o n d i t i o n s i n t h i s country, and i t i s noteworthy t h a t i n s t e a d of attempting t o impost r e s t r i c t i o n s upon the Bank, Parliament l i b e r a l i z e d i t s powers and r e l i e v e d i t from the old r e s t r i c t i o n s which had s e r i o u s l y impaired i t s e f f i c i e n c y i n d e a l i n g with the s i t u a t i o n . In e x p l a n a t i o n of the f a c t t h a t the discount r a t e s of the Federal r e s e r v e banks are a t the p r e s e n t time below the market r a t e s i t may be —2— X—2091st appropriate to quote the following from an address which I made t o the American Farm Bureau Federation a t Indianapolis on December 7, 1920: "Normally the discount r a t e of a Federal reserve hank should not c o n t r o l the r a t e s a t which member hanks loan money to t h e i r customers. In the c o u n t r i e s which have c e n t r a l "banks there i s a well-estaiblished policy t h a t the c e n t r a l hank d i s count r a t e should he maintained a t a f i g u r e s l i g h t l y i n excess of the current market r a t e . The wisdom of such a policy i s apparent f o r i t eliminates a l l consideration of p r o f i t i n r e d i s count t r a n s a c t i o n s and gives the c e n t r a l hank b e t t e r c o n t r o l over i t s owe reserves and causes the banks which d e a l with the p u b l i c to r e l y to a g r e a t e r degree upon t h e i r own resources in extending accommodations while s t i l l a f f o r d i n g them an o u t l e t f o r any undue accummulation of loans. Because of the exigencies of war f i n a n c i n g , i t has not been p r a c t i c a b l e f o r the Federal reserve banks up to t h i s time to adopt t h i s p o l i c y and as a rule Federal reserve bank discount r a t e s are lower than the r a t e s charged by member banks. I t i s believed t h a t conditions are gradually a d j u s t i n g themselves so t h a t Federal reserve bank r a t e s may be maintained at a level s l i g h t l y h i g h e r than c u r r e n t rates not only without any disturbance t o commerce and business but to t h e i r d i s t i n c t b e n e f i t . In f a c t , t h i s adjustment has already begun in some c i t i e s where member banks have reduced t h e i r rates on commercial paper". The enactment of a law f i x i n g the maximum r a t e to be charged by Federal reserve banks a t f i v e p e r cent would, of course, make i t impossible to b r i n g t h i s necessary c o r r e c t i v e p r i n c i p l e i n t o permanent operation, f o r i t would be e f f e c t i v e only a t times when c u r r e n t market r a t e s f o r money might f a l l below f i v e p e r c e n t . The Board d e s i r e s t o c a l l your a t t e n t i o n to the f a c t t h a t only three S t a t e s - I l l i n o i s , Louisiana, and Michigan - have a l e g a l rate of i n t e r e s t as low as 5$ and i n each of these S t a t e s a h i g h e r contract r a t e i s permissible I l l i n o i s and Michigan, 7^, Louisiana, 8$. In t h i r t y - t w o S t a t e s the legal r a t e of i n t e r e s t i s 6$; seven States have a l e g a l r a t e of 7$» and in s i x States and in the D i s t r i c t of Columbia the l e g a l r a t e ef i n t e r e s t is 0$. In eleven S t a t e s - Arizona, Arkansas, F l o r i d a , Kansas, Minnesota, Nebraska, North Dakota, Oklahoma, Oregon, Texas and Wisconsin a c o n t r a c t r a t e of 10% i s allowed, and i n ten o t h e r S t a t e s - Colorado, Connecticut, Idaho, Montana, Nevada, New Mexico, South Dakota, Utah, Washington and Wyoming — 12$ i s the contract r a t e . In seven S t a t e s Georgia, Indiana, Iowa, M i s s i s s i p p i , Missouri, Ohio and South Carolina having a le.^al r a t e of l e s s than 8$, a c o n t r a c t r a t e of 8$, i s allowed. Four S t a t e s - C a l i f o r n i a , Maine, Massachusetts and Rhode Island - permit any r a t e t o be charged under c o n t r a c t , and i n New York any r a t e agreed upon i n w r i t i n g i s l e g a l on c o l l a t e r a l demand loans of *5i000 and over. The theory t h a t discount t r a n s a c t i o n s should y i e l d a p r t f i t t o the member banks i s a f a l l a c y which owes i t s wide credence in p a r t to -3- X-209Xa the f a c t t h a t the Federal reserve "banking system, which has some of the a t t r i b u t e s of a c e n t r a l banking system, i s comparatively new, and p a r t l y to the abnormal times through which we have passed, the i n e v i t a b l e e f f e c t s of which are now being experienced. The f a c t i s , however, t h a t the p o t e n t i a l p r o f i t s of the member banks should n o t be permitted to i n f l u e n c e the determination of the Federal reserve bank r a t e s . On the c o n t r a r y , member banks should r e l y mainly upon t h e i r own resources i n normal times i n order t h a t when seasonal and emergency demands do a r i s e the r e s e r v e s of the Federal reserve banks may be a v a i l a b l e to meet those demands and s u f f i c i e n t to prevent the emergencies from d e v e l oping i n t o panic c o n d i t i o n s . In t h i s connection your a t t e n t i o n i s i n v i t e d to an e d i t o r i a l which appeared in the Dallas (Texas) Morning News of F r i d a y , June 11, 1920, copy of which is enclosed h e r e w i t h . If Federal reserve bank r a t e s we re f i x e d a t 5$ at the p r e s e n t time there would undoubtedly be a v e r y strong i n c e n t i v e t o the member banks to u t i l i z e t o the utmost the rediscount f a c i l i t i e s of the Federal reserve banks, because i n an 8$ money market there would be a spread of 3$ between t h a t r a t e and the Federal reserve bank r a t e which would r e p r e s e n t a p r o f i t to be derived by the member banks on rediscount t r a n s actions. In s t a t e s which have no important f i n a n c i a l c e n t e r s b u t i n which r a t e s as high as ten and twelve per c e n t , are authorized by law, the incentive t o rediscount with the Federal reserve banks would be even great® r I t i s the opinion of the Federal Reserve Board, confirmed by p a s t experience, t h a t the lowering of the Federal reserve bank r a t e s t o 5$ would have but very l i t t l e if any e f f e c t on the market r a t e s which could n o t be f i x e d by l e g i s l a t i v e enactment but which a r e determined by the i n e v i t a b l e o p e r a t i o n of the law of supply and demand. Nor a r e banks g e n e r a l l y i n c l i n e d - p a r t i c u l a r l y banks i n a g r i c u l t u r a l s e c t i o n s - t o give t h e i r customers the b e n e f i t of Federal 'reserve bank discount r a t e s . I t should , be borne i n mind a l s o t h a t with Federal reserve bank r a t e s a t 5$ the ihcentive t o s p e c u l a t i o n would increase the demand f o r c r e d i t and the n e t r e s u l t would be t h a t borrowers f o r legitimate commercial and a g r i c u l t u r a l purposes would f i n d i t d i f f i c u l t and expensive t o o b t a i n c r e d i t . Ultimately, of course, the l i m i t of expansion would be reached, and i n the Board's opinion i t would be reached w i t h i n a very short time, f o r i t must not be f o r g o t t e n t h a t there are about $25,000,000,000 of Government o b l i g a t i o n s a v a i l a b l e as c o l l a t e r a l f o r loans e l i g i b l e f o r rediscount by Federal reserve banks. If the l i m i t of expansion should be reached, the Board b e l i e v e s t h a t a c o n d i t i o n of depression i n f i n i t e l y more s e r i o u s and more widespread than t h a t now e x i s t i n g would f o l l o w . . The Board c a l l s the a t t e n t i o n of the Committee t o the f a c t t h a t the b i l l under c o n s i d e r a t i o n would operate as a r e p e a l of the p r o v i s i o n s of Section 11 (c) of the Federal Reserve Act which r e q u i r e the Federal Reserve Board to impose a graduated tax, upon a Federal reserve bank whenever i t s r e s e r v e s f a l l below a s p e c i f i e d minimum, the Federal reserve bank being r e q u i r e d " t o add an amount equal to s a i d t a x to the r a t e s of i n t e r e s t and d i s c o u n t f i x e d by the Federal Reserve Board". If the b i l l under c o n s i d e r a t i o n were enacted, f i v e p e r ' c e n t would be the maximum r a t e a Federal r e s e r v e bank could charge even i f i t s r e s e r v e s were r a p i d l y dwindling to the vanishing p o i n t . In conclusion and by way of summary, if t h i s b i l l should become a 1 m i t i s the Board's f i r m b e l i e f t h a t the F e d e r a l reserve banks would 1191 -4- X~2091» find i t impossible while functioning in a normal way to protect their gold reserves, that the Federal reserve system would within a very short time cease to be in any sense a reserve system and would, become a mere instrument for the acceleration and perpetuation of expansion, and that a wholesale scramble for the funds of the Federal reserve banks would ensue which would leave those banks only two alternatives - one, to lend their funds at the rate prescribed until the exhaustion of their reserves had been completed* and the other to f i x a d e f i n i t e limit upon their total volume of loans, thus adopting a rigid system of credit rationing# In the one case they would reach a point where they Would be unable to make further rediscounts no matter ho* insistent "or meritorious the demands might be, and in the other they would find i t necessary to place a l l applications for discount accommodations on a waiting l i s t until repayment of prior loans made new funds available. Very truly yours, V. p . G. BARDIW* Governor. Hon. George P. MiLean, Chairman, Committee On Banking and Currency, United States Senate.
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