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R e p ro d u ce d from th e U ncla ssified / D e cla ssified H o ld in g s ot th e N a tional A rcm ve s August 19, TO Discount Rate Committee Su bject: Volume o f Borrowing v s . FROM Mr. R ie fle r P r o f i t a b il i t y o f Borrowing To what exten t do member banks re s o r t more f r e e ly to borrow in g a t the Federal Reserve Banks as the le v e l o f ra tes in the money market in r e la tio n to the discount ra te makes i t more p r o fita b le to do so? This i s a c e n tra l question fo r discount ra te p o lic y . That some banks do borrow fran kly fo r p r o f it when market ra te s o f in t e r e s t r is e above the borrowing ra te i s e sta b lish ed by the ad m in istrative experience o f the Federal Reserve Banks' discounting a c t i v i t i e s . They have had, on occasion, to admonish member banks where the p ra c tic e was fla g r a n t and to in d ic a te t h e ir d e sire th a t outstanding discounts be repaid. That other member banks r e fr a in from borrowing from the Reserve Banks even when market ra te s make such borrowing h ig h ly p r o fita b le i s a lso demon stra te d by the ad m in istrative experience o f the Federal Reserve Banks. A la rg e number o f member banks never borrow a t the Reserve Banks a t a l l and a fu rth er number, who do borrow, are c le a r ly apprehensive of indebtedness to the Reserve Banks and repay t h e ir borrowing qu ick ly, ir r e s p e c tiv e o f the p r o f i t a b i l i t y o f m aintaining th a t borro’/dng. The problem, th erefo re, i s not one o f e s ta b lis h in g whether or not member banks ever borrow fo r p r o f it or whether or not member banks are e x c lu s iv e ly m otivated by a d e sire to remain out o f deb t. The problem, rath er, i s to come to a judgment on which o f these m otivations has been preponderant under conditions such as p rev a iled in the 1920's and conditions p r e v a ilin g sin ce the accord. I devoted a great deal o f e f f o r t to an a n a lysis o f th is problem in the 1920»s and came to the considered conclusion a t th a t time th a t a d e sire to avoid la rg e or continuous indebtedness had been the preponderant m otivation o f member banks. To the extent th is was tru e, market ra te s o f in t e r e s t tended to r is e when the n e c e s s ity fo r borrowing in creased . Correspondingly, they tended to f a l l when the n e c e s s ity fo r borrowing de creased. I t was th is re la tio n s h ip , furthermore, th a t made open market operations e f f e c t iv e as an instrum ent o f System p o lic y . At the same time, the evidence seemed to in d ic a te th a t p r o f i t a b i l i t y o f borrowing, though not a preponderant fa c to r as a m otivating fo rc e , was s u f f ic i e n t ly o p era tive to moderate flu c tu a tio n s in open market ra tes o f in t e r e s t , and to cause these ra te s , except in periods o f extreme ease or extreme t ig h t ness, to form themselves around the discount r a t e . Under these con d ition s, changes in discount ra te s were extrem ely important as a means o f e s ta b lis h in g a general le v e l around which market ra tes o f in t e r e s t flu c tu a te d . They a lso acted as a s o r t o f d is c ip lin e th a t maintained an a ttitu d e among member banks where borrovdng would be used fo r short adjustments but con tinuous or heavy borrowing was avoided. R e p ro d u ce d from the U ncla ssified / D ecla ssifie d H o ld in g s o f the N a tional A rch ive s 2 These conclusions were based both on the behaviour o f market ra te s o f in te r e s t , in th at they showed in t h e ir movements a much c lo s e r co rre la tio n w ith the volume o f borrowing than w ith f lu c tu ation s in discount rates* and a lso on an a n a ly sis o f th e b a sic reasons fo r changes i n the volume o f borrowing as revealed in the elements a n a ly sis o f fa c to rs responsible fo r the demand fo r Reserve Bank c r e d it. As a matter of fact, the elements analysis as a precise inclusive com putation was worked out in it ia l ly to see what lig h t i t could throw on th is problem, Karl Bopp, in his paper on the ’’Role of the Discount Rate", presented to the Conference of Presidents of the Federal Reserve Banks on June 21, 195U* has put forth certain fundamental modifications of these conclusions. 'While not denying d irectly the relationship of the elements analysis to fluctuations in member bank borrowing, he comes to the conclusion, nevertheless, th at the volume of member bank borrowing has been more larg ely affected by the p ro fita b ility of borrowing than my analysis would have shown, and th at "7fithin . . . . (a) lim it of perhaps several b illio n dollars . . . . the general level of borrowing is closely related to the spreads between the discount rate and market rate s." The only concrete evidence adduced to support these conclusions is summarized in two charts, one covering the period 1919-1930, the other covering the period 19%2-Sh* Both charts present data on fluctuations (1 ) in discount rates, (2 ) in rates in the most sensitive open market, and (3 ) in the volume of member bank borrowing. Both charts, also, contain a lin e showing the difference, positive or negative, between the discount rate a t New York and the most sensitive open market ra te . This lin e is used as a measure of the p ro fita b ility or lack of p ro fita b ility of borrowing at the Reserve Bank. There is a high degree of visual correlation be tween th is lin e and changes in the volume of borrowing, and i t is on the basis of th is visual correlation th at the conclusion is reached th at "the general level of borrowing is closely related to the spreads be tween the discount rate and market rate. This is the experience of the 1920’sj i t was confirmed in 195>2-?3. Borrowing increases when the discount rate is re la tiv e ly low and decreases when i t is relativ ely high in the structure of ra te s." These chart relationships also fur nish the evidence for the conclusion th a t " I t would appear, therefore, th at the (discount) ra te is an effective means of regulating to ta l volume of borrowing." The conclusions, therefore, re st on the thesis portrayed in the charts th at the relationship between the p ro fita b ility of borrowing and the volume of borrowing is a causal relationship in which changes in the p ro fita b ility of borrowing are the predominant causal factor in the changes in the volume of member bank borrowing. This is d irec tly contrary to findings which I have se t fo rth and. I would lik e to raise sharp issue with them. I would challenge these conclusions on two grounds. F irst, as a matter of analysis, I do not be liev e th a t a situ atio n in which member bank borrowing was motivated solely R e p ro d u ce d from the U ncla ssified / D ecla ssifie d H o ld in g s o f th e N a tional A rch ive s -3 - or primarily by profitability would lead to a situation where changes in the profitability of borrowing was reflected proportionately in changes in the volume of borrowing. I think the striking correlation shown on the chart between profitability of borromng to lend in the most sensi tive open market and the actual volume of borromng proves conclusively the opposite* namely, that member banks were not primarily or pre ponderantly motivated by profitability of borromng in most of the years shown on the chart, particularly "within a range of perhaps several billion dollars.'* If they had been so motivated, the striking month-tomonth correlation shown on the charts would not exist. It is very important to be clear about the kinds of causal relationships that can be deduced from statistical correlations. The history of statistical and economic analyses is well sprinkled with "spurious" and "reverse" causal findings. In the case in point, i.e., a comparison of fluctuations in market rates of interest with fluc tuations in member bank borromng and in discount rates, the correct relationships are as follows: A. The more member bank borromng is motivated by profit considerations and the less by a desire to avoid indebtedness, the more closely will fluctuations in market rates of interest correlate with the changes in the dis count rate and the less closely m i l they fluctuate with changes in the volume of member bank borromng. B. The more member bank borromng is responsive to the desire to avoid a situation of indebtedness, the more closely will fluctuations in market rates of interest correlate with fluctuations in member bank borrowing and the less closely will they fluctuate with changes in dis count rates. These are the principles from which the relevant charts must be read,both those I have presented and those presented in the paper "The Role of the Discount Rate". The reasoning leading to this con clusion is quite simple. If member banks, within a range of several billions of dollars, borrowed when (and because) it was profitable to do so and repaid their borromng when (and because) it became unprofit able to do so, they would borrow and lend in the most sensitive open market as soon as the rate of return in that market rose to a sufficient level above the discount rate to make the transaction profitable after administrative costs. They would continue to borrow as long as that margin persisted and they would retire from that market and pay off their borromng as soon as the excess reserves accruing to the market from that borromng put sufficient competitive funds into the market to drop the most sensitive open market rate below the margin of profitability. The result would be that the most sensitive market rate would tend to rise to R e p rod uced from th e U ncla ssified I D ecla ssified H o ld in g s o f th e N ational A rch ive s - u a certain margin above the discount rate and then tend to stabilize there as long as the factors in the elements analysis indicated a demand for borrowed funds at the Reserve Banks. A close month-to-month correlation would not be expected between fluctuations in profitability of borrowing and fluctuations in the volume of borrowing under these conditions. The correctness of this conclusion is proved, in fact, by one of the very charts presented in the paper to prove the opposite. There is one year shown on the chart when there was no correlation between profitability and volume of borrowing. In fact, the relationship was strikingly inverse. I refer to the year 1920. At that time, profit ability decreased sharply throughout the year while the volume of borrow ing increased sharply. In 1919, also, the correlation was poor. '!7e know from history that those were the years when, because of relation ships built up to promote war financing, the commercial bank tradition against being in debt to the Reserve Banks was weakest. Those were the years in which commercial banks were most willing to borrow to make a profit. I would not for a moment contend that the whole or any large part of the' striking increase in actual borrowing in 1919 and 1920 shown on the chart represented a response to this profit motive. We know from the elements analysis that this is not the case and that gold outflows and demands for currency account primarily for the increase in borrowing. I Tjjould contend, however, that a very small increment of profit-motive borrowing from the Reserve Banks is sufficient to reduce market rates of interest to a relatively small margin above the discount rate, and that when profitability as a motive for borrowing is present in appreciable degree a correlation between fluctuations in the profitability and fluc tuations in the volume of borrowing becomes conceptionally impossible. Certainly such correlations could not exist if profit-motivated borrowing remotely approached ranges of one billion dollars, to say nothing of several billion dollars. This leads to my second grounds for questioning the findings of this paper. I feel an analysis resting on a simple demonstration of a correlation between profitability of borrowing and the volume of borrow ing is incomplete. We have also at our disposal, as a tool that mil help in understanding these relationships, the elements analysis which permits us to "account" exactly for each dollar of member bank borrowing. We know in what proportions that dollar, if it was made available to the market through borrowing, served, for example, (1) to permit gold or currency to flow out, (2) to permit an increase in required or excess reserves, or in Treasury or foreign balances, etc., and (3) to replace a dollar withdrawn through open market operations. Similarly, a dollar of member bank borrowing repaid to the Federal Reserve Banks can be pro portioned through the elements analysis to concurrent movements in gold, currency, reserves, excess reserves, Treasury and foreign balances, etc., and open market operations. R e p ro d u ce d from th e U ncla ssified I D ecla ssified H o ld in g s o f th e N ational A rch ive s - 5 - The availability of this additional tool should help us to evaluate the line of causation between borromng, the profitability of money rates in the money market and gold and currency movements, open market operations and other factors in the demand for borrowing. We have, as a starting point, the two charts presented in the paper "Role of the Discount Rate.” These charts show a fairly close relationship between fluctuations in the volume of member bank borrowing and fluc tuations in the difference, plus or minus, between the discount rate, i.e., the member bank borrowing rate, and the most sensitive rate in the open market. In the chart covering the 1920's, where profitability is measured as the difference between the New York Bank's discount rate and the widely fluctuating call loan rate, the scale of the chart has been so drawn that a change of 1 per cent plus or minus in the margin between the call loan rate and the discount rate is related roughly to a comparable change of 100 million dollars in the volume of member bank borrowing. In the chart covering the years 1952-51;, where profitability is measured as the difference between the New York Reserve Bank's discount rate and the more stable rate (as compared with the call loan rate in the 1920's) on Treasury bills, the scale of the chart has been so drawn that a change of 1 per cent plus or minus in the margin between the Treasury bill rate and the discount rate is related roughly to a comparable change of one billion dollars in member bank borrowing. Now, we have here a demonstrated and consistent (except for 1919 and 1920) relationship, on the one hand, between the volume of borrowing and the profitability of borromng, and, on the other hand, we have in the elements analysis a consistent and completely invariant relationship between changes in the volume of borromng and changes in the other factors in the element analysis, i.e., open market operations, gold movements, currency movements, changes in the volume of required and excess reserves, etc. It follows as an algebraic necessity that, as shown below, we can combine these two relationships into one statement, and in the process cancel out the common term, i.e., changes in the volume of borrowing and thus relate directly, for purposes of causal analysis, changes in profitability of borromng to changes in the factors for reserve funds other than member bank borrowing. Let a = changes in member bank borromng in any given period, b - changes in the profitability of borromng at the Reserve Banks in the same given period, and c = the net sum of concurrent changes in factors in the demand for Reserve Bank credit other than changes in member bank borrowing. R e p ro d u ce d from th e U ncla ssified / D ecla ssified H o ld in g s o f th e N a tional A rch ive s - 6 - Mow since a r b and a = c (roughly) according to the charts pre sented in "Role of the Discount Rate", (by definition) since the elements analysis is carried through to a com pletely balanced accounting concept, it follows that b = c, if the analysis presented in the paper is valid. In my view, this logical and algebraic necessity affords the acid test of the thesis presented in "Role of the Discount Rate." It means that if a 1 per cent change in profitability of member bank borrow ing in the 1920’s, as defined by the chart, was directly related sta tistically to a 100 million dollar change in member bank borrowing, then the same 1 per cent change in such profitability was equally directly re lated to a 100 million dollar change in the factors in the elements analysis other than member bank borrowing. If, for example, all of these other factors in a given period had remained unchanged except the one factor, open market operations, then a change in that one factor in such a way as to add 100 million dollars to the open market portfolio would fn the 1920’s be directly related to the concurrent decrease in the profitability of borrowing of 1 per cent. Similarly in the period since the accord, it means that if an increase of 1 billion dollars in the open market portfolio was directly related statistically to the concurrent de crease of one billion dollars in member bank borrowing, then the same in crease of one billion dollars in the open market portfolio was directly related to a decrease of 1 per cent in the profitability of borrowing. These relationships follow inexorably from the logic of the charts pre sented in "Role of the Discount Rate", from the scales used in those charts and from the ray in which the charts are cited to provide evidence for the conclusion that ""Within .... (the) limit of perhaps several billion dollars .... the general level of borrowing is closely related to the spreads be tween the discount rate and market rates. This is the experience of the 1920’s; it was confirmed in 1952-^3• Borrowing increases when the dis count rate is relatively low, and decreases when it is relatively high in the structure of rates." IVhile the relationships portrayed on the chart are purely associative, that is, a relationship of correlation is shown between changes in profitability and changes in borrowing with (so far as the chart is concerned) no indication of causality, the quotation cited clearly indicates that in the author's view the causality runs from profitability to changes in the volume of borrowing, i.e., that member banks in the aggregate borrow more not only when but because it is profitable to do so and reduce their borrowing not only when but because it becomes unprofitable. No other logic would be consistent with the reference to several billion dollars as the frame within which the re- R e p ro d u ce d from fh e U ncla ssified / D ecla ssifie d H o ld in g s o f th e N a tional A rch ive s - 7 - lationship was true or to the final conclusion that '’It would, appear, therefore, that the rate is an effective means of regulating total volume of borrowing." If that logic is correct, namely, that changes in the profit ability of borrowing have directly and preponderantly caused changes in the volume of borrowing both in the 1920 's and in 19$2-5h, it follows, according to the arithmetic of the elements analysis, that an addition to the open market portfolio of $100 in the 1920 *s that permitted member banks to reduce their borrowing by 100 million dollars would have been caused by a decrease of 1 per cent in the profitability of borrowing to lend on call loans, and that an increase in the open market portfolio in 19$2-5k that permitted member banks to pay off a billion dollars of borrowing would have been caused by a decrease of 1 per cent in the profit ability of borroyjing by member banks to buy Treasury bills. Now, changes in the open market portfolio are Initiated by the Federal Reserve System, not by the market. There have been large purchases and sales <5f securities by the Federal Open Market Account during the years covered by the chart. The decisions to make those purchases and sales have been arrived at after full discussion in duly recorded minutes of the Fed eral Open Market Committee. I have not checked the minutes through but I doubt whether any purchases have ever been made because the profitability of borrowing had decreased or any sales had been made because the profit ability of borrowing had increased. Strange things happened during the period of the pegs, but even these purchases and sales were not so moti vated. In the years covered by the chart, which do not include the years of pegging, purchases and sales of Open Market Committee were predominantly motivated by a desire to decrease or increase the necessity to borrow at the Reserve Banks. In carrying out these decisions, the profitability of borrowing was inevitably affected. That is the direction in which the causation runs. It does not run in the other direction as is indicated by the use made of the charts in the paper. Profitability did not first de crease because of discount rate action or extraneous market conditions, member banks did not then pay off their discounts because profitability had decreased, and the Federal Open Market Committee did not subsequently meet and decide to buy securities to provide funds to member banks to pay off borrowing that had already been repaid. On the other hand, purchases and sales were made in the full knowledge that they would have noticeable effects upon (a) the volume of member bank borrowing, (b) the level of rates in the money market, and (c) on the margin between those rates and the discount rate. This point can perhaps be made concrete by analyzing the figures and correlations shown on the chart presented in "Role of the Discount Rate" over the period April 19!?3 to June 1951+. In April 1953* with a dis count rate of 2 per cent, the average market yield on 90-day Treasury bills was 2,19 per cent, having a margin of profitability of .19 per cent. In R ep rod uced from th e U ncla ssified / D ecla ssified H o ld in g s o f th e N ational A rch ive s - 8 - June 19Sh> with a discount rate of 1-1/2 per cent, the average market yield on Treasury bills was .61; per cent, having a negative margin of profitability of .86 . The shift in profitability between the two dates, therefore, was 1.05 per cent. Correspondingly, borrowings at the Reserve Banks in April 1953 average 1,18 I4. millions of dollars, and in June 195U, 166 millions of dollars, a decrease of 1,018 millions of dollars. The question at issue is whether the decrease of 1 .0 5 per cent in the profit ability of borrowing caused member banks, as suggested by the paper, to pay off over 1 billion dollars since holding of Treasury bills on borrov/ed money was no longer profitable, or conversely, whether the decrease in profitability reflected huge accessions of reserve funds put into the money market by the Federal Reserve System, accessions which permitted member banks to pay off their borrowing and also had an effect on Treasury bill rates. The elements analysis shown in the table can supply a clue to the answer. The table shows that demands on the market Changes in Member Bank Reserves and Related I terns April 1953— June 195H (millions of dollars) Factors absorbing funds from market Factors adding to funds in market 1. 2. 3. Increase in F. R. holdings of U. S. securities outright 1,018 2. Decrease in gold stock 635 3. Increase in money in circulation 1,15U Decrease in member bank reserve balances 337 All other factors net 236 Total Decrease in F. R. dis counts and advances 1. 1,727 Total 7U 1,727 during the period as a whole were limited to a withdrawal of 635 millions of gold by foreign interests and an increase of 7U million in money in circulation. Against this, funds were supplied by aggressive purchases of U. S. securities in the open market by the Federal Open Market Account, amounting to 1,15U millions of dollars and by a huge cut in reserve require ments which permitted member banks to build up their excess reserves and still reduce their aggregate balances by 337 millions. The effect of all other factors was an additional supply to the market of 236 millions of dollars. It is exceedingly difficult, if not impossible, to envisage a line of reasoning by which a decrease in the profitability of borrowing R e p rod uced from th e U ncla ssified I D ecla ssified H o ld in g s o f th e N ational A rch ive s caused member banks in this period to reduce their discounts by 1,018 millions of dollars. Yet the correlation over this period between the drop in profitability of borromng and the drop in the volume of borrow ing is one of the major and most striking correlations shown on the chart. It is not difficult at all, on the other hand, to go over the debates within the Federal Reserve Board and the Federal Open Market Com mittee and find the considerations which led them to reduce reserve re quirements and purchase securities aggressively in the open market in full knowledge and expectation that their actions would supply member banks with funds to pay off their borrowing and that lower money rates in the market and a decline in the margin between those rates and the discount rate would ensue. Conclusions 1. Historically, when the Federal Reserve System was not pegging the Government securities market, there has been a close re lation between fluctuations in the volume of borromng and fluctuations of money rates in the open market. This was true of the period 19211930 and has been true since the accord. 2. Since money rates in the open market have fluctuated over a wider range than discount rates, there has necessarily been a similar but less close relation between fluctuations in member bank borromng and in the estimated profitability of borromng as measured by the difference plus or minus between open market money rates and discount rates. 3. These relationships have been closest when member banks predominantly observed the tradition against continuous indebtedness and resorted to the discount privilege primarily for temporary accommodation pending other portfolio adjustments. The relationships have been loosest or nonexistent in those periods, such as 1919 and 1920, when an appre ciable proportion of member banks have shown a disposition to resort freely to the discount window of the Reserve Banks either to make a profit or to defer or avoid other adjustments in their operations. iu It is logically permissible to cite these relationships be tween fluctuations in the volume of borromng and in open market money rates as valid statistical evidence of the predominant attitude of member banks toward the discount privilege. So long as that attitude is against borrowing for profit, it is also permissible to cite these relationships as evidence that factors which supply or absorb reserve funds, particularly factors representing instruments of Federal Reserve System policy, such as open market operations and changes in reserve requirements, can and do affect money rates in the money market roughly in proportion to their effect on the borromng of member banks. R e p rod uced from th e U ncla ssified I D ecla ssified H o ld in g s o f th e N ational A rch ive s - 10 - 5. It is not logically permissible to draw from these re lationships the conclusion that within a limit of several billions of dollars the general level of member bank borrowing has been related in a causal sense (except in 1.919-1920) to spreads between market levels of interest rates and discount rates. Before making any such deduction, with cause running from the profitability of borrovang to changes in the volume of borrowing, the latter changes would, at the least, first have to be corrected for funds put into or taken out of the market through open market operations or other factors outside the control of member banks. In other words, the day-to-day correlation to test the effect of profitability on borrowing or the volume of borrowing would probably have to be run in terms of excess reserves, or possibly, also, in terms of changes in required reserves. I feel that it would be extremely difficult to isolate valid correlations. 6** A close examination of the historical evidence suggests that some member bank borrowing is affected by profitability. ”7hen this has happened on a vri.de scale as in 1919-1920, the simple statistical correlation between volume of borrowing and profitability disappears. Ihen it occurs on a smaller scale, the correlation, while it does not dis appear, is weakened. In either case, historically, the volume so affected has never ranged over billions of dollars. The effective range is probably in the tens or 5>0 millions of dollars. Any amounts, even in the hundred million dollar range, would flood the open market with sufficient reserve funds to remove the element of profitability. 7- So long as member banks predominantly observe the tradition against large or continuous indebtedness, it will be difficult, if not impossible, to isolate statistically the influence of the discount rate on the volume of borrowing. That volume is determined primarily by factors not subject to control by the member banks. As noted above, such fluc tuations in borrowing as result from changes in profitability are likely to be too small in relation to concurrent fluctuations caused by changes in float, open market operations, etc., to be isolated and detected. 8. These conclusions do not mean that the discount rate is un important, that it does not affect the willingness of member banks to borrow, or that it cannot affect the level of money rates in the market. Clearly, it can and does, but that importance and effectiveness is not measurable by a comparison of spreads between discount rates and rates in the market with the volume of borrovdng. When Federal Reserve policy actions have established a situation where the market as a whole must come to the Federal Reserve to borrow funds in appreciable volume to maintain required reserves, open market rates will, of course, be above the discount rate, and if the discount rate is raised above the market rates,those market rates will have to rise further. This will happen because most banks will try to avoid borrowing to make even temporary adjustments at a penalty rate. The consequences of these attempts to avoid borrowing at a penalty rate will R ep rod uced from th e U ncla ssified / D ecla ssified H o ld in g s o f th e N ational A rch ive s - 11 - raise market rates to a point where the penalty disappears. American experience has shown that it is impossible to have a penalty discount rate when the market is under pressure. 9. Profitability of 'borrowing has a direct relation to the volume of borrowing in one very important sense, namely, that little or no borrowing will take place at a penalty rate. It is always possible, of course, to establish a rate that can formally be described as a penalty rate by keeping the market so supplied with excess reserves through open market operations that no borrowing is necessary. It is a very different proposition to attempt to establish a discount rate that appears formally as a penalty rate, i.e., a discount rate higher than the bill rate, under circumstances where the Federal Reserve System desires to bring pressure against overexpansion by requiring member banks to obtain reserve funds through the discount window. In this case, the fact that member banks m i l go to 'great lengths to adjust their reserve positions, as for example through sales of securities, rather than borrow at a penalty rate, will set in motion the forces that cause market rates of interest to rise to such a point above the discount rate that the penalty disappears and borrowing appears profitable. Since different banks have different degrees of profitability at which they m i l undertake to adjust their reserve positions through borrowing rather than by other means, rates in the money market must rise, when the factors in the elements analysis require that some banks borrow, to the point where the mar gin of profitability was sufficient to induce the marginal member bank to borrow enough funds from the Federal. Reserve Bank to bring balance in the elements analysis. Understood in this sense, profitability is not really a cause of borrowing, it is rather a necessary condition that must be established by rising interest rates in the market to induce the volume of borrowing that is necessary to clear the market. Understood in this sense, also, it becomes clear why a penalty rate could not be established and maintained under conditions where reserve policy was actively directed at restraint. 10. Under certain rigid assumptions as to the distribution of the schedule of the willingness or aversion felt by member banks toward borrowing at different degrees of profitability, it might be theoretically possible to find a correlation similar to that shown on the charts between the volume of borrowing and the profitability of borrowing. It would have to differ from the relationships shown on the charts, however, in one re spect, namely, the correlation between changes in the volume of borrowing and changes in profitability of borrowing would have to be closer rather than less close than the correlation between changes in the volume of borrowing and changes in rates in the open money market. The most important limiting assumption would be that no important number of member banks borrow freely because it was profitable to do so. If even a relatively small number of larger member banks borrowed freely on the appearance of a margin of profit between the bill rate and the discount rate, that margin would dis appear. The correlation, moreover, would tend to be inverse, i.e., the R e p ro d u ce d from th e U ncla ssified / D e cla ssified H o ld in g s o f th e N a tional A rch ive s - 12 - larger the volume of borroiving the smaller the margin of profitability. Any correlation between money rates or the profitability of borrowing thus rests essentially on the desire of banks to avoid debt. Perhaps the essential statistical analysis will become more clear if it is stated as follows: (a) If the desire of member banks to avoid indebted ness was so strong that they never borrowed under any circumstances, banks would have to adjust to deficiencies in reserves by credit contraction sufficient to balance the elements analysis mainly through reductions in required reserves, contraction of the currency or the inducement of a gold inflow. Under these circumstances, money rates in the open market would fluctuate over a very large range in response, say, to open market operations, a range much larger than any in the ex perience of the Federal Reserve System* (b) Since member banks in general have desired to avoid continuous indebtedness but have borrowed for temporary periods pending other adjustments when the market was deficient in reserves, money rates in the open market have fluctuated with the volume of borrowing and have brought about a situation where borrowing appeared profitable when there was need for it. The ranges of fluc tuation of money rates, however, have not been extreme. These developments account for the correlations we have actually observed between 1921 and 1931 and also in recent years. (c) If any really appreciable volume of borrowing was motivated solely by its profitability, fluctuations in money rates in the open market would be very much smaller than they have been in Federal Reserve experience. They would be limited for all practical purposes to the range of fluctuation of the discount rate and in fact would closely approximate that rate. How close that approximation can be in the highly sensitive.New York money market was proved by the behaviour of acceptance rates in the 1920's. Acceptances represented an asset which the member banks and the market could sell to the Reserve Banks to obtain reserve funds without showing indebtedness on their balance sheet. They were sold freely to the Reserve Banks, consequently, whenever it was profitable to do so. The result was not a statistical correlation be tween the volume of acceptances sold to the Reserve Banks and the margin between the market acceptance rate and the acceptance buying rate posted by the Reserve Banks but an almost exact and invariant correlation between rates on Reproduced from the Unclassified / Declassified Holdings of the National Archives - 13 - acceptances in the market and the buying rate on acceptances posted by the Reserve Banks. Then there were any dis crepancies, investigation would show, X think, that they reflected unwillingness of the Reserve Bank to buy all bills offered at the posted rate. 11. The charts corroborate the finding that for the years shown since 1921, the role of the discount rate predominantly was to police the tradition against unjustified reliance on the borrowing privilege. When the System desired to tighten the market, it customarily did so through sales from its open market portfolio or by failing to add to its portfolio when reserve funds were in demand. This threw the burden of obtaining funds on the member banks who were forced to borrow them at the discount window. The immediate effect was to tighten the market and also widen the spread between the discount rate and market rates of interest, '"hen this spread had vddened to the point where the potential profitability of borrowing threatened to break down'the tradition against undue reliance on borromng, the System usually raised discount rates. Market rates also rose in consequence, ■with the result that the spread as such was not greatly affected. The effect of the generally higher level of rates, however, engendered a conservative financial attitude and a decision on the part of most bankers to get their houses in order. 12. Changes in the discount rate can, of course, affect the volume of borrowing to the extent that they affect the demand for cash balances, either currency or deposits, or attract or repel funds to other financial centers (via gold movements). These are longer range effects. They would not be sho^m in a correlation analysis on a current basis. They can be analyzed, however, in accounting for the forces which cause changes in the elements analysis. If the world was func tioning freely under the gold standard (not the gold exchange standard), it would be perfectly possible, theoretically, for changes in discount rates to affect decisively the profitability of borrowing and through these repercussions the volume of borrowing. Even so, however, the results of these effects could not be tested by the simple linear correlations used as proof in these charts. Reproduced from the Unclassified / Declassified Holdings of the National Archives December 20, 195U Christmas Verse — Allan Sproul Short-term, long-term, Nearest thing to money, Treasury bills and arbitrage And other things — not funny? Forget it all this Christmastime, Dismiss it with a laugh, Who knows but Scots and Dutchmen May find a middle path. Reproduced from the Unclassified I Declassified Holdings of the National Archives i/BCQiat>er Christaum 7er»o — kil&n Bprml Short-term, long-tam , Hoardst thing to ewney, Treasury b ills And arbltr&g* And other things —* not funny? Forget i t a l l th is Christmastime, M seise i t with «, laugh, ttho kriarws but Scots ar»«i Dutchmen lM $ find a middle path* £0, 19>« Reproduced from the Unclassified I Declassified Holdings of the National Archives COPY DEPARTMENT OF HEALT;!, EDUCATION, AND WELFARE O ffic e o f The Under S e c r e ta r y December 21, 195k D ear Win: Thank you v e ry much f o r y o u r l e t t e r o f th e t h i r t e e n t h and f o r sen d in g me y o u r memorandum, " P ro p o sal to In s u re S h ares o f C re d it U nions." I t was good o f you to p re p a re th e m a te r i a l , and I look fo rw a rd w ith i n t e r e s t to re a d in g i t . W ith b e s t w ish e s, S in c e re ly , (S ig n e d ) Nelson N elson A. R o c k e fe lle r Mr. W in fie ld W. R i e f l e r A s s is ta n t to th e Chairman Board o f G overnors o f th e F e d e ra l R eserve System W ashington, D. C. Reproduced from the Unclassified I Declassified Holdings of the National Archives December 13, 19#*. The Honorable Kelson A* Rockefeller, Under secretary, Department of Health, Education, and Welfare, Ifealth, Education, and Welfare Building, Washington 25, D. C. Dear Nelsom lou asked m to prepare a stenorandua expressing off apprehensions about the direction in which Federal credit unions are moving* 1 tried to put thea dam on the enclosed paper. Xou understand, of course, that this is completelypersonal* Sincerely yours, Winfield w. Riefler, Assistant to the Chairman. Enclosure. xt?K*dk* Reproduced from the Unclassified / Declassified Holdings of the National Archives pecotnbor 13, 19&. The Honorable Arthur P. Burns, Chairman, Council of Economic advisers, Executive Office Building, 'Washington 25, D. €. Dear Arthur* »Vhen Nelson Roeieefelliir asked that I prepare a expressing wp apprehensions with respect to the direction in which Federal credit unions were going* you asked that you re ceive a copy also* 1 have just sent the enclosed memorandum to Mr* Rockefeller. You understand, of course, that this is purely personal. Very sincerely yours, Winfield 1# Jlieflar, Assistant to the Chairman. Enclosure, M tc le Reproduced from the Unclassified I Declassified Holdings of the National Archives ffrq p a s ttl t o I n t i r o S h ra m o f C r a d lt a n io n s W in fie ld W. H s f l s * * Ths Oowrnasnt of tbs Halted gtates putt its general credit St thS of tfr* gfnwgnywt 9rgfints*tia& «hen it gUflZWlteeB the paper shioh that organisation issues to obtain fund# for its operations. Suoh paper is m so lon#sr flmsd be ths longer sub^eot to r isk . ** tfr shat is frff'fog foj* sxsspls# of its loans* ths rats of return ths tsm s Its purchasers nith their nonsy, Their only concern is with on ths pspsr oan be llqpldfttsd. Is onion? in §i^ desirable fo r ths aenbsrs of a credit &ossn*t this nsgate ths idsa %tn?lf of s credit union? Crsdit «*>*.<«** have rtn* and only ons uniQus fsature to Justify ths law persitting their charter ss s separate type of lend ing institution. That feature is thsir non^rofssslonsl charsetsr* It s n t h s oontsntlon of Ihntt 1t!s s T lifts sbo sponsored t h s o r s d i t onion ls» that ths plight o f poor but frugal faailies caught i n t h s ssb o f financial sd w sitg r, because o f s is k x is s s , disaster, e t c . , could bs s3JU rfi*ts< & i f provision were nads for the chartsr of oredlt u n io n s . I t sm contended that ^4 not haws t o b s pm fnssi frrttl 1 ta d *fosn th s tso partis* t o th s tr s n s s o t4 o n knsw each o th e r ^ » » w > o f d o s e p e r s o n a l jjn ro rl if il rwij nsiflhbdrhood. It w as p o o l thsir funds for a s arlsss naturally i n ft tiN y o r th s t oeoole. s o aasociated. to s s o h o th e r ifa s n thsgr vwni i n nsed snd Reproduced from the Unclassified / Declassified Holdings of the National Archives • 2• thus. eliminate the scope of operation of the loan shark. It was Such people, held, Old not need skilled training in credit analyses, elaborate examination, or * hlgfcOy professional set up, since share holders would not entrust their savings to officers of a credit anion who would lend them Imprudently or foolishly, and these officers in turn would not lend these' savings to the improvident. Clearly, no one of these incentives would apply with aj^rthing like the saxae force if savers could purchase shares in credit unions with the assurance that their share* were as safe as E bonds so far as safety of principal was concerned, and with the prospect that they might yield a return to the purchaser materially higher than E bonds. The problem posed by the credit union today is not how to attract more funds into this particular type of institution but rather how to preserve its character as a small non-professionalised insti tution for mutual self-help aiaang closely associated people, such as neighbors or co-workers. It is this attribute of credit unions that justifies (1) the law ptn&tting their charter, (2) their tax exempt status, and (3) the free services in the way of office space, unpaid services, etc., which they frequently enjoy. Most existing credit unions are saall and, so far as they can be judged by this factor alone, appear to be still non-professional, the story is different when the distribution of total assets of credit unions and of their expense statements are examined# Twenty per cent of tha total incosae of Federally chartered credit unions goes for wage and salary expense. This compares with 29 per cent for banks which are completely Reproduced from the Unclassified / Declassified Holdings of the National Archives *» 3 ** professionalised. A3#t*4r 111 Federally chartered orsdlt unions he** passed th* Billion dolUr lino. A nillion dollar financial inetitutlon no longer mrlt* the classification e f nan-professional• Xt needs skilled full~tia« aanftgeasnt, Its lendin® officers suet be m n o d in highly specialised mmil loan lending techniques and in professional methods for policing aollections. It protoefely reqt&re* the suum mtleuloa* m m t w M m prooeGaree and personnel bonding devices aa other professional *w institutions of eaoroarabls else. Tbs oredit union operates in the field of personal credit. An ft professional landing Institution, it can grew rapidly and go far in this field* Total consumer oredit outstanding it around teenty billions of dollars. It is ehareetsrised by relatively high rates of interest. Credit unions, vlth free quarters, no taxation, and the aTeilabilit* of uflpsdUl senrioee oaa really go to tarn if thsy start ooopeting for this business, most of which originates in that sector of the tm. *here thsy find their waabers* Thera be alfaoet aa Halt to their aotcntiil sranrth if they had federal guarantee of their shares and therefore eoctld coopete vlth S bonds for eatings. The oiftfriui ianediate orable* la to Draserve ths essential oharaoteriaties of eredit unions* I f that is preserved, they oan aake a unique contribution in iRaamiaing our society. This contribution i» lost ehen they beooae a sort of "fringe benefit" of the personnel dapar&nent o f a corporation and devote th*H 8*lw e to suoh aotivities as financing the autoaoMlii purchases of its eaployeae* That path leads to s is e , to professionalisation, te reposeesalon techniques. Reproduced from the Unclassified I Declassified Holdings of the National Archives . I i and to elaborate supervision procedures. ufam th* sod of th* path is reached, m v il l find ourselves with * matter of laoMm fwnftMMiwMtl lowti rm lnstltutioiiB. Trtvmr srcmrth aaui fostered toy tax a««iptioa, Federal guarantee and eubaidy, no aatter bow mioh m ssek to safecaard auch large profeaslonal lnstltutiona by acre elaborate auperrlsicm and examination procedures, they w ill alwaya, and inevitably, oonatitute elew nta of instability aad potential danger to tha aaaooth functioning of tha eoomwy booauae of concentra tion of riek, it la that prafoaalnnal tseri financial lnstltutiona p n o tlo i aa m oh diverslficstion of risk as possible* thla oredit unions oannot do, sines thay ara organised basically m m m A a single shop* Thalr auto***hlpa and thalr borrowers a ll a m aubjaot to tha m m seoaoodo hasard of unaag&oyMant in that ahop* It is thla fsar of what m y happen in a. depression to a onedlt unto© that Has baok of the proposal to Insure their shaxws. Surely it ia important 'that astbods other than insurance ba devised to fKTOfeaot against this two?. Deoewbor 13t 19Slu Reproduced from the Unclassified I D edaflified Holdings of the National Archives 7tt4Zc/eUj V '* > , ^ , <L w ^ c iA u u . /•< « /< _ >7" - & .«(. ^ h ^ <K & t M t n U .A .__ it K &f~ ^ flr f- *ft 'J ^ o j .r f a .7 L i u U ' ^ ^ ’u . y**^ ^ w/ C o i/^ * < & ,/ " ^ ^ Q y ^ s ^ J la ./n io <A n 4 ~ S h fiA - *//£ I L t iu i* , 'P- <4 Reproduced from the Unclassified I Declassified Holdings of the National Archives August 15, 1956. Dear Sandra: If you are really interested, oagrbe the following will help you locate Hilton Head; Hilton Head, by Josephine Pinckney TUlus. by Rafaello feuaoni)* Published 19kl fcgr Farrar & Rinehart (at $2.75). Also published by F. & S.’s Canadian affiliate, Oxford (Toronto), at $3*2£. <2k o a s e s . If you do anythirgwith It, I imagine you will be the first teacher of history north of the Haaon-Dixon ULne that has, Sincerely, W in fie ld W. R i e f l e r , A s s is t a n t to t t o C h a lra a n . M rs. S o g e r P ie r c e , 2836 C h esap eak e Street, N. W ., W ash in g to n , S . C . W iS te l*
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