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THE FEDERAL RESERVE SYSTEM TH E FEDERAL RESERVE SYSTEM Its Purposes and Functions P rinted In U. S. A. B y T h e N ational C apital P ress W a sh in gton , D. C. TABLE OF CONTENTS CHAPTER I PAGE A G eneral O utline of th e F ederal R eserve System ...................................................................... 13 The Federal Reserve System comprises the Board of Governors, the twelve Federal Reserve Banks, the Federal Open Market Committee, the Fed eral Advisory Council, and the Member Banks; the System’s functions lie in the field of money, credit, and banking. II T he Service F unctions of th e F ederal R e serve B an ks ........................................................... 25 The twelve Federal Reserve Banks hold the legal reserves of member banks, furnish currency for circulation, facilitate the collection and clearance of checks, exercise supervisory duties with respect to member banks, and are fiscal agents of the United States Government. III T he F unction of B ank R eserves..................... 39 The amount of reserves held in relation to legal requirements is a controlling factor in the lend ing policy of banks. IV T he E xpansion and C ontraction of B a n k R eserves .................................................................. The ability of member banks to lend is largely dependent upon the volume of their reserves; they are required to keep their reserves on deposit with the Federal Reserve Banks; and the Fed eral Reserve authorities are empowered to extend Federal Reserve Bank credit for the expansion of those reserves. Therefore, the Federal Rasorve authorities, through the medium of bank reserves, are able to influence the extension of member bank credit. 5 47 6 CONTENTS CHAPTER V PAGE T he C omposition of B ank R eserves................... 59 Federal Reserve Bank credit and gold are the two main sources of bank reserves; checks are the principal means by which reserves are trans ferred from bank to bank. VI R eserves of the I ndividual B a n k and of the B a n kin g S ystem as a W h o l e ........................... 68 Additional reserve funds that enable the indi vidual bank to enlarge its own loans by an almost equal amount, enable the banking system as a whole to enlarge the aggregate of loans by several times as much. V II F ederal R eserve P owers and L im it a tio n s . . . 76 Although Federal Reserve powers are important and extensive, they are nevertheless constantly subject to limitations inherent in the conditions under which they are exercised. V III M ember B a n k R eserves and R elated I tems . 87 The principal factors involved in Federal Reserve policy are member bank reserve balances, gold stock, Federal Reserve Bank credit, money in circulation, and Treasury cash and balances. IX W hat th e T welve F ederal R eserve B anks Ow n and W hat T h e y Ow e ................................ 96 The central banking functions of the Federal Re serve System are reflected in the balance sheet of the Federal Reserve Banks. X F ederal R eserve B a n k E a r n in g s ...................... The operations of the Federal Reserve Banks, although not conducted for profit, yield an in come which is ordinarily sufficient to cover expenses. 104 7 CONTENTS CHAPTER XI PAGE M argin R equirements........................................ 109 The Federal Reserve authorities have special power to curb the use of credit for speculation in securities. X II Su m m a r y ............................................................... 113 The Federal Reserve System has successfully overcome certain difficulties that formerly beset American economic life and imposed upon it great losses; the System still has constantly to meet new problems and difficulties. Federal Reserve Publications............................ 119 ............................................................... ... 121 Index . •'V* CARTER \ ■ -D E F E N D E R OF T H E F E D E R A L RESERVE SYSTE M I IN THE F E D E R A L R E SE R V E A C T A G R E A T A N D V IT A L BAN NOT M ERELY T O P E R IO D IC A L CORRECT AND F IN A N C IA L N O T SIM P L Y IN D E E D DEBAUCHES TO A ID C O M M U N IT Y ALO N E BUT T O G IV E V I S I O N A N D S C O P E A-N D S E C U R I T Y T O C O M M E R C I AND A M P L IF Y T H E O P P O R T U N I T I E S AS WELL AS T O THE C A P A B IL IT IE S A T -H O M E A N D IN C R E A S E O F O U R I N D U S T R I A L L IF E AM ONG F O R E IG N N A T IO N S AN ADVENTURE in CONSTRUCTIVE fINANC CARTER CtASS B ronze B as-relief and I nscription , L eft W all , E ntrance F ederal R eserve B uilding , W ash in gto n , D. C. to the W O O D R O W W IL S O N FOUNDER O F T H E F E D E R A L RESERVE SYSTEM W E S H A L L D E A L W IT H AS IT IS A N D AS N O T AS OUR IT M I G H T IF W E H A D A C L E A N TO AND E C O N O M IC BE SHEET O F W R IT E PAPER UPON S T E P B Y ST E P W E S H A L L M A K E WHAT SYSTEM IT M A Y B E M O D I F I E D IT S H O U L D IT BE r FIRST INAUGURAL ADDRESS WOODROW WILSON B ronze B as -relief and I nscription , R ight W all , E ntrance F ederal R eserve B uilding . W ash in gto n . D. C. to the FOREWORD This book is intended primarily for students, bankers, business men, and others who desire an authoritative statement of the purposes and functions of the Federal Reserve System. It is neither a primer, nor is it an exhaustive treatise. The aim has been to have it cover the middle ground between those ex tremes and to make it clear and readable without neglect of essentials. The Federal Reserve System is twenty-five years old this year. Its operations have become a factor of great importance in American economic life. While they chiefly concern banks and the Government, their effects extend into all forms of economic activity and are felt indirectly by everyone. It is desirable, therefore, that the Federal Reserve System be as fully understood as possible by the public in whose interest it was established and in whose inter est it is administered. The text of the book has been prepared by Bray Hammond and the staff of the Board of Governors of the Federal Reserve System. T he Washington, D. C. May 1 , 1939. 11 B oard of G overnors of t OS F ederal R eserve SYsfem . F ederal R eserve B uilding , C onstitution A venue at 20t h Street, W ashington , D . C. CHAPTER I A GENERAL OUTLINE OF THE FEDERAL RESBBKVE SYSTEM The Federal Reserve S ystem comprises the Board oj Governors, the twelve Federal Reserve Banks, the Federal Open M arket Com m ittee, the Federal Advisory Council, and the M em ber B anks; the S ystem ’s functions lie in the field of m oney, credit, and banking. HE Federal Reserve System was organized in 1914. As now constituted, the System comprises the following: T 1. The B oard of G overnors . 2. The twelve F ederal R eserve B a n k s . 3. T h e F ederal O p e n M a r k e t C o m m i t t e e . 4. 5. The The F ederal A d viso ry C o u n c i l . M em ber B a n k s . Responsibility for Federal Reserve policy and deci sions rests on the first three of the above. In some matters the law puts primary responsibility on the Board, in some on the Reserve Banks, and in some on the Committee, though in practice there is close coordination of action. Accordingly, for the sake of simplicity, the term “Federal Reserve authorities” is frequently used when it is unnecessary to indicate which of the three is responsible for action or to what extent the responsibility is shared. - 1. The B oard of G overnors is composed of seven members. Their appointments are made by the Presi dent of the United States and confirmed by the Senate. Members are appointed for terms of fourteen years, so arranged that one term expires every two years. The 13 p^itAra^S A»u«)' ‘fouitk. gitki ftgiiK. ^gciuv Di'lriu /Si'iuuUirics ‘ftmtuK ‘ ffrrili.n jV-urwliuics P ain tin g , E ast W all of the B oard R o o m , F ederal R eserve B uilding , W ash in gto n , D . C. THE FEDERAL RESERVE SYSTEM 15 Board’s responsibilities lie in the field of money and banking. Their objective in a broad sense is to main tain sound banking conditions and an adequate supply of credit at reasonable cost for use in commerce, in dustry, and agriculture. The Board supervises the operations of the twelve Federal Reserve Banks. Its offices are in Washington, D. C. 2. Each F ederal R eserve B a n k serves a district comprising several States or parts of States. The Fed eral Reserve districts, and the location of the Federal Reserve Banks and their branches are shown on the preceding map. They are as follows: Federal Reserve Bank of Boston District Number 1 Federal Reserve Bank of New York District Number 2 Branch at Buffalo, New York Federal Reserve Bank of Philadelphia District Number 3 Federal Reserve Bank of Cleveland District Number 4 Branches: Cincinnati, Ohio Pittsburgh, Pennsylvania Federal Reserve Bank of Richmond District Number 5 Branches: Baltimore, Maryland Charlotte, North Carolina Federal Reserve Bank of Atlanta District Number 6 Branches: Birmingham, Alabama Jacksonville, Florida Nashville, Tennessee New Orleans, Louisiana Agency at Savannah, Georgia Federal Reserve Bank of Chicago District Number 7 Branch at Detroit, Michigan Federal Reserve Bank of St. Louis Branches: Little Rock, Arkansas Louisville, Kentucky Memphis, Tennessee District Number 8 16 THE FEDERAL RESERVE SYSTEM Federal Reserve Bank of Minneapolis District Number 9 Branch at Helena, Montana Federal Reserve Bank of Kansas City- District Number 10 Branches: Denver, Colorado Oklahoma City, Oklahoma Omaha, Nebraska Federal Reserve Bank of Dallas District Number 11 Branches: E l Paso, Texas Houston, Texas San Antonio, Texas Federal Reserve Bank of San Francisco District Number 12 Branches: Los Angeles, California Portland, Oregon Salt Lake City, Utah Seattle, Washington Each of the twelve Federal Reserve Banks is a cor poration organized and operated in the public service. The Federal Reserve Banks differ essentially from pri vately managed banks in that they are not operated for profit, and their stockholders, which are the mem ber banks, do not have the powers and privileges that customarily belong to stockholders of privately man aged corporations. Each Federal Reserve Bank has nine directors, three of whom are known as Class A directors, three as Class B directors, and three as Class C directors. These nine directors are not chosen the way the directors of busi ness corporations are usually chosen. Class A and Class B directors are elected by member banks, one director of each class being elected by small banks, one of each class by banks of medium size, and one of, each class by large banks. The three Class A directors may be bankers. The three Class B directors must be actively engaged in the district in commerce, agricul ture, or some other industrial pursuit, and must not be OUTLINE OF THE SYSTEM 17 officers, directors, or employees of any bank. The three Class C directors are designated by the Board of Gov ernors of the Federal Reserve System. They must not be officers, directors, employees, or stockholders of any bank. One of them is designated by the Board of Governors as chairman of the Reserve Bank’s board of directors. Under this arrangement, business men other than bankers constitute a majority of the directors of each Reserve Bank. The directors are responsible for the conduct of the affairs of the Reserve Bank, subject to the supervision of the Board of Governors. They choose the Reserve Bank officers, but the law requires that their choice of president and first vice-president be approved by the Board of Governors. The salaries of all officers and employees are also subject to the approval of the Board of Governors. Each branch of a Federal Reserve Bank has its own board of directors, a majority of whom are selected by the Reserve Bank and the remainder by the Board of Governors. These conditions with which the law circumscribes the selec tion of Reserve Bank directors and the management of the Reserve Banks, indicate the public nature of the Reserve Banks. Decentralization is an important characteristic of the Federal Reserve System. Each Reserve Bank and each branch office is a regional and local institution as well as part of a nation-wide system. Its officers and employees are residents of the district, and its trans actions are with regional and local banks. It gives effective representation to the views and interests of the particular region to which it belongs and at the same time helps to administer nation-wide policies. The Federal Reserve Banks derive an income from 18 THE FEDERAL RESERVE SYSTEM their operations which has been sufficient to cover expenses, to pay dividends limited to 6 per cent per annum, cumulative, to pay a substantial amount to the United States Treasury, and to make additions to sur plus. This surplus, if the Federal Reserve Banks were to be liquidated, would belong to the United States Government. 3. The F ederal O p e n M arket C o m m it t e e com prises the seven members of the Board of Governors and five representatives of the Federal Reserve Banks. The Committee directs the open market operations of the Federal Reserve Banks, that is, the purchases and sales of United States Government securities and other obligations in the open market. The purpose of these operations is to maintain a basis for bank credit ample to meet the business needs of the country. 4. The F ederal A dvisory C o u n c il consists of twelve members, one selected annually by each Federal Re serve Bank through its board of directors. The Council meets in Washington at least four times a year. It confers with the Board of Governors on general busi ness conditions and makes recommendations regarding the affairs of the Federal Reserve System. Its recom mendations are purely advisory. 5. M ember B a n k s include all national banks in the continental United States, and such State banks and trust companies as apply for membership, meet the requirements; and are admitted. On December 31, 1938, the membership comprised 5,224 National banks and 1,114 State banks. There were over 8,000 other State banks and trust companies (exclusive of mutual savings banks) that did not belong to the System; these were mostly small banks, their aggregate deposits OUTLINE OF THE SYSTEM 19 being about 17 per cent of the total deposits of all commercial banks. Each member bank, as required by law, holds stock in the Federal Reserve Bank of its district. This stock, equal to 3 per cent of its own capital and surplus, is acquired directly from the Federal Reserve Bank; it can not be sold, transferred, or hypothecated, and can be disposed of only by being surrendered to the Federal Reserve Bank. Each member bank is also required to maintain its legal reserves on deposit with the Federal Reserve Bank of its district. These legal reserves are propor tionate to the member bank’s own deposits, the pro portion varying according to the location of the mem ber bank and the character of its deposits. Higher reserves are required against demand deposits than against time deposits, and banks in large cities, gener ally speaking, are subject to higher reserve require ments than banks in smaller cities and rural regions. No interest is paid on these reserves. Member banks may and do maintain reserves in excess of requirements. On December 31, 1938, thenreserve balances amounted in the aggregate to about nine billion dollars, of which about three billion were excess reserves. The Monetary and Credit Functions of the Federal Reserve System The monetary and credit functions of the Federal Reserve System mean much more than merely the issuance of paper currency and coin. Currency is acta* ally used for only a small part of the country’s total volume of payments, the greater part being effected 20 THE FEDERAL RESERVE SYSTEM by the use of bank checks. Whenever business is so active that additional means of payment are required, the additional amounts may, to some extent, be called for in the form of currency, in which event the Federal Reserve Banks have facilities for furnishing promptly all that is required. Or the addition may be wanted in the form of bank deposits transferable by check, in which event member banks lend the required amounts. In case the member banks have any difficulty in mak ing the loans that are asked for, because their own funds are inadequate, it is possible for them to borrow additional funds from their Federal Reserve Bank and possible for the Federal Reserve authorities on their own initiative to supply additional funds through open market purchases of securities. Before the establishment of the Federal Reserve System, banks maintained the reserves required to be held against their deposits partly in the form of cash in their own vaults and partly in the form of deposits in other banks. In general, banks in smaller cities and rural regions maintained the bulk of their reserve bal ances with banks in larger cities. A very large volume of these reserve balances was maintained in New York City and Chicago. These two cities and St. Louis were designated as central reserve cities, and National banks therein had to maintain all their legal reserves in the form of cash in their own vaults. Under these circumstances, when banks throughout the country needed to draw down their reserve bal ances, the demand necessarily converged on a few banks situated in the financial centers. In ordinary times the demand was not excessive, for while some country banks would be drawing down their balances, others would be building theirs up. Now and theu, OUTLINE OF THE SYSTEM F ederal R eserve B a n k of 21 B oston 30 Pearl Street, Boston, Massachusetts however, the demand became wide-spread and intense. Banks all over the country would call on the Chicago and New York banks for currency, which the city banks were to supply and charge to the reserve bal ances of the country banks. In such circumstances, it might be difficult for the city banks to meet this demand, because the currency constituted their own reserves and there was no source on which they could rely for additional reserve funds. The efforts of these banks to protect their reserves frequently involved the sale of securities and the refusal to make loans and renewals, with the result that securities prices would fall, interest rates would rise sharply, borrowing 22 TH E FED ERAL RESERVE SYSTEM would become difficult, and loans would have to be liquidated. Panics and crises like this were apt to occur every few years, and in 1907 there was one of unusual severity. Congress appointed a National Monetary Commission shortly thereafter for the purpose of de termining what should be done. There was active and thorough consideration of the question for several years, and though Congress greatly modified the plan recommended by the Commission, it eventually adopted legislation embodying the results of study both by the Commission and by other authorities inside and outside Congress. This legislation is the Federal Reserve Act. It became law December 23, 1913. The Federal Reserve Act directed that the Federal Reserve Banks be established, required that reserves of member banks be deposited with the Federal Re serve Banks, and empowered the Reserve authorities to discount paper for member banks, to engage in open market operations, and to issue Federal Reserve notes. The member banks use the reserve accounts that they maintain with the Federal Reserve Banks in very much the same way that a bank depositor uses his checking account. On the one hand, they may deposit in the reserve accounts the checks on other banks and the surplus currency received from their customers; and on the other hand, they may draw on the reserve accounts for various purposes, especially to procure currency and to pay the checks drawn on them by their customers and deposited in other banks. The volume of reserves required by law is much greater, ordinarily, than these uses alone would make OUTLINE OF THE SYSTEM 23 necessary. The reason for this is that required re serves have an additional purpose: they are the means through which the Federal Reserve authorities influ ence the lending and investing activity of banks. As long as a bank has reserves in excess of requirements, it is in a position to enlarge its extensions of credit, assuming a demand. As long as it is without reserves in excess of requirements, it is not in a position to en large its extensions of credit and may be impelled to borrow additional funds. Since the Federal Reserve authorities have the power to increase or decrease the supply of reserve funds and within limits to increase or decrease reserve requirements, they are able to exer cise considerable influence over the amount of credit, in the aggregate, that banks may be in a position to extend. These functions of the Federal Reserve authorities are sometimes called “ central banking” functions. Practically every modern country has an institution for the performance of such functions. In Canada, it is the Bank of Canada; in England, it is the Bank of England; in France, it is the Bank of France. In the United States, however, there are twelve Federal Re serve Banks embraced in a regional system, and the coordination of their activities is effected through the Board of Governors in Washington. The duties of the Reserve authorities fall into two main groups. One group includes duties which relate primarily to the maintenance of monetary and credit conditions favorable to sound business activity in all fields— agricultural, industrial, commercial. They call for policy decisions from time to time rather than rou tine activity. They involve lending to member banks, 24 THE FEDERAL RESERVE SYSTEM open market operations, fixing reserve requirements, establishing discount rates, and issuance of regulations relating to these and other functions. The other group includes duties which relate pri marily to the maintenance of regular services for the member banks of the Federal Reserve System, the United States Government, and the public. These services are principally the following: holding mem ber bank reserve balances; furnishing currency for circulation; facilitating the clearance and collection of checks; supervising member banks and obtaining reports of condition from them; and acting as fiscal agents, custodians, and depositaries for the United States Government. These regular services engage by far the greater part of the time and attention of the officers and em ployees of the twelve Federal Reserve Banks. They will be described with more detail in the chapter im mediately following. In later chapters the monetary and credit functions of the Federal Reserve authorities will be discussed. CHAPTER II THE SERVICE FUNCTIONS OF THE FEDERAL RESERVE BANKS The twelve Federal Reserve Banks hold the legal reserves of m ember banks, furnish cur rency for circulation, facilitate the collection and clearance of checks, exercise supervisory duties with respect to m ember banks, and are fiscal agents of the United States Government. NE of the primary functions of the Federal Re serve Banks is to hold the legal reserves of mem ber banks. The member banks do not normally let these reserves lie in idleness awaiting an emergency but keep them in active use. This use entails a heavy amount of continuous work for the Federal Reserve Banks: furnishing the member banks coin and paper money of all denominations; receiving and sorting de posits of currency; and receiving, sorting, collecting, and clearing checks. O Furnishing Currency for Circulation On December 31, 1938, the amount of United States money in circulation— that is, the amount of currency outside the vaults of the Treasury and the Federal Reserve Banks— was $6,856,000,000. It was made up of the following classes: Federal Reserve Notes ................................... $4,405,000,000 Treasury Currency: Silver certificates ...................................... 1,339,000,000 Silver d o lla r s ............................................... 42,000,000 Subsidiary silver coin............................... 357,000,000 Minor c o i n .................................................... 151,000,000 United States n o t e s ....... .......................... 257,000,000 25 26 THE FEDERAL RESERVE SYSTEM Currency in Process of Retirement: National bank notes................................. Gold certificates (old fo r m )* ................ Federal Reserve Bank n o te sf.............. Treasury notes of 1 8 9 0 ............................ 201,000,000 75,000,000 28,000,000 1,000,000 $6,856,000,000 Federal Reserve notes are liabilities of the Federal Reserve Banks that issue them. They are a prior lien on the assets of the Federal Reserve Banks and are specifically secured by the pledge of collateral of at least equal amount. They are also obligations of the United States Government. As of December 31, 1938, the collateral pledged by the Federal Reserve Banks against the Federal Reserve notes in circulation com prised $4,888,000,000 of gold certificates (new form) and $3,000,000 of promissory notes and other obliga tions discounted by the Federal Reserve Banks, or $4,891,000,000 in all. Treasury currency, comprising silver certificates, silver dollars, subsidiary silver, minor coin, and United States notes, is issued by the Treasury itself, but it is placed in circulation for the most part through the Federal Reserve Banks. The kinds of currency in process of retirement, com prising national bank notes, gold certificates (old form), Federal Reserve Bank notes, and Treasury ♦There are two forms of gold certificates. The old form, com monly in circulation before 1934, is no longer in use, except for certi ficates still outstanding. These are being retired as rapidly as they come into the Treasury. The new form of gold certificate is issuable by the Treasury only to the Federal Reserve Banks and is not in circulation. t Federal Reserve notes and Federal Reserve Bank notes are two distinct types of currency authorized by the Federal Reserve Act. The distinction between them is technical and for all practical, pur poses Federal Reserve notes are sufficient. Federal Reserve Bank notes are, therefore, no longer issued. SERVICE FUNCTIONS 27 notes of 1890, are being replaced by other types of currency—mainly Federal Reserve notes and silver certificates. Their retirement does not mean that the amount of money in circulation is being reduced but that fewer different kinds of money are now being issued. All of the kinds of currency listed above are legal tender for all debts, public and private, public charges, taxes, duties and dues. All United States paper currency is printed at the Bureau of Engraving and Printing in Washington, D. C., and all United States coins are made at the Philadelphia, Denver, and San Francisco mints. The Bureau of Engraving and Printing and the mints are operated by the United States Treasury. Federal Re serve notes are printed by the Bureau at the expense of the Federal Reserve Banks. The total amount of paper money and coin in circulation — which, as indicated above, is about $6,856,000,000 — fluctuates relatively little. The new currency being constantly produced by the Bureau of Engraving and Printing and by the mints for the most part merely takes the place of old currency that has been soiled, mutilated, or worn so that it is no longer fit to use. How Currency Is Distributed There are two principal ways by which any indi vidual gets paper money and coin. Either he draws it out of his bank and has it charged to his account; or he is paid for his labor, his services, or his merchandise with money that has been drawn out of a bank by some one else. Practically all money, therefore, passes into and out 28 THE FEDERAL RESERVE SYSTEM of banks at one time or another. There are times when banks are called on to pay out more cash than they receive and there are times when they receive more than they pay out. The demand varies from season to season, from place to place, and from bank to bank. A heavy demand for currency at Christmas time is practically universal. In agricultural regions there is a heavy demand for cash at times when crops are being harvested; in cities there is a heavy demand for cash at certain times in the summer, particularly around the Fourth of July and Labor Day, when people with draw money for their vacations. Moreover, the demand varies for different kinds of cash. Some communities use more coin than others and less paper money, and some use more of certain denominations than others do. In accordance with this demand, banks provide themselves with the amounts and kinds of cash that the people in their communities want. Member banks depend upon the Federal Reserve Banks for replenish ment of their supply, ordering what they require and having it charged to their reserve accounts. Non member banks generally get their supplies from mem ber banks. The twelve Federal Reserve Banks in turn keep a large stock of all kinds of paper money and coin on hand to meet this demand. This includes both Federal Reserve notes, which are their own liabilities, and coin, silver certificates, and United States notes, which they obtain from the Treasury, giving the Treasury credit in its checking account for the amounts obtained. Until the Federal Reserve Banks were established in 1914, the means of furnishing currency for circula tion were unsatisfactory. A gap existed between the SERVICE FUNCTIONS A Sh ip m e n t of N ew C urrency , C ash D epartment 29 of a F ederal R eserve B ank Treasury and the banking system, and demand for in creased circulation could not always be met promptly. This was the case in the panic of 1907, and as already indicated, the experience of that year was one of the things that led to formation of the Federal Reserve System. The currency mechanism provided under the Federal Reserve Act has worked satisfactorily—money moves into and out of circulation automatically in re sponse to increase or decrease in the public demand. The Treasury, the twelve Federal Reserve Banks, and the thousands of local banks throughout the country form a system of currency distribution that reaches every community, that enables cash to be furnished 30 THE FEDERAL RESERVE SYSTEM promptly where it is needed, and that also enables sur plus cash to be retired from circulation at times when the public demand subsides. Collections, Clearances, and Transfers of Funds Currency and coin are indispensable, yet they are used only for the smaller transactions of present-day economic life. A hundred years ago they were used much more generally. The use of bank checks has increased to such an extent that payments made by check are now many times greater than payments made with currency and coin. The use of checks is facilitated by the service of the Federal Reserve Banks in clearing and collecting them through the reserve accounts of member banks. For example, suppose that a manufacturer in Hartford, Connecticut, sells $1,000 worth of electrical equipment to a dealer in Sacramento, California, and receives in payment a check on a bank in Sacramento. The check is an order on the Sacramento bank to pay the Hart ford manufacturer $1,000. Obviously, the Hartford manufacturer does not want to make a trip to Cali fornia to collect the $1,000 in cash, nor does he want to pay postage and insurance on a shipment of cur rency. He does not ordinarily want cash at all. What he wants is to have $1,000 placed to his credit in his checking account. Accordingly, he deposits the check in his Hartford bank. The Hartford bank does not require cash for the check; it wants credit in its re serve account at the Federal Reserve Bank of Boston. Accordingly, it sends the check to the Federal Reserve Bank of Boston. The Federal Reserve Bank of Boston sends it to the Federal Reserve Bank of San Francisco. The Federal Reserve Bank of San Francisco sends it SERVICE FUNCTIONS C heck Sorting, C heck C ollection D epartment R eserve B an k 31 of a F ederal to the bank in Sacramento. The bank in Sacramento charges the check to the account of the depositor who wrote it, and either remits the amount to the Federal Reserve Bank of San Francisco or authorizes the San Francisco Reserve Bank to charge the amount to its reserve account. The Federal Reserve Bank of San Francisco thereupon credits the Federal Reserve Bank of Boston. The Federal Reserve Bank of Boston in turn credits the account of the Hartford bank. Thus the check effects the transfer through the Federal Re serve Banks of $1,000 of deposit credit from the check ing account of the dealer in Sacramento to the check ing account of the manufacturer in Hartford. 32 THE FEDERAL RESERVE SYSTEM Even though a bank is not a member of the Federal Reserve System, it may nevertheless arrange to main tain with the Federal Reserve Bank what is called a “ clearing balance.” Checks drawn on other banks which are received by the nonmember bank and for warded by it to the Reserve Bank may be credited to this clearing balance, and checks drawn against the nonmember bank and deposited in other banks may be paid with funds from the balance. Checks which are collected and cleared through the Federal Reserve Banks must be paid in full by the banks on which they are drawn, without deduction of a fee or charge. That is, they must be paid “ at par.” The Federal Reserve Banks have greatly shortened and simplified the process of clearing and collecting checks. By doing so, they have improved the means by which goods and services are paid for and by which monetary obligations are settled; they have also re duced the cost to the public of making payments and transferring funds. The Federal Reserve Banks also handle other items for collection besides checks, such as drafts, promissory notes, and bond coupons. In order to make transfers and payments as promptly and efficiently as possible, the twelve Federal Reserve Banks maintain a fund in Washington called the Inter district Settlement Fund, in which each Reserve Bank has a share. Through this fund money is constantly being transferred by telegraphic order from the account of one Reserve Bank to that of another. Many millions of dollars of transfers and payments are made every day, including large transfers for member banks and for the United States Treasury. The relative importance of currency and of checks in Federal Reserve operations is indicated roughly by SERVICE FUNCTIONS 33 the following figures: in the year 1938 the twelve Federal Reserve Banks handled about five billion sep arate pieces of coin and paper money, the total value of which was $9,000,000,000. In the same period they handled a billion checks, the value of which was $232,000,000,000. In other words, the number of pieces of coin and paper money was five times as great as the number of checks, but the monetary value of the checks was over twenty-five times as great as the amount of currency and coin. Su p ervisory F u n ction s According to the preamble to the Federal Reserve Act, one of the purposes of the Act was “ to establish a more effective supervision of banking in the United States.” However, specific duties of supervision are entrusted by law to other agencies as well as to the Federal Reserve authorities. The examination and supervision of all national banks, which comprise the majority of banks belonging to the Federal Reserve System, are conducted by the Comptroller of the Cur rency. Examination reports made by his examiners as to the condition of banks are available to the proper Reserve authorities. The other banks which belong to the System— all of them State banks— are supervised by State authorities and examined by them with the cooperation of the Federal Reserve Banks. Informa tion is available to the Reserve authorities not only from the reports of examiners but also from periodic reports of condition submitted by the member banks themselves. Banks that are not members of the Fed eral Reserve System, but have deposit insurance in the Federal Deposit Insurance Corporation, are examined by the Corporation and by State authorities. 34 THE FEDERAL RESERVE SYSTEM Each of the Federal Reserve Banks has an examin ing staff for the examination of banks in its district. The Federal Reserve Banks themselves are examined by the examining staff which the Board of Governors in Washington maintains. Among other supervisory powers exercised by the Federal Reserve authorities, the most important are: 1. The power to fix the maximum rates of interest which member banks may pay upon time and savings deposits. The main purpose of this power is to prevent banks from paying such high rates, in competition for deposits, as to weaken their condition. 2. The power to take disciplinary action, including the following specific powers: to remove officers and directors of member banks— after citation in the case of national banks by the Comptroller of the Currency and in the case of State member banks by the Federal Reserve Agent— for continued violation of banking law or for continued unsafe or unsound banking practice; and to suspend member banks from recourse to the credit facilities of the Federal Reserve System if it is found that they are making undue use of bank credit for speculation in securities, real estate, or commodities. 3. The power to grant permits to national banks to exercise trust powers. 4. The power to grant permission to holding com panies so that they may vote the stock of member banks controlled by them. Such companies are usually corporations which own all or a majority of the stock of one or more member banks. 5. The power to grant permits to member banks to establish branches in foreign countries. Under this authority seven large banks situated in New York, Boston, and San Francisco maintain foreign branches, SERVICE FUNCTIONS 35 about a hundred in all, situated in twenty-three dif ferent countries. Fiscal A g e n c y F u n ction s The twelve Federal Reserve Banks carry the princi pal checking accounts of the United States Treasury, handle much of the work entailed in issuing and re deeming Government obligations, and perform numer ous other important fiscal duties for the United States Government. The Government has an enormous amount of bank ing business to do. It is continuously receiving funds in all parts of the United States and spending them in all parts. Its receipts come mainly from taxpayers and purchasers of Government securities and are deposited in the Federal Reserve Banks to the credit of the Treasury. Its funds are disbursed mostly by check, and the checks are paid by the Federal Reserve Banks and charged to the Treasury’s account. The Federal Reserve Banks also perform important services for the Treasury in connection with the public debt. When a new issue of Government securities is sold by the Treasury, the Reserve Banks receive the applications of banks, dealers, and others who wish to buy, make allotments of securities in accordance with instructions from the Treasury, deliver the securities to the purchasers, receive payment for them, and credit the amounts received to the Treasury’s checking account. The Reserve Banks also redeem securities as they mature, make exchanges of denominations or kinds, handle transfers and conversions, pay interest coupons, and do a number of other things involved servicing the Government debt. They issue and United States savings bonds and upon request in redeem hold 36 THE FEDERAL RESERVE SYSTEM them in safekeeping for the owners. For the conven ience of the Treasury and also for the convenience of investors in Government securities, it is necessary that there be facilities in various parts of the country to handle such transactions, and the Federal Reserve Banks furnish these facilities. Since the Federal Re serve authorities are constantly in touch with the money and investment markets, the Treasury follows the practice of consulting them for their advice as to the terms and conditions that will affect the sale and the refunding of Government obligations. In connection with the lending and other financial activities of such Government agencies as the Recon struction Finance Corporation, the Commodity Credit Corporation, and the Home Owners’ Loan Corporation, the Federal Reserve Banks act as custodians of collat eral and securities. This involves not only safekeeping but disbursement of funds upon receipt of proper docu ments and maintenance of accurate records of large quantities of securities, warehouse receipts for com modities, and other valuable papers which are con stantly in process of being received, transferred, and returned, as loans are granted, as partial payments are made, and as maturing obligations are paid off or renewed. The Federal Reserve Banks are reimbursed by the United States Treasury and other Government agen cies for much of the expense incurred in the perform ance of fiscal agency functions. Because of its situation in one of the principal finan cial centers of the world, the Federal Reserve Baj»k of New York acts as the agent of the United States Treasury in the foreign exchange operations of the SERVICE FUNCTIONS 37 F ederal R e s e r v e B a n k of N ew Y o r k 33 Liberty Street, New Y ork City, New Y ork Treasury’s Stabilization Fund. The Federal Reserve Bank of New York also has occasion to receive deposits of foreign central banks and to perform certain inci dental services as correspondent of such banks. The Board of Governors exercises special supervision over all relationships and transactions of Federal Reserve Banks with foreign banks. Such relationships are con fined almost wholly to the Federal Reserve Bank of 38 THE FEDERAL RESERVE SYSTEM New York, which in these matters generally acts as agent for the other Federal Reserve Banks. The service functions that have been described ab sorb the attention and time of the greater part of the Federal Reserve personnel. The fiscal agency and re lated activities alone occupy the full time of about 2,500 employees out of a total of about 11,000. These functions differ greatly in this respect from the task of determining and administering monetary and credit policy. Decisions as to discount rates, reserve require ments, and open market operations may need to be made by the Reserve authorities only occasionally. Yet, though they may take, on the whole, less time than functions that must be performed daily through the year, they may have more far-reaching effects upon the country’s economic life. CHAPTER III THE FUNCTION OF BANK RESERVES* The amount of reserves held in relation to legal requirements is a controlling factor in the lend ing policy of banks. HE aggregate deposits in the banking system as a whole represent mainly funds lent by banks or paid by banks for securities, mortgages, and other forms of investment obligations. It may seem that it should be the other way round— that bank loans and investments would be derived from bank deposits in stead of bank deposits being derived from loans and investments; and it is true that deposits would not grow out of loans if currency were to be used by the public for monetary payments to the exclusion of bank deposits transferable by check. But as it is, the public in general prefers to have its monetary funds— includ ing what it borrows— on deposit in banks rather than in the form of currency in its own possession. The result of this preference is that the proceeds of loans go on deposit to be disbursed by check, and aggregate deposits are increased. Suppose, for example, that a man borrowed $1,000 from a bank and took his loan in currency. The bank would have $1,000 less currency than before and in its place a promissory note for $1,000. Its deposits would remain untouched and unchanged. But suppose that the borrower, preferring not to take currency, asked for $1,000 deposit credit instead. In that case the bank’s currency would remain unchanged, it would T * The term “ reserves” as used in this book denotes asset reserves exclusively— that is, the reserves that count virtually as cash. It does not denote tee reserves against contingencies that m ay be set up on the liability side of a balance sheet. 39 40 THE FEDERAL RESERVE SYSTEM have the promissory note, and it would have $1,000 more deposits on its books. The loan, instead of de creasing the bank’s cash holdings, would have increased its deposits. Or suppose that the bank purchases a $1,000 Gov ernment bond from one of its customers. The customer does not want payment in currency— he wants pay ment in deposit credit. Accordingly, the bank acquires a $1,000 bond and its deposits increase by $1,000. The bank’s currency is not involved in the transaction and remains what it was.* It does not follow that bank deposits can be enlarged without limit by increased bank loans and investments. When banks give deposit credit to their customers, they assume an obligation to pay the customers’ checks. Consequently, they must have funds on hand for the purpose; though ordinarily the amount need not be more than a fraction of the total deposit liability. How much it should be depends largely on circumstances. But its amount relative to deposit liabilities limits the ability of banks to lend and to invest. The fact that banks can not increase their loans and investments unless adequate funds are available to them makes bank reserves of key importance. Upon the adequacy of reserves hinges the power of banks to expand loans and investments and therewith to ex pand deposits. Upon reserves also hinges the power of the Federal Reserve authorities to influence the credit policy of the member banks. * A s this and the preceding paragraph indicate, a bank’s purchase of investments, i.e., bonds, mortgages, etc., is an extension of credit just as a loan i s ; and bank investments increase bank deposit* just as bank loans do. For the sake of simplicity, the terms “ lending” and “ extension of credit” are often used where the purchase of in vestments b y banks as well as lending b y banks is meant. FUNCTION OF RESERVES 41 Bank reserves need to be understood from both the operating and the legal point of view. From the oper ating point of view, they may be described as that portion of a bank’s assets which the bank has not lent or invested but holds in cash or other forms readily available for use. In the early years of banking, re serves consisted of gold and other coin kept by each bank in its own chests; later on, reserves included also the funds which a bank might keep on deposit with another bank— usually with a larger one situated in an important financial center. The more conservative a banker was, the larger and more liquid the reserves he was inclined to maintain. Such reserves usually meant a sacrifice of income, but they also meant protection in time of emergency. Although sound banking practice called for the maintenance of adequate reserves, there were banks that failed to observe sound banking practice. Conse quently, about a hundred years ago, legislatures began to adopt legal standards, which might require, for ex ample, that a bank’s reserves be not less than 10 per cent of its note and deposit liabilities. But, while a legal requirement made certain that reserves be main tained, it also might interfere with their availability, since occasions would arise when a bank could not make the necessary use of its reserves without reducing them below the legal minimum. Just at a time when it was especially desirable, in the public interest, for banks to lend, they might be impelled to stop lending in order to avoid depleting the reserves which the law required them to maintain. Accordingly, it became clear after long and painful experience that to require reserves to be maintained in certain volume was not 42 THE FEDERAL RESERVE SYSTEM enough— there should also be means whereby banks could obtain additional reserve funds when needed. This need was met by the establishment of the Federal Reserve Banks and the organization of the Federal Reserve System; member banks were required to maintain reserves of a certain volume with the Federal Reserve Banks, and at the same time the Federal Reserve Banks were given the power to ad vance additional reserve funds to them either by lend ing to them directly or by purchasing securities and other forms of obligations in the open market. Since it became possible under this power for the earning assets of banks to be converted readily into cash and reserve funds, the maintenance of large liquid reserves by individual banks became less necessary. Banks were put in a more secure position than they had been in when no means existed for enlarging their reserves. In addition, the Federal Reserve authorities were directed to use their power not merely so as to as sure ample credit for the legitimate monetary needs of commerce, industry, and agriculture, but so as to curb the use of credit in speculation. Under these circum stances, reserve requirements took on a new signifi cance. They became important as a means of giving effectiveness to the regulatory powers to be exercised directly with respect to the volume of bank reserves and indirectly with respect to the extension of credit by banks. R e se rv e R eq u irem en ts As stated in the Federal Reserve Act, the reserve balances that must be maintained by member banks with their Federal Reserve Banks are as follows: T For member banks in central reserve cities (New 43 FUNCTION OF RESERVES York City and Chicago), not less than 13 per cent of their demand deposits (checking accounts) and 3 per cent of their time deposits (including savings). For member banks in reserve cities (sixty other cities of lesser size), not less than 10 per cent of their de mand deposits and 3 per cent of their time deposits. For member banks elsewhere (so-called “ country banks” ), not less than 7 per cent of their demand de posits and 3 per cent of their time deposits. The great est number of banks falls in this third classification, but the total volume of their deposits is smaller than that of either of the other classes. The law permits the foregoing requirements to be changed by the Board of Governors of the Federal Reserve System, “ in order to prevent injurious credit expansion or contraction.” It limits the possible change, however; requirements may not be made lower than those stated in the law nor more than twice as high. The following table shows the reserve requirements that have been in effect at different periods since 1917: June 21, Classes of deposits 1917and banks A ug. 15, 1936 A ug. 16, 1936Feb. 28, 1937 M ar. 1, 1937A pr. 30, 1937 M a y 1, 1937Apr. 15, 1938 Apr. 16, 1938 and after (P e r cent o f denosits') On net demand dep osits: Central reserve city banks . . . R eserve c ity banks ............... Country b a n k s .. On time deposits: A ll member banks ............... 13 10 7 3 19 % 22% 26 22% ioy2 17 % 12% 20 14 17% 12 4% 5% 6 6 15 44 THE FEDERAL RESERVE SYSTEM In practice, these requirements relate to balances maintained on the average over a period (semi-weekly, weekly, or semi-monthly depending on the bank’s location) and do not imply that the funds are to be left untouched. While maintaining his average reserve balance at or above the required minimum, a banker may make constant and active use of his reserve ac count. From day to day he may have credits to the account for checks on other banks received from his depositors; and from day to day he may have charges to the account for checks that have been drawn on him and deposited in other banks. He may also from time to time withdraw currency and have it charged to the account, and when he has more currency than he needs, he may deposit it at the Reserve Bank to be credited to his account. These current uses of his reserve ac count will not necessarily reduce his average balance below the requirement. Since reserve requirements govern the ratio between reserves and deposits, it is apparent that they may be regarded as limiting either the extent to which reserves may be allowed to shrink in relation to a given volume of deposits or the extent to which deposits may be al lowed to expand on the basis of a given volume of re serves. Sometimes an increase or decrease in deposits results in a simultaneous increase or decrease in re serves, but this is not necessarily so. Suppose, for ex ample, that a given bank has $2,000,000 of deposits, is required to have reserves of 10 per cent, and has ex actly that amount, namely $200,000. If a customer deposits an additional $100,000, either in cash or in the form of a check on another bank, the first bank not only has its deposits increased by that amount, but also is put in position to increase its reserves equally FUNCTION OF RESERVES Federal R eserve B a n k of 45 P hiladelphia 925 Chestnut Street, Philadelphia, Pennsylvania by depositing the currency or check in the Federal Reserve Bank. But suppose that instead of depositing $100,000 in cash, the customer borrowed that amount from the bank and deposited it in his account; in that case the bank’s deposits would be increased, but the deposit would bring no currency or check with which the bank’s reserves might be increased. Furthermore, the $100,000 which the customer borrowed might be checked out, in which case the bank’s reserves would be reduced by half, while its original deposits would remain unchanged. In brief, when borrowed funds are checked out, the 46 THE FEDERAL RESERVE SYSTEM result is a decrease in reserves; and when they remain on deposit, the result is an increase in deposits without an increase in reserves. In either event, lending has an immediate reaction upon the ratio of reserves to de posits. And, as a corollary, the amount of reserves held in relation to legal requirements is a controlling factor in the lending policy of a bank. CHAPTER IV THE EXPANSION AND CONTRACTION OF BANK RESERVES The ability of m ember banks to lend is largely dependent upon the volume of their reserves; they are required to keep their reserves on deposit with the Federal Reserve B a n ks; and the Federal Reserve authorities are em powered to extend Federal Reserve Bank credit for the expansion of those reserves. Therefore, the Federal R e serve authorities, through the medium of bank reserves, are able to influence the extension of m ember bank credit. HERE are three prominent factors that, in the absence of operations by the Federal Reserve au thorities, may render bank reserves inadequate in amount. One is an increased demand for borrowed funds, which, as banks increase their loans and invest ments in response to it, results in an expansion of bank deposits without a corresponding expansion of reserves. The second is an increased demand by the public for circulating currency: as the currency is withdrawn, it reduces both the reserves and the deposits of banks by the same amount, but the reduction in reserves is relatively greater than the reduction in deposits, since reserves are smaller than deposits. The third is a drain of gold out of the country, a condition which, like with drawals of currency, effects a reduction of reserves rela tively greater than the reduction it effects in de posits. Payments of Federal taxes by the public and purchases by the public of new issues of Government securities also tend temporarily to reduce bank re^ serves, but these reductions are soon offset when Government disburses funds it has received. T the 47 the 48 THE FEDERAL RESERVE SYSTEM When any of these factors renders member bank re serves insufficient, an occasion arises for Federal Re serve Bank credit— that is, for funds which the Federal Reserve authorities are empowered to supply for the specific purpose of replenishing or increasing member bank reserves. This need may be confined to rela tively few banks, or it may affect banks in general. It may be met through loans to individual member banks or through open market purchases, depending on pre vailing credit conditions and policies. D iscou n ts and A d va n ces for M e m b e r B an ks The loans which individual member banks may ob tain from the Federal Reserve Banks are of two main classes: (1) the discount of so-called eligible paper; and (2) advances. Eligible paper consists principally of notes, drafts, and bills of exchange used to finance payments for agricultural and industrial products. Such obligations are eligible for discount if their maturities at the time of discount are not more than ninety days in the case of commercial or industrial paper and not more than nine months in the case of agricultural paper. A mem ber bank owning such obligations may transfer them by endorsement to the Federal Reserve Bank, which will credit the proceeds thereof to the member bank’s reserve account after deducting a discount or interest charge at the established rate. Advances may be made by a Federal Reserve Bank to a member bank on the latter’s promissory note secured by collateral. An advance secured by eligible paper may have a maturity of not more than ninety days and is subject to the same discount or interest charge as eligible paper itself. An advance secured by EXPANSION AND CONTRACTION 49 other collateral satisfactory to the Federal Reserve Bank may have a maturity of not more than four months and is subject to a rate of interest not less than one-half of one per cent per annum above the current discount rate on eligible paper. Under the two foregoing provisions a Federal Re serve Bank may supply a member bank with any amount of additional reserves the member bank needs, the only limitation being the amount of good assets the member bank can offer the Federal Reserve Blink as security. D iscou n t R a tes Although the discount or interest rate which the Federal Reserve Banks charge their member banks is generally lower than the rate which commercial banks charge their customers, banks do not make it a prac tice to borrow from the Federal Reserve Banks for the purpose of gaining a profit by lending at a higher rate, nor has it been the policy of the Federal Reserve au thorities to encourage borrowing for such a purpose. When member banks borrow, it is for the immediate reason that they need to in order to avoid a deficiency in their reserves. The Federal Reserve authorities may raise or lower the discount rate from time to time, accordingly as it seems advisable to impose restraint upon the lending activities of banks or to encourage such activities. During the earlier period of the System’s operation — that is, until very recent years—member banks had no excess reserves and in the aggregate were substan tially in debt to the Reserve Banks. Under such cir cumstances, changes in the discount rates, which made this indebtedness either more or less expensive, were 50 THE FEDERAL RESERVE SYSTEM the principal instrument by which the Federal Reserve authorities gave effect to credit policy. In recent years, however, banks have had a large volume of excess reserves, there has been little occasion for them to borrow from the Federal Reserve Banks, and the discount rates have not had the importance they formerly had. Since 1934 they have been maintained at a low level. Throughout the entire year 1938 dis count rates on eligible paper were 1 per cent at the Federal Reserve Bank of New York and 1^/2 per cent at the other eleven Federal Reserve Banks, whereas in the 1920,s they varied from 3 per cent to 7 per cent at different Federal Reserve Banks at different times. The Federal Reserve Bank discount rates are more closely related to the so-called open market rates than to rates on the loans that banks make to their cus tomers. Open market rates include the rates on com mercial paper, bankers’ acceptances, Treasury bills, stock market call loans, and other forms of obligations that may be bought and sold in the open market or called without regard to the borrowers’ convenience. Open market rates are more sensitive to Federal Re serve credit policy or to market developments than are the rates banks charge their customers, because it is open market paper that banks usually purchase first when they have an excess of funds and dispose of first when they need funds. The relationship between open market rates and Federal Reserve Bank discount rates tends to be close when banks are borrowing and less close when they are not borrowing. O p en M a rk et O perations addi The second method of supplying banks with tional reserve funds is through open market purchases EXPANSION AND CONTRACTION F ederal R eserve B a n k of 51 C leveland East 6th Street and Superior Avenue, Cleveland, Ohio of Government securities and other obligations. These purchases are undertaken at the initiative of the Fed eral Reserve authorities and not of individual member banks. They do not have particular banks in view, but the aggregate reserves of the banking system as a whole. Securities purchased by the Federal Reserve authori ties in the open market come out of the portfolios either of banks themselves or of investors and corpora tions that are the customers of banks. If they come out of the portfolios o f in vestors and corporations, the checks given in payment by the Federal Reserve au 52 THE FEDERAL RESERVE SYSTEM thorities are deposited by the investors and corpora tions in their respective banks, and as a result bank deposits are increased. The banks in turn deposit the checks in their reserve accounts at the Federal Reserve Bank, so that bank reserves also are increased. If the securities come out of the p ortfolios o f banks, however, there is no resulting increase in bank deposits, because the funds paid for the securities are received directly by the banks themselves—not through their customers. There is a resulting increase in bank reserves, however, for the funds received by the banks are deposited by them in their reserve accounts at the Federal Reserve Bank. Open market purchases of securities by the Federal Reserve authorities always increase the re serves of banks, therefore, but whether they increase deposits as well depends on whether the securities pur chased come out of the portfolios of banks themselves or of bank depositors. To the extent that open market purchases increase bank reserves relative to bank deposits, they tend to furnish member banks a larger basis for credit expan sion, because expansion is limited by the excess of re serves over the ratio required by law to be held against deposits. Thus if $100,000,000 of securities purchased by the Federal Reserve authorities came from the port folios of investors, with the result that bank deposits as well as reserves were increased by that amount, a portion of the reserves— say $20,000,000— would be required as reserves against the $100,000,000 of new deposits, and only the portion remaining— in this case, $80,000,000— would be available for credit expansion. If, however, the $100,000,000 of securities came the of the banks themselves, the whole portfolios from EXPANSION AND CONTRACTION 53 amount, when received by the banks and added to their reserves, would be available as a basis for credit expansion. The funds paid for securities by the Federal Reserve authorities do not necessarily remain with the banks that happen to receive them first. Demand will deter mine to what particular banks the funds will go, in what volume, and how long they will stay with certain banks before being transferred to others. No matter what bank happens at any time to have possession of the funds, however, they continue to be part of the aggregate reserves of the banking system as a whole. The reverse of the process described in the preced ing paragraphs occurs when the Federal Reserve au thorities sell, rather than buy, securities. If the securities are purchased by investors and corporations — that is, by the customers of banks— there will be a reduction not only in bank reserves but also in bank deposits. If they are purchased by banks, the reduc tion will be in bank reserves on ly. In either event the reduction in reserves tends to diminish the amount of credit that banks can extend, but a reduction in re serves without a reduction in deposits tends to dimin ish it more rapidly, because there is no accompanying reduction in the amount of reserves required. Open market operations have different objectives at different times. At times their purpose may be to expand reserves, in which case securities are purchased. At other times their purpose may be to reduce reserves, in which case securities are sold. This does not mean that open market operations are a mechanical process by which any desired result may be obtained at On the contrary their efficacy is dependent upon a will. THE FEDERAL RESERVE SYSTEM 54 variety of conditions. In recent years, with reserves at a high and rising level chiefly because of the gold inflow, but with business recovery still incomplete, the policy of the Federal Reserve authorities has been to maintain the existing portfolio in substantially un changed volume. This policy has reflected the purpose of the Federal Reserve authorities to contribute to the maintenance of monetary conditions that would encourage recovery in commerce, industry, and agri culture. FEDERAL RESERVE BANK CREDIT 1914 1916 1918 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 The accompanying chart (Federal Reserve Bank Credit) shows the amount of Federal Reserve Bank credit year by year for the period the Federal Reserve Banks have been in operation. It reflects the fact that in the 1920’s Federal Reserve Bank credit was principally in the form of discounts for member banks, whereas in recent years it has been in the form of United States Government securities purchased in the open market. EXPANSION AND CONTRACTION 55 Federal R e se rv e B an k C redit and M e m b e r B an k Credit Loans and purchases of securities by the Federal Reserve authorities are one of the important sources of member bank reserves; member bank reserves in turn are the basis of member bank credit— that is, of the loans and investments of member banks. And member bank credit is a source of the bank deposits transferable by check wherewith business men and other persons make the bulk of their monetary pay ments. Member bank reserves function, therefore, as the link between Federal Reserve policy and member bank policy. Thus, for example, when there is an active demand for goods, there is a corresponding need for means of payment wherewith the purchasers may settle their obligations to the sellers. This need is reflected in part in a demand for member bank credit— that is, for funds to be lent by banks to the purchasers. The member banks can furnish the credit— that is, they can lend the funds— only if they have adequate re serves. But additional reserve funds are always avail able to them in the form of Federal Reserve Bank credit, which they may get either as the proceeds of loans made to them by the Federal Reserve Banks or as the proceeds of purchases of securities by the Fed eral Reserve Banks. In other words, member bank credit is used chiefly in the form of member bank deposits subject to check; Federal Reserve Bank credit is used chiefly in the form of member bank reserves held on deposit with the Reserve Banks; and the volume of member bank re serves— deriving in greater or less degree from Federal Reserve Bank credit— determines the ability of mem 56 THE FEDERAL RESERVE SYSTEM ber banks to meet the demands of their borrowers for member bank credit. It is important to note, however, that Federal Re serve Bank credit and member bank credit are not the equivalent of each other, dollar for dollar. Member bank reserves do not have to be increased by $500,000,000 of Federal Reserve Bank credit in order to make possible an increase of $500,000,000 in member bank credit. The additional Federal Reserve Bank credit needed will be only a fraction of the additional member bank credit to be extended. The explanation of this goes back to the fact that an increase in mem ber bank credit brings about an increase in bank de posits, because the funds that bank customers borrow commonly go on deposit; and to the fact that the re serves which member banks are required to maintain are only a fraction of their deposits. Suppose that banks were required to maintain reserves of 20 per cent and that they had just 20 per cent and no more. Then if their deposits were to be increased by $500,000,000, they would have to increase their reserves by but $100,000,000. Accordingly, $100,000,000 of Federal Reserve Bank credit obtained by borrowing or by the sale of securities to the Federal Reserve Bank would increase their reserves sufficiently to enable them to expand their own credit by $500,000,000. Under vary ing circumstances, depending on what the reserve re quirements are at the time and on the character of the deposits, the expansion of deposits may be as much as ten times the expansion of required reserves. In recent years the possible expansion of deposits would be con siderably less than ten times the expansion of reserves. But, however the ratio may vary, the fact remains that when the Federal Reserve authorities have occasion to EXPANSION AND CONTRACTION 57 provide the amount of reserves necessary to facilitate a given expansion of member bank credit and member bank deposits, the amount of Federal Reserve Bank credit that they need to supply is only a fraction of such expansion. The situation is different when a deficiency of mem ber bank reserves arises from withdrawals of currency by the public for circulation or from shipments of gold abroad. Whatever the deficiency, it must be made up in full, and the Federal Reserve authorities may in such circumstances have to supply their member banks with Federal Reserve Bank credit to the whole amount of currency or gold withdrawn. Since the ability of member banks to lend is largely dependent upon the volume of their reserves, since they are required to keep their reserves on deposit with the Federal Reserve Banks, and since the Federal Re serve authorities are empowered to extend Federal Reserve Bank credit for the expansion of those re serves, it follows that the Federal Reserve authorities, by the extension of Federal R e se r v e B an k credit, may influence very considerably the extension of m em b er bank credit. By enlarging the volume of member bank reserve funds they can make it possible for the latter to meet almost any conceivable volume of demand by borrowers; and by reducing the volume of reserve funds they can apply restraint to an over-extension of member bank credit. Yet, while Federal Reserve authorities have very great powers, they are also very much limited in the exercise of these powers. They can expand member bank reserves and to the extent that they do so, they can subsequently contract reserves. But they have no power to compel an extension of member bank credit. 58 THE FEDERAL RESERVE SYSTEM The initiative must be taken by business men and others who wish to borrow. The member banks may extend credit as long as they have adequate reserves; when their reserves become inadequate, Federal Re serve Bank credit is available with which to replenish these reserves; to the extent that their enlarged re serves permit, the member banks can expand their loans as long as there is sufficient demand. Thus, Fed eral Reserve Bank credit can not insure a dem and for member bank credit; it can and does insure the avail a bility of ample member bank credit when and if a demand exists. CHAPTER V THE COMPOSITION OF BANK RESERVES Federal Reserve Bank credit and gold are the two main sources of bank reserves; checks are the principal means by which reserves are trans ferred from bank to bank. ROM the point of view of member banks taken col lectively, reserves are derived chiefly from the fol lowing sources: F F ederal R eserve B a n k C redit , in the form of loans by the Federal Reserve Banks and pur chases by them of bills and securities. G old, either produced from domestic sources or received from other countries. From the point of view of the individual banker, the funds with which he currently maintains his reserves are: C h e c k s on other banks and C u r r e n c y . Although the principal sources of bank reserves are Federal Reserve Bank credit and gold, this does not mean that every individual bank, in order to have re serves, must have borrowed from its Federal Reserve Bank or have come into possession of gold. On the contrary, gold may be and actually is the basis of re serves of banks that have not possessed it, and Re serve Bank credit may be and actually is the basis of reserves of banks that have not borrowed. 59 60 THE FEDERAL RESERVE SYSTEM H o w R e se r v e F u n d s M o v e fro m B an k to B an k When the Federal Reserve Bank receives a deposit of gold,* or when it makes a loan or a purchase of securities, and the resulting credits are entered to the reserve accounts of the member banks concerned, the additional reserve funds resulting from the transaction immediately lose their connection with the transac tion. They become simply reserve funds, indistin guishable from other reserve funds and transferable to other banks, regardless of how they originated. Like water circulating through connecting chambers, what is introduced at one point mingles with the rest and flows freely throughout the system. Suppose, for example, a gold mining company has produced $100,000 worth of gold, has sold it to the United States Treasury, and has received a check in payment for it from the Treasury. The company de posits the check with the X National Bank, and re ceives credit for $100,000 in its checking account. The bank then deposits the check with the Federal Reserve Bank and receives credit for $100,000 in its reserve ac count. The mining company buys equipment, pays salaries, and distributes profits; in the process it issues checks aggregating $100,000 which are deposited by their recipients in other banks. These other banks, * A t present, gold purchased by the United States Treasury is not in fact deposited at a Federal Reserve Bank but is delivered to one of the United States Assay Offices, and the check received from the Treasury in paym ent is deposited in the Federal Reserve Bank. The technical steps involved in the transaction have no significance for present purposes, the effect being the same as if the gold were actually deposited in the Federal Reserve Bank and b y it turned over to the Treasury. T h e gold, though held in the vaults of the Treasury, is nevertheless a part of the m oney supply of the country; on its way into the Treasury it gives rise to bank deposits and bank reserves, and if withdrawn from the banking system , through export or otherwise, it would reduce them . COMPOSITION OF RESERVES F ederal R eserve B a n k of 61 R ich m on d 9th and Franklin Streets, Richm ond, Virginia having given their depositors credit for the checks, send them to the Reserve Bank and receive credit for them in their reserve accounts. At the same time the checks are paid out of the reserve balance of the X National Bank. Thereby, the reserve funds derived from the original sale of gold become the reserve funds of banks which never heard of the gold. These other banks know only that checks drawn on the X National Bank were deposited by them in the Reserve Bank and that their reserve accounts have been credited accord ingly. It is gold imports rather than domestic mining that has produced the great increase in our gold stock since 1933; but gold from whatever source gives rise 62 THE FEDERAL RESERVE SYSTEM to bank deposits and bank reserves substantially as just described. The same is true of Reserve Bank credit. If the X National Bank borrows $100,000 at the Reserve Bank or receives funds paid for securities purchased by the Federal Reserve Bank, its reserve account is increased by a corresponding amount. It uses these additional funds incorporated in its reserves to pay checks drawn against it by its customers, and in the process the funds leave its account and become credited to the reserve accounts of other banks. The funds are part of the total reserves dispersed in hundreds and thou sands of reserve accounts and constantly circulating in and out of each. No connection remains between them and the particular transaction which called them into being. Although comparatively few banks receive gold and Federal Reserve Bank credit directly, yet all banks are daily receiving checks on one another. About a bil lion such checks were handled by the Federal Reserve Banks in 1938; no doubt many times that number, cleared locally and through banks in financial centers, never reached a Federal Reserve Bank. But, by what ever means they are cleared, checks deposited in banks other than those on which they are drawn maintain a constant flow of reserve funds from bank to bank. T h e F low o f F u n d s and the V o lu m e o f F u n d s Sometimes a banker receives larger check payments from other banks than they receive from him. When that is the case, he gains reserves. Sometimes other banks receive more from him than he receives from them. In that case he loses reserves. It is obvious, COMPOSITION OF RESERVES 63 however, that when a check is deposited in the reserve account of one bank and charged to the reserve ac count of another, the total volume of reserves, taking all banks together, is not increased or decreased at all. One bank loses what another bank gains. But when gold is deposited and the reserve balance of a given bank is increased thereby, there is no cor responding charge to the reserve balance of any other bank, for the gold came either from abroad or out of an American mine. In this case, consequently, not merely the reserve balance of one bank but the total volume of reserves held by all banks taken together is increased. The same is true if the Reserve Bank makes a loan or buys securities: the resulting increase in the reserves of the banks directly affected is not offset by a charge to the reserves of other banks. In stead, total reserves are increased. In both cases the total remains at the higher level regardless of the stream of checks by which funds are transferred from one reserve account to another. It remains at the higher level until any one of these things happens: (1) the Federal Reserve sells securities; (2) loans by the Federal Reserve are repaid; or (3) currency or gold is withdrawn. When any of these things occurs, and is not offset by a factor of opposite effect, there occurs a decrease in the aggregate amount of reserves. It comes about because the securities sold by the Re serve Bank are paid for by a charge against the re serves of the bankers by whom or by whose customers the securities were purchased; or because the loans are repaid by a charge against the reserves of the bankers that borrowed; or because the currency or gold when withdrawn is charged to the reserve account of the banker by whom it was withdrawn; and because the 64 THE FEDERAL RESERVE SYSTEM charges to these reserve balances are not offset by any corresponding credits to other reserve balances.* From the individual bank’s point of view, therefore, reserves are principally maintained by the deposit of checks on other banks; and from the point of view of all banks as a whole, reserves consist fundamentally of Federal Reserve Bank credit and gold. In other words, Federal Reserve Bank credit and gold are the two important basic factors in which bank reserves originate, and checks are the principal means by which reserves come to be transferred and distributed among all banks. Every banker has daily experience of the transfer of reserve funds resulting from check transac tions and of his own consequent gain or loss of re serves; but experience of the origination and extinc tion of reserve funds resulting from gold transactions, open market operations, and Reserve Bank loans is far less common. Very few banks outside those cities where gold shipments are received or Government obli gations are bought and sold in large amounts ever have any direct experience of gold transactions and open market operations; and borrowings from the Re serve Bank, while more common, are never a matter of daily routine as check transactions are. O ther Factors Other factors affect the aggregate volume of bank reserves, but mostly in a minor or transitory way as compared with gold and Federal Reserve Bank credit. The acquisition of silver by the Treasury has the same effect on member bank reserves as the acquisition of gold, but the dollar amount of silver acquired is far * Gold may be withdrawn from the United States Treasury, under present law and regulations, at the discretion of the Secretary at Treasury, for export or for use in the arts but not for domestic circulation. the COMPOSITION OF RESERVES 65 less than that of gold. Chief among the transitoryfactors affecting the aggregate volume of reserves are receipts and expenditures by the United States Treas ury. When Federal taxes are paid, the effect is to re duce the reserve balances of banks and to enlarge the cash balances of the Treasury. The same is true when banks use current funds to pay for new Government obligations issued by the Treasury. When the funds are disbursed by the Treasury the effect is to reduce the Treasury’s cash balances and restore the reserve balances of the banks. The Treasury’s transactions are in this way constantly producing large fluctuations which in the long run cancel each other. Similarly, fluctuations in the volume of currency in circulation affect the volume of reserves, but mostly in a tem porary way. Currency on going into circulation is charged to member bank reserves and reduces them, and on retirement from circulation it is credited to reserves again and increases them. While these fac tors are of importance in explaining current fluctua tions in the volume of reserves, they do not alter the fact that the basic constituents of reserves are gold and Federal Reserve Bank credit. T h e R ela tion B e tw e e n Federal R e se r v e B an k Credit and G old Before the Federal Reserve Banks were established, the basic reserves of the banking system consisted al most exclusively of gold, silver, and currency. There was no Federal Reserve Bank credit, nor any institu tion whose purpose it was to supply additional reserve funds. Banks could borrow from one another, but that meant merely the use of existing reserve funds, not the creation of new ones. Moreover, with banks holding one another’s reserves and advancing reserve 66 THE FEDERAL RESERVE SYSTEM funds to one another, the aggregate bank reserves shown on the books of banks always included duplica tions and exceeded the amount of gold and other cur rency that could be counted as reserves. Reserves shown in excess of this amount, however, were ficti tious. In times of stringency it always developed that reserves were actually less than they appeared to be. With the establishment of the Federal Reserve Banks these faults were corrected. Existing reserves were transferred to the Federal Reserve Banks, and the Re serve Banks were empowered to create additional re serve funds. The result is that the aggregate volume of reserves became a definitely known figure, without duplication; and the Reserve authorities can create the necessary additional funds, either by lending to individual banks or by purchasing securities in the open market. Since the establishment of the twelve Federal Re serve Banks, therefore, bank reserves have consisted basically of gold, the amount of which is not readily subject to control, and of Reserve Bank credit, the amount of which is wholly subject to control. Neither is fixed either in amount or in relation to the other. At times Reserve Bank credit has been a more decisive factor and at times gold. The two tend to dis place each other; that is, the more gold there is com ing into the country the less need there tends to be for Reserve Bank credit, and the less gold there is coming in or the more gold there is going out the more need there tends to be for Reserve Bank credit. The move ment of gold is largely independent of control; al though under certain conditions an increase in the volume of Reserve Bank credit may tend to drive gold out of the country by bringing about lower money rates, and a decrease in its volume may tend to draw COMPOSITION OF RESERVES F ederal R eserve B a n k of 67 A tlanta 104 Marietta Street, Atlanta, Georgia gold into the country by bringing about higher money rates. If, for example, there were a reversal of the gold movement of recent years, and gold, because of altered international conditions, began to be exported in large volume, the Reserve authorities, by lending or by the purchase of Government securities and other obligations, could furnish funds which would add to member bank reserves as fast as the gold withdrawals subtracted from them. The Reserve authorities could by this action prevent the banks of the country from suffering such a depletion of reserves as would force them to make drastic reductions in their loans and investments. CHAPTER VI RESERVES OF THE INDIVIDUAL BANK AND OF THE BANKING SYSTEM AS A WHOLE Additional reserve funds that enable the indi vidual bank to enlarge its own loans by an almost equal amount, enable the banking system as a whole to enlarge the aggregate of loans by several times as much. ANK deposits result chiefly from loans and other extensions of credit by banks. This does not mean, though, that an individual banker can increase his deposits to any desired extent simply by lending. He can not do that, because when his customers borrow they use the money they borrow; they pay it to others by whom most or all of it will be deposited in other banks. The banker has to part with most of what he lends and must be prepared for reduction of his re serves accordingly. When he makes a loan and the funds are credited to the deposit account of the bor rower and then checked out, the funds sooner or later leave his bank and go on deposit in another bank. Under these circumstances, his loan increases another bank’s deposits. If the other banker is also lending, then the deposits of both will increase still further. Each gets a part or most of what the other lends. So, in fact, the individual banker normally has more money to lend when other bankers are lending than he has when they are not lending. It is only when this process of lending is general and simultaneous on the part of many bankers that it can cause a rapid growth of bank deposits. No one banker has control of such a process. He has no means of making other bankers B 68 THE SINGLE BANK AND ALL BANKS 69 lend— no means of making customers start borrowing. He has to feel his way, constantly watching the vol ume of his reserves. Unless his reserves are adequate, he will not wish to lend and run the risk of having them depleted. Accordingly, the requirement that he maintain a certain ratio between his reserves and his deposits is in effect a limitation on his power to lend. A ssu m in g T here W e r e O n ly O ne B an k Suppose there were only one bank instead of sev eral thousand, and that this one bank did all the com mercial banking business in the country. Suppose further that this bank were required by law to have reserves equal to at least 20 per cent of its deposits. Thus if it had deposits of $5,000,000,000, its reserve balance with the Reserve Bank would have to be at least $1,000,000,000. Suppose that it had just exactly that— $5,000,000,000 of deposits and $1,000,000,000 of reserves, with $4,000,000,000 of loans and investments. In such case, if it were to lend a single additional dollar it would reduce its reserves below the legal requirement, be cause if it did make a loan, the borrower would be given credit for it in his checking account, the bank’s deposits would go up, its reserve balance would n ot go up, and in consequence the reserve balance would be less than 20 per cent of the bank’s deposits. The borrower, of course, would write a check for the amount he wanted to use, and so his deposit balance would be reduced; but the money would not neces sarily leave the bank, or if it did it would come right back. For if the check were deposited by its recipient it would merely transfer a certain amount of deposit credit from the borrower’s account to the recipient's 70 THE FEDERAL RESERVE SYSTEM account. Or if it were cashed by the bank, the cur rency would sooner or later be deposited, and the funds which went out of the bank through one account would come back in through another. The bank’s de posits would be increased by the loan in any event, except only if the money were kept in circulation, sent out of the country, or permanently lost, destroyed, or hidden. There would be no other bank for it to go to. Realizing that any additional loans it made would in crease its deposits out of proportion to its reserves, the commercial bank might stop making new loans. Sup pose, however, that the Reserve authorities were of the opinion that more loans might advantageously be made and that the bank should be provided with addi tional reserves so that it could make them. Suppose they therefore purchased $20,000,000 of securities in the open market. The sellers of the securities would deposit in the commercial bank the money they re ceived in payment. The commercial bank in turn would deposit it in its reserve account at the Reserve Bank. Having these additional reserves of $20,000,000, the commercial bank, by making loans, could increase its deposits to five times as much, or $100,000,000— the $20,000,000 being the 20 per cent reserves required against deposits of $100,000,000. Another possibility is that the commercial bank might borrow the $20,000,000 from the Reserve Bank. But whether the commercial bank took the initiative in borrowing or the Federal Reserve authorities took the initiative in purchasing securities, in either event the sum total of reserve funds would be increased, and lending on an increased scale would be possible. In either event also, the Reserve authorities would not need to advance the full amount that the commercial THE SINGLE BANK AND ALL BANKS 71 bank would lend, but only enough to supply the 20 per cent reserve required against the increased deposits resulting from its lending. Taking A ll B an ks T ogeth er The same principle that would operate if there were only one bank holds true of all banks taken together— the great difference being that effects which are im mediately and directly discernible when there is as sumed to be only one bank are much more difficult to follow when the explanation is applied individually to the thousands of banks actually in operation. What is true of banks as a whole is not true of every individual bank; there are always exceptions. When bank re serves in the aggregate are in excess of requirements, there nevertheless will be individual banks with no ex cess reserves; and when, therefore, banks in general are in a position to extend abundant credit, there nevertheless will be individual banks in no such easy condition. In particular, when the sum total of re serve funds is augmented by Federal Reserve or other action the increase will manifest itself first at certain individual banks which happen to be recipients of the additional funds. But no bank can expect to keep per manently what it receives. Its customers are always checking its funds elsewhere. By the normal and ac tive process of clearing the enormous number of checks that are constantly being drawn on one bank and de posited in another— thereby entailing the transfer of funds from the reserve balance of one bank to the reserve balance of another— a rapid movement or cir culation of reserve funds is maintained. The result is that any increase in the total volume of reserve funds tends sooner or later to spread itself from the few 72 THE FEDERAL RESERVE SYSTEM banks where it originates to many other banks, if not all. Let us assume that the Reserve authorities realize that banks as a whole have insufficient reserves for the expansion of credit that is needed and proceed to buy Government securities in order to supply the money market with additional funds. Suppose as before that they buy $20,000,000 worth and that the entire sum happens to be deposited in some one bank. That par ticular bank’s deposits and reserves will both be in creased by $20,000,000. But the bank is not required to have reserves of more than 20 per cent, and 20 per cent of the increase is $4,000,000. Therefore, $16,000,000 of what the bank receives is excess reserves. It lends the $16,000,000— assuming it can find borrowers — and the whole amount, let us suppose, is checked out and deposited in a second bank. This second bank with increased deposits of $16,000,000 against which it is required to keep reserves of only 20 per cent, or $3,200,000, gets in consequence excess reserves of $12,800,000. It lends these funds, and they are checked out by the borrowers and deposited in a third bank. The third bank, having to keep reserves of only 20 per cent against the increase of $12,800,000 in its de posits, gets excess reserves of $10,240,000 to lend. It lends, and the amount is checked out by the borrowers and deposited in a fourth bank. It is evident that this process could go on till the amounts involved for suc cessive banks were negligibly small. Including six more banks in the illustration, or ten in all, the addi tional deposits, loans, and reserves made possible by the Federal Reserve Bank’s disbursement of $20,000,000 would be as follows: 73 THE SINGLE BANK AND ALL BANKS Additional Deposits Received Additional Loans M ade Additional Reserves Retained (1 0 0 % ) (8 0 % ) (2 0 % ) 1st bank .......................... .. 2nd b a n k .......................... . . . 3rd bank .......................... . . . 4th bank .......................... . . . 5th bank .......................... 6th bank .......................... 7th bank .......................... 8th bank .......................... 9th bank .......................... 10th bank .......................... $20,000,000 16,000,000 12,800,000 10,240,000 8,192,000 6,553,600 5,242,880 4,194,304 3,355,443 2,684,355 $16,000,000 12,800,000 10,240,000 8,192,000 6,553,600 5,242,880 4,194,304 3,355,443 2,684,355 2,147,484 $ 4,000,000 3,200,000 2,560,000 2,048,000 1,638,400 1,310,720 1,048,576 838,861 671,088 536,871 . T otal first 10 banks .. Other banks in t ur n. . . . . . . $89,262,582 10,737,418 $71,410,066 8,589,934 $17,852,516 2,147,484 $100,000,000 $80,000,000 $20,000,000 These figures assume, for the sake of simplicity, that every bank is able to find borrowers for the full amount that it can lend and that the full amount of every loan is checked out to some one other bank; that there are no left-overs and that the different banks come into the picture one at a time. They make no allowance for the fact that an individual bank in making loans is not limited to its excess reserves, because it can bring them up to the required level by borrowing from its Reserve Bank. On this basis, the figures show that the first ten banks had additional reserves of $17,852,516, addi tional loans of $71,410,066, and additional deposits of $89,262,582. Other banks sharing in the remaining portion of the $20,000,000 of additional reserves would increase their loans by $8,589,934 and would have ad ditional deposits of $10,737,418. In the end, accord ingly, an expansion of deposits amounting to $100,000,000 would be made possible by the $20,000,000 of addi tional reserves created by Federal Reserve action. 74 THE FEDERAL RESERVE SYSTEM F ederal R eserve B a n k of C hicago 230 South LaSalle Street, Chicago, Illinois The result would be the same if the banks were to purchase securities instead of making loans. Of course, there would never be such an absolutely uniform division as we have been supposing, but the principle nevertheless holds true. Each bank could lend whatever reserves it had in excess of what it was re quired to have, and in the end the total additional loans and the total additional deposits would be several times as great as the total additional reserve funds created THE SINGLE BANK AND ALL BANKS 75 by the Reserve authorities’ purchase of securities.* The fact that what can be done by the banking sys tem as a whole differs so much from what can be done by any individual bank is one of the most difficult things to understand clearly in the whole field of bank ing. It seems paradoxical. Yet it is a fundamental fact of utmost importance. The difficulty is to see that the limited power of the individual bank, which can lend somewhat less than the amount of additional re serves it receives, can, when exercised by many indi vidual banks, enable them all together to lend several times the amount of the additional reserves. But what each bank receives is in each case the greater part of what has already been received by another bank, so that the same amount keeps working over and over again, a little diminished each time. The practical consequence of this is that the Federal Reserve authorities, by supplying a rela tively small volume of additional reserve funds, make it possible for the banking system as a whole to supply the public with a jar greater additional volume of credit. Con trariwise, by withdrawing a relatively small amount of funds, when member banks have no excess reserves, the Federal Reserve authorities can make it necessary for the banking system to borrow the amount with drawn or to reduce loans and investments— and con sequently deposits— by several times that amount. * T he reserves required are not in fact 20 per cent at present, but about 15 per cent on the average. T h e figure of 20 per cent has been used for greater simplicity in illustration. T h e actual figure is always the result of several factors and varies from tim e to tim e, partly because of changes in the various required percentages and partly because of changes in the amount of deposits subject to the various required percentages. Between 1918 and 1929 the ratio of required reserves to deposits declined from about 9 per cent to about 7 per cent and thereafter rose again to about 8 per cent b y the middle of 1936. In 1937 it rose to about 16 per cent, as a result o f changed reserve requirements, and in 1938 it fell to about 15 per cent. CHAPTER VII FEDERAL RESERVE POWERS AND LIMITATIONS Although Federal Reserve powers are important and extensive, they are nevertheless constantly subject to limitations inherent in the condi tions under which they are exercised. HE limitations upon the powers of the Federal Reserve authorities are partly statutory and partly practical. Those that are statutory relate primarily to the reserves that the Federal Reserve Banks are re quired to maintain against their note and deposit lia bilities. The circulating notes issued by the Federal Reserve Banks and the reserve deposits maintained with them by member banks are alternative forms of Federal Re serve Bank liability. As of December 31, 1938, Fed eral Reserve notes in circulation amounted to about $4,500,000,000, and member bank reserve balances on deposit with the Reserve Banks amounted to about $8,700,000,000. When a member bank needs addi tional Federal Reserve notes, they are obtained from its Federal Reserve Bank, which charges their amount to the member bank’s reserve balance. Correspond ingly, when a member bank finds that it has more Federal Reserve notes on hand than it needs, it may send the notes to the Federal Reserve Bank and have their amount credited to its reserve balance. The Federal Reserve authorities expand the volume either of notes or of reserve balances in response to the demands of the public and of the member banks. Al though they may at times take action to reduce the volume of bank reserves, they never need take T action 76 POWERS AND LIMITATIONS 77 to reduce the amount of notes in circulation. Cur rency in excess of the public’s needs is promptly de posited in banks and by them is deposited in the Fed eral Reserve Banks. The process is spontaneous. In effect, therefore, the amount of money in circulation is governed by the public’s action, not by action issuing authorities, and no more currency will in use than is required. of the remain Legal L im itation s The Federal Reserve Act stipulates that the Federal Reserve Banks shall have reserves of gold certificates equal to at least 40 per cent of the Federal Reserve notes in circulation and reserves comprising gold cer tificates or lawful money equal to at least 35 per cent of their deposits. Taking the figures as of December 31, 1938, this means that the Federal Reserve Banks must have at least $1,800,000,000 in gold certificates as the 40 per cent reserve against their Federal Reserve notes of $4,500,000,000, and $3,535,000,000 of gold cer tificates— assuming they have no other lawful money — as the 35 per cent reserve against their $10,100,000,000 of total deposits. That is $5,335,000,000 of gold certificates, taking the two requirements together. Ac tually, however, the Federal Reserve Banks had $12,000,000,000 in gold certificates, or more than twice the maximum amount required. Notes in circulation and reserve deposits could therefore be more than doubled on the basis of present gold reserves, so far as the law is concerned. And since the Reserve authori ties are empowered to suspend for limited periods the requirements stated in the law, the volume of and reserve deposits could be much more than bled if an emergency should make it necessary. notes dou 78 THE FEDERAL RESERVE SYSTEM FEDERAL RESERVE BANKS - RESERVE POSITION 1914 1916 1918 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 The accompanying chart (Federal Reserve Banks— Reserve Position) shows the volume of Federal Re serve Bank liabilities in the form of deposits and cir culating notes during twenty-four years of Reserve System operations. It also shows the ratio of the Re serve Banks’ reserves, which at their lowest, during 1920, were about 40 per cent of note and deposit lia bilities, but in recent years have been about 80 per cent. Practical L im itation s The practical limitation on Federal Reserve powers to expand note circulation and reserve deposits can best be understood when Federal Reserve notes and member bank reserves (which are deposits on the books of the Federal Reserve Banks) are considered together with Federal Reserve Bank credit and gold. POWERS AND LIMITATIONS 79 These four factors are closely interrelated, and no one of them can change without a corresponding change in one or more of the other three. They are the four principal items on the Federal Reserve Banks’ state ment of condition. Rounding them off and disregard ing other items, they may be shown in balance as fol lows: (a) Gold certificates ................................................. $12,000,000,000 (b ) Discounts and securities ............................... 2,500,000,000 $14,500,000,000 (c) Deposits ................................................................ $10,000,000,000 (d) N otes in circulation ........................................ 4,500,000,000 $14,500,000,000 In the latter part of the year 1938 the deposits on the books of the the Federal Reserve Banks as shown above (c) were $10,000,000,000, and the Federal Re serve notes outstanding (d) were $4,500,000,000. At the same time the Banks held (a) $12,000,000,000 in gold certificates and (b) $2,500,000,000 of obligations in bonds, promissory notes, etc. The two groups of figures, taken together, show that $14,500,000,000 of gold and Federal Reserve Bank credit made possible $14,500,000,000 of Federal Reserve Bank deposits and notes. In other words, the gold certificates (a) and the Federal Reserve Bank credit (b) were the sources of funds amounting to $14,500,000,000, and the re serve deposits (c) and the notes (d) represented the uses of those funds in like amount. The Federal Reserve authorities have no control over the volume of gold. Its shipment into the United States is due to various causes, chief among them the excess of exports over imports and the flight of capital induced by the economic and political conditions in other countries. As the gold is received, the Federal 80 THE FEDERAL RESERVE SYSTEM Reserve Banks’ holdings of gold certificates (a) and their deposits (c) are both equally increased. By the same token, the reserve balances of member banks— which constitute the bulk of Federal Reserve Bank de posits—are increased, and member banks accordingly find it easier to, meet reserve requirements. The de mand for Federal Reserve Bank credit (b) is conse quently lessened; the member banks will have little occasion to borrow and the Federal Reserve authori ties will have little occasion to purchase securities. If, however, the Federal Reserve authorities were to pur chase additional securities, the result would be to ex pand member bank reserves (c). If they sold securi ties or if some of the discounts (b) were paid, deposits (c) would correspondingly decrease; unless there were simultaneously an increase in gold certificate holdings, or a decrease in the amount of notes in circulation. The amount of notes in circulation (d) represents what the public requires; if an increase in the amount occurred— more notes being drawn into use— there would be a corresponding decrease in deposits, and if a decrease occurred— a smaller volume of notes being used— there would be a corresponding increase in de posits. Although the power of the Federal Reserve authori ties to create reserve funds by the extension of Federal Reserve Bank credit is subject to the statutory require ment as to the reserves in gold certificates and lawful money that they shall maintain against their notes and deposits, it is evident that the practical limitations upon that power lie in conditions reflected in the other three factors, namely, gold, member bank reserves, and circulating notes. These conditions will of course be diverse. The amount of gold in the country de POWERS AND LIMITATIONS 81 pends upon world-wide political and economic condi tions. The amount of bank reserves depends upon the amount of gold and upon the demand for cur rency, as well as upon the amount of Federal Reserve Bank credit. The demand for currency depends upon business conditions. The demand for Federal Re serve Bank credit is affected by '$1 these factors and by the demand for member bank credit. In brief, monetary factors are not only dependent on one another, they are dependent on other factors. A given economic situation is the resultant of a wide variety of forces— such as invention, labor, agriculture, foreign trade, Government expenditures, taxation, war, weather—besides money and credit. Federal Reserve policy must always be related to other factors, and its effectiveness is not independent of their influence. R eq u ired R eserves The power to change member bank reserve require ments is closely related to the power to create and ex tinguish reserve funds. If member banks are under a requirement to have reserves of $6,000,000,000 and actually have reserves of $10,000,000,000, it is apparent that they have $4,000,000,000 of reserves in excess of requirements. This excess would enable them to in crease by an enormous amount the volume of bank credit extended by them, assuming a strong enough demand arose. If the Federal Reserve authorities were to lower the reserve requirements, the amount of excess reserves and therewith the volume of mem ber bank credit that it might be possible to extend, assuming sufficient demand, would be still further in creased. If the Federal Reserve authorities were to raise the reserve requirements, the amount of excess 82 THE FEDERAL RESERVE SYSTEM reserves and therewith the volume of member bank credit that it might be possible to extend would be diminished, so long as the higher reserve requirements remained effective. While an increase in reserve re requirements of itself tends to restrict the volume of member bank credit that might be extended, its effect can be offset, if advisable, by increasing the volume of Reserve Bank credit outstanding; with the possible advantage that in principle excess reserves which arise from Federal Reserve Bank credit are more flexible and better subject to current adjustment than excess reserves arising from gold. Consequently, a situation in which the aggregate volume of reserve funds is to a great extent dependent upon Federal Reserve policy is apt to be more in the public interest than one in which the aggregate volume is dependent upon gold, the movements of which are largely beyond control. At the present time reserve requirements, as shown in Chapter III, are a little less than double what they formerly were. The reason for increasing them was that bank reserves had become expanded to an in ordinate degree by the immense increase in the coun try’s gold stock. As a result member bank reserves were so much in excess of requirements that the lend ing power of member banks, instead of being subject, as contemplated in the Federal Reserve Act, to the corrective influence of the Federal Reserve authori ties, depended too largely upon the abnormal stocks of gold received from abroad and too little upon domestic factors subject to control. In an endeavor to return more nearly to conditions under which the normal regulatory powers established by Congress are effective, the volume of reserves in excess of require ments was reduced by raising the requirements. This POWERS AND LIMITATIONS F ederal R eserve B a n k of 83 St . L ouis 411 Locust Street, St. Louis, Missouri action had the effect of offsetting, to a partial extent, the increase in the gold stock. An increase in reserve requirements does not in crease the power of the Federal Reserve Banks to lend or to hold securities. The lending and investing power of the Federal Reserve Banks is not derived from member bank reserve deposits, and larger required reserve balances do not increase that power. The lending power of the Federal Reserve Banks is a stat utory power whereby the Federal Reserve Banks may acquire promissory notes, acceptances, bonds, and other obligations and give in exchange therefor Fed eral Reserve notes or credit to the reserve accounts of 84 THE FEDERAL RESERVE SYSTEM member banks. Having such power, their ability to lend and to purchase securities is not limited volume of funds deposited with them by their mem ber banks. by the T h e N a tu re o f Federal R e se r v e B an k C redit Credit in general is a matter of monetary agree ments, the essence of it being an acceptable promise to pay. Bank credit is a special form of credit, pecul iar in that it involves a promise or assumption of lia bility b y a bank, given in exchange for a promise made to the bank. Thus, a bank accepts the promissory note of a customer and in exchange promises to pay the customer a corresponding amount, which, pending his order, is carried on its books as a deposit in his favor. Bank credit plays a vitally important part in modern economic life. As a source of bank deposits transferable by check, it provides the funds with which the bulk of monetary payments is effected. It is always interchangeable with legal tender money, but for the most part it is not derived from legal tender money, nor does the volume of bank credit bear any rigid relationship to the volume of legal tender money. If the volume of loans that banks could make and of deposits that they could accept were limited to the volume of currency in existence, bank credit would not have the utility it now has in our economic sys tem. Bank credit is a means by which wealth in other than monetary forms can be transmuted tem porarily into monetary forms; as when, for example, a man borrows a thousand dollars on mortgage lateral security and thereby obtains monetary funds without selling his property. or col POWERS AND LIMITATIONS 85 Federal Reserve Bank credit resembles bank credit in general, but under the law it has a limited and spe cial use— as a source of member bank reserve funds. It is itself a form of money authorized for special pur poses, convertible into other forms of money, con vertible therefrom, and readily controllable as to amount. Federal Reserve Bank credit, therefore, as already stated, does not consist of funds that the Reserve au thorities “ get” somewhere in order to lend, but consti tutes funds that they are empowered to create. The process of creation is one of giving the promises of the Federal Reserve Bank— in the form of Federal Reserve notes and reserve deposits—in exchange for the prom ises made by others to the Federal Reserve Banks, the reason for the exchange being that the Federal Re serve Banks’ promises are recognized by law as having a particular monetary utility not possessed by the promises of individuals or of private institutions. That is, Federal Reserve Bank promises— or “ liabilities,” as they are commonly called— serve in the form of F e d eral R e se rve n o tes as the principal element of the circulating medium, and they serve in the form of reserve d eposits as a basis for the extension of credit by member banks. These are the specific uses of the funds that have their source in Federal Reserve Bank credit. Although the powers possessed by the Federal Re serve authorities are important and extensive, never theless they are constantly subject to limitations in herent in the conditions under which they are to be exercised. They are most effective when there is an active demand for credit. When the demand is slack, 86 THE FEDERAL RESERVE SYSTEM or member bank reserves are greatly in excess of re quirements, the powers are much less effective. The Federal Reserve authorities can create credit when it is in demand, they can encourage the demand for it by making funds abundant and cheap, they can create deposits by open market purchases of securities from others than member banks; but they can not create a demand for credit or cause the created deposits to be actively used. CHAPTER VIII MEMBER BANK RESERVES AND RELATED ITEMS The principal jactors involved in Federal R e serve policy are member bank reserve balances, gold stock, Federal Reserve Bank credit, m oney in circulation, and Treasury cash and balances. I N THE four preceding chapters the factors of Fed eral Reserve policy have been discussed at length. The accompanying chart (Member Bank Reserves and Related Items) shows the movement of the more im portant of these factors from the early years of the MEMBER BANK RESERVES AND RELATED ITEMS 1918 1920 1922 1924 1926 IMS 87 1980 "1 9 3 2 1934 1988 088 88 THE FEDERAL RESERVE SYSTEM Federal Reserve System to the present. This chart, slightly modified for present purposes, and the chart (Member Bank Reserve Balances) which appears later in this chapter, are regularly published in the F ederal R eserve B u l l e t in to portray current mone tary developments. The chart shows five fines, which may be considered in the following order: Member Bank Reserve Balances Gold Stock Reserve Bank Credit Money in Circulation Treasury Cash and Deposits From 1918 through 1932 member bank reserve bal ances in the aggregate never exceeded $2,500,000,000 for more than a few days at a time, and until 1932 and 1933 their total fluctuated relatively little. Since 1933 the amount of these balances has greatly increased, until by the end of 1938— that is, in a period of five years— they were $9,000,000,000, or three times as much as they ever were before the increase began. These reserve balances are a potential base for a credit expansion far in excess of anything this country has ever experienced. G old and Federal R e se r v e B a n k Credit As explained in preceding chapters, the principal sources of reserve balances are gold and Federal Re serve Bank credit. Which of these is responsible for the remarkable increase in reserve balances since 1933? It is obvious from the chart that it is gold, the total amount of which has doubled since 1934, while the RESERVES AND RELATED ITEMS 89 amount of Reserve Bank credit has remained practi cally stationary; gold has risen to about $15,000,000,000, while Reserve Bank credit is only $2,500,000,000. Before 1934, however, and prior to the recent large increase in the gold stock, the volume of Federal Re serve Bank credit showed wide fluctuations. It was then a more active factor in the volume of reserves. Before 1932 banks generally had no reserves at the Federal Reserve Banks in excess of what was required, and they frequently found occasion to borrow. At the same time and for the same reason, the Federal Re serve authorities had more occasion to buy and sell securities currently in the open market as a means of increasing and decreasing the volume of reserve funds. When the Reserve Banks increased their holdings, banks gained reserves and were enabled to pay off their borrowings and extend additional credit; when the Reserve Banks decreased their holdings, banks lost reserves and were forced to borrow or else curtail their extensions of credit. In 1932 and 1933 the Reserve Banks increased their holdings of United States Gov ernment securities, and the funds given in payment for their purchases first enabled the member banks to re duce their borrowings and then increased their excess reserves. Since 1933 the rapid inflow of gold shown by the chart has increased member bank reserves much more rapidly than bank credit has been expanded. Con sequently, banks have held large amounts of reserves in excess of requirements, and there has been little occasion for them to seek Federal Reserve Bank credit, or for Federal Reserve Bank credit to be expanded by open market operations. 90 THE FEDERAL RESERVE SYSTEM M o n e y in Circulation, T reasury Cash, and T reasury Balances It will be noted from the chart that at all times the volume of bank reserves has been less than the total of gold and Federal Reserve Bank credit combined. This reflects the fact that gold and Federal Reserve Bank credit are the principal sources not only of bank reserves, but also of money in circulation, which consists principally of Federal Reserve notes. They are also a source of the cash held by the Treasury or deposited by it in its checking account with the Federal Reserve Banks. The amount of these Treasury balances was relatively small until 1934, when it was substantially enlarged by the increased value of the gold stock result ing from revaluation of the dollar. As explained in a preceding chapter, fluctuations in Treasury balances generally represent a temporary rather than a perma nent or basic use of funds. When the Treasury collects taxes, it receives the bulk of the payments by check. These checks in effect transfer money from the com mercial banks to the Treasury; that is, they enlarge the Treasury’s balances at the Federal Reserve Banks and reduce the reserve balances of member banks. The same thing occurs, in effect, when the Treasury borrows. On the other hand, when the Treasury ex pends the funds it has received, its own balances at the Federal Reserve Banks are reduced and the reserve balances of member banks are increased. Because Treasury receipts and disbursements alternately de crease and increase the reserves of banks, they tend to cancel out; though at any given time they may account for current changes of considerable magnitude in the volume of bank reserves and of Reserve Bank credit. RESERVES AND RELATED ITEMS F ederal R eserve B a n k of 91 M inneapolis 73 South 5th Street, Minneapolis, Minnesota Another factor of potential importance, not shown on the chart, is Treasury currency. This includes coin, silver certificates, and United States notes. When these forms of money go into circulation, they are ordinarily deposited by the Treasury in the Federal Reserve Banks and are paid out by them to member banks as currency is required by the public. Like gold and Federal Reserve Bank credit, they are a source of bank reserves. They are not funds obtained by the Treasury from existing reserves through bor rowing or taxation. Accordingly, an increase in the is sue of coin, silver certificates, or United States notes will tend to increase bank reserves. 92 THE FEDERAL RESERVE SYSTEM Interrelations B e tw e e n Factors All of the factors shown on the chart are closely and necessarily interrelated. Some of them are not directly subject to control by the Federal Reserve authorities, while others are subject to control in part. Increases and decreases in the volume of gold are relatively un controllable. The same is true of money in circula tion; whatever the public requires is supplied without delay or interference. Changes in Treasury cash and deposits and in Treasury currency generally reflect fiscal requirements and occasionally monetary policies (e.g., revaluation of gold, gold sterilization, and issu ance of silver certificates); at any rate they are not among the factors directly subject to control by the Federal Reserve authorities. This leaves Federal Re serve Bank credit as the one factor that is largely controllable. As explained in the preceding chapter, the fact that it is controllable is the reason for its exist ence; it can be increased or decreased as a counter weight to changes in the less controllable factors. At the present time, the interplay of the foregoing controllable and uncontrollable factors determines the volume of member bank reserve balances. At any given moment this volume may be affected by the un con trolled movement of gold, or changes in the amount of money in circulation, or Treasury receipts and dis bursements, and by the controlled increase and de crease in the volume of Federal Reserve Bank credit. Bank reserves are not always or necessarily, how ever, so passive a resultant of other factors as they are under present conditions. At times when member banks have almost no reserves in excess of what they are required to have, as tihey did before the gold RESERVES AND RELATED ITEMS 93 influx of recent years, there will be a greater need for Federal Reserve Bank credit, and member banks will borrow from the Reserve Banks. Under those circum stances changes in the volume of reserves will be a governing cause of changes in the volume of Federal Reserve Bank credit. It will be noted that prior to 1934 there was a very close relation between money in circulation and Re serve Bank credit, seasonal fluctuations in the two lines almost duplicating each other. This reflects the fact that increases in the volume of money in circula tion mean withdrawals of currency from the Federal Reserve Banks, with a consequent decline in the volume of member bank reserves. Similarly, when currency is retired from circulation, and deposited in the Federal Reserve Banks, it is credited to the reserve balances of member banks and increases them. When the reserve balances represent merely what banks are required to have and there is no excess, the with drawals of currency for circulation purposes have to be offset by extensions of Federal Reserve Bank credit. A given member bank, for example, that needs $100,000 in currency, but has no excess reserves, will borrow $100,000 from the Federal Reserve Bank and have the amount credited to its reserve account so that the with drawal will not reduce its reserves below the required amount. And, correspondingly, as soon as the member bank accumulates sufficient currency, it will deposit what it can spare in the Federal Reserve Bank and pay off its borrowing. Therefore, when banks have only such amount of reserves as they are required to have— as was generally true before 1934— increases and decreases in the amount of money in circulation 94 THE FEDERAL RESERVE SYSTEM bring about corresponding increases and decreases in the volume of Federal Reserve Bank credit. But when banks have large excess reserves— as they have had since 1934— increases and decreases in the amount of money in circulation do not appreciably affect the volume of Federal Reserve Bank credit but only the volume of the excess reserves. A striking feature of the chart is the abrupt increase in the gold stock in 1934. This reflects revaluation of the dollar, by which the price of gold was raised from $20.67 to $35 an ounce. Before this action was taken, all gold already in the country, which for the most part was held by the Federal Reserve Banks, was turned over to the Treasury. The whole increase in the monetary value of the gold went to the United States Government, therefore, and was added to the Treasury’s cash balance. Except to the extent that a part of this increment was later expended by the Treasury, the increase in the value of the gold stock had no effect on member bank reserves. MEMBER BANK RESERVE BALANCES WEDNESDAY FIGURES BILLIONS OF DOLLARS BILLIONS OF DOLLARS 10 8 6 4 2 0 1930 1931 1 93 2 1933 1934 1935 1936 1937 1938 1939 RESERVES AND RELATED ITEMS 95 R eq u ired and E x c ess R e se r v e s The accompanying chart (Member Bank Reserve Balances) shows reserve balances divided into required reserves and excess reserves. Required reserves are the part of total reserves which banks must keep in proportion to their own deposits, and excess reserves are the part in excess of what is required. Before 1932, banks had almost no excess reserves. They maintained just what they were required to maintain and little more. When they needed larger, reserves they used Federal Reserve Bank credit, which was therefore a much more active factor, as already explained, than it is now. CHAPTER I X W H A T T H E T W E L V E F E D E R A L R E SERVE BANKS OW N AND W H A T T H E Y OW E The central hanking junctions of the Fed eral Reserve System are reflected in the balance sheet of the Federal Reserve Banks. HE functions described in the preceding chapters are all reflected in the balance sheet of the twelve Federal Reserve Banks, which is made public every Friday and shows the condition of the Reserve Banks as of the Wednesday immediately preceding. It ap pears in the Friday issue of the principal daily news papers of the country and is usually accompanied by explanatory comment, particularly as to changes in member bank reserves and related factors. The statement as of December 31, 1938, in con densed form is as follows, only the most important items being shown separately. T A SS E T S 1. G old C ertificates on hand and due from U . S. 2. 3. 4. 5. 6. 7. Treasury ............................................................................. Other cash . . ......................................................................... U . S. G overnm ent S ecurities ...................................... D iscounts for M ember B a n k s ................................... Other earning assets ....................................................... Uncollected items .............................................................. Miscellaneous assets ....................................................... T otal A ssets ............................................................ $11,798,000,000 368,000,000 2,564,000,000 4,000,000 16,000,000 711,000,000 120,000,000 $15,581,000,000 L IA B IL IT IE S 8. F ederal R eserve N otes ................................................. $ 4,452,000,000 of M ember B a n k s .................................... U . S. Treasurer’s account ...................................... Other deposits ................................................................ 10. Deferred availability items ...................................... 11. Miscellaneous liabilities .............................................. 8,724,000,000 923,000,000 441,000,000 694,000,000 3,000,000 9. D eposits: R eserves T otal L iabilities $15,237,000,000 96 FEDERAL RESERVE BANK STATEMENT C A P IT A L 12. 13. 14. 15. ACCOUNTS Capital .................................................................................... Surplus (section 7) ............................................................ Surplus (section 13b) ................................................... Other capital accounts ................................................... T otal L iabilities and 97 C apital A ccounts . . . . $ 135,000,000 149,000,000 27,000,000 33,000,000 $15,581,000,000 E xplanation o f A sse t A ccou n ts 1. G old C e r t if ic a t e s on hand and due from the United States Treasury. This amount comprises cer tificates due the Federal Reserve Banks for gold acquired by the Treasury, including both gold trans ferred by the Federal Reserve Banks to the Treasury upon adoption of the Gold Reserve Act of 1934 and gold subsequently acquired. It includes $ 1 0 ,0 0 0 ,0 0 0 constituting a redemption fund for Federal Reserve notes. 2. Other cash is coin and paper money (not includ ing gold certificates or Federal Reserve notes) in the Reserve Bank vaults. 3. U n it e d S ta te s G o v e r n m e n t S e c u r it ie s are bonds, Treasury notes, and Treasury bills purchased from dealers and others in the open market. This account shows the amount of Federal Reserve Bank credit created by such purchases in order to increase or replenish member bank reserves. Like the account which follows, Discounts for Member Banks, it re flects one of the most important Reserve Banking func tions. Under the present law, Government obligations are never purchased from the Treasury by the Federal Reserve Banks but are purchased only in the open market. 4. D i s c o u n t s f o r M e m b e r B a n k s . This account shows the amount of Federal Reserve Bank credit created by lending and is represented in part by prom 98 THE FEDERAL RESERVE SYSTEM issory notes of member banks, secured by collateral, and in part by promissory notes or other obligations endorsed over to the Federal Reserve Bank by member banks. These are usually called discounts, or redis counts, because when the Reserve Bank acquires them it gives credit for the amount thereof less a discount, i.e., an interest charge deducted in advance at the established rate. Like the account which precedes, United States Government Securities, it reflects one of the most important central banking functions. Until recent years, before gold imports expanded the reserves of member banks and made it unnecessary for them to borrow except infrequently and on a small scale, discounts were very large. In 1920, for example, discounts for member banks were $2,500,000,000, United States Government securities owned were only $300,000,000, and other earning assets (mostly accept ances bought in the open market, now less than $1,000,000) were $400,000,000. This is in marked con trast to the more recent figures. 5. Other earning assets are now mainly loans made to industrial and commercial enterprises in accordance with section 13b of the Federal Reserve Act. This item also includes bills purchased, which, as referred to in the preceding paragraph, now amount to less than $1,000,000. At times when the supply of bank reserves has been low, however, the Federal Reserve Banks have bought substantial amounts of bills and thus have sup plied funds for seasonal credit and currency demands, especially in the autumn months. These bills are ac ceptances, that is, two-party obligations arising from transactions in commodities, especially in the import and export trade. The Federal Reserve Banks pur- FEDERAL RESERVE BANK STATEMENT 99 F ederal R eserve B a n k of K ansas C it y 10th Street and Grand Avenue, Kansas City, Missouri chase them at established rates in such volume as they are offered for sale. 6. Uncollected items include checks and other cash items deposited with the Federal Reserve Banks and still in process of collection at the time the statement is made up. 7. Miscellaneous assets consist of several items, of which the largest is the bank premises owned by the 100 THE FEDERAL RESERVE SYSTEM Federal Reserve Banks and carried at $43,000,000. They also include premium on securities owned and accrued interest receivable. E xplan ation o f L ia bility and Capital A ccou n ts 8. F ederal R eserve N otes are the obligations of the Federal Reserve Banks that circulate as money. They are described in Chapters II and VII. 9. Deposits consist mainly of the R eserves of M e m ber B a n k s . They also include checking accounts of the United States Treasury and other Governmental agencies, deposits of foreign banks, and deposits main tained by certain nonmember banks for use in clear ing and collecting checks. 10. Deferred availability items are of technical rather than general significance. The account arises from the fact that Federal Reserve Banks do not give immediate credit for checks deposited for collection. Broadly speaking, deposit credit is deferred until the checks have had time to reach the banks upon which they are drawn and to be paid by them. Pending this, the Federal Reserve Banks give what is known as “ deferred credit.” These items are generally in ap proximate balance with “ Uncollected items,” shown among the assets (Number 6). 11. Miscellaneous liabilities consist of several items, the principal ones being discount on bills and secu rities and miscellaneous accounts payable. 12. All of the capital stock of the Federal Reserve Banks is owned by banks which are members of the Federal Reserve System. See Chapter I. 13. Surplus (section 7) is governed by section 7 of the Federal Reserve Act. It can be drawn on to meet deficits or losses, if any. It can not be distributed to FEDERAL RESERVE BANK STATEMENT F ederal R eserve B an k of 101 D allas W ood and Akard Streets, Dallas, Texas the stockholding member banks, except as may be necessary to pay the regular 6 per cent dividend. The law provides that, if the Reserve Banks are dis solved, any surplus be paid to the United States. 14. Surplus (section 13b) represents the funds re ceived from the Secretary of the Treasury for the purpose of making loans in accordance with section 13b of the Federal Reserve Act, plus or minus the net earnings or net loss arising from the use of such funds. 15. Other capital accounts consist primarily of re serves for contingencies, amounting to $33,000,000, and undistributed earnings, if any. 102 THE FEDERAL RESERVE SYSTEM It is plain from a glance at the statement that four items are by far the largest, namely, G o l d C e r t i f i c a t e s and G o v e r n m e n t S e c u r i t i e s among the assets, and N o t e s and R e s e r v e D e p o s i t s o f M e m b e r B a n k s among the liabilities. These items, with D i s c o u n t s f o r M e m b e r B a n k s , reflect the essential operations of the Federal Reserve Banks as central banking institu tions. The amount of gold certificates is increased from time to time as the Treasury makes use of the gold it acquires. The Government securities, dis counts, and other earning assets are acquired when the Federal Reserve authorities create additional reserve funds for member banks. They represent the Re serve Bank credit advanced by the Reserve Banks and discussed in previous chapters. Federal Reserve notes, on the liability side, consti tute the largest and most flexible portion of the country’s circulating medium. As already explained, their amount can increase or decrease in immediate response to the public’s requirement of increased or decreased amounts of cash. The reserve deposits standing to the credit of mem ber banks on the books of the Reserve Banks serve at the same time (a) as clearing balances through which bank checks are collected and through which currency is drawn into circulation and returned therefrom, and (b) as the means through which regulation of the lending power of commercial banks is effected. See Chapters II, III, and IV. It will be observed that the Federal Reserve Bank statement shows a very small proportion of assets that yield income— only about 15 per cent of the total. That 85 per cent of the assets are in such form that they yield no income is abnormal from the viewpoint FEDERAL RESERVE BANK STATEMENT 103 of privately managed enterprise operated for profit. It is not usual even for a central bank, but since such an institution is conducted for public purposes and is not guided by the motive of earnings, circumstances may be such as to result in a large proportion of its lending power remaining unused. Such circumstances exist today. CHAPTER X FEDERAL RESERVE BANK EARNINGS The operations of the Federal Reserve Banks, although not conducted for profit, yield an in come which is ordinarily sufficient to cover expenses. HE creation of Federal Reserve Bank credit through lending and through purchases of secu rities incidentally yields an income to the Federal Re serve Banks in the form of interest. Ordinarily this income is adequate to cover the necessary expenses of the Federal Reserve Banks and the Board of Governors and to leave a balance. Around the year 1920, the net earnings of the Federal Reserve Banks were large, to a great extent because of operations in connection with war financing, but since that period they have been relatively small. Some of the Federal Reserve Banks in certain years have operated at a loss. In twenty-four years (1914-1938) the total earnings of the twelve Federal Reserve Banks have amounted to $1,277,000,000. The distribution of these earnings is shown in the accompanying chart (Distribution of Earnings of Fed eral Reserve Banks, 1914-1938). In round numbers, earnings have been used as follows: T Expenses and reserves for contingencies ......................... Dividends ....................................................................................... Paid to United States Treasury ...................... ................. Paid to Federal Deposit Insurance Corporation............. Surplus remaining ....................................................................... $669,000,000 170,000,000 150,000,000 139,000,000 149,000,000 $1,277,000,000 104 FEDERAL RESERVE BANK EARNINGS 105 DISTRIBUTION OF EARNINGS OF FEDERAL RESERVE BANKS, 1914 - 1 9 3 8 TOTAL EARNINGS - $ 1 ,2 7 7 ,0 0 0 ,0 0 0 RESERVES FOR CONTINGENCIES 4 3 3 , 0 0 0 ,0 0 0 The twelve Federal Reserve Banks operate with a force of about 11,000 officers and employees, and the total payroll in the course of twenty-four years, after deducting salary reimbursements, has been about $345,000,000. Other important items of expense in the same period have been $51,000,000 for depreciation and charge-offs on bank premises; $50,000,000 for the expense of issuing and redeeming Federal Reserve cur rency; $56,000,000 for postage, expressage, and insur ance on currency and securities shipments; $22,000,- 106 THE FEDERAL RESERVE SYSTEM 000 for local taxes; and $20,000,000 for maintenance of the Board of Governors, in Washington, which regu lates and supervises the Federal Reserve System. The Board is not supported by Government funds or ap propriated moneys but by assessment upon the twelve Reserve Banks. Congress provided in the Federal Reserve Act that dividends of 6 per cent per annum, cumulative, be paid by the Reserve Banks on their capital stock. The Act requires that this stock be purchased and held by member banks. Dividends are paid after all necessary expenses have been met. Until 1933, the Federal Reserve Act required each Federal Reserve Bank to pay to the United States Treasury an annual franchise tax consisting of all net earnings after payment of dividends and certain addi tions to surplus. The sum paid in the course of eight een years amounted to about $150,000,000. In 1933, Congress required the Reserve Banks to pay about $139,000,000 to the Federal Deposit Insurance Corpo ration, which had just been organized. This payment reduced the surplus by about half. At the same time Congress removed the requirement that the Reserve Banks pay the Government a franchise tax. This enabled the Banks to apply unused earnings to a more rapid restoration of their depleted surplus. As indicated, the surplus of the Federal Reserve Banks is now about $149,000,000. This, with their capital of about $135,000,000, gives them capital and surplus combined of about $284,000,000. The surplus is available to the Federal Reserve Banks for meeting losses, deficits, and unearned divi dends, but it can not be otherwise distributed to stockholding member banks. As stated, already the the 107 FEDERAL RESERVE BANK EARNINGS law provides that if the Reserve Banks should be liquidated, any surplus would be paid to the United States, after payment of debts and the par value of the stock with dividends due thereon. DISPOSITION OF NET EARNINGS OF FEDERAL RESERVE BANKS MILLIONS OF DOLLARS MILLIONS OF DOLLARS 100 50 0 -5 0 100 50 0 50 0 150 100 50 0 1915 192 0 1925 1 930 1935 1940 CONTRIBUTION TO CAPITAL OF F.D.LC., * 1 3 3,000.000 The accompanying chart (Disposition of Net Earn ings of Federal Reserve Banks) covers the whole period of Federal Reserve Bank operations and shows, year by year, the amount of net earnings transferred to surplus, the franchise tax paid to the Government, and dividends paid to member banks. It reflects the fact that there were large additions to surplus in the years 108 THE FEDERAL RESERVE SYSTEM about 1920 when earnings were highest, and in some subsequent years either there have been no additions or surplus has been drawn down. It reflects the fact that in 1933, as stated, Congress directed the Federal Reserve Banks to pay an amount equal to half their surplus to the Federal Deposit Insurance Corporation and also discontinued the franchise tax. It also re flects the fact that dividends have remained about the same. As the chart shows, the net earnings of the twelve Federal Reserve Banks have varied considerably in the course of years. They were highest in 1919, 1920, and 1921, when the total was $310,000,000. In these three years there was a strong demand for credit, and the Reserve Banks made a large volume of loans. Their net earnings in those three years amounted to approximately one-half their total net earnings in twenty-four years. In 1936, 1937, and 1938 the total net earnings were $29,000,000. The reduced earnings in recent years reflect the fact that there has been little demand for credit. In 1920 when the Federal Reserve Banks had the highest earnings, they had loans and investments of more than $3,000,000,000, most of which were loans yielding from around 4 y 2 per cent to 6 per cent or 7 per cent. In 1938, when their net earn ings were only a small fraction of what they were in 1920, they had loans and investments of about $2,500,000,000, most of which were Government securities yielding less than 1y 2 per cent. CHAPTER X I MARGIN REQUIREMENTS The Federal Reserve authorities have special power to curb the use of credit for speculation in securities. HE regulatory powers of the Federal Reserve authorities so far described relate to the volume and cost of bank credit in general, without regard to the particular field of enterprise or economic activity in which the credit is used. In one respect, however, the Federal Reserve authorities are enjoined by law to give particular attention to the use to which credit is put. That is its use in speculation. Speculation may occur in almost any field. It may occur in land, in commodities, or in securities; and wherever it occurs it is apt to have marked effect upon credit conditions in general. The Reserve authorities are instructed by the statute to keep themselves in formed as to “ whether undue use is being made of bank credit for the speculative carrying of or trading in securities, real estate, or commodities” and are authorized to take certain actions to prevent undue use of credit in these fields. In addition, they have special power to curb the use of credit for speculation in securities. This power is exercised by limiting the amount which holders of securities may borrow upon them, either from banks or from brokers and securities dealers, for the purpose of purchasing or carrying securities. The amount is a percentage.^ the current market value of the securities. It is determined by the Board of Governors of the Federal fteserve System. T 109 110 THE FEDERAL RESERVE SYSTEM Since 1934, when Congress gave the Board this authority, the figure has been as low as 45 per cent and as high as 60 per cent. A figure of 60 per cent means, for example, that a person owning listed stocks currently worth $1,000 may borrow on them for specu lative purposes no more than $600. The limitation does not apply, however, to any loan for commercial purposes, even though the loan be secured by stocks. When it appears that there is borrowing on a large and growing scale to finance purchases of stock, and that it is in the public interest to exercise further re straint on speculation in securities, the Board may reduce the percentage which can be borrowed. As indicated, the limit has been as low as 45 per cent. In this field, as in the general field of credit regula tion, therefore, the Reserve authorities undertake to exercise a stabilizing and corrective influence. This power to establish loan values for securities is commonly spoken of as a power to establish “ margin requirements,,, that is, the amount of collateral which must be put up by the borrower in excess of the amount of his loan. If one is buying $1,000 worth of securities, and the loan value is 60 per cent, he may borrow $600 against the securities and must furnish the other $400 himself. The banker or broker who makes him the loan then holds collateral worth $400 in excess of the amount of the loan. This is his margin. The Board’s regulation may be thought of, therefore, either as prescribing minimum margin re quirements or as limiting maximum loan values. The Board’s regulation applies t o . the margin, re quired at the time the loan is made. If the collateral security subsequently declines in value, the regulation MARGIN REQUIREMENTS F ederal R eserve B a n k of 111 San F rancisco Sansome and Sacramento Streets, San Francisco, California does not make it necessary either to put up additional collateral or to reduce the loan. Aside from having to do with a specific use of credit, the authority with respect to security loans differs from other Federal Reserve powers in reaching outside the Federal Reserve System to banks which are not mem bers of the System and to brokers and dealers in secu rities. It is closely related, however, to other regu latory powers of the Federal Reserve authorities, be cause the use of credit for purchasing or carrying securities has a very important bearing upon its use for business purposes in general. The greater part 112 THE FEDERAL RESERVE SYSTEM of credit used in carrying securities is extended by brokers, whose customers pay only partly in cash for the securities they purchase and go into debt to the broker for the balance. The broker himself must pay in full for the securities he buys, however, and ordi narily he borrows from his bank. Since brokers could not carry customers on any substantial scale unless they were themselves carried by the bank, most of the credit used by the customers in buying the securities is in reality furnished by the banks, and fluctuations in bank loans to brokers, as in any other bank loans, directly affect the banks’ reserve position. A strong demand on brokers for credit, reflected in a strong demand by brokers for bank loans, may occasion sub stantial changes in money rates. By limiting the amount that can be borrowed on securities, therefore, and so restraining such demand for credit, the Federal Reserve authorities are able to impose restrictions on the use of bank funds for stock market speculation without restricting the volume of credit available for commercial and industrial needs or raising its cost. CHAPTER X II SUM MARY The Federal Reserve System has successfully overcome certain difficulties that formerly beset American economic life and imposed upon it great losses; the System still has constantly to meet new problems and difficulties. HE basic powers of the Federal Reserve author ities relate to money and banking. They are monetary in that they deal with the means of pay ment, which consists in part of currency, in part of deposit credit originating from gold, and in part of deposit credit originating in loans and in purchases of securities by banks. Before the Federal Reserve System was organized, the outstanding defects of American banking were diagnosed as “ inelastic currency” and “ scattered bank reserves.” Establishment of the System promptly cleared the way for the anticipated improvements. Elasticity of the currency was achieved. The machin ery for note issue proved adequate for the purpose and in time was found to work almost automatically. For many years now the volume of money in circula tion has expanded and contracted smoothly and effi ciently in accordance with the varying requirements of the public, and the currency function of the Federal Reserve Banks has become virtually a matter of rou tine, entailing no uncertainties and no difficult admin istrative problems. The reserve function, on the other hand, has assumed far greater importance. It has come to be recognized T 113 114 THE FEDERAL RESERVE SYSTEM as much more than a matter of “ pooling” or “ mobiliz ing” scattered reserves and making available to banks in need of funds the surplus reserves of banks that have more than they need. It involves a power to create reserve funds and to extinguish them. If the funds lent by a Federal Reserve Bank, or paid by it for securities, were merely the funds deposited with it by its member banks, the loans and the purchases would not enlarge the total volume of reserve funds. In fact, however, they do enlarge the total volume of reserve funds. By acquiring the obligation of a member bank or other obligor and in exchange crediting an equivalent amount to the reserve balance of the member bank, a Federal Reserve Bank expands both its assets and its liabilities, and the expansion continues in effect so long as the obligation is held. The action is creative. This does not mean that the power of the Federal Reserve authorities is unlimited and that they can create something out of nothing. The law itself limits their power to expand their deposits— that is, the re serve balances of member banks— and to expand their note issue by requiring that their liabilities not exceed a certain ratio to their holdings of gold certificates. Al though this limitation has lost effectiveness, because of the present large gold stock, a fully effective limitation of more practical nature remains. This is that Federal Reserve action will not result in an increased use of bank credit unless there is a demand from the public for additional funds. The Federal Reserve authorities have considerable control over the v olu m e of bank reserves, but they have no corresponding control over the use of bank reserves, and in particular they do not have power to create a demand for credit. They are able to expand bank reserves to meet almost any SUMMARY 115 conceivable demand for credit once that demand comes into existence and also to curb or discourage a demand for credit when it shows signs of developing specula tive excesses. They possess no means, however, of im pelling bank customers to borrow or of impelling bankers to lend. The purpose of Federal Reserve functions, like that of Governmental functions in general, is the public good. Federal Reserve policy can not be adequately understood, therefore, merely in terms of how much the Federal Reserve authorities have the power to do and how much they have not the power to do. It must be understood in the light of its objective— which is to maintain monetary conditions favorable for an active and sound use of the country’s productive facilities, full employment, and a rate of consumption reflecting widely diffused well-being. In formulating their policy, the Federal Reserve authorities take into ac count the factors making up the prevailing situation and use their powers in the way that seems to them best calculated to contribute, with other agencies, to economic stability. In recent years the most important problems affect ing Federal Reserve policy have arisen from the en largement of bank reserves as the result of the in creasing amount of gold in this country. This increase has been contributed to by increased production of gold from domestic mines, but to a much larger extent it has been the result of movements of gold into this country from abroad. The stock of gold in the United States has become about four times as great as it ever was before 1934 and amounts to about 60 per cent of all the monetary gold in the world. Various causes have brought about this unprecedented accumulation, but 116 THE FEDERAL RESERVE SYSTEM the principal cause has been the disturbed economic and political situation in Europe. The result of the accumulation has been the expansion of the reserves of American banks to an amount and degree never before approximated. Member bank reserve balances, which scarcely ever exceeded $2,500,000,000 before 1933, have mounted to $9,000,000,000 and more— prin cipally as a result of gold shipments from other countries. The potential lending power derived by banks from receipt of this gold creates an unprecedented problem of control; because the unused reserves of banks are much greater than can be absorbed by the Federal Re serve authorities under present powers. If changed conditions should result, however, in a return of gold to Europe, the powers of the Federal Reserve author ities would be found highly effective in protecting American interests from being hurt by the withdrawal. The principal means through which the Federal Re serve authorities may exercise their powers over bank reserves are, in review, the following: O pen M arket O perations . These operations di rectly affect the volume of reserves: purchases of secu rities by the Federal Reserve authorities supply banks with additional reserve funds, and sales of securities di minish the volume of such funds. As a means of credit expansion, these operations are limited only by the supply of bills and securities available for purchase and by the reserve position of the Federal Reserve Banks themselves, assuming a demand for bank credit. As a means of credit contraction, they are limited by the amount of bills and securities held by the Reserve Banks. This amount at the end of 1938 amounted to about $2,500,000,000, which of course is considerably SUMMARY 117 less than the amount of member banks’ excess reserves. D isc o u n ts . Through the power to discount and make advances, the Federal Reserve authorities are able to supply individual banks with additional reserve funds and may make these reserve funds more or less expensive for member banks by raising or lowering the discount rate. Discounts can expand only when mem ber banks need to borrow. R eserve R e q u ir e m e n t s . Raising or lowering re quirements as to the reserves which member banks maintain on deposit with the Federal Reserve Banks has the effect of diminishing or enlarging the volume of funds that member banks have available for lending. Under existing law, the requirements may be raised from the present level by only about one-seventh and lowered by about three-sevenths. As already stated, the foregoing powers directly af fecting the volume of member bank funds have no immediate effectiveness with respect to the utilization of those funds. In the field of stock market specula tion, however, the Reserve authorities have a direct means of control over the use of funds— namely, through margin requirements. The Reserve authorities may also exercise limited influence over the credit prac tice of banks through bank examinations. In addition to the credit functions which have just been described, the Federal Reserve Banks perform certain services of which the most important are: hold ing member bank reserve balances; furnishing cur rency for circulation; facilitating the clearance and collection of checks and the transfer of funds; and act ing as fiscal agents, custodians, and depositaries of United States Government. Establishment of the Federal Reserve System the has 118 THE FEDERAL RESERVE SYSTEM made it possible to meet and overcome many difficul ties that formerly beset American economic life and imposed upon it great losses. The System has accom plished improvements in the monetary and banking field that are now taken for granted. Yet new prob lems and needs are always arising. Those that result from recent changes in monetary conditions here and abroad are especially complex and difficult. Federal Reserve policies must be constantly adapted to condi tions in an ever-changing world. FEDERAL RESERVE PUBLICATIONS The F ederal R eserve B u l l e t in , published monthly by the Board of Governors, contains reviews of current economic develop ments, special articles on banking and credit matters, regulations and rulings of the Board, and statistics on domestic and foreign financial and business developments. It is sent to all member banks without charge; to others in the United States the sub scription price is $2.00 a year; and single copies are 20 cents. A n A n n u a l R eport , reviewing operations and policies o f the System, is submitted by the Board of Governors to Congress and is available to the public. The Board releases special statements from time to time as to actions taken and regular weekly statements on the C o n d it io n of t h e of T w e l v e F ederal R eserve B a n k s and on the C o n d it io n R eporting M em ber B anks in 101 L e a d in g C it i e s . Com prehensive statistics compiled from the C a l l R eports of all mem ber banks are issued either three or four times a year. Each Federal Reserve bank publishes a M onthly R e v ie w o f banking and business conditions in its district. A set of F ederal R eserve C h a r t s R ates, and on B a n k C r e d it , M oney B u s in e s s has been published by the Board and is for sale to the public at 50 cents a copy. The F ederal R eserve A ct as A m e n d e d has been printed by the Board and will be supplied without charge. A D ig est of R u l in g s of t h e B oard from 1914 to October 1, 1937 has been compiled and is available at $1.25 a copy. Reprints have been made from time to time of statements made by the Board, of special articles, and of statistical com pilations published in the Bulletin or the Annual Report. The more important of these reprints, which will be supplied upon request without charge, are as follows: P roblem s of B a n k in g B a n k S u p e r v is io n . and Excerpts from the 1938 Annual Report of the Board of Governors of the Federal Reserve System. M onetary M e asu res and O b j e c t iv e s . Containing three statements by the Board on objectives of monetary policy, on proposals to maintain prices at fixed levels through monetary action, and on legislative proposals relating to monetary measures and objectives. 119 TH E FEDERAL RESERVE SYSTEM 120 T he H ist o r y op R eserve R e q u ir e m e n t s for Banks in th e U n it e d S t a t e s . Su p p ly and use op M B a n k R eserve F u n d s . em ber An explanation of the method of analyzing the sources of member bank reserve funds and the uses to which such funds are put. M em ber Bank S t a t is t ic s . A discussion of the statistics compiled and published by the Board covering the opera tions and condition of member banks. Copies of this book, T po ses a n d he F ederal R eserve S y s t e m — I t s P u r F u n c t i o n s , are obtainable in cloth binding at 50 cents a copy and in paper cover without charge. They can be furnished individually or in quantities for classroom and other use. Orders should be addressed to the Board of Governors of the Federal Reserve System, Washington, D . C . I N D E X Acceptances: Page Asset item in statement of condition of Federal Reserve Banks ........................................................................................................ 98 Affiliates, Holding C o m p a n y : Permits granted by Federal Reserve authorities........................ 34 Assets of Federal Reserve Banks: Definition of items in statement of condition...................... 96-100 Balance sheet of Federal Reserve Banks: D ec. 31, 1938 ................................................................................................. 96 Description of ite m s.................................................................. 79, 96-103 Bank credit. (See Credit, Bank.) Bank examinations: Federal Reserve Bank examination of banks ind istr ict.. . . 34 Federal Reserve Banks examined by Board of Governors 34 National banks examined b y Comptroller of Currency........... 33 Nonm em ber insured banks examined by Federal Deposit Insurance C o rp o r a tio n ....................................................................... 33 State member banks examined by State authorities................ 33 Bank premises of Federal Reserve Banks: 99 Asset item in statement of condition............................................ Charge-offs on ........................................................................................... 105 Bank supervision: Federal Reserve A ct provision o n ......................................... 33 Federal Reserve a u th o r itie s.................................................... 33-35 “ Problems of Banking and Bank Supervision” ......................... 119 Responsibility diffused ......................................................................... 33 Bills bought by Federal Reserve Banks: Asset item in statement of condition............................................... 98 Board of Governors of Federal Reserve S ystem : Annual report ............................................................................................. 119 Exam ination of Federal Reserve B an ks........................................ 34 Expenses assessed on Federal Reserve B an ks............................. 106 Foreign bank relations with Federal Reserve Banks, super vised b y ................................................................................................... 37 Functions ...................................................................................................... 15 Margin requ irem en ts....................................................................... 109-112 M em b ers: Appointm ent of ............................................................................... 13 Term s of office.................................................................................... 13 Photograph of building........................................................................... 12 Publications ...................................................................................... 119-120 Rulings, Digest o f. . . ......................................................................... 119 Statements to the public....................................................................... 119 Brokers and dealers in securities: Margin requirements ............................................................ 109-112, 117 Capital accounts of Federal Reserve B a n ks.......................................... 1Q1 Capital stock of Federal Reserve Banks: Dividends on .................................................................................... 106, 107 Liability item in statement of condition........................................ 100 Ownership of .......................... 16, 106 121 122 IN D E X C ash : Paee Definition of “ other cash” in condition statement of Fed eral Reserve B a n k s........................................................... 97 Central banking functions of Federal Reserve authorities . . . . 23 C harts: Disposition of net earnings of Federal Reserve B an ks........... 107 Distribution of earnings of Federal Reserve Banks, 1914-1938 .............................................. 105 Federal Reserve bank c r e d i t .............................................................. 54 Federal Reserve Banks— Reserve position ................................... 78 Federal Reserve chart b o o k .............................................................. 119 94 M em ber bank reserve balances ....................................................... M em ber bank reserves and related ite m s................................... 87 Check clearing and collection: Check sorting at Federal Reserve B a n k .......................................... 31 Discussion of ................................................................................ 30-33, 117 Check payments .................. ............................................... 19, 30-33, 62, 64 C o in s: Circulation of ...................................................................................... 25, 26 M inting o f ................................................................................................... 27 Reserves of member banks affected by circulation o f ............. 91 Comptroller of Currency: Examination of National ban ks....................................................... 33 Condition statem ents: Federal Reserve Banks: Dec. 31, 1938 ........................................................................................ 96 Description of ite m s......................................................... 79, 96-103 W eek ly statement issued.............................................................. 119 M em ber banks: Call report ...................................................................................... 119 W eek ly statement issued.............................................................. 119 Credit, B ank: Description o f ............................................................................................. 84 footnote 40 “ Extension of credit,” Definition o f ............................... Federal R eserve: Chart ...................................................................................................... 54 Dem and for .................................................................................... 80-81 Gold in relation t o ....................................................................... 65-67 M em ber bank credit in relation t o ...................................... 55-58 M on ey in circulation in relation t o .......................................... 93 Nature of ........................................................................................ 84-86 Reserves of member banks in relation t o ........... 88-89, 92-94 Source of member bank reserves....................................... 59-67 M em ber ban k: Federal Reserve Bank credit in relation t o .................... 55-58 Reserve requirement changes effect o n ........... 22, 81-84, 117 Reserves a factor i n ................................................... 39-46, 53, 114 Currency: Circulation: A m ount of .................................................................... 25-27 Reserves of member banks affected by ........... 4 7 ,6 5 ,9 2 -9 3 Dem and for ............................................................................................. 27-30 Distribution of ...................................................................................... 27-30 Inelastic currency prior to establishment of Federal Reserve System ............................................................................................... 28, 113 Issuance b y Federal Reserve B an ks................................. 20, 25, 117 K inds in process of retirement............................................................ 26 IN D E X 123 Currency— Continued. Page Legal tender ............................................................................................... 27 Shipment received at Federal Reserve B a n k .............................. 29 Deferred availability item s: Definition of term in statement of condition............................. 100 D ep osits: Federal Reserve Banks: Liability item in statement of condition...................... 79, 100 Insurance o f : Federal Reserve Bank contribution t o .................... 106, 108 Interest on, Regulation o f ..................................................................... 34 Loans and investments create deposits........................................ 39-40 R atio of reserves to deposits a factor in bank credit........... 39-46 Reserves required against. (See Reserve requirements.) Directors: Federal Reserve B an ks........................................................................... 16 Discount rates of Federal Reserve B a n k s.......................................... 49-50 Discounts and advances: Federal Reserve Banks for member banks: Asset item in statement of condition of Federal Reserve Banks ............................................................................................... 97 Direct advances ................................................................................ 48 Eligible p a p e r .................................................................................... 48 Reserves of member banks affected b y ................................. 117 D ivid en d s: Federal Reserve B an ks......................................................... 17, 106, 107 Earnings and expenses: Federal Reserve Banks: C h a r t s ........................................................................................... 105, 107 Discussion of .................................................................... 17, 104-108 Undistributed earnings as liability item in statement of condition ..................................................................................... 101 Econom ic stability as objective of FederalReserve p olicy......................... 115 Eligible paper ................................................................................................... 48 Examinations. (See Bank examinations.) Expenses. (See Earnings and expenses.) Federal Advisory Council: Organization and du ties......................................................................... 18 Federal Deposit Insurance Corporation: Bank examinations ............................................................................... 33 Federal Reserve Bank contribution t o ................................ 106, 108 Federal Open M arket C o m m ittee: Organization and duties ....................................................................... 18 Federal Reserve A c t: Enactment of ............................................................................................. 22 Publication of Federal Reserve A ct, asam ended...................... 119 Federal Reserve authorities: Definition of term .................................................................................. 13 F unctions: Central banking ....................................................................... 23, 102 M onetary and credit........................................................ 19-24, 113 Security speculation control................................... 109-112, 117 Service ................................................................................................. 24 Supervisory .................................................................................... 33-35 Foreign branches of member banks................................. 34 Holding company affiliates................................................. 34 124 IN D E X Federal Reserve authorities— Continued. Pase Functions— Continued. Supervisory— Continued. Interest on deposits, Regulation o f ................................. 34 R em oval of officers and directors of member banks 34 Suspension of member ban ks............................................ 34 34 Trust powers for National B a n k s................................... Objectives ......................................................................... 15, 54, 115, 119 Powers limited ....................................................................... 5 7 ,7 6 -8 6,1 1 4 Federal Reserve Bank notes: Retirement o f ............................................................................................. 26 Federal Reserve Bank of N ew Y o r k : Agent of Treasury in operation of Stabilization F u n d -----36 Federal Reserve Banks: Bank premises: Asset item in statement of condition ................................. 99 Charge-offs on .................................................................................. 105 Branches: Directors ............................................................................................. 17 Location of ......................................................................................... 15 Directors ........................................................................................................ 16 Dividends .................................................................................... 1 7 ,1 0 6,1 0 7 Earnings and expenses: Charts ............................................................................................. 105, 107 Discussion of ..................................................................... 17,104-108 Examination of ban ks............................................................................. 34 34 Examined by Board of Governors................................................... Franchise tax p aid ............................................................................... 106, 107 Functions: Central banking ................................................................................ 102 Fiscal agen cy......................................................................... 35-38, 117 25, 117 Reserves of member banks h eld ....................................... Service ....................................................................... 25-33, 35-38, 117 Loans and investm ents........................................................................... 108 Location of .................................................................................................. 15 M onthly reviews ....................................................................... , ........... 119 Officers and em ployees...................................................................... 17, 105 P a y r o ll............................................................................................................ 105 Photographs of buildings: Atlanta ................................................................................................. 67 B o s t o n .................................................................................................... 21 Chicago ................................................................................................. 74 Cleveland ............................................................................................. 51 Dallas .................................................................................................... 101 Kansas C ity ...................................................................................... 99 M in n e a p o lis ........................................................................................ 91 New Y ork ........................................................................................... 37 Philadelphia ...................................................................................... 45 Richm ond ........................................................................................... 61 St. Louis ................................................................................................ 83 San Francisco .................................................................................... 112 Stock owned b y member ban ks..................................................... 16,19 Surplus ............. ................................................................. 18, 100-101, 106 Federal Reserve building, Photograph o f ............................................ 12 Federal Reserve Bulletin ..................................... 119 Federal Reserve chart b o o k ....................................................................... 119 IN D E X 125 Federal Reserve districts: Page List o f ............................................................................................................ 15 M ap of .......................................................................................................... 14 Federal Reserve notes: Circulation o f .................................................................... 25, 26, 76, 78-81 Collateral security......................................................................... 26, 77-79 Description o f ............................................................................................. 26 Issuance o f ................................................................................................... 76 Liability item in statement of condition of Federal Reserve B anks................................................................................................... 100, 102 Printing o f ................................................................................................... 27 Federal Reserve policy: Objectives of ..................................................................... 15, 54, 115, 119 Federal Reserve S ystem : Organization of ........................................................................................ 13 35-38 Fiscal agency functions of Federal Reserve authorities............... Foreign banks: Federal Reserve Bank relations with foreign banks super vised by Board of G overnors......................................................... 37 Foreign branches of member banks: Permits granted b y Federal Reserve authorities......................... 34 Franchise ta x : Paid to Treasury by Federal Reserve B an ks...................... 106, 107 Glass, Carter, Bas-relief o f ........................................................................... 8 G o ld : Deposits and withdrawals.............................................. footnotes 60, 64 Federal Reserve Bank credit in relation t o .............................. 65-67 Reserves of member banks affected b y .......................................... 47, 7 9 -8 3 ,8 8 -8 9 ,9 2 ,9 4 ,1 1 5 R e v a lu a tio n ................................................................................................. 94 Source of member bank reserves................................................... 59-67 G old certificates: Asset item in statement of condition of Federal Reserve Banks ................................................................................................. 97, 102 Federal Reserve holdings of gold certificates as reserves. . 77-81 Forms and uses............................................................................. footnote 26 Retirement of .......................................................................................... 26 Holding company affiliates: Permits granted by FederalReserve authorities..................... 34 Industrial loans of Federal Reserve Banks: Asset item in statement of condition............................................ 98 Insurance of deposits: Federal Reserve Bank contribution t o ................................. 106, 108 Interdistrict Settlement F u n d ....................................................................... 32 Interest on deposits: Regulation of ............................................................................................. 34 Legal tender ........................................................................................................ 27 “ Lending” : Definition of the term as u sed.............................................. footnote 40 Liabilities of Federal Reserve Banks: Definition of items in statement of condition...................... 100-101 Loans and investments: Deposits created b y ............................................................................. 39-40 Federal Reserve B an ks........................................................................... 108 M argin requirements......................................................................... 109-113, 117 126 INDEX M em ber banks: Page Call report ................................................................................................. 119 Condition statements ........................................................................... 119 National bank m em bers......................................................................... 18 State bank m em bers................................................................................ 18 Statistics ...................................................................................................... 120 Stock of Federal Reserve Banks owned b y ........................... 16, 19 Trust company m em bers............................................................... 18 M onetary policy: Objectives of .................................................................. 15, 54, 115, 119 M on ey in circulation: Dec. 31, 1938 .......................................................................................... 25-27 Federal Reserve Bank credit affected b y ...................................... 93 Reserves of member banks affected b y ...................... 47, 65, 92-93 M on ey rates: Open m a r k e t ............................................................................................... 50 National Bank notes: Retirement o f ............................................................................................. 26 National banks: Examined by Comptroller of Currency........................................ 33 M embers of Federal Reserve S yste m ............................................ 18 National M onetary Com m ission................................................................ 22 Nonm em ber banks: Insured: Examined by Federal Deposit Insurance Corporation. . 33 Objectives: 15, 54, 115, 119 Federal Reserve p olicy.............................................. Open M arket C o m m ittee, F ederal: Organization and duties......................................................................... 18 Open market operations: 50-54 Description o f ........................................................................................ Federal Open M arket Com m ittee, organization and duties. . 18 Objectives .................................................................................................... 53 Reserves of member banks affected b y .................... 50-53, 89, 116 Open market rates............................................................................................. 50 Paper currency: Printing o f ................................................................................................... 27 Par clearance of checks.................................................................................. 32 Price control; Board of Governors statement o n ............................. 119 Public d ebt: Fiscal agency functions of Federal Reserve Banks in con nection w i t h ............................................................................................. 35 Reserve bank credit. (See Credit, Bank.) Reserve requirements: Federal Reserve B an ks.............................t ....................................... 76-78 “ History of Reserve Requirements for Banks in U . S.” . . . . 120 M em ber banks: Credit control functions .............................................................. 22 Effect of changing requirements on member bank credit .................................................................................... 81-84, 117 Legal requirements....................................................... 19, 22, 42-46 Open market operations effect o n ........................................ 52-63 Table of requirements since 1917............................................ 43 Prior to establishment of Federal Reserve S y ste m ............. 20-22 IN D E X 127 R eserves: Pase Definition of te rm ........................................................................ footnote 39 Federal Reserve Banks: Dec. 31, 1938 ...................................................................................... 77 Chart ...................................................................................................... 78 101 Liability item in statement of condition.......................... Function of .................................................................... 39-46 Individual bank reserves in relation to banking system as a whole ................................................................................................. 68-75 M em ber banks: Dec. 31, 1938 .................................................................................. 19, 76 Balances held by Federal Reserve B a n k s .. . 19, 22, 25, 117 Bank credit in relation t o .......................... 39-46, 53, 55-58, 114 C h a r t s ............................................................................................... 87, 94 Composition of ............................................................................. 59-67 Discounts of Federal Reserve Banks effect o n .................. 117 19, 49, 81, 89, 92, 93, 95 Excess ....................................................... Expansion and contraction o f ................................................. 47-58 Federal Reserve Bank credit in relation t o ........................ 59-67 88-89 92-94 Gold in relation t o ...........4 7 ,5 4 ,5 9 -6 7 ,7 9 -8 3 ,8 8 -8 9 ,9 2 ,9 4 ,1 1 5 Gold stock revaluation had no effect o n ............................... 94 90, 92 Government deposits effect o n ............................................ Liability item in statement of condition of Federal Reserve B a n k s......................................................................... 100, 102 M on ey in circulation in relation t o .................... 47, 65, 92-93 Open market operations effect o n ...................... 50-53, 89, 116 R atio to deposits a factor in lending p olicy................ 39-46 Related items ............................................................................... 87-95 Required ........................................................................................ 19, 95 Silver as a source o f ......................................................................... 64 Sources o f ........................................................................................ 59-67 “ Supply and Use of M em ber Bank Reserve Funds” . . . 120 Treasury currency a source o f ..................................................... 91 Treasury receipts and expenditures effect o n .. 47, 65, 90, 92 Prior to establishment of Federal Reserve System 20-22 ,6 5,1 1 3 Security speculation: Controlled through margin requirements...................... 109-112, 117 S ilver: Source of member bank reserves....................................... 64 Silver certificates: Circulation of ...................................................................................... 25, 26 Reserves of member banks affected by circulation o f ............. 91 Speculation in securities: Controlled through margin requirements...................... 109-112, 117 Stability, E conom ic: Objective of Federal Reserve p olicy.............................................. 115 Stabilization F u n d : Federal Reserve Bank of N ew Y ork as agent fo r .................... 36 State banks: M em bers of Federal Reserve S yste m ............................................ 18 State member banks: Examined by State authorities......................................................... 33 Stock market speculation: Controlled through margin requirements...................... 109-112, 117 128 INDEX Page Supervision of banks. {See Bank supervision.) Surplus: Federal Reserve B an ks................................................. 18, 100-101, 106 Surplus accounts of Federal Reserve B a n k s: Liability items in statement of condition............................. 100-101 Treasury currency: Kinds in circulation........................................................................... 25, 26 91 Source of member bank reserves....................................................... Treasury notes of 1890: Retirement o f ............................................................................................. 26 Trust companies: M em bers of Federal Reserve S ystem ............................................ 18 Trust powers of National banks: Permits granted by Federal Reserve authorities...................... 34 Uncollected items: Definition of term in statement of condition of Federal R e serve B a n k s ............................................................................................. 99 United States Governm ent deposits: Fiscal agency functions of Federal Reserve B a n k s............. 35-36 Reserves of member banks affected b y ...................................... 90, 92 United States Governm ent securities: Asset item in statement of condition of Federal Reserve Banks ................................................................................................. 97, 102 89 Federal Reserve Bank holdings o f ............................................... Fiscal agency functions of Federal Reserve B an ks............. 35-36 United States notes: Circulation o f ........................................................................................ 25, 26 Reserves of member banks affected b y ........................................ 91 United States Treasury: Receipts and expenditures effect on member bank reserves.. 47, 65, 90, 92 W ilson, W oodrow , Bas-relief o f .................................................................. 9