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FUNDAMENTAL REAPPRAISAL OF THE DISCOUNT MECHANISM

EVOLUTION OF THE ROLE AND
FUNCTIONING OF
THE DISCOUNT MECHANISM
CLAY J.ANDERSON
Prepared for the Steering Committee for the Fundamental Reappraisal ofthe
Discount Mechanism Appointed by
the Board of Governors of the Federal Reserve System



The following paper is one of a series prepared by the research staffs of the Board of Governors
of the Federal Reserve System and of the Federal Reserve Banks and by academic economists
in connection with the Fundamental Reappraisal of the Discount Mechanism.
The analyses and conclusions set forth are those of the author and do not necessarily indicate
concurrence by other members of the research staffs, by the Board of Governors, or by the Federal
Reserve Banks.






FUNDAMENTAL REAPPRAISAL OF THE DISCOUNT MECHANISM

EVOLUTION OF THE ROLE AND THE
FUNCTIONING OF THE DISCOUNT MECHANISM

By
Clay J. Anderson
The Federal Reserve Bank of Philadelphia
November, 1966

C O N T E N T S

Page
INTRODUCTION
CHAPTER

I

1-3
SUMMARY OF FINDINGS

Regulating Use of Credit
Allocation Among Banks
Appropriate Borrowing.
The Discount Rate.
Concluding Remarks • • •
CHAPTER II EVOLUTION OF THE DISCOUNT FUNCTION:
OF CURRENT SIGNIFICANCE.

4-14

» • • • •
• • • • •

EPISODES

Why Do Member Banks Borrow?
Need Theory
Profit Theory
Synthesis and Evaluation
• .
Attempts to Regulate Final Use of Credit • •
Eligibility Requirements,
Preferential Discount Rates
Direct Pressure
Amendments in Early Thirties
Allocation Among Banks , • • •
Additional Collateral
Progressive Discount Rates. .
Preferential Rate
Appropriate and Inappropriate Use
Disuse and Revival
Eliminate Eligibility Requirements
Discount Rate Policy « . . . .
•
Role of the Discount Rate
Guides to Discount Rate Action
Effect of Rate Changes
Coordination with Open Market Operations.
BIBLIOGRAPHY




5-7
7-8
8-10
10-11
11-13

14-62
. .
• •
*
. •
• •

• •

•

e

•
.

. •

• .

14-20
15-16
16-17
17-20
20-33
21-22
22-25
25-30
31-33
33~43
35-46
36-41
41-43
43-46
46-49
49-51
51-62
52-56
56-58
58-60
60-62
63-65*

FUNDAMENTAL REAPPPAISAj Of THE DISCOUNT .MECHANISM
INTRODUCTION
There are two major aspects of the discount function, both of
which exercise some influence on the volume of reserves supplied via the
discount window*
Discount policy (administration of the discount window)
influences the total volume of borrowing.

It also affects the alloca-

tion of Reserve Bank credit among member banks and indirectly it may
influence the allocation of member bank credit among final uses. And
the discount rate affects the cost of member bank borrowing.

But dis-

count policy is not considered an effective means of influencing
specific uses of credit.
A complete history of the evolution of the discount function -philosophy, principles, and policies embraced in administration of the
discount window and in discount rate policy -- as recorded in the literature within the System and by outside economists would be a weighty
document*

Much of the material, however, is of historical interest

only. This paper is limited to information and experiments that might
be helpful in determining what the role of the discount function should
be.i'
The principal sources of material used were:
1,

Unpublished material available within the System, especially

the Proceedings of the four policymaking groups prior to 1935 —
JL/ It should be noted that academic literature since World War II is
included in another project.




- 2 *
Conferences of the Governors of the Federal Reserve BanksJ

Conferences

of the Chairmen and Federal Reserve Agents of the Federal Reserve Bahks;
the joint conferences of these groups with the Federal Reserve Board;
and minutes of the Open Market Investment Committee.
Other unpublished System material included special studies,
such as the report of the ad hoc Committee on the Discount Mechanism
in 1954, and the excellent "History of the Lending Functions of the
Federal Reserve Banks,ff by Howard H. Hackley, which includes all amendments to the Federal Reserve Act relating to the discount function and
revisions of Regulation A.
2.

Published material, including u->rks of the better-known

academic economists (prior to World War II); Annual Reports of the
Federal Reserve Board;

and Congressional Hearings, particularly the

"Agricultural Inquiry,11 Joint Coirnn^sion of Agricultural Inquiry in 1921
and "Operations of the National and Federal Reserve Banking System11
(U.S. Senate) in 1931.
It should be noted that the bulk of the material to be covered
in this project appeared prior to thn Great Depression.

The discount

function fell into disuse following the Great Depression and did not
become a significant policy instrument again until after the Accord in
March, 1951. Within the System, policy discussions since the Accord,
except for the study in 1953-54 and the current study, have dealt
largely with open market operations.
The paper is divided into two main parts.

Chapter I is a

brief summary of the evolution of the discount function;




Chapter II

- 3 deals in more detail with the principal concepts and philosophies
embraced in discount and discount rate policies, and some experiments
which appear of relevance in determining the current role of the discount mechanism.

Evaluation, other than that made in the literature

covered, is often unnecessary.
No attempt has been made to cover each amendment affecting
the discount function or each revision of Regulation A.
the V-loan and 13b-loan programs included*
with in the study by Howard Hackley.




Neither are

These are adequately dealt

CHAPTER I
SUMMARY OF FINDINGS
Evolution of the discount function during the past haIf-century
reflects the influence of economic thought and economic events.

The

underlying philosophy of the discount provisions of the Act was the real
bills doctrine that bank credit should be confined to short-term productive uses. This view strongly conditioned the evolution of the discount
function in the first two decades.

It even led to efforts, at times, to

use discount policy to curb the use of bank credit for certain purposes.
Economic events, however, soon created doubts as to the
validity of this doctrine, both in principle and in practice.

Confin-

ing credit to "productive uses" would not necessarily automatically
result in the proper total quantity of bank credit.

During an inflation

boom, total bank credit expansion resulting from lending for so-called
"productive uses11 could be excessive; hence it was necessary to regulate the total quantity of bank credit in the interest of sustained overall stability.
These two views had significant implications for the discount
function.

For selective regulation, such as confining bank credit to

certain uses, discount policy was considered a more useful Instrument;
the discount rate was regarded as a more effective instrument for
regulating the total quantity of bank credit.




- 4 -

- 5 -

Regulating Use of Bank Credit
The philosophy embodied in the Federal Reserve Act contemplated
that Reserve Bank credit should be extended for a short term only, and
confined to financing production and the distribution of goods from
producer to consumer*

It should not be used to finance investments or

speculative activity of any kind —
estate*

securities, commodities, or real

Confining bank credit to productive purposes, it was believed,

would result in an automatic response of supply to the expanding and
contracting needs of commerce, industry, and agriculture.
The implications of this "real bills11 doctrine for Federal
Reserve policy were twofold:

Use of Federal Reserve credit to finance

unproductive activities should be prevented, and System officials should
pursue a passive policy allowing the supply of credit to respond to
changing demands of "legitimate11 business and agriculture.
At first, eligibility requirements were considered the principal
method of confining Reserve Bank credit to productive uses;

however,

experience soon demonstrated that the kind of paper offered for discount
was no indication of the uses made of the bank credit extended on the
basis of the proceeds.
Following World War I, emphasis shifted to "direct pressure"
as a means of confining bank credit to appropriate uses*

Even though

Reserve Bank officials might not be able to identify the specific uses
made of the proceeds of a discount, they could and should keep informed
of the loan and investment policies of their member banks.

Reserve

Bank credit should be denied those banks using it for unproductive purposes.




Most System officials were sympathetic with the ultimate goals
of direct pressure, but there was growing opposition to the policy in
the twenties.
impractical.

One of the major points of opposition was that it was
It was impossible to confine credit to productive uses

through administration of the discount window.

A member bank discounts

or borrows to replenish a reserve already deficient —
usually results from a number of transactions.

a deficiency which

Moreover, reserves created

by loans to banks making only "productive" loans might flow to banks
extending credit for speculative and nonessential purposes.

Secondly,

a substantial number of banks do not borrow from the Fed and hence are
not subject to direct pressure.

Finally, there was increasing doubt that

confining credit to productive uses would result in the proper total
quantity of credit.

The total quantity of credit, even under a produc-

tive use criterion, may expand more rapidly than ability to produce
goods and services to inatch it.

Discount policy by itself has not been

an effective means of regulating the total quantity of bank credit.
The controversy over direct pressure intensified in the latter
part of the twenties as an increasing flow of bank credit went into the
stock market.

With business operating below capacity and prices tend-

ing downward, the situation called for selective control to curtail
credit for speculation without making it scarcer or more expensive for
business and agricultural purposes.

Those favoring direct pressure

instead of an increase in the discount rate thought the latter would
have little effect on speculative use of bank credit but would work a
hardship on business and agriculture.




Others, however, thought the

- 7 -

policy of direct pressure could not be implemented effectively.

Some

loans against securities might be for speculation but others were for
productive purposes.

They favored an increase in the discount rate.

The Great Depression brought to a close attempts to implement
the real bills doctrine as a means of achieving business stability.

The

quantity of eligible short-term commercial paper dwindled and eligibility
requirements handicapped the Reserve Banks in providing adequate assistance to some member banks. Then, too, emphasis continued to shift from
selective control to regulating the total quantity of bank credit and
the money supply.
Allocation Among Banks
Preventing excessive borrowing by individual member banks
has always been a problem, especially in the earlier years of the Federal
Reserve System.

System officials thought too much borrowing was unsound

banking policy because experience had shown that banks heavily indebted
to the Reserve Banks were among the first to fail. Excessive borrowing
was also considered inconsistent with the spirit of the Federal Reserve
Act which authorized Reserve Banks to administer the discount window so
that each member bank would be able to get its fair share of Reserve
Bank credit.

The problem here involved allocation of Reserve Bank credit

among member banks instead of allocation of member bank credit among uses.
One of the early experiments In attempting to prevent excessive
borrowing by some member banks was the establishment of progressive discount rates by four Reserve Banks*

Progressive rates would penalize ex-

cessive borrowers without making borrowing more expensive for member
banks not abusing the privilege*




- 8 The four Reserve Banks establishing progressive rates soon
abandoned them*

A fundamental weakness was that the penalty was based

entirely on quantity of borrowing in excess of a basic line, which in
turn was computed in an illogical manner*

The device worked a hardship

on banks suffering unusually large seasonal or other types of deposit
drains, and exceptionally high rates paid by a few banks aroused widespread criticism and subjected the System to political attack.

The con-

sensus of Federal Reserve officials seemed to be that excessive borrowing could be better controlled by discretionary discount policy than by
a rigid, mechanical formula such as progressive discount rates*
The burden of preventing excessive borrowing by individual
banks fell mainly on administration of the discount window*

Reserve

Bank officials soon began to keep closer tab on member banks borrowing
unusually large amounts or continuously*

In the case of problem banks

the usual investigation was supplemented by conferences with officers
or directors of the borrowing bank*

Reserve Bank officials also used

various contacts and methods to try to educate member banks on proper
use of the discount window*
Appropriate Borrowing
Another aspect of discount policy discussed in the twenties
was appropriate uses of the discount window*

There seemed to be general

agreement that borrowing from the Fed should be short term to meet temporary needs, that habitual borrowing was unsound and undesirable, and
that banks should not borrow to profit from higher rates*




~ 9*
.
The discount window was not used much from about the mid-thirties
until 1951 because of large excess reserves generated by gold imports
and the ready availability of reserves under the policy of supporting
the prices of Government securities.

With the return to a flexible

monetary policy, System officials launched studies in order to reappraise
use of both the discount window and open market operations in the new
environment.
The studies and the Revision of Regulation A in 1955 were
concerned primarily with appropriate and inappropriate types of borrowing from the Reserve Banks*

The principles adopted were largely a reaf-

firmation and refinement of principles which evolved, mainly in the
twentiesf
Appropriate uses of the discount window were principally twofold:

short-term advances to meet temporary reserve drains, such as

from a deposit loss, and seasonal requirements that could not reasonably
be anticipated;

and advances for longer periods if necessary to enable

member banks to meet unusual and emergency situations.
Inappropriate uses included continuous borrowing to supplement
a bank f s own resources, borrowing for speculative purposes,'and borrowing to profit from interest-rate differentials or to obtain a tax
advantage.
The philosophy embodied in the revision of Regulation A contemplated only a limited use of the discount window.

Except in emergency

situations, advances are to help meet temporary reserve drains that a
well-managed bank ordinarily would not be in a position to meet out of




- 10 «
its own resources.

Borrowing is to afford time for a more orderly

adjustment of assets and/or lending policy.
The Discount Rate
The Federal Reserve Act contained little guidance for discount
rate policy.

Section 14 stated that rates should be established "with

a view of accommodating commerce and business.11
Initially, there was little crystallized thinking among System
officials either as to the role of the discount rate or as to criteria
that would be useful in determining the timing of rate changes.

The

penalty-rate concept was widely accepted in principle but considered
impractical in the United States,
Several factors influenced the role of the discount rate in
the twenties.

Emphasis on the use of discount policy for selective credit

regulation, and a consensus among System officials that the discount
rate was ineffective for preventing excessive borrowing by an individual
member bank, tended to relegate the discount rate to a secondary role.
On the other hand, belief by some officials that "direct pressure" was
impractical, and increasing emphasis on the need to regulate the total
quantity of credit favored a more important role for the discount rate.
Discovery of open market operations in the early twenties gave System
officials two quantitative tools. The discount rate and open market
operations soon came to be regarded as the "twin instruments" of Federal
Reserve policy.
System officials devoted considerable attention to guides that
might be useful in determining the timing of discount rate changes.




The

*Udominant view that emerged was that no simple rule or formula would
suffice.

Instead, decisions should be made on the basis of a wide range

of relevant information on current credit and business conditions.

Per-

haps the most widely accepted principle was that the discount rate should
be raised when there was evidence that bank credit expansion was becoming
excessive in relation to the volume of business activity, and that the
rate should be lowered in periods of depression to encourage expansion.
Studies were also initiated to determine the effects of discount
rate action.

Surveys, including questionnaires and calls on member

banks by field men, indicated that changes in the discount rate had
little effect on bank loan rates to customers.

Exceptions were loans

which were closely related to market rates, such as call loans, and
business loans of the larger banks in financial centers.
Even though most member banks indicated that changes in the
discount rate had little effect on customer loan rates, some System
officials thought the cost effect of a change on borrowed reserves had
a significant influence on the total volume of bank credit.
Since 1951, open market operations have been the major policy
instrument.

One new proposal regarding the discount rate,, .advanced in

the academic literature^ was for tying it to some relevant market rate.
Concluding Remarks
The evolution of the discount

function, even though interrputed

by a long period of quiescence in both implementation and thought, has
some significant implications for discount policy.

On the basis of past

experience, the principal implications, in the opinion of the author,
are the following:




- 12 »
1, Administration of the discount window has in the past been
neither an equitable nor an effective instrument for implementing a
policy of selective credit control. At best, it has reached only a
minority of commercial banks (a large number of member banks plus all
nonmember banks that do not use the discount window) and an even smaller
fraction of all lenders. Discount officers can ordinarily identify
"misuse11 only after it shows up in bank condition
accompli*

reports — a fait

Moreover, banks denied access to the discount window because

of noncompliance may have an inflow of reserves from banks which do borrow from the Reserve Banks, and they can acquire reserves in the market*
2,

The use of mechanical devices in administering discount policy

has never been a satisfactory substitute for discretion.
The experiment
soon abandoned.

with progressive discount rates in 1920 was

Some of the shortcomings were the result of the parti-

cular type of plan adopted.

But even more serious weaknesses are inher-

ent in progressive rates. First, no logical basis has thus far been
proposed for computing a basic line. Any basic line, regardless of how
computed, implies that quantity is the primary determinant of validity
of borrowing from a Reserve Bank.

Borrowing in excess of sotrie arbitrary

basic line is automatically penalized regardless of the reasons for the
borrowing.

This view is the antithesis of the concept (and the spirit

of Section 4 of the Act) that, in deciding whether to extend credit to
a member bank, Reserve Bank officials should take into consideration
the condition and policies of the applicant bank and whether the proposed
borrowing is consistent with the maintenance of sound credit conditions.




- 13 Second, progressive rates hit especially hard member banks subject to
erratic and pronounced seasonal and other temporary reserve drains*
Preferential discount rates, used only briefly except in war
financing, proved to be discriminatory and ineffective. The preferential
rate soon became the effective rate.
One of the lessons of experience is that courageous and wellinformed discount officers have been more effective in implementing discount policy than any rule or mechanical formula yet developed.
3«

Eligibility requirements have been more of a handicap than a

help in implementing policy.

They never achieved the purpose for which

they were intended, and the philosophy underlying the requirements has
been inappropriate for the economic environment that has prevailed for
many years. It is for this reason mainly that the System has recommended
to the Congress their elimination from the Federal Reserve Act.
4.

Experience has demonstrated that the discount function has

been useful in reinforcing anticyclical monetary policy —

forcing banks

into the discount window and raising the discount rate when desirable
in implementing a restrictive policy, and lowering the discount rate and
using open market operations to take member banks out of debt in periods
of monetary ease.




CHAPTER II
EVOLUTION OP THE DISCOUNT FUNCTION:
EPISODES OF CURRENT SIGNIFICANCE

This chapter is devoted primarily to issues and episodes
believed to be of some relevance in the current reappraisal of the discount function.

It attempts to summarize the dominant views expressed

within the System and in academic literature prior to World War II. The
principal topics covered are: Why member banks borrow; attempts to regulate the final use of bank credit; techniques of allocating Reserve
Bank credit among member banks; appropriate and inappropriate borrowing; and the discount rate*
Why Do Member Banks Borrow?
Soon after the System began operations Reserve Bank officials
became concerned over the general attitude of member banks toward borrowing from the Reserve Banks, Many banks thought of borrowing from the
Reserve Bank in the same way as borrowing from a correspondent — a
source of funds to lean on when its own resources were short. Reserve
Bank officials tried to inculcate in bankers the philosophy that Reserve
Banks should be regarded as a lender of last resort.
In the twenties, two divergent views emerged (most of the
analyses being in academic literature) as to why member banks borrow.
One view was that member banks borrow only when in need of additional
funds;

the other put more emphasis on profit motivation.

These views

had significant policy implications, especially for the role of the discount rate,




- 14 -

* 1$ "
Need theory
One view which emerged in the early twenties and still prevails
is that member bank borrowing is motivated primarily by need rather than
by profit,—

In essence, the doctrine was that member banks are reluc-

tant to borrow from the Reserve Banks;
meet a reserve deficiency;

they generally borrow only to

and they repay indebtedness to the Reserve

Bank as soon as practicable.

In repaying, however, banks usually with-

draw funds from the money market and shift the reserve deficiency to
other banks*
It is obvious that need is substantially influenced by open
market policy*

If sufficient reserves are supplied through open market

purchases there is little need to borrow;

if, however, insufficient

reserves are supplied through open market operations, member banks may
be compelled to turn to the discount window.
Experience was used to support the need motivation of borrowing,
A substantial spread between the discount rate and market rates was not
unusual.

Hence it was alleged that if member banks borrow primarily

for profit, market rates could not long remain above the discount rate.
Borrowing to take advantage of higher market rates would soon eliminate
the spread*

Neither could market rates remain much below the discount

rate so long as there was any appreciable volume of member bank indebtedness to the Reserve Banks,
jL/ For example, see Winfield W* Riefler, Money Rates and Money Markets
"
~ in the United States, New York: Harper & Brothers, publishers,
1930, pp* 19-32* Riefier was a leading advocate of the need theory*




- 16 »
A significant implication of the need theory is that the
discount rite is not a majot determinant of the volume of member bank
borrowing.

Exponents of the doctrine thought the volume of member bank

borrowing had a greater influence on market rates than changes in the
discount rate. The discount window, although only a marginal source of
funds, had an important influence on market supply and hence on market
rates.

Evidence cited was that market rates moved closely with the

volume of member bank borrowing, and changes in the volume of borrowing
usually preceded changes in rates.
The discount rate had some influence on market rates, however.
If the discount rate is above market rates, banks may turn to call loans
or other market sources for reserves instead of the discount window.

If

the discount

rate is below market rates, the tendency would be for banks
2/
in need of funds to turn to the discount window.—

Profit theory
The profit theory, simply stated, is that member bank borrowing
from the Reserve Bank is motivated primarily by profit.
tend to borrow when it is profitable.

Member banks

Profitability of discounting or

borrowing from the Reserve Banks is a major determinant of the volume
of member bank borrowing.
The profit theory, although not expressly stated and developed,
is implicit in a substantial part of System material dealing with discount
rate policy since World War I.
2/




Proceedings of policy discussions prior

For example, see Riefler, o£. cit.

- 17 to the Great Depression frequently reveal general acceptance of the
principle that the discount rate should be a penalty rate in order to
discourage borrowing for a profit;

it was agreed, however, that imple-

mentation was impracticable in the United States because of the wide
3/
variation in interest rates regionally and by type of loan.—
A more sophisticated version of the profit theory is that
member banks, faced with a reserve deficiency, will tend to select the
4/
lower costamong alternative reserve adjustment media.—

When the

discount rate is above market rates on assets available for readjustment
-- so-called secondary reserve assets—-banks tend to turn to the market
instead of borrowing from the Reserve Banks to cover reserve deficiencies.

Banks are encouraged to borrow from the Reserve Banks when the

discount rate is below market rates on these assets.

The view widely

accepted since revival of the discount function in post-World War II

—

that the discount rate should be equal to or above market rates on commonly used alternative assets for reserve adjustment, especially in
periods of restraint -- implies acceptance of this version of the profit
theory.
Synthesis and evaluation
The need-profit doctrines came under close scrutiny in the midthirties, especially by Robert Turner who attempted to test the two
theories, both analytically and empirically.

3/
~"

4/




For example, see Proceedings of a Conference of the Federal Reserve
Board with the Governors and Chairmen and Federal Reserve Agents of
the Federal Reserve Banks, October 25-28, 1921 (p. 20 et passim) ;
Proceedings of a Conference of the Federal Reserve Board with the
Governors of the Federal Reserve Banks, November 19-21, 1919, Vol. I.
(pp. 59-73 et passim); April 12-15, 1921, Vol. I. (et passim).
For example, see Robert C. Turner, MMember-Bank Borrowing," The Ohio
State University, Columbus, Ohio, 1938, pp. 92-97.

* 18 *
A critical weakness of the need theory is the nebulous nature
of the basic concept. Advocates of the doctrine did not give a clear
definition of need, usually referring to seasonal drains»and temporary
reserve deficiencies arising from market factors such as deposit flows.
Need in this sense, however, should have little effect on the total
volume of member bank borrowing.

Seasonal drains and other market flows

shift reserves among banks but do not affect significantly reserve needs
of the banking system.

If, on the other hand, need is defined to embrace

all types of reserve deficiencies, reserve "needs" resulting from loan
and deposit expansion, including lending and investing to take advantage
of a rate spread, would be included."""
Turner points out that a spread between market rates and the
discount rate does not prove

that member banks do not borrow for profit,

only that they do not borrow in sufficient volume to bring market rates
into line with the discount rate.

Banks may borrow to re-lend or invest

at a profit, but limits imposed by discount policy and the tradition
against borrowing may prevent sufficient volume to eliminate the rate
spread.
Turner, using available statistical data, attempted to test
the validity of the profit theory.

His findings may be summarized as

follows:
1«

There was no correlation between the volume of member bank

borrowing and the profit spread between the discount rate and bank customer
J7

For an explanation and evaluation of the two doctrines, see Turner,
op. cit.» Chapters IV, V, and VI.




- 19 «
loan rates, or between borrowing and the profit spread between the
discount rate and bond rates*

In other words, banks try to take care

of their customers regardless of whether they are able to borrow from
the Reserve Banks at a profit. And apparently they do not borrow from
the Fed to invest in bonds even when the return affords a profit.
2.

There was a fairly close correlation between the volume of

member bank borrowing and the profit spread for three types of open
market paper:
mercial paper*

call loans to brokers, time loans to brokers, and comThere was also close correlation between the volume of

borrowing and the profit spread between the discount rate and the average
of these three market rates•
3.

Changes in the profit spread for open market paper appeared to

be an important determinant of changes in the volume of member bank
borrowing in the period 1922-1930, but the correlation was not so close
for the period 1931-1936.
On the basis of his research and analysis, Turner concluded
that the profit theory is not a complete explanation of the volume of
member bank borrowing but it is a significant one. The volume of borrowing tends to Increase as the profit spread widens, but because of the
tradition against borrowing there is a point beyond which widening of
the spread has gradually less effect.

There is an observable tendency

for changes in the profit spread either to lead or to occur at the same
time as changes in the volume of borrowing. A negative profit spread
is associated with a low volume of borrowing but appeared not to be so
important in determining changes in the volume of borrowing.




Finally,

* 20
•

-

a general theory of member bank borrowing must embrace consideration of
factors influencing reserve positions as well as the profit theory.
Turner's conclusions are valid*

Bank loan and investment

policies are not directed toward taking advantage of every profit spread
between their earning assets and the discount rate.

The tradition

against borrowing, and administration of the discount window, Inhibit
such actions. Nevertheless, a profit spread may induce some banks, especially the more aggressive ones, to pursue more liberal lending and
investing policies; and the relation of the discount rate to rates on
alternative reserve adjustment media surely influences the source of
funds used to cover reserve deficiencies.
Attempts to Regulate Final Use of Bank Credit—
The general philosophy underlying the discount provisions of
the Federal Reserve Act was that Reserve Bank credit should be confined
to productive uses in industry, commerce, and agriculture.

It should

not be used to finance speculative activity of any kind — securities,
real estate, or commodities -- or to finance investments other than
Government securities.
6/

The principal sources, within the System, used on the discount function in the period prior to the mid-thirties were: Proceedings of
conferences of the Governors of the Federal Reserve Banks, and conferences of the Governors and the Chairmen and Federal Reserve Agents
of the Federal Reserve Banks with the Federal Reserve Board; minutes
of meetings of the Open Market Investment Committee; and Annual
Reports of the Federal Reserve Board. The proceedings of the annual
conferences of the Federal Reserve Board with the Governors and
Chairmen of the Federal Reserve Banks, usually held in October or
November, in the first part of the twenties are especially useful
because the meetings were devoted entirely to papers and discussions
of the Federal Reserve policy.




- 21 -

This philosophy of the discount function was expanded and
refined in the twenties.

A view prevalent inside and outside the System

was that confining bank credit to short-term productive purposes was
the real pathway to economic stability.

Productive purposes included

financing an orderly flow of goods from producer to consumer, but not
the building up of inventories in anticipation of higher prices.

For

example, the Federal Reserve Board's Annual Report for 1923 stated, "the
economic use of credit is to facilitate the production and orderly marketing of goods and not to finance the speculative holding of excessive
stocks of materials and merchandise.11-

Confining bank credit to pro-

ductive uses, as here defined, would automatically result in the appropriate quantity of credit.

This point was also well stated in the 1923

Annual Report:
It is the belief of the Board that there will be
little danger that the credit created and contributed
by the Federal reserve banks will be in excessive
volume if restricted to productive uses. . . . . Administratively, therefore, the solution of the economic problem of keeping the volume of credit issuing from the
Federal reserve banks from becoming either excessive or
deficient is found in maintaining it in due relation to
the volume of credit needs as these needs are derived
from the operating requirements of agriculture, industry,
and trade, and the prevention of the uses of Federal
reserve credit for purposes not warranted by the terms
or the spirit of the Federal Reserve Act.8/
Eligibility requirements
The initial view was that confining bank credit to productive
uses could be implemented by eligibility requirements.

If Page 5.
8/




Pages 34-35.

The original

- 22 Federal Reserve Act limited access to the discount window primarily to
short-term paper arising from or the proceeds to be used in financing
industrial, commercial, and agricultural activities*

Except for a mini-

mum gold reserve requirement of 40 per cent, eligible commercial paper
could also be pledged as collateral against the issue of Federal Reserve
notes.

Thus access to the discount window and, to a large extent the

issue of Federal Reserve notes, were directly related to holdings of
eligible commercial paper. As a result, it was expected that Reserve
pank credit and Federal Reserve notes would automatically respond to the
changing needs of production and trade*
Events and experience soon demonstrated that eligibility
requirements were not an effective method of regulating use of credit.
To facilitate financing the large defense expenditures incurred in World
War I, the Reserve Banks vjere given authority to make loans to member
banks against Government securities. More significant, however, experience soon demonstrated that the kind of paper offered for discount or
put up as collateral for loans afforded no indication whatever of the
use a member bank was to make of the proceeds.

In fact, member banks

came to the discount window to cover a reserve deficiency that had
already occurred and which usually reflected the combined effects of a
large number of transactions.
Preferential discount rates
Another early experiment in trying to influence the use of
credit was the preferential discount rate.

In 1915, a preferential rate

was established on trade acceptances to encourage development of a market




- 23 for acceptances and broaden the use of this type of paper, A broader
market for acceptances x^ould tend to stimulate United States exports and
increase the liquidity of member banks.

In the same year a preferential

rate was established on paper based on some staple commodities to facilitate seasonal financing of the marketing of agricultural products.
In World War I and World War II, System officials established
preferential rates on discounts and advances collateralled by Government
securities in order to facilitate financing large wartime expenditures.
The preferential rate in World War II applied to member bank

borrowing

collateralled by short-term Government securities*
Experiments with preferential discount rates, except against
Government securities in wartime, were short-lived.
serious disadvantages.

There were two

One was that banks in need of funds offered for

discount the type of paper with the lowest discount rate. The preferential rate was the effective discount rate.
were discriminatory.

Second, preferential rates

Member banks holding the types of paper with pre-

ferential rates could borrow more cheaply than banks not holding such
paper.

Except for Government paper in wartime, System officials

—

especially Reserve Bank officials — were strongly opposed to preferential discount rates, believing that all types of eligible paper should
carry a uniform rate.
Preferential discount rates (or a penalty rate) have been
proposed occasionally other than in wartime since the early experiments.
In 1928, the System had been following a policy of moderate restraint
in order to curb speculative use of bank credit, but there was no need




* 24 *
•

to curtail bank credit for business and agricultural purposes.

A member

of the Federal Reserve Board recommended establishing a special preferential discount rate for paper drawn to finance the marketing of agricultural products and a preferential buying rate for bankers1 acceptances
drawn for the purpose of seasonal crop movement.

The intention was to

ease the impact of restraint on the marketing of agricultural products.
The proposal which was presented to the Open Market Investment Committee
was opposed by the Preserve Bank Governors,

They opposed such preferential

rates as a matter of principle and also on the basis that they would not
9/
result in lower rates to farmers.—
In the fall < t 1028, Professor O.M.tf. Sprague proposed a penalty
.
discount rate for metf.bcr ••»anks making s^ock •...change loans*

For example,

he stated:
To -urb !'< r^nnr.v] f br-.k.-u for credit, it is
-:•
necessary r-, Ac ;':roy the confident belief that additional
funds will always ho. forthcriring in response to an
advance in rates. This can be readily accomplished by
the addition of a simple provision to the Federal Reserve
act, authorizing, or perhaps c Erecting, the Reserve Banks
'
to impose a rate 1 per cent higher than the call renewal
rate upon rediscounts for member banks that are lending
on the Exchange at the time the accommodation is secured.
If need be also a minimum torrowing period of seven days
might be established.£0/
Serious objections wore raised to the Sprague proposal.

In

addition to the usual objections, it would be difficult to implement
such discretionary power wisely.

Bank credit was needed to facilitate

distribution of new corporate securities which, in turn, v?ere needed at

9/ Minutes of the Open Market Investment Committee, August 13, 1928.
JLO/ O.M.W. Sprague, "A New Device for Reserve Bank Control of Brokers1
"" Loan Inflation,11 The Annalist, October 19, 1928, p. 599.




* 25 times to encourage business recovery*

It would not be easy to determine

when securities loans \*ere excessive.

Passage of such legislation

might also imply that securities loans are objectionable per s e . —
Direct pressure
Ineffectiveness of eligibility requirements along with immobilization of discount rate policy following World War I because of Treasury financing requirements resulted in a shift of emphasis to "direct
pressure11 via the discount window.

There was substantial support within

the System to use direct pressure both to regulate the final use of bank
credit and to prevent excessive member bank borrowing from the Reserve
Banks.
In the spring of 1920, the Federal Reserve Board asked the
Reserve Banks to submit a written report of methods used to keep informed
on how member banks were using Reserve Bank credit.

Some members of the

Federal Reserve Board were ardent advocates of using discount policy to
bring pressure on member banks to curtail credit for nonessential uses.
According to this view, Reserve Bank officials should keep informed on
member bank lending and investing policies and deny access to the discount
window to those extending credit for speculative and other nonessential
uses.

In general, Reserve Bank officials did try to keep

informed of

their member banks' loans and investments through regular reports, bank
examination reports, and interviews with officials of problem banks.
Most of the Reserve Banks, through circular letters and other methods,
11/




For example, see Harold L. Reed, Federal Reserve Policy 1921-1930,
New York: McGraw-Hill Book Company, Inc., 1930, pp. 183-184.

- 26 urged membar banks not to make loans for speculative activities, such
as in securities or to enable borrowers to hold commodities for higher
prices.

The Governor of one of the Reserve Banks stated that borrow-

ing to buy automobiles was one of the most extravagant things they had
to cope with and that people were buying cats who could not afford
them.

One Reserve Bank refused to discount paper arising from the

sale of pleasure automobiles, on the basis that the industry was overextended.

The policy was soon abandoned, however.

Some Reserve Banks,

upon receiving a request for discount accommodation from member banks
making speculative loans, followed the policy of asking the banks to
liquidate such loans instead of borrowing from the Reserve Bank.
There was considerable sentiment that it was impractical to
try to distinguish between essential and nonessential uses of bank
credit in peacetime; however, discretionary discount policy could
have beneficial results.

Knowledge that Reserve Bank officials were

scrutinizing their loans and lines of credit would cause member bank
officials to be more selective in extending their credit.

This atti-

tude of member bank officials would in turn cause borrowers to be more
careful in their applications for credit. A potential borrower contemplating purchasing some luxury which he would "be better off
without," for example, would likely decide not to buy if the appro12/
priateness of such borrowing were questioned.—
12/

See Proceedings of a Conference of the Federal Reserve Board
with the Governors of the Federal Reserve Banks, April 10, 1920,
Vol. IV, especially pp. 515-516, et passim.




- 27 Strong support for direct pressure to influence allocation
of member bank credit emerged again in the latter port of the twenties
System officials became concerned as early as the mid-tvaaf/ias about
the flow of credit into fcha stock market.

The growing volume of bank

credit being absorbed for speculation in securities confronted System
officials with a dilemma.

The excessive flow of ha^U credit Into the

stock market called for a policy of restraint; a - i i g f oi unused reva-it
sources and declining prices called for a policy of e a ^ %
Actions to curtail the total quantity of bank credit and to
make it more expensive in order to curb speculation won* :l havs h.^iaful
effects on legitimate business.

The solution, according to scne

officials was to use discount policy to prevent mernb r Vmkn; from
making speculative loans.

The Federal Reserve Boznv., t-.ny lured chat

an increase in the discount rate would not be efferti ? in curbing
speculation, sent a letter to the Reserve Banks on Fctr.wy 2, 19?. ' ,
J
calling attention to the large volume of speculative u:,:;n;. ana t o the
:
fact that use of Reserve Bank credit to support such I > ^
to the spirit of the Federal Reserve Act.

is contrary

For exar. [>i«-. t£t letter
:'f

stated:
The Federal reserve act does not, in the opi, .U; « f
>
the Federal Reserve Board, contemplate the use or tnc
resources of the Federal reserve banks for the cr uioa
or extension of speculative credit. A member bank is
not within its reasonable claims for rediscount a il~
ities at its Federal reserve bank when it borrows




- 28 cither fot the purpose of making speculative loans or for
the purpose of maintaining speculative loans.A^'
The Board also stated that it had no intention of interfering with the
loan practices of member banks so long as thoce practices did not in*
volve tha Federal Reserve Banks.

But the Board has a responsibility

when member banks are maintaining speculative securities loans with
the aid of Federal Reserve credit*
From the very beginning, there was strong opposition to the
policy of trying to use administration of the discount window as a
tool of selective bank credit control. For example, the Governors of
the Reserve Banks were unanimous that it was not practical to try to
distinguish between essential and nonessential uses of credit in
14/
peacetime,—

The principal objections to a policy of direct pressure

were as follows:
1,

It is impossible to determine the specific use a member bank

makes of the proceeds of a loan from a Reserve Bank.

The loan is to

replenish reserves already impaired, usually by a large number of
transactions.
2.

Even if Reserve Bank credit should be denied to member banks

making speculative loans or for other purposes not considered desirable,
13/

14/




See Federal Reserve Bulletin, February, 1929, Vol. 15, p. 94.
Another good source of information on pros and cons of direct
pressure is Hearings on S.R. 71, "Operation of the National and
Federal Reserve Banking Systems," Subcommittee of the Committee
on Banking and Currency, United States Senate, 1931, especially
the statements of A. C. Miller of the Federal Reserve Board and
George L. Harrison, Governor of the Federal Reserve Bank of New
York.
See Proceedings of a Conference of the Federal Reserve Board
with the Governors of the Federal Reserve Banks, April 8, 1920,
Vol. II, pp. 287-290.

- 29 reserves created by loans to other member banks may be transferred
through ordinary commercial and financial transactions to member
banks making such loans.
3.

Direct pressure cannot be applied to the large number of

banks not borrowing from a Reserve Bank,
4.

Direct pressure, at best, is only feasible for preventing

excessive borrowing by the individual bank; it is impossible for
Reserve Bank officials, in passing on loan applications of member
banks, to determine what the total volume of reserves at the disposal of the banking system should be.
5.

The Federal Reserve Act does not give either the Federal

Reserve Board or a Reserve Bank control over the loan policy of a
member bank. A Reserve Bank cannot compel a member bank to make a
loan which it does not desire to make nor restrain a member bank
from making a loan which it wishes to m a k e , —
Another aspect of the policy of direct pressure was discussed in the early twenties.

There was considerable concern that

some member banks might be investing too heavily in bonds and that
some of the smaller banks especially were being induced by salesmen
to buy bonds of poor quality.
15/




One of the questions discussed by the

See Annual Report of the Federal Reserve Board, 1921, pp. 95*96.
A good statement of the objections to a discount policy of
direct pressure is given in Interpretations of Federal Reserve
Policy in the Speeches and Writings of Benjamin Strong, W.
Randolph Burgess, editor, New York: Harper & Brothers Publishers, 1930, pp. 126-133; 190-193

- 30 Governors was whether, when a member bank comes in to borrow, Reserve
Bank officials should go over its statement and try to tell the bank
what its investment policy should be; also whether the bank should be
advised to sell some of its bonds before the Reserve Bank would lend
to it. Although discussed at some length, there was vigorous opposition to advising member banks on their investment policy because it
would be undue interference in member bank management.

No action was

taken toward trying to implement such a policy,—
A leading academic economist stated that the experiment of
attempting to use discount policy to regulate use of bank credit was a
failure.

It did not result in curtailing the use of bank credit for

speculation without affecting its use for business and agricultural
purposes.

At best, it might have held down total Reserve Bank credit

somewhat, with little effect on the allocation of member bank credit
among particular uses.

In his opinion, a real effort to carry out the

doctrine would have required:

denying Reserve Bank credit to member

banks making loans on the stock market; extending liberal loan privileges at low rates to member banks not making such loans; and open
market sales of securities as necessary to mop up any excess reserves created in the process.—

16/
17/




See Proceedings of the Conference of Governors of the Federal
Reserve Banks, October 10-11, 1922, Vol. II, pp. 336-356.
See Charles 0. Hardy, "Credit Policies of the Federal Reserve
System,ff Washington, D.C.: The Brookings Institution, 1932,
pp. 140-146.

- 31 18/
Amendments in early thirties—
Additional authority for selective regulation just about coincided with the termination of attempts to use the discount window as
a means of influencing final use of bank credit.

Legislation in the

Great Depression, in addition to giving the Federal Reserve Board
authority to fix margin requirements on loans to purchase or carry
securities registered on a national exchange (excluding Government
securities), also conferred additional powers to regulate member bank
loans for speculation in securities.

Section ll(m) of the Federal

Reserve Act was amended to provide that the Board on an affirmative
vote of six members could establish for each district the percentage
of each member bank's capital and surplus that could be represented
by loans secured by stock and bond collateral, the percentage to be
fixed

ll

with a view of preventing the undue use of bank loans for the

speculative carrying of securities.11

Under an amendment of Section

13, if any member bank while indebted to a Reserve Bank and despite
warning from a Reserve Bank or the Board of Governors, increases its
collateral loans or loans to securities dealers for the purpose of
purchasing or carrying securities (other than U.S. Government securities) its note to the Reserve Bank shall be immediately due and
payable and the member bank will be ineligible to borrow for a period
to be determined by the Board of Governors.

18/




For a complete statement of legislation in the early thirties
affecting the discount function, see Howard H. Hackley, "A
History of the Lending Functions of the Federal Reserve Banks11
(unpublished manuscript), Chapters 8-11.

* 32 *
The financial crisis accompanying the severe depression revealed a serious weakness in trying to tie Reserve Bank credit too
closely to narrowly defined eligible commercial paper.

Eligibility

requirements handicapped the System in meeting member bank needs in
two way8.

First, some banks did not have enough eligible paper and

Government securities to borrow adequate amounts to meet reserve
drains, especially if subjected to heavy deposit withdrawals.

Second,

System open market purchases of Government securities to help check
deflation resulted in a reduction in member bank indebtedness and the
supply of eligible paper available to be put up as collateral for the
issue of Federal Reserve notes. As a result, ability to issue Federal
Reserve notes was declining at the same time public demand for currency
was soaring*

Some of the Reserve Bank Governors became concerned over

this situation as early as 1930.
The Federal Reserve Act was amended to remove these handicaps*

The Reserve Banks were given authority to lend against any

satisfactory asset under rules and regulations prescribed by the
Board of Governors but at a penalty rate 1/2 per cent above the discount rate on eligible assets.

The Reserve Banks were also given

authority for the first time to extend credit directly to individuals,
partnerships, and corporations (which included nonmembcr banks) for a
period not to exceed 90 days against Government securities as collateral, under rules and regulations prescribed by the Board.

Government

securities were also made eligible as collateral for the issue of
Ftdaral Reserve notes.




* 33 *
Regulation A was revised effective in October, 1937.

The

revision was concerned primarily with bringing the regulation into conformity with amendments to the Federal Reserve Act; however, there was
a statement of general principles in a preface to the regulation.

The

general principles may be summarized as follows:
1*

The guiding principle underlying discount policy is advance-

ment of the public interest; hence the effect of granting or refusing
credit on the member bank, its depositors, and the community is of
primary importance.
2.

Reserve Banks are expected to consider not only the quality

of paper offered for discount, but whether it is in the public interest to put additional funds at the disposal of member banks.
3.

Reserve Banks, in accordance with the provisions of the

Banking Act of 1933, are to keep informed on the loans and investments of member banks and whether funds are being used for speculative purposes, fixed investment, etc.
4.

In determing its discount policy, a Reserve Bank is to take

into consideration the general business situation as well as the
19/
general conduct and management of the applying banko—
Allocation Among Banks
Another objective in implementing the discount function,
especially in the early twenties, was an appropriate allocation of
Reserve Bank credit among member banks.
19/




Section 4 of the Federal

See Federal Reserve Bulletin, October, 1937, p. 977.

- 34 Reserve Act directed that the affairs of each Reserve Bank shall be
administered "fairly and impartially19 as among member banks and that
each member bank should be extended such discounts and advances "as
may be safely and reasonably made with due regard for the claims and
demands of other member banks...."
Little use was made of the discount window prior to World
War I because most banks had ample reserves, and many banks still
preferred to borrow from their correspondents as formerly.

During

the war, Federal Reserve policy was directed toward facilitating war
financing, and member bank borrowing on Government securities rose
sharply.

Discounts and advances to member banks continued to soar

during the postwar boom and then plummeted in the depression.

One

of the problems confronting System officials after the depression was
a substantial number of habitual borrowers.
A study revealed that in mid-1925 nearly 900 member banks
had been borrowing steadily for over a year. Over 250 national banks
had failed since 1920, and over four-fifths of these banks were habitual borrowers from the Federal Reserve prior to failure. A large
number of the habitual borrowing banks still confronted problems that
20/
had their origin in the war and early postwar periods.—

20/

See the report on member bank borrowing by Professor 0. M. W.
Sprague in Proceedings of a Conference of the Federal Reserve
Board with the Governors and the Chairmen and Federal Reserve
Agents of the Federal Reserve Banks, November 5-7, 1925,
pp. 72-86.




* 35 Banking policy in contrast to credit policy was directed toward maintaining the sound financial condition of individual member
banks.

This policy was considered to be the joint responsibility of

the discount function and supervisory authorities.

Here we ate con-

cerned only with the discount function*
One of the problems confronting the System's discount officials was preventing individual member banks from making excessive use
of Reserve Bank credit both with respect to what is sound banking
policy and the member bankfs fair share relative to the needs and demands of other member banks*

The discount rate could not be relied on

to prevent excessive borrowing, as already mentioned, because a penalty
rate was considered impracticable in our type of banking system.
Additional collateral
One device used by several Reserve Banks to prevent exces21/
sive borrowing was to require additional collateral•—'

With use of

the discount rate immobilized until early 1920 because of Treasury
financing requirements, System officials were pressed to seek other
methods of trying to deal with excessive borrowing.

Some of the Re-

serve Banks required a margin of collateral, in addition to the usual
amount, for member banks borrowing more than they considered appro22/
priate.—'
21/
22/




In the early post-World War I period, additional collateral was
frequently required also for purposes of safety.
See Proceedings of the Governors of the Federal Reserve Banks;
Proceedings of a Conference of the Federal Reserve Board with the
Governors of the Federal Reserve Banks, July 1-2, 1918, March
20-22, 1919, April 7-10, 1920; "Agricultural Inquiry,11 Joint
Commission of Agricultural Inquiry, 1921 (Washington, D.C.,
1922), Vol. II, p. 157.

- 36 Additional collateral was usually required when a member bank
borrowed in excess of a certain amount, such as its capital and surplus,
or a basic line computed for each member bank by the Reserve Bank*

In

extreme cases, one Racerve Bank compelled such member banks to put up
extra collateral in order to reduce their holdings of eligible paper
and hence their capacity to discount or borrow from the Reserve Bank,
Even though the device apparently was not widely used it
aroused criticism.

John Skelton Williams, formerly Comptroller of the

Currency and ex officio member of the Federal Reserve Board, stated
that sometimes the large additional margin--as much as 50 or even 100
23/
per cent--made it impractical for country banks to get credit.—
Additional margins of collateral of this magnitude, however, were
apparently infrequent.
Progressive discount rates
In 1918, the Federal Reserve Board proposed for discussion
the establishment of progressive discount rates on brackets of borrowing above a member bank's normal or basic line.

The purpose was to

prevent some banks from borrowing more than their proportionate share
of Reserve Bank credit.
Several objections were raised against the proposal, especially by the Governors of the Reserve Banks, and it was decided that
aggressive borrowers could probably be better dealt with by moral
suasion.

23/




The proposal was made again in 1919*

See Agricultural Inquiry, p. 157.

The Federal Reserve

* 3? Act was amended in April, 1920, on the recdttttendatlon of the Federal
Reserve Board, providing authority for the establishment of progressive discount rates.
There were two principal reasons f6r the tequfest for authority to establish progressive tates. One purpose Was to prevent excessive borrowihg by relatively few member banks without penalizing those
borrowing infrequently and only moderate amounts, A second purpose
was to achieve a better allocation of Reserve Bank credit among member
banks in accordance with the provisions of the Federal Reserve Act
that credit should be extended "with due regard for the claims and
demands of other member banks,,..11 In some districts, borrowing was
concentrated in a small number of large banks which, in turn, extended credit to their smaller correspondents. Most large banks
wanted to continue to serve their correspondents instead of having
them borrow directly from the Reserve Bank.
Four Reserve Banks (Kansas City, Dallas, St. Louis, and
Atlanta) established progressive discount rates in April and May, 1920.
The schedule for the four Banks provided that for each 25 per cent by
which a member bank's borrowing from the Reserve Bank exceeded its
basic line, a super rate of 1/2 per cent was added to the regular
discount rate.
The key part of the plan was establishment of a basic line
for each member bank.

The consensus of the Governors of the Reserve

Banks was that the basic line should represent the member bank's contribution to the lending resources of the Reserve Bank.




The latter,

- 38 *
It was agreed, consisted of a member bank's reserve deposit and its
paid-in capital to the Reserve Bank.

The Kansas City, St. Louis, and

Atlanta Reserve Banks adopted as a basic line 2-1/2 times a sum equal
to 65 per cent of the reserve balance maintained or required to be
maintained by the membet bank plUg its paid-in subscription to the
capital stock of the Reserve Bank.

The Dallas Bank established as the

basic line an amount equal to the combined capital and surplus of each
member bank.

Advances to member banks collateralled by Government

securities were excluded from progressive rates in order not to affect
adversely the market prices of Government securities or to work a hardship on those still carrying a large part of the Liberty Bonds acquired
24/
on original subscription.—
The experiment with progressive discount rates lasted only a
short time. One Reserve Bank terminated progressive rates in the latter part of 1920, and the other three in 1921. Only a small percentage
of member banks paid a rate of 10 per cent or more--44 in the Atlanta
25/
district, 49 in St. Louis, 114 in Kansas City, and 20 in Dallas.—
Great publicity was given to the fact that a member bank in the South
paid a discount rate of 87.5 per cent.
24/
25/

The bank had experienced a

For example, see the Annual Report of the Federal Reserve Board,
1920, pp. 58-59.
See Robert F. Wallace, "The Use of the Progressive Discount Rate
by the Federal Reserve System,11 Journal of Political Economy,
Vol. 64, February, 1956, p. 61. Good outside sources on progressive discount rates are Wallace, loc. cit., pp. 59-68 and
Benjamin Haggott Beckhart, The Discount Policy of the Federal
Reserve System (New York: Henry Holt and Company, 1924), pp.
357-377, 405-410.




- 39 large outflow of deposits and ita reserve balance dropped to $86,
drastically reducing its basic line.

The 87.5 per cent, of course,

applied only to the upper bracket of its total borrowing.
Progressive discount rates resulted in widespread criticism,
especially in political circles.

It was alleged that progressive

rates resulted in member banks charging their customers exorbitant
rates; and that progressive rates put great pressure on member banks
to reduce their borrowings, which in turn caused the banks to put
pressure on their customers to repay their loans » Available evidence,
however, did not support the charge that progressive rates resulted in
member banks charging excessive

rates to their customers. Instead,

data revealed that there was no difference in the rates charged by
member banks borrowing from the Fed and those not borrowing.

In view

of the criticism about exorbitant rates, the Atlanta and Kansas City
Reserve Banks rebated all interest paid by member banks in excess of
a 12 per cent rate.
One of the principal beneficial results claimed for progressive discount rates was a better distribution of Reserve Bank credit
among member banks.

It discouraged large borrowings by city banks in

order to re-lend to smaller correspondents, and resulted in more of
these smaller banks borrowing directly from the Reserve Bank,
There was strong opposition to progressive discount rates
both within and outside the System*

First, member banks experiencing

strong seasonal pressures and aggressive banks extending credit to
meet the needs of their communities were likely to be penalized.




- 40 Second, as applied by the four Reserve Banks, a hardship was imposed
on banks in rural areas which were experiencing an outflow of funds as
a result of the depression.

Reserve drains reduced the basic line and

esulted in higher super rates.

Third, politicians and demagogues

seized upon the relatively few iridtances of membar banks paying unusually high discount rates to critize and ridicule the System.
Fourth, a rigid, automatic rule was substituted for discretion in administration of the discount window.

Finally, with only four Reserve

Banks using progressive rates, banks could evade the penalty by borrowing from a correspondent in a Reserve District that did not have
progressive rates.
Some of the weaknesses of the progressive rate experiment in
1920 resulted from the type of plan adopted.

The basic line, above

which penalty rates were applied, reflected an attempt to relate a
member bank's fair share of borrowing to its contribution to the lend*
ing resources of the Reserve Bank.

This was an erroneous idea and

there was no logical reason why a bank borrowing in excess of such a
basic line should be required to pay a higher discount rate. Adoption
of progressive rates by all Reserve Banks would eliminate the problem
of avoidance by borrowing from correspondents in districts without
such rates*
But there are serious weaknesses inherent in progressive
rates, regardless of how the basic line is computed.

Borrowing beyond

a certain amount is assumed to be unwarranted and hence should be discouraged by a penalty rate.




Progressive rates are applied on the

- 41 -

basifl of\amount without regard to reasons for borrowing*

The effect

is to discriminate against member banks subject tb large reserve
drains, regardless of circumstances or how well the banks are managed.
A member of the Federal Reserve Board, discussing progressive rates,
stated that he hoped few Reserve Banks would resort to "the mechanical
and bureaucratic device of that kind in order to control a situation
26/
that ought to be controlled through firm, discriminating governing.M-*~
Progressive rates apparently were not effective in restricting member bank borrowing*

One Reserve Bank official stated that mem-

ber banks were not discouraged so much by progressive rates as by the
fear that they might not be able to borrow from a Reserve Bank*

The

Federal Reserve Board conceded that progressive rates apparently were
not as effective as the flat 7 per cent rate adopted by some other
Reserve Banks.
Preferential rate
One of the staff papers in the discount study of 1953-1954
27/
dealt with a preferential discount rate on non-continuous borrowing.—
One basis suggested for the preferential rate was member banks borrowing against Government securities for 15 days or less and which had
not borrowed for at least a 15-day period.

Other bases for applying

a preferential rate to encourage non-continuous borrowing could be used.

26/

27/




Proceedings of a Conference of the Federal Reserve Board with the
Governors of the Federal Reserve Banks, April 10, 1920, Vol. IV*,
p. 523.
William J. Abbott, Jr., flA Preferential Rate on Noncontinuous
Member Bank Borrowing,11 May, 1953.

- 42 Some of the advantages that might derive from such a preferential rate were:
X.

Penalize the continuous use of Reserve Bank credit and

strengthen the sagging tradition against borrowing.
2.

The device would have considerable flexibility as the spread

between the preferential and the regular discount rate could be varied
over time and among Reserve Districts.
3.

The preferential rate could be changed without the psycholog-

ical impact of a change in the regular discount rate.
4.

An increase in borrowing at the regular discount rate woulJ

be an indication of growing tightness.
5.

It would assist in policing the discount window and encomar.e

member banks to maintain greater liquidity.
The proposal had serious disadvantages.

It would discrim-

inate against member banks with heavy seasonal loan demands which
might have to borroitf in several reserve periods even after liqrtd*t:4n::
securities anJ making other asset adjustments. In trying to solve -nproblem it

'.J?
.^V

1 create another — that of preventing one member bank

iron borrovLng at the preferential rate in order to re-lend, to anoth*
which could borrow only at: the regular discount rate.

Finally, te.
h-*

public relations impact of a preferential rate might be harmful.

The

conclusion was that continuous borrowing could probably be prevented
more effectively through discretionary administration of the discount
window than by some mechanical device such as a preferential rate,




A similar proposal was made by a member of the Board of

- 43 Governors in 1957. He suggested, however, a penalty discount rate for
continuous borrowers; for example, banks borrowing for the third or possibly the fifth successive reserve period.—'
Appropriate and Inappropriate Use
Even though two major considerations in discount administration in the twenties were influencing the final use of bank credit and
a fair allocation of Reserve Bank credit among member banks, appropriate
uses in the modern sense of the term were also discussed.
One of the problems was the attitude of member banks toward
borrowing from the new central bank.

In general, member banks thought

of borrowing from a Reserve Bank in the same way as borrowing from a
correspondent.

The widespread misunderstanding of the discount func-

tion among member banks focused attention on educating them as to the
proper uses of the discount window.
The procedure followed by most Reserve Banks in administering
the discount window varied somewhat according to the borrowing record
and condition of the member bank. Well-managed banks borrowing only
infrequently were given only a routine investigation—determining
eligibility of the paper offered for discount or as collateral, and
analysis of readily available data on the bank's condition.

Con-

tinuous and frequent borrowers, banks borrowing unduly large amounts,
and banks with unsound policies or in poor condition were given much
more careful scrutiny.
28/




Problem borrowers were typically subjected to

See minutes of Federal Open Market Committee, May 7, 1957.

- 44 much more careful analysis, such as the character of the bank's loans
and its lending policies; behavior of its deposits; its borrowing
record from the Reserve Bank; examination reports on its condition;
and perhaps discussion with bank examination officials as to the
quality of the bank's management.

Such internal analysis and inves-

tigation were often supplemented by interviews with the borrowing
29/
bank's officers or directors.—
Provisions of the Federal Reserve Act were often referred to
for guidance as to appropriate uses of the discount window.

In general,

member banks should use the discount window for only short terms to
meet seasonal, emergency, and other temporary credit needs. WitU respect to member banks in poor condition, a Reserve Bank should take T
reasonable risk to prevent a member bank from failing but it should
not make advances on worthless paper or paper that would result in
loss.
More attention was devoted apparently to inappropriate uses
of the discount window.

First, Reserve Bank credit should not be used

for either speculative purposes or investments.
29/

The Annual Report of

Proceedings of meetings of practically all of the policymaking
groups in the twenties contained some discussion of discount
policy and administration of the discount window. For example,
see the Proceedings of a Conference of the Federal Reserve Board
with the Governors, and Chairmen, and Federal Reserve Agents of
the Federal Reserve Banks, November 12-16, 1923, especially pp.
102-136, and November 5-7, 1925; Proceedings of a Conference of
the Chairmen and Federal Reserve Agents of the Federal Reserve
Banks, November 4-10, 1926, especially Vol. III., pp. 503-525;
Proceedings of a Conference of Governors of the Federal Reserve
Banks, March 22-24, 1926, Vol. !•, pp. 43-59, and November 8-10,
1926, Vol. 1., pp. 28-53.




* 4*
the Federal Reserve Board for 1923 stated:
It is not a system of credit for either investment or
speculative purposes,.,.. The exclusion of the use of Federal reserve credit for speculative and investment purposes
and its limitation to agricultural, industrial, or commercial purposes thus clearly indicates the nature of the
tests which are appropriate as guides in the extension of
Federal Reserve credit.12/
Second, member banks should not borrow to take advantage of
a differential between the discount rate and the bank's own lending
rates.

The Annual Report of the Federal Reserve Board for 1928 stated;

"It is a generally recognized principle that reserve bank credit
should not be used for profit,,...11—
Third, continuous borrowing from a Reserve Bank was inappropriate for several reasons.

It was inconsistent with the spirit of

the Federal Reserve Act in two respects: Borrowing should be only for
short term; and the principles laid down in Section 4 that the discount window should be administered impartially and with due regard to
the claims and demands of other member banks. Continuous borrowing
was also unsound banking policy.

The Annual Report of the Federal Re-

serve Board for 1926 stated that continuous borrowing "would not be
in accordance with the spirit of the Federal reserve act and. would not
be fair to the other member banks which may be active competitors of
the borrowing bank.

It may also impair the ability of the borrowing

32/
bank in case of insolvency to meet its obligations to depositors.11—

30/
31/
32/




Page 33.
Page 8.
Page 4.

- 46 Discussion at policy meetings revealed three types of continuous borrowers: banks in an over-extended position; those using Federal Reserve credit as a means of enlarging their own operations; and banks
borrowing to profit from a differential between the discount rate and
their own lending rates.
Other instances of inappropriate discounting or making advances to member banks were cited in System discussions. For example,
a Reserve Bank should not discount or make advances to member banks
when the effect is to perpetuate unsound policies and poor management.
Illustrations of the latter were when 60 per cent of a member bank's
assets consist of loans to officers and directors, or when an increase
in borrowing from the Reserve Bank is accompanied by a persistent decline in the bank's deposits.

In such cases, a Reserve Bank should

make advances only when it appears the member bank can be salvaged,
and only after a plan is agreed on for eliminating the unsound policies
and practices; otherwise, extension of Federal Reserve credit enables
some depositors to be paid at the expense of other depositors.
Disuse and Revival
From the Great Depression until the Accord in March, 1951,
the discount function fell largely into disuse and problems other than
discount policy were of concern to System officials. Discount rate
policy also received relatively little consideration.
Restoration of a flexible monetary policy and revival of the
discount function focused attention once again on the role of discount
policy*




A System committee was established in 1953 to make a study of

- 47 the discount mechanism and its role in the new environment.

Several

staff studies were made and the committee submitted its report in
! larch, 1954. Regulation A was revised in 1955.
The ravisioa of Regulation A largely reaffirmed the guiding
principles for discount policy that had been developed earlier.

Appro-

priate uses of the discount window, stated in the form of general
principles in the foreword of the revised regulation, were analyzed in
more detail in the staff papers and committee report.
Appropriate uses of the discount window may be summarized as
follows:
1.

To assist member banks in making very short-term reserve ad-

justments required by a temporary loss of deposits or impairment of
liquidity.
2.

To assist member banks in providing short-term and, to a

limited extent, seasonal credit to facilitate production and the move
ment of goods through the productive process from raw material to the
ultimate consumer.

The foreword to Regulation A states, "seasonal re-

quirements for credit beyond those which can reasonably be met by use
of the bank's own resources."
Permitting member banks to use the discount window to meet all of
their seasonal reserve needs was considered undesirable because such a
policy would probably result in the creation of excess reserves for the
banking system as a whole and interfere with appropriate monetary
policy.
practice.




Moreover, such a policy would not contribute to round banking
Member banks should manage their assets so as to be in a

- 48 * •
position to meet normal or expected seasonal fluctuations.—
3,

Borrowing for longer periods Is appropriate, according to the

foreword to the Regulation, "when necessary In order to assist member
banks In meeting unusual situations, such as may result from national,
regional, or local difficulties or from exceptional circumstances involving only particular member banks/ 1

In other words, borrowing for

longer periods may be appropriate to enable member banks to meet
situations arising out of adverse economic conditions, money panics,
or other economic crises which threaten maintenance of sound banking
and credit policies or the public Interest.
Inappropriate uses of the discount window include:
1.

To help finance speculative activities whether in securities,

real estate, or commodities or to enable a member bank to increase its
investments (except to assist in the secondary distribution of Government and other securities).
2.

Borrowing to take advantage of a rate differential or for tax

avoidance,
3»

Borrowing for a purpose that is inconsistent with the ob-

jectives of sound credit policy or the public Interest.
4.

Continuous borrowing, in effect using Reserve Bank credit to

supplement a bank's own resources.
The committee report offered several objections to continuous borrowing.

33/

First, it wjuld convert the discount window from a

See Committee report, March 1954, Appendix D.




- 49 source of temporary and emergency assistance to one of semi-permanent
investment for a relatively small number of member banks.

Second, a

small number of banks would probably get an undue proportion of the
reserves that should be made available through the discount window
consistent with an appropriate monetary policy.

Third, large and con-

tinuous indebtedness would contribute to an unsound banking practice,
create substantial claims prior to that of depositors, and could
threaten stability of the banking system.

Fourth, a policy of per-

mitting continuous borrowing might result in the injection of more re•
34/
serves than would be desirable for monetary policy.—
Perhaps it should be pointed out that in the staff studies,
the committee report, and revision of Regulation A no sentiment was
expressed for using discount policy to influence the final use of bank
credit, except that borrowing to support speculative activities and
investments was considered inappropriate.

Eliminate Eligibility Requirements
The System Committee on Eligible Paper, in its report of
May, 1962, recommended that present eligibility requirements be repealed and that the Reserve Banks be authorized to make advances to
member banks on their own note secured to the satisfaction of the Reserve Banks, subject to rules and regulations prevscribed by the Board
of Governors.

The recommendation was approved by System officials,

and the Chairman of the Board of Governors in a letter to the Chairmen

34/




Committee report, March, 1954, Appendix D.

- 50 of the Senate and House Banking and Currency Committees of August 21,
1963, recommended legislation to achieve these results. A draft of a
pvoposed bill accompanied the letter.
There were several reasons for the recommendation to eliminate present eligibility requirements and broaden access to the discount window.

First, drastic changes in the economy since 1914 have

resulted in marked changes in commercial bank assets. A marked trend
toward loans of longer maturity and an increase in investments in the
past three decades have resulted in a substantial decline in the proportion of bank assets eligible for discounting.

In the postwar per-

iod there has also been a downward trend in bank holdings of Government securities.

In view of the basic changes that have occurred,

elimination of eligibility requirements is desirable in order that the
Reserve Banks, "will always be in a position to perform promptly and
efficiently one of their principal responsibilities — the extension of
appropriate credit assistance to member banks to enable the latter to
35/
meet the legitimate credit needs of the economy."—A second important reason for the recommendation Is that the
narrowly defined eligibility requirements serve no useful purpose.
Initially, it was expected that the requirements would result in Reserve Bank credit, including Federal Reserve notes, automatically responding to changing needs of business.
35/

Experience soon proved these

Letter to the Chairmen of the Senate and House Banking and
Currency Committees by Chairman William McC. Martin, Jr.,
August 21, 1963.




- 51 *

expectations unjustified.

Departures from the principle that Reserve

Bank credit should be extended only on the basis of short-term, selfliquidating commercial paper began in 1916 when the Reserve Banks were
authorized to make advances up to 15 days on Government securities.
As already pointed out, even more significant departures were made in
the early thirties.
Inasmuch as present eligibility requirements serve no useful
purpose, and at some future time might seriously handicap the Reserve
Banks in meeting legitimate member bank reserve needs, the emphasis
should be on "soundness of the paper offered as security for advances
36 /
and the appropriateness of the purposes for which member banks borrow."-—

Discount Rate Policy
A thorough analysis and review of the evolution of academic
and System thinking about the discount rate as an integral part of
monetary policy is outside the scope of this study.

Its focus is

directed primarily to the role of the discount rate as a part of the
discount mechanism, particularly the aspects of significance for current appraisal of the discount function as a whole.

Thus there is no

attempt to give a complete chronological evolution of the discount
rate's role in monetary policy.

Accordingly, this section deals with

the broader course of thinking on the function of the discount rate,
guides for determining changes in the discount rate, and effects of
discount rate changes.

The bulk of the material covered deals with

the period prior to the Great Depression.
36/




Ibid.

- 52 -

Role of the discount rate
The role of the discount rate depends largely on the reliance monetary authorities put on discount policy and other instruments,
cuch as open market operations and changes in reserve requirements.

A

widespread belief that frequent borrowing is a sign of weakness and unsound banking policy, a consensus that a penalty discount rate relative
to customer loan rates is impractical, a belief that the Reserve Banks
should be lenders of last resort, and reliance on open market operations as the principal tool of monetary policy have all tended to relegate the discount rate to a minor role.
There was little in the way of a theory or philosophy of
discount rate policy prior to the twenties•

System officials had had

no experience in central banking, and initially there was a wide range
of vievjs on the principles that should be followed in establishing
discount rates, some being relevant for a central bank while others
reflected thinking more appropriate for a commercial bank.
two main views:

There were

one that the discount rate should be above bank lend-

ing rates in order to discourage discounting for a profit, and the
other that the discount rate should be low enough to encourage use of
the resources of the new Reserve Banks.
Conditions prior to World War I were not favorable to the
development of a discount rate philosophy.

Lower reserve requirements

provided in the Federal Reserve Act and an inflow of gold supplied
banks with ample reserves, so that there was little need to borrow or
discount at the Reserve Banks.




During the war and the postwar period

- 53 prior to 1920, discodnt rate policy was directed toward assisting the
Treasury in financing the war and the large volume of expenditures
which continued into the postwar period.
The marked change in economic environment from pre-war, and
the postwar boom and depression emphasized the need for serious study
and consideration of the objectives and instruments of Federal Reserve
policy.

In the first part of the twenties, annual meetings attended

by members of the Federal Reserve Board, and the Governors and Chairmen of the Federal Reserve Banks were devoted entirely to Federal Reserve policy.

The consensus was that policy should be directed pri-

marily toward maintaining sound credit conditions and business
stability.
There was a sharp difference of opinion within the System
on the discount function, as already mentioned.

Some favored direct

pressure to regulate the use of credit; others thought more reliance
should be placed on the discount rate.

The latter thought the dis-

count rate had several advantages over direct pressure as a means of
credit control:

it was impersonal and applied to all borrowers alike;

it was suitable for regulating the total volume of bank credit, whereas
direct pressure was effective only in regulating borrowing of individual banks; and rate changes did affect willingness of individual banks
to borrow.




It was not necessary for the discount rate to be above

• 54 37/
bank lending rates to have some restraining influence,—
A modern, forward-looking type of philosophy regarding discount rate policy began to emerge in the early twenties.

Discount

rate policy should be directed toward mitigating the upward and downward swings of the business cycle.

In order to achieve this objective

the discount rate should lead market rates on the upswing to prevent
or at least mitigage inflation; it should lead market rates on the
downswing to prevent liquidation from becoming a straitjacket of deflation.

There was no danger that a low discount rate in depression

would stimulate borrowing for illegitimate purposes, as some feared.
Business firms do not borrow merely because credit is cheap.
This type of discount rate policy was considered consistent
with the provision in the Federal Reserve Act that the rate should be
established with a view to accommodating commerce and business.
37/

The

Some of the better sources of information on the discount rate
in the twenties are: Proceedings of a Conference of the Federal
Reserve Board with the Governors, and Chairmen and Federal
Reserve Agents of the Federal Reserve Banks, October 25-28,
1921, October 10-13, 1922, November 12-16, 1923; Proceedings
of a Conference of Chairmen of the Federal Reserve Banks,
October 25-29, 1921; Proceedings of a Conference of Goyernors
of the Federal Reserve Banks, November 3-6,. 1925; statements
of A. C. Miller, Benjamin Strong, and O.M.W. Sprague in
Hearings, "Agricultural Inquiry,11 Joint Commission of Agricultural Inquiry, Washington, D. C,, 1921; statements of
A. C# Miller and Governor Harrison in Hearings S. 71,
"Operation of the National and Federal Reserve Banking
Systems,11 Subcommittee of the Committee on Banking and
Currency, U. S. Senate, Washington, D. C., 1931; Benjamin
Haggott Beckhart, The Discount Policy of the Federal Reserve
System (New York: Henry Holt & Co., 1924), pp. 520-532;
Interpretations of Federal Reserve Policy in the Speeches
and Writings of Benjamin Strong, edited by W, Randolph
Burgess (New York: Harper & Bros. Publishers, 1930).




- 55 discount rate should be low in depression:

"...you do not accommodate

commerce and business by high rates when four million men are out of
employment and business is sick for lack of markets and markets are
38/
lacking because the v o . U is more or less in commercial chaos. 11 —
A
reduction in rates when business is in a slump can have a considerable
effect in accelerating business revival; an increase when business is
booming can do much to restrain, if not prevent, inflation.

In imple-

menting this type of discount rate policy, however, "Timeliness of
39/
action is of the essence of successful Federal reserve action. 11 —
The role of the discount rate was influenced significantly
by two developments which emerged in the twenties. First, open market
operations began to be used in the early twenties as an instrument of
monetary policy.

This diminished reliance on the discount rate and

raised the problem of coordinating the two instruments.

Second, there

was growing support for using Federal Reserve tools to regulate the
total quantity of bank credit instead of its quality or use.

The

shifting emphasis toward regulating quantity instead of quality of
bank credit was accompanied by greater reliance

on the discount rate

and less on discount policy.
Discount rate policy was of relatively little significance
during the long period from the mid-thirties until the Accord of March,
33/
39/




Proceedings of a Conference of the Federal Reserve Board and the
Governors and Federal Reserve Agents of the Federal Reserve Banks,
October 25-28, 1921, p. 160.
Ibid., p. 156.

- 46 1951t for reasons already given*

Studies of the discount mechanism in

1953 and the System committee's report in 1954 dealt mainly with discount policy.

Consideration of the discount rate was largely in terms

of coordination with open market operations.
Discussion of discount rate policy, especially in the twenties, dealt largely with guides and effects of rate changes and coordination of the discount rate with open market operations.
Guides to discount rate action
Prior to the twenties, the reserve ratio was frequently mentioned as a guide for determining changes in the discount rate, but
proceedings of policy discussions indicate that it was rarely, if ever,
a major reason for a rate change. A much more important consideration
was the relation of the discount rate to market rates—usually the
market rate on prime commercial paper prior to the Great Depression
and the market rate on three-month Treasury bills since World War II.
As already mentioned, the penalty rate was generally accepted in principle but was considered impractical in terms of bank lending rates.
There was a consensus that the discount rate should lead
market rates up in a period of expansion; a discount rate below market
rates would likely encourage speculative activity and borrowing to invest at a profit.

Keeping the discount rate generally above market

rates in a period of expansion would discourage development of a
speculative boom and misuse of the discount window.
There was a difference of opinion as to the proper relationship in a downswing.




One school of thought was that the discount rate

- 57 should lead market rates down in a period of declining business activity.

Encouraging a decline in interest rates would relieve some of

the pressure for liquidation and help stimulate a revival in business
activity.

There would be no danger, according to this view, of stim-

ulating speculation and other improper uses of credit. Another school
of thought, however, was that on the downswing the discount rate should
follow market rates down.

The discount rate should not be lowered un-

til an accumulation of funds had brought a decline in market rates.
Leading market rates down involved the danger of encouraging speculative borrowing and the lower rate would not stimulate borrowing for
productive purposes.
The objective of trying to maintain economic stability and
a growing belief that this required regulation of the total quantity
of bank credit shifted attention from maintaining a certain relationship to market rates to a much broader range of information.
Federal Reserve Board in its Annual Report for 1923 stated:

The
"Broadly

stated, an effective Federal reserve discount rate will be one that
gives effective support to a Federal reserve bank's credit and discount policy.

The objective in Federal reserve discount policy is the

constant exercise of a steadying influence on credit conditions.11 In
deciding whether to change the discount rate, officials should look to
the total flow of credit and general business and financial conditions.
In 1931, a System official stated that, "if central banking authorities
see and have reason to believe in view of the statistics available to
them that the total volume of credit of the country is expanding at a




- 58 rate and volume faster than any normal growth of business could justify,
it is incumbent upon th£ central banking authorities to put pressure or
40/
restraint on that growth by an increase it the rediscount rate. 11 —
Discretion based on a large amount of business and financial
information instead of a few guides was needed for sound decisions in
making discount rate changes.

This vieu was well stated in the Board's

Annual Report for 1923:
No statistical mechanism alone, however carefully contrived, can furnish an adequate guide to credit administration* Credit is an intensely human institution and as such
reflects the moods and impulses of the community--its hopes,
its fears, its expectations. The business and credit
situation at any particular time is weighted and charged
with these invisible factors. They are elusive and can not
be fitted into any mechanical formula, but the fact that
they are refractory to methods of the statistical laboratory
makes them neither nonexistent nor nonimportant. They are
factors which must always patiently and skillfully be evaluated as best they may and dealt with in any banking administration that is animated by a desire to secure to the
community the results of an efficient credit system. In
its ultimate analysis credit administration is not a matter
of mechanical rules, but is and must be a matter of judgment-of judgment concerning each specific credit situation at the
particular moment of time when it has arisen or is developThe view that policy actions should be based on informed judgment instead of rules or a few statistical guides still prevails.
Effect of rate changes
The effect of discount rate changes was also the subject of
considerable study in the early twenties. Many System officials
40/
41/

Hearings S. 71, "Operations of the National and Federal Reserve
Banking Systems," Subcommittee of the Committee on Banking and
Currency, U. S. Senate, Washington, D. C., 1931, pp. 67-68.
Annual Report of the Federal Reserve Board, 1923, p. 32.




- 59 thought the discount rate had little influence on the volume of member
bank borrowing.

The principal reason was that it was impractical to

keep the discount rate above bank lending rates, with the result that
banks could usually employ funds borrowed from a Reserve Bank profitably.
Some officials disagreed.

They thought the cost effect of

rate changes influenced willingness to obtain additional reserves by
borrpwing even though the discount rate may be below bank lending
rates.
Attempts were made to determine whether changes in the discount rate affected rates banks charged their ov;n customers.

Surveys

and discussions with bankers indicated there was little effect on the
lending rates of smaller banks; however, there was some effect on
rates charged by the larger banks in financial centers. Large borrowers with alternative credit sources would often use a reduction in
the discount rate as a bargaining point for lower rates.
rate also had some effect on loan

The discount

rates tied more closely to market

rates, such as brokers1 loans and acceptances.
The effect of the discount rate on the volume of bank credit
was another aspect frequently discussed.

Linkages between a discount

rate change and the volume of bank credit were twofold.

First, an in-

crease in the discount rate made borrowed reserves more expensive and
caused member banks to scrutinize their loan policies more carefully.
Second, the discount rate served as a signal to the public ot Federal
Reserve policy intentions. An increase in the rate was interpreted as




- 60 an indication that credit would likely be less readily available as
well as more expensive.

As a result, business enterprises were less

willing to <ince.z into future commitments in anticipation of higher
prices or for other reasons.
Academic economists apparently had more confidence in the
effectiveness of the discount rate than most System officials.

Lead-

ing economists thought low discount rate3 were largely responsible for
credit expansion and rising prices following World War I, and that increases in the discount rate in 1920 were a major factor in checking
the expansion.

They, too, thought an increase in the discount rate

caused banks to be more careful about loans and induced some of them
to raise their own lending rates. An increase was also interpreted by
the public as a signal of more expensive and tighter credit.

Some

economists disagreed, pointing out that interest cost is only a small
part of total costs.—
Coordination with open market operations
Open market operations were discovered as a tool of Federal
Reserve policy in the early twenties.

It was soon recognized that

when properly coordinated the two instruments used in combination were
more effective than either used singly.

For restraint, open market

operations could be used to force member banks into the discount window,
thus making an increase in tha discount rate more effective. A policy
of ease would be more effective if lowering the discount rate were
42/

See Beckhart, op. cit.» pp. 467-471; Caroline Whitney, Experiments
in Credit Control: The Federal Reserve System (New 2ork?
Columbia University Press, 1934), pp. 211-217.




* 61 *
combined with open market purchases to supply reserves and reduce member bank indebtedness to the Reserve Banks.
Turner, as a result of his studies in the mid-thirties, concluded that Federal Reserve policy would be more effective if more emphasis were placed on the discount rate and less on open market operations.

Open market operations could be used to offset the reserve

effect of market factors and to maintain a more stable and continuous
volume of borrowing from the Reserve Bank,

The latter would provide

the basis for more effective use of the discount rate. Adjusting the
discount rate relative to market rates on alternative reserve adjustment media would enable the System to effectively encourage or dis43/
courage expansion.—
Coordination of the discount rate with open market operations
was discussed occasionally in the fifties.

There was some difference

of opinion as to whether a policy shift should be initiated by open
market operations or by a change in the discount rate.

Some favored

probing with open market operations, pending clearer evidence as to
whether a definite move toward restraint or ease would be desirable.
Open market operations have less psychological impact than a change in
the discount race and are flexible both as to timing and amount.

Such

operations could be reversed, if desirable, without the risk of serious
psychological repercussions that might accompany a roll-back in the
discount rate.

43/




See Turner, oj>. cit,, pp. 145-160.

- 62 Others favored discount rate action to initiate a change in
policy.

Leading with open market operations to implement a restrictive

policy would likely result in the discount rate being below market rates
much of the time*

There would be an inducement for bank3 to borrow from

the Fed instead of adjusting reserve positions in the market and to borrow from the Fed in order to invest the proceeds at a profit*

Monetary

restraint would be rendered less effective. With the discount rate
leading market rates upward, the restrictive effectr of open market
policy would be reinforced instead of alleviatedv—•

44/




For example, see minutes of the Federal Open Market Committee,
August 23, 1955.

SELECTED BIBLIOGRAPHY
B o o k s

Beckhart, Benjamin Haggott, The Discount Policy of the Federal Reserve
System, New York: Henry Holt &"Co., 1924
Burgess, W. Randolph, The Reserve Banks and the Money Market, New York:
Harper & Bros., Publishers, 1936 (revised edition)
Interpretations of Federal Reserve Policy in the Speeches and Writings
of Benjamin Strong, edited by W, Randolph Burgess, New York: Harper &
Bros., Publishers, 1930
Currie, Lauchlin, The Supply and Control of Money in the United States,
Cambridge: Harvard University Press, 1935
Hardy, Charles 0., Credit Folicies of the Federal Reserve System,
Washington, D. C.: The Brookings Institution, 1932
Harris, Seymour E., Twenty Years of Federal Reserve Policy, Cambridge:
Harvard University Press, 1933, Vol. I and II
McKinney, George W. Jr., The Federal Reserve Discount Window, New
Brunswick: Rutgers University Press, 1960
Reed, Harold L., Federal Reserve Policy, 1921-1930, New York:
McGraw-Hill Book Company, 1930
Riefler, Winfield W., Money Rates and Money Markets in the United
States, New York: Harper & Bros., Publishers, 1930
Turner, Robert C., Member-Bank Borrowing, The Ohio State University,
Columbus, Ohio, 1938
Whitney, Caroline, Experiments in Credit Control: The Federal Reserve
System, New York: Columbia University Press, 1934
Articles, Studies, and Reports
Goldenweiser, E. A., "Significance of the Lending Function of the
Federal Reserve Banks,11 Journal of the American Statistical
Association, March, 1936, Vol. 31 (pp. 95-102)




m9 "Instruments of Federal Reserve Policy," Banking
Studies, Board of Governors, Washington, D. C., 1941

- 63 -

- 64 Articles, Studies, and Reports
(continued)
Cassel, Gustav, "The Connection Between the Discount Rate and the
Price Level,ff Skandinaviska Kreditakliebolaget Quarterly Report,
October, 1927
Currie, Lauchlin, "Member-Bank Indebtedness and Net Demand Deposits in
the Federal Reserve System,11 Quarterly Journal of Economics,
August, 1928
Hackley, Howard H., "A History of the Lending Functions of the Federal
Reserve Banks,11 April, 1961 (mimeographed)
Leffingwell, R« C., "The Discount Policy of the Federal Reserve Banks:
Discussion," American Economic Review, March, 1921
Smith, Warren L. , "The Discount Rate as a Credit-Control Weapon,11
Journal of Political Economy, Vol. 66, 1958
Sprague, O.M.W. , "The Discount Policy of the Federal Reserve Banks,11
American Economic Review, March, 1921
, "A New Device for Reserve Bank Control of Brokers1
Loan Inflation,11 The Annalist, October 19, 1928
Steiner, W. H», "Paper Eligible for Rediscount at Federal Reserve
Banks: Theories Underlying Federal Reserve Board Rulings,"
Journal of Political Economy, June, 1926
Wallace, Robert F., "The Use of the Progressive Discount Rate by the
Federal Reserve System," The Journal of Political Economy,
Vol. LXIV, 1956 (pp. 59-68)
Youngman, Anna, "The Efficacy of Changes in the Discount Rates of the
Federal Reserve Banks," The American Economic Review, September,
1921
"The Discount end Discount Rate Mechanism," Special Studies prepared
by Board and Reserve Bank personnel, May, 1953
Annual Reports of the Federal Reserve Board
Hearings, "Agricultural Inquiry," Joint Commission of Agricultural
Inquiry, U. S. Congress, 1931




- 65 Articles, Studies, and Reports
(continued)

Hearings, S. 71, "Operations of the National and Federal Reserve
Banking Systems," Subcommittee of the Committee on Banking and
Currency, U. S. Senate, 1931
"The Discount and Discount Rate Mechanism," statements of Associate
Economists of the Federal Open Market Committee before the
Conference of Presidents of the Federal Reserve Banks, June 21,
1954
Proceedings of the Conference of the Federal Reserve Board with the
Governors, and Chairmen and Federal Reserve Agents of the
Federal Reserve Banks, 1914-1935
Proceedings of the Conferences of the Governors of the Federal Reserve
Banks, 1914-1935
Proceedings of the Conferences of the Chairmen and Federal Reserve
Agents of the Federal Reserve Banks, 1914-1935
Report of the System Committee on the Discount and Discount Rate
Mechanism, March 12, 1954





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