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FUNDAMENTAL REAPPRAISAL OF THE DISCOUNT MECHANISM

RATIONALE AND OBJECTIVES
OF THE 1955 REVISION OF
REGULATION A
BERNARD SHULL
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.







REAPPRAISAL OF THE DISCOUNT MECHANISM

RATIONALE AND OBJECTIVES
OF THE 1955 REVISION
OF REGULATION A

by
Bernard Shull

June 1966

TABLE OF CONTENTS
I.
II.

Introduction
The Current Regulation:
A.
B.

C.

III.
IV.

V.




2
Objectives and Techniques

Objectives in revising Regulation A
"General Principles"
1. Type of credit available
2. Appropriate and inappropriate purposes
3. General supervisory considerations
Contemplated Administration of Regulation A
1. Restriction on "continuous" borrowing
2. "Purpose" restrictions

3
4
8
11
11
12
13
14
16

Administration of Regulation A

18

Restrictive Impact of Regulation A
A. "General Principles"' and demand for credit
B. "General Principles" and the discount rate
C. "General Principles" and the supply of credit
D. Demand and supply relationships

20
21
24
25
29

Summary and Conclusions

32

-2I.

Introduction
The 1955 revision of the Federal Reserve System's Regulation

A governing discounts and advances developed out of a study by a Federal
Reserve System Committee in 1953 and 1954.

The report issued by the Com-

mittee recommended the principal change adopted, a set of General
Principles to guide borrowing and lending at the discount window.—

Its

recommendations were deeply rooted in the development of the discount
mechanism during the 1920 f s, and also in the System decision to rely principally on open market operations in the conduct of monetary policy once
flexibility

was re-established after the Treasury-Federal Reserve Accord.

This paper reviews and evaluates the rationale and objectives
of the 1955 revision of Regulation A -- in particular as they relate
to the mechanisms for rationing credit established by the "General Principles.ff

The analysis is based principally on the 1954 System

report on the discount mechanism

Committee

and is supplemented by responses to a

questionnaire on discount operations sent to each Reserve Bank in 1965.
The historical development of the discount mechanism in the 1920fs and the
2/
principal changes represented by the 1955 revision are discussed elsewhere.—

1/

2/

System Committee on the Discount and Discount Rate Mechanism, MReport
on the Discount Mechanism," March 12, 1954, unpublished document.
(Hereafter referred to as ''Report on the Discount Mechanism," 1954.)
See Bernard Shull, Report on Research Undertaken in Connection with
a System Study, Board of Governors, Federal Reserve System, August 1968.




-3II.

The Current Regulation:

Objectives and Techniques

The 1953-54 study of discounting was instituted as a result
of concern about the possible Mover-extension" of Federal Reserve credit
through the discount window.

In mid-1952 discounts and advances had

increased to over $1.6 billion; while declining somewhat through the
first half of 1953, they still exceeded $1 billion in each of the
1/
first months of the year.

1/

According to the "Report on the Discount Mechanism, 1954," p. 22:
"In part the rapid rise in borrowing during 1952 was a direct
effect of restrictive credit influence exerted by the System.
But it also represented borrowing by some member banks to avoid
excess profit taxes, by others to profit from differentials
between prevailing discount rates and market yields that developed
under the tightening credit market conditions, and by still others
to supplement operating resources in order to accommodate the
active credit demands being generated by inflationary trends.
These developments in particular brought under discussion within
the System the whole question of the philosophy and effectiveness
of its existing discount mechanism." The circumstances leading
to a revision in Regulation A were also described in the Annual
Report £f the Board of Governors of the Federal Reserve System,
1957, p~~9~* "In 1952^53 as credilTdemands expanded and Federal
Reserve policy limited the amount of reserves made available
through open market operations, pressure on bank reserves increased,
and member bank borrowing from the Reserve Banks rose rapidly.
During this initial revival of the discount mechanism after a
generation of disuse numerous problems arose, including uncertainty
among many member banks about what was an appropriate use of the
discount privilege... . As a result of these developments, the
System re-examined historical experience, notably in the 1920's....
In the light of practices shown by experience to be appropriate
and sound and also in the light of statutory provisions ..., the
Board of Governors revised its Regulation A."




-4This upsurge in the volume of funds borrowed from
the discount window developed after almost 20 years of low
levels of activity.

Between 1934 and 1943, discounts and

advances averaged $11.8 million per year; betx-;een 1944 and
1951 they averaged $253 million.

Only in the early post-

World War I period (1918-21) and in the late 1920fs

(1928 and 29)

did discounts and advances approximate, in dollar amount, the
levels reached in 1952 and early 1953.-

A.

Objectives in revising Regulation A
In developing and recommending a reformulation of

Regulation A, in these circumstances, the System Committee
emphasized several objectives.

These may be summarized as

follows:

1/




In the 1918-21 period, they averaged $1,840 million; in the
1928-29 period they averaged $886 million. However, it should
be noted that, in the 1918-21 period discounts and advances
averaged close to 70 per cent of total Federal Reserve credit
outstanding. In 1928-29, they represented about 60 per cent
of
such credit. At the peak of discount activity in
December 1952, discount credit represented only 6 per cent
of Federal Reserve credit outstanding. "Member Bank Reserves
and Related Item," Supplement _to Banking and Monetary Statistics,
Section 10, 1962, pp. 14-19.

-5(1) The discount mechanism should not
serve to relieve for long or indefinite
periods the pressure of monetary restraint
upon the banking system and its customers.—
(2) Individual banks should not be permitted
to depend on the discount window as a normal
source of funds for investments and loans.
Such dependence on borrowing unduly raises
2/
the risk of their insolvency and/or illiquidity.—

JL/

fl

7J

n




(T)he borrowing facility should not provide a channel through
which member banks generally or an important segment of them
may be able to avert the over-all credit and monetary policies
of the System ... (T)he discount facility [can] serve as a
safety valve, easing temporarily the special reserve pressures
on individual banks. At the same time, [the facility need not
become] a gaping hole through which are released all the
pressures on bank reserves built up within the banking system
as a whole." "Report on the Discount Mechanism, 1954," pp. 9
and 12.
A major lesson brought out by the bank credit liquidation [in
the early 1920's] ... was that it was unsound for any member
bank to use continous indebtedness to its Reserve Bank as a
resource for conducting regular banking operations.... In
the severe banking crises and liquidation in the early thirties,
adjustment problems of the aggressive, continuous borrowing
banks made evident the hazards to safety of depositor funds
and the dangers to bank solvency resulting from the injections
between bank capital and deposits of borrowed funds having
creditor status ahead of deposit liabilities.11 Ibid., pp. 10, 11.




-6Furthermore, increases in the risk of insolvency and illiquidity for individual
banks, aside from being undesirable

per

se, endanger the stability of the financial
system and militate against the effective
operations of monetary policy. —
(3) That member banks are generally reluctant to borrow is, for the reasons
above stated, in the public interest.
In order to prevent a weakening of this

"Chronically indebted banks risk depositor pressure in the
event that economic conditions turn adverse and the fact
of their difficulties in a closely inter-dependent banking
community can make other banks, even those in a strong
position, highly sensitive about their own liquidity needs.
This kind of banking climate can set the stage for a period
of irrational bank credit liquidation. As Federal Reserve
experience in at least one important period illustrates,
constructive credit and monetary policy to cushion economic
recession and foster revival can be rendered substantially
ineffectual by persistent dependence on the discount facility
developed by some banks in a prior phase of economic boom.11
Ibid. , pp. 12, 13.

-7attitude, it is necessary that Regulation
A be formulated so as to give support to
the extant

"tradition against borrowing."-

With the achievement of these objectives, the Committee
believed the discount mechanism could and should serve to meet the
"needs" of individual member banks for credit accommodation to
facilitate short-run adjustments in response to changes in the
and to meet
degree of monetary restraint^ "unexpected11 changes in deposit
2/
flows or loan demand, and to ameliorate emergency situations .~
In this role, discounting would complement open market purchases
and sales in achieving the desired degree of monetary restraint.
jL/ "Because of this costly lesson [during the 1930 f s], it was
possible by the mid-thirties to speak of an established tradition
against member bank reliance on the discount facility as a supplement to its resources.... In a banking organization made up
of thousands of member banks engaged in widely differing kinds of
banking business, a well entrenched tradition against commercial
bank reliance on borrowed funds is an important aid to reserve
banking •.• (S)uch a tradition permits the discount facility to
serve as a safety valve.... From the standpoint of strong and
responsive banking conditions, the tradition against borrowing in
long periods of economic prosperity helps to prevent the more
aggressive member banks from building up undue dependence on discount
credit.... The Committee believes that the tradition against continous member bank dependence on the discount facility is sound in
principle. . .. Future discount policy, in its opinion, should build
on the tradition as a keystone.... (Italics added.) [However] (t)he
tradition against large and continuous borrowing, being without
adequate regulative support, is subject to the risk of weakening in
periods of credit tightness
Ibid., pp. 11-13, 22, 23.
2/ "It is desirable ... to keep open the privilege of individual
member banks to borrow at the Reserve Banks to meet essential
temporary or emergency needs•" Ibid,. p.9.




-8The Committee also expressed the belief that formulation
of Regulation A to meet the objectives cited would serve to eliminate
"incompatible inter-district differences in discount methods11 among
the Reserve Banks.—
B.

"General Principles"
To achieve these objectives, the

Report on the Discount

Mechanism" recommended a set of "General Principles" to be incor2/
porated into Regulation A.-

These were designed "... to guide

Reserve Banks in lending and member banks in Reserve Bank borrowing,11 and
•••to give clear and full expression to the discount obligations of
3/
the Reserve Banks as they are stated in, or implied by, present law."—
The Committee indicated that M (a) key premise underlying
the ... suggested revision of Regulation A is that explicit standards
for use of the discount facility would reinforce the member bank
tradition against borrowing by providing a frame of reference for

T^l The "lack of a modernized System discount philosophy ... is a
factor fostering
undesirable regional differences in discount practices
.... While some incompatible inter-district differences in discount
methods may now exist, the committee is persuaded that the differences
not supported by variations in regional conditions and needs would be
largely eliminated by a Regulation A re-oriented along the lines
suggested.11 Ibid, pp. 23 , 24.
2/ tfReport on the Discount Mechanism," 1954, Appendix D.
3/ Ibid, pp. 23 , 24.




-9evaluating undue reliance on discounting by aggressive member banks
...."—

The majority of banks who were viewed as ''reluctant to

borro\\7tr would, presumably, receive support from the position taken by
the Federal Reserve and the observed change in behavior on the part of
2/
the "aggressive" few.~

The relatively few 'aggressive" borrowers,

it was expected, could be persuaded to shape their demands for credit
to the standards of

reluctance

The Report noted that

established by the Regulation.
"(i)f the discount standards advanced

should ... be applied too inflexibly by Reserve Banks ... then the
regulation could tend increasingly to supplant tradition."—

The

principles advanced, the Committee stated, were "...intended to be general guides and standards and not precise administrative instructions
4/
inflexibly applicable to all cases.11"" Nevertheless, the principles
were not intended to \rary with cyclical changes in monetary policy,
though

the amount of credit flowing through the discount window would.**

2/ Since relatively few banks ever borrowed at all, it was inferred
that the majority were "reluctant to borrow." The System Committee
indicated that a possible objection to its suggested revision was that
the System's discount mechanism problem was mainly one of relatively
few insistent borrowers. "Report on the Discount Mechanism," 1954,
pp. 36, 37. The Committee stated: "the majority of member banks are
now administering their affairs in line with the philosophy of the
suggested revision/1 Ibid., p. 40. A more recent expression of the
view is contained in The Federal Reserve and the Treasury Answers to
Questions from the Commission on Money and Credit, 1953, p. 139.
27 "The majority of member banks ... now administering their affairs
in line with the philosophy of the suggested revision ... might feel
kindly rather than antagonistic to a revision of the regulation that
would help bring less conservative banks into conformity." Ibid.
3/ Ibid., p. 36
4/ Ibid., pp. 24, 25.
j>/ The Report indicated that "(w)hile the Committee contemplates a
System discount activity varying in accordance with general credit
policy, it wishes to stress particularly that it is not recommending
a set of discount principles that would in themselves flex with such
policy by administrative discretion,11 Ibid. , p. 32.




-10The "General Principles" as finally embodied in a new
Foreword to Regulation A show minor alterations

in emphasis and

considerable editorial revision; but they show relatively little
in the way of substantive change.-

The "General Principles" of

J7 The revision suggested by the System Committee Report incorporated
the suggested "General Principles" in Section 1 of the Regulation. An
introduction indicated the basic objectives underlying Federal Reserve
credit policy, the methods utilized to achieve these objectives, the
effect of borrowing on the supply of reserves, and, consequently, the
need for "guiding principles" in extending credit by discounting. It
indicated also that "(a)ccess to the credit facilities of the Federal
Reserve Banks is a privilege of membership ... which must be considered
in the light of these principles." Eight "Principles" were stated.
These were, in abreviated form, as follows: fl(l) Due regard must be
given to the effect of any extension of credit upon the maintenance
of sound credit conditions.... (2) Federal Reserve credit should
normally be extended for short periods to meet temporary credit needs
of member banks. (For example ... in order to enable a member bank
to adjust its asset position because of such developments as a temporary loss of deposits or to assist a member bank in meeting requirements for seasonal credit which cannot reasonably be anticipated
and met by use of the member bank's own resources). (3) In order to
enable member banks to meet unusual and exigent situations, Federal
Reserve credit should be extended for as long a period as may be
deemed necessary.... (4) (U)nder ordinary conditions continuous use of
Federal Reserve credit... would not be appropriate.... (5) In determining
whether to grant or refuse credit ... Federal Reserve Banks are required
... to consider the general character and amount of the loans and
investments of the member bank and whether the bank is extending an
undue amount of credit for speculative purposes.... (6) Federal Reserve
credit should not be extended where it appears that the member bank's
principal purpose is to profit from rate differentials or to obtain a
tax advantage. (7) The law permits only such extensions ... as may be
'reasonably and safely made 1 ; and the acceptance of paper offered for
rediscount or as collateral ... must be determined in the best judgement
of the Federal Reserve Bank.... (8) The board of directors of each
Federal Reserve Bank is required by law to administer the affairs of
such Bank fairly and impartially and without discrimination."
Section 1 of the suggested revision closed with a statement that
"(i)n passing upon requests for credit accommodation ... the Federal
Reserve Bank should give consideration to all of the principles ...
together with any other factors which may be pertinent." Ibid.,
Appendix D, pp. 1-5.
With the exceptions of (7) and (8), the "Principles11 suggested
by the System Committee were incorporated in the Foreword to the
Regulation, as revised in 1955, rather than in Section 1. The actual
revision did not list the principles by number, and some minor changes
in language were made. But there seemed to be little in the way of changes
in substance. The "Principles11 numbered (7) and (8) in the System
Committee Report were not explicitly incorporated in the "General
Principles" in their final form; but the portion of the Federal Reserve
Act from which they derive (Section 4, paragraph 8) is referred to in
a footnote. See Howard H. Hackley, "A History of the Lending Functions
of the Federal Reserve Banks," p. 432.



-li-

the current Regulation may be viewed as the device designed to achieve
the objectives developed in the System Committee Report.
The credit-restrictive portions of the "General Principles"
can be divided into three types:

(1)

descriptive

statements

about the "type" of credit available at the discount window; (2) statements about the "purposes" for which the type of credit described may
and may not be appropriately extended; and (3) statements reserving
the right to restrict credit on the basis of bank supervisory considerations in general.




(1) Type £f credit available. Credit available
at the discount window is normally short-term,
and maturities are generally limited to 15 days.
This "short-term" credit is not to be extended
on a "continuous basis.

(Longer-term credit

is available, but only in exigent situations;
i.e. for certain "purposes.")
(2) Appropriate and inappropriate purposes.
The appropriateness of any given request for
short-term credit is dependent on the purposes
for which the credit is requested.

Short-

term credit may be appropriately extended to
meet a "sudden withdrawal of deposits or
seasonal requirements beyond those which can
reasonably be met by use of the bank's own
resources,"

-12A credit request is not appropriate if the
funds are to be used to obtain M a tax

advan-

tage," to profit "from interest rate differentials,11 or for the "undue" extension of credit
for speculative purposes.

Long-term credit,

as mentioned, is available for certain "purposes."—
(3) General supervisory considerations.

A Reserve

Bank will, in extending credit, give "due regard ...
to its probable effects upon the maintenance of
sound credit conditions, both as to the individual
institution and the economy generally.
informed of and

It keeps

takes into account the general

character and amount of loans and investments of
the member banks."
It is stated in the Regulation that "access to the ...
discount facilities ... is granted as a privilege of membership
... in the light of the ... general principles."

This statement

J7 "Federal Reserve credit is also available for longer periods 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." Regulation A, 12 CRF 201.




-13was interpreted at the time and in the ensuing years as meaning
that "Reserve Banks do not discount eligible paper or make advances
to member banks automatically,"—

as they presumably would if access

to the discount window were granted as a "right.11

C.

Contemplated Administration of Regulation A
The 1954 "Report on the Discount Mechanism" discussed how

Regulation A, if revised as recommended, would be administered.

It

also suggested how the restrictions on credit (in the "General
Principles") would operate.
It was evidently expected that an "initial" request for
credit by a member bank would normally be granted.

The Report notes

that "..• promptness of discount action would require reliance in the
2/
first instance on a member bank's own statement of purpose;"— and
the question of continuous borrowing "... would arise first at the
3/
time of the first renewal."—
of

borrowing

In determining the appropriateness

thereafter, the restrictions on continuity and pur-

pose would, presumably, operate in a coordinated fashion, since all
4/
the "principles ... are closely interrelated/1—
1/ The Federal Reserve System: Purpose and Functions, Board of
Governors, Washington, D. C , 1963, p. 42.
2/ "Report on the Discount Mechanism, 1954," p. 34.
1/ Ibid., Appendix C^ p, 7.
4/ Ibid,, p, 24.




-14The intended relationship between the "purpose11 and
"continuous borrowing1' restrictions,however, is not obvious; nor
for that matter are the relationships among the "purpose11
restrictions themselves.

The two major types of restrictions and

the intended relationships require some consideration.
(1) Restriction on 'Continuous" borrowing
It might seem, at first, that the restriction on "continuous"
borrowing was intended to be sufficient, in and of itself, to limit
the supply of credit.

While it is possible to interpret the

restriction in this fashion, there is good reason to believe that
such was not intended.

It seems more likely that the intent was to

use duration--or more exactly, frequency of borrowing over some
duration--to establish no more than a rebuttable presumption of
"inappropriate purpose,"

The Report explicitly

indicates that the

continuation of borrowing, with some degree of frequency, is to be
taken as progressively more persuasive prima facie evidence that the
credit extension is not for an appropriate purpose.




"With each successive period in which
borrowing occurs ... the probability
that the borrowing stems from inadvertent causes obviously decreases ....
Consequently, if a bank borrows at
least once in each of a number of consecutive reserve periods, there exists

-15a presumption that it is using this
means deliberately to avoid more
basic adjustments in its position
and hence that the borrowing is
continuous in the sense indicated
here.11 1/
Consistent with this view of the restriction, the
"Report on the Discount Mechanism11 refrains from a specific
definition of "continuous" borrowing, though the Committee
2/
went into some detail on the issue,—
It noted that it is
11

... necessary [to develop] some reasonable empirical standard

for judging the number of reserve periods that a bank may borrow
3/
successively before it is to be considered a continuous borrower."—
But

the Report states, "(t)he specific guideposts

for identifying

such borrowing can be established only on the basis of broad
discount experience of individual Reserve Banks and discussion among
4/
the Reserve Banks ." 1/ Ibid.. p. 10. It is conceivable that some specific duration of
indebtedness (in terms of number of periods or frequency over a period
of time) might have been chosen as establishing a conclusive presumption that the borrowing is for an "inappropriate purpose." Continuous
borrowing would then be sufficient to restrict credit, but still only
as a proxy for "purpose." However, the author has been informed by
one reviewer, intimately familiar with the deliberations during the
period, that there was a System-wide consensus that the definition of
continuous borrowing should not be pushed further.
If The Report does indicate that both "extended-repetitive" borrowing
i.e., cases in which banks are in and out of debt vbver nearly
successive reserve periods," and "extended-uninterrupted" borrowing,
i.e., borrowing over successive periods, should be included under the
definition of "continuous borrowing."
3/ Ibid.. Appendix C, p. 9.
4/ Ibid., p. 11.




-16Given that the "continuous borrox^ing" restriction was
intended to represent evidence that would help illuminate the
"purpose11 of borrowing, it follows that borrowing for an "appropriate
purpose11 (e.g., "the result of chance factors,11 or to meet
extraordinarily large deviations from usual seasonal developments,
or for "emergency11 reasons) would not, in principle, be limited
in duration by the restriction on continuity.

Rather, most

"appropriate" purposes would be such as to involve only shortterm borrowing.—
(2) "Purpose11

restrictions

The "purpose" restrictions may, then, be considered the
basic restrictions on the supply of discount credit.

Presumably

it would be on the basis of "purpose," as perceived by the Reserve
Banks, that a determination would be made as to whether or not an
extension of credit was "appropriate."

It was contemplated, under

the revised Regulation A, that the Reserve Bank would give "...
more attention to the purpose of member bank borrowing.ff

And

that certain "... objective procedures ... would facilitate
administration where findings indicated developments other than
2/
those stated [by the member bank] were responsible ..." —
1/ So, for example, the provision of Regulation A permitting longterm credit in emergency situations could be thought of as establishing not
a separate category of "emergency11 loans, but rather a separate "purpose"
for which extended credit is "appropriate."
2/ "Report on the Discount Mechanism, 1954," p. 34. The "Report11 also
stated that a Reserve Bank would ff... engage in analyses of changes in the
balance sheet items of its member banks and of the seasonal changes in
their loans and deposits so that it would be in a position to make an
independent, objective judgment of the factors giving rise to borrowing.
The methods applicable would not present too difficult technical problems.'1






-17Th e Report, however, does not provide specific
definitions of the three "appropriate11 purposes cited in
the "General Principles" (borrowing to meet "sudden" withdrawals, seasonal requirements beyond those that can "reasonably" be met, and emergency needs resulting from "unusual
situations" or "exceptional circumstances"); nor does it
provide definitions of the three "inappropriate" purposes
cited (borrowing "principally" to profit from rate differentials, to obtain a tax advantage, or to extend an "undue"
amount of credit for speculative purposes).

In consequence,

the purposes cited did not, on their face, establish
mutually exclusive categories of "appropriate" and "inappropriate" borrowing.
As will be discussed below it is not believed
that the establishment of mutually exclusive categories
was

intended.

Moreover, the "purpose" terms themselves

are closely inter-related.

So, for example, in defining

a word such as "reasonably" in the phrase that limits the
extension of credit for seasonal purposes, the definitions
of the three "inappropriate" purposes cited in the
Regulation are, of necessity, qualified.

The "General

-18Principles11 can be confusing because, taken literally, borrowing
could seem to be simultaneously for both an "appropriate11
and "inappropriate" purpose.
The closely related nature of the credit-restrictive
terms of the "General Principles11 warrants further analysis.
An attempt will be made below to provide an explanation of this
"relatedness."

It x>zill be helpful, however, to consider first

some aspects of the way in which the Regulation is administered.
III. Administration of Regulation A
Information on the manner in which the standards
incorporated in the "General Principles11 of Regulation A are
being administered was obtained through a
sent to the Reserve Banks.-

questionnaire

It would appear that "initial11

requests for credit are invariably accommodated promptly, with
little if any discussion and with little inconvenience to the
2/
borrower."" The information requested by the Reserve Banks
1/ "Questionnaire to Federal Reserve Banks Regarding Discount Operations,11 October 1965, (hereafter referred to as "Reserve Bank
Questionnaire, 1965").
2/ By "initial" is meant the first request of a bank that is not
currently subject to surveillance at the discount window for reason
of previous borrowing.




-19on application for credit suggests that in most circumstances no
substantial effort is made to ascertain the "purpose"

of such an

initial borrowing.
Beyond this initial accommodation, the administrative
process can, for purposes of analysis, be broken down into at least
three stages:

(1) surveillance of the borrowing bank; (2) a decision

on the appropriateness of the borrowing; and, (3) in cases in which
the borrowing is judged "inappropriate,11 the undertaking of
"administrative counseling" or "discipline11 aimed at securing repayment and "educating" the borrower in the appropriate use of the
discount window. These stages may be viewed as elements in the
process of nonprice rationing and moral suasion at the discount
window.
The "counseling" and "discipline" procedures, are quite
similar at each Reserve Bank. They typically involve contact with
the borrowing bank, generally first by telephone, to inquire about the
"purpose11

of borrowing and about the presumed plans of the bank to

"work out of" its debt.

If a definitive judgment is reached that

the borrowing is inappropriate, the effort is escalated.

Such

"escalation" involves contacts between Reserve Bank and borrowing
bank officials at increasingly higher levels, meetings with Bank




-2011

officials to ''explain

the standards established by Regulation A, requests

for the presentation of a repayment program, and, as a final measure,
an indication that the bank's continued request for credit will not
be honored.
The procedure described appears to reflect an attempt to
persuade borrowers that further borrowing is not in their own best
interest. -

If a mutual understanding cannot be reached, the Reserve

Banks are in a position to deny credit and to curtail the borrowing
privilege in the future.

Replies to the 1965 Questionnaire provided

evidence, however, that there were important differences in understanding
among Districts as to the significance of the restrictive terms of the
"General Principles."

In consequence, it appeared that the Regulation

2/
could be and was administered in substantially different ways. ~
IV.

Restrictive Impact of Regulation A
The principal intention of the 1955 revision of Regulation A

was to limit the flow of credit through the discount window, particularly
during periods of monetary restraint, and to develop an acceptable
rationale for doing so.
course,

However, the Regulation itself does not, of

spell out in detail under what economic conditions credit limita-

tions would be imposed.

Conceivably, the restrictive effects could stem

from constraints on the supply of credit, from persuasive efforts aimed
at limiting the demand for credit, and/or from adjustments of the discount
rate relative to market rates.

An evaluation of the current discount

mechanism requires consideration of the kind of restrictive impact
intended and realized.
JL/

2/



For further discussion of this point, with reference to experience
in the 1920's, see Report on Research Undertaken in Connection
with a System Studyt op. cit.
For a statement as to the kinds of differences found, see
Ibid., pp. 14, 15.

-21A. "General Principles'1 and demand for credit
It may be recalled that the System Committee Report in
1954 stressed the fact that the key to the revision it was suggesting
was the intent to give regulatory support to the "tradition against
borrowing."

This explicit intention

implies an effort to limit

the flow of credit by influencing bank attitudes toward borrowing.
There is much in the Report, in the "General Principles" and in the
way the Regulation operates to suggest that the principal restriction
on credit was intended to operate
credit—through a form of

on the demand for Reserve Bank

lf

moral suasion."

When the purpose and continuous borrowing restrictions of
the "General Principles" are considered as reflecting an effort to
restrict the demand for Reserve Bank credit, and not as independent
constraints on the supply of such credit, the lack of preciseness in the
individual restrictions is somewhat clarified.

The stated restric-

tions on borrowing--for purposes such as profiting from interest
rate differentials, accommodating seasonal demands for commercial
or agricultrual credit, and compensating for expected withdrawals
of deposits--may be thought of as reflecting a somewhat impressionistic
regulatory image of the behavior that could be expected of a bank
that, to some degree, was "reluctant to borrow."




For such a bank,

-22-

being in debt would entail some nonmonetary "cost.11

Consequently,

the bank would not borrow simply because borrowing was profitable
in money terms.

At equal, and perhaps even at higher costs, it

would prefer to obtain reserves in other ways.

If the "reluctance

to borrow" were very strong, the bank might borrow only small
amounts "occasionally" on a "short-term, noncontinuous" basis.

In

this way, the duration of borrowing, in conjunction with other
information, would represent evidence of the "purpose" of borrowing,
or, more exactly, the degree of reluctance of the borrower.
In actual operation the restriction on "extended" borrowing
provides the vehicle for discussion between the Reserve Bank and the
member bank about the purpose of borrowing; i.e., about the "reluctance"
of the borrower.

"Surveillance" of borrowing banks and periodic con-

versations on the "purpose" of borrowing presumably provide the Federal
Reserve with an opportunity to influence bank behavior and, by persuasion, bank attitudes.

Such persuasion, of course, is backed by the

mutual understanding that credit can be curtailed and that further
borrowing capacity at the Federal Reserve can be impaired.
these member bank-Reserve Bank discussions

Presumably

would, at a minimum,

provide an incentive for banks to conduct their business as "reluctant
borrowers" would.




-23It is not easy to draw an exact line between the influence
of administration on bank attitudes, and therefore on the demand
for credit, and nonprice

rationing of the supply of credit. It

seems clear, however, that a principal intent was to provide a
mechanism whereby member banks would be persuaded on their own to
limit their demands for Reserve Bank credit. To summarize the
evidence provided thus far:

(1) the 1954 "Report on the Discount

Mechanism11 indicated that one of the principal purposes of revising
Regulation A was to give regulatory support to the "tradition against
borrowing;11

(2) the "General Principles" can be reasonably thought

of as an attempt to influence bank attitudes by establishing a
model of "appropriate" behavior•

The restrictive terms of the

"General Principles" could not and do not represent a very
efficacious constraint on supply because they do not establish
mutually exclusive categories of "appropriate" and "inappropriate"
borrowing; and (3) the administrative procedure associated with
the current Regulation is consistent with this interpretation and
is difficult to understand otherwise. The decision to retire an
outstanding debt is generally intended to reflect agreement between the




-24-

Reserve Bank and, however reluctantly, the borrowing bank.
Such an agreement, reached after

considerable persuasive

discourse, strongly suggests a process designed to influence
bank attitudes and future bank behavior.
B.

"General Principles" and the discount rate
Flexible use of the discount rate, as a principal

device to ration credit, was rejected by the System Committee
in 1954.

However, the Committee did consider briefly the role

of the rate under its proposed revision.
the conclusion

Its view tends to confirm

stated above that the intention was to restrict

borrowing by building on the general "reluctance" of banks to
borrow.




The Committee noted:
"if member banks generally felt free to
borrow and remain in debt when borrowing
was profitable, the discount rate would
need to be adjusted frequently to keep
it at a level equal to or not far below
short-term market rates in order to
function as a primary deterrent to discounting when the demand for credit is
higher. If member banks limit their

-25ordinary discounting to meeting temporary
needs pending other adjustments, however,
the sensitiveness of their borrowing to
the spread between the discount rate and
market rates would be less marked. The
need for frequent change in the discount
rate to keep borrowing from appearing pro- - /
i
fitable, therefore, would be diminished . • • "
~
C.

"General Principles" and the supply of credit
Consistent with the intention to restrict the demand for

Federal Reserve credit by supporting the "tradition against borrowing $" the "General Principles' of Regulation A also appear to
represent an attempt to facilitate the distinction between borrowing
that is in accordance with the "tradition" (sufficiently reluctant)
and borrowing that is not (insufficiently reluctant).
dicated,

But, as in-

the distinctions that the Reserve Banks have drawn in

practice are not, and cannot be, clear-cut,

Typically, an "initial"

borrowing request is assumed to be "appropriate," (i.e., sufficiently
reluctant)

2/
and is accommodated at the going discount rate.—

Through "surveillance" that takes place over time, a judgment is
reached as to whether

the borrowing (or the pattern of borrowing

that has developed) is, in fact, "appropriate."

When a

judgment is reached that the borrowing is "inappropriate,"
counseling or disciplinary action is undertaken.

The ultimate

1/ JMd., p. 43.
2/ No doubt, there is some limit on the amount that a Reserve Bank
would lend to an individual institution. However, there is no
explicit limit (either in absolute or relative terms) in Regulation
A or in the Federal Reserve Act.




-26step in this "disciplinary11 procedure would be a Reserve Bank
indication to the borrowing bank that

the bank's note, if presented

again, would not be honored. But some time would go by before
such a step were taken; and

in fact, the final recourse to

credit rationing in this strict sense is apparently rarely reached.
Short of explicitly denying the continued extension
of credit, the "disciplinary" procedure is perhpas best
viewed as imposing an additional "cost" on the borrowing bank
above the discount rate. The additional "cost" may be thought of as
reflecting a threat to future borrowing capacity at the Federal
Reserve and the "inconvenience" of having to negotiate with Federal
Reserve officials.
specific money

This "surcharge11 is not easily translated into

terms.

Since the threat to future borrowing and the "inconvenience"
imposed by negotiations increase progressively once a judgment is
reached that the borrowing is for an "inappropriate purpose,1* the
actual "costIJ of credit to the bank would rise over time.—

Since

1/ Since the amount of a loan (relative to bank size) is taken as
one indication of "purpose,51 the cost of borrowing over an extended
period of time would be positively related to its amount, ceteris
paribus. The System Committee "Report" stated: "The amount borrowed
is one piece of evidence to be taken into account in judging whether
the borrowing is intended or complacent. The larger the amount of
borrowing in relation to required reserves and capital •.. the greater
the presumption that borrowing is planned or complacent and not the
result of a succession of chance developments." Ibid., Appendix C,
p. 11. The amount borrowed currently appears fce be treated in this
way by the Reserve Banks.




-27the Federal Reserve has almost complete discretion in making and
renewing loans, the true "cost" could rise very rapidly and at
some point credit could be cut off completely.
Given the Reserve Bank's interpretation of the Regulation,
the duration over which a particular loan (or pattern of borrowing
behavior) is considered "appropriate" would depend on a variety of
factors. These include some that are "known" at the time credit
is extended (such as the amount of the borrowing, the previous
borrowing record

of the bank and, if available, its statement of

purpose); some that vary while the credit is outstanding

(such as

the borrowing bankfs portfolio and liability management); and "time11
itself, since the duration over which the credit is outstanding is
presumed to provide evidence of "purpose."—

These factors may be

conceived of as interacting in influencing the "appropriate 2/
inappropriate" decision.—
1/ Even a loan to meet a sudden deposit withdrawal that was initially
"appropriate" would not be "appropriate" indefinitely since the bank
is expected to adjust its portfolio within a reasonably brief period
of time if the funds do not return. Moreover, a succession of "sudden"
deposit withdrawals would not be "sudden" under the terms of the
Regulation over any extended period of time. And extended borrowing
to meet these withdrawals would presumably not be "appropriate."
If They may be thought of as independent variables in a joint functional
relationship with the "appropriate-inappropriate" decision. The value
of the independent variable "time," at the point at which the decision
is reached that the loan is not for an appropriate purpose would give
the duration over which the "cost" of credit woul4 equal the discount
rate.




-28From the member bank's point of view, a considerable
degree of uncertainty must attach to the use of a discount mechanism
operating in this way.
duration over which
purpose

There would be uncertainty about (1) the

an initial request for credit for a particular

is considered appropriate; (2) the rate at which the

cost of credit rises once it is decided that the borrowing is for
an "inappropriate purpose11; and (3) the effect of the past record
of

borrowing and disciplinary conflict, if any, on (1) and (2).
At the time the initial credit request (assumed

''appropriate'1) is granted, the Reserve Bank is generally not in
a position to indicate to the borrowing bank how often or
how long borrowing will be considered appropriate.
rise in the

The

ff

costM of credit, once an inappropriate decision is

reached is, by its nature, a matter of much uncertainty also.
The effect of "inappropriate" borrowing behavior in the past on
the availability and "cost" of credit currently cannot be indicated
except in a very general manner.

To take the extreme question:

if,

after an extended period of borrowing, credit to a bank is denied,
how long would the discount privilege be withheld?-^
previously mentioned, such cases are rare.

As

But the "threat" to

J7 One Reserve Bank indicated that after the ultimate step in
disciplinary procedure is reached, the borrowing bank receives reassurance
about the availability of credit for initial requests, "In no event
would a banker be told that the borrowing privilege was being permanently curtailed but only for the relatively short run; it would be
made plain that truly emergency needs of the member bank would always
receive appropriate consideration."




-29future borrowing capacity is, of necessity, implicit at all stages in
the disciplinary procedure, not simply the final stage of credit
rationing.
cases.

Consequently, similar questions arise in all such

Specifically, these are: (1) how soon will a credit request

be honored after repayment; (2) to what extent will the previous
borrowing record shorten the period over which the loan is
and/or "judged" appropriate•

lf

assumedM

There is no information available to

suggest that credit will be denied for any lengthy period of time
after repayment brought about by "disciplinary action.11

However,

as is well understood, the duration over which a loan is considered
appropriate is influenced by the previous borrowing record of the
bank.—
D.

Demand and Supply Relationships
It has been suggested that the 1955 revision of Regulation

A was intended to influence the demand for Federal Reserve credit by
supporting the "tradition against borrowing."

The intention was to

keep demand for Federal Reserve credit relatively low,and inelastic
V At some Reserve Banks, the previous borrowing record would
include borrowing from other sources as well as the Federal
Reserve. In either case, the previous record would suggest the
degree to which the borrowing bank was "reluctant to borrow."




-30-

with respect to the differentials between market rates and the discount
rate.

The administrative procedures designed to facilitate this

intention imply, however, a rising supply schedule for credit.

This

would, in and of itself, serve to limit the flow of discount credit.
A rising supply schedule is implicit in the limitations on
future borrowing capacity incorporated in disciplinary procedures and,
to some degree, in the physical inconvenience of negotiations instituted
while credit is outstanding.
borrowing bank.

Such conditions impose real costs on the

However, uncertainty surrounding the threat to future

borrowing capacity

and the troublesomeness of negotiations would also

work, through bank preferences, to limit the demand for Reserve Bank
credit.

It is quite conceivable that many banks would have a strong

preference to avert the risk of incurring "disciplinary action.11

The

administrative procedures under Regulation A would, for such banks,
imply an even greater limitation on their demand for Federal Reserve
credit than is suggested by a rising supply schedule, or by the
intent to support or alter bank attitudes toward borrowing.




-31It might be argued that uncertainties with respect to
the duration over which no questions are asked, the vigor of
"disciplinary action" once questions are raised, and the effects
of "disciplinary action11 on subsequent borrowing exist^ for the
most part, in those relatively rare cases of "extended borrowing;11
and that most banks, applying reasonable caution, would not normally
encounter a situation in which their borrowing behavior became
suspect. This argument begs an important issue in that it assumes
that banks are, for the most part, sufficiently "reluctant to
borrow" so as to generally conform to the rough regulatory image
described in the purpose restrictions of Regulation A as administered.
If such is not the case: i.e., to the extent banks are less reluctant
to borrow than

deemed appropriate, there would be more certainty

in the extreme

than in the normal run of cases. For example, banks

that borrow heavily to sell Federal funds at rates above the discount
rate would be fairly certain of quick and vigorous "disciplinary
action." Banks that borrow to avoid or postpone the sale of
investments (also to earn a profit) would have to determine in each
instance the duration over which the holding of such investments
would be considered appropriate and the "costs" incurred in
exceeding this duration.




-32V.

Summary and Conclusions
The intention of the 1955 revision of Regulation A was to

limit the amount of credit available at the discount window, particularly during periods of monetary restraint.
limitations were envisioned.

Both demand and supply

The "General Principles11 in the Foreword

to the revised Regulation appear

to describe roughly the kind of

borrowing behavior expected of a bank that was reluctant to borrow.
They were principally intended to support the attitudes of the large
majority of banks considered to be reluctant borrowers.

In this sense,

they represented a form of moral suasion designed to limit the demand
for credit.
The "General Principles11 also seem intended to facilitate a
distinction

that discount officers and committees would, from time

to time, be required to make between borrowing behavior that was sufficiently reluctant ("appropriate")

and borrowing behavior that was

insufficiently reluctant ("inappropriate").

However, it was not thought

that it would be necessary to make this distinction often.
instances where such

In those

nonprice rationing proved necessary, it was believed

there would be a remedial effect.
The current mechanism clearly provides for adequate control
over the volume of credit available at the discount window.

In fact,

it apparently creates a degree of uncertainty about the terms and
conditions of credit that would tend to limit borrowing more than




-33intended.

This is particularly true in a financial environment in

which large numbers of banks are not reluctant to borrow in accordance with the regulatory image implicit in the "General Principles."
Nonreluctant

attitudes on the part of banks would tend to place a

heavy burden on the administrative machinery of Regulation A principally because the General Principles were not designed and are not
well-suited for large-scale rationing of credit from the supply side.
The distinction between sufficiently reluctant and insufficiently
reluctant borrowing is not easily drawn in practice.

The restrictions,

both individually and collectively, are not easily understood or communicated.

Differences in administration among Federal Reserve districts may be

viewed as a reflection of difficulties involved in implementing the
current regulation.





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102