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Prepared for the Steering Committee for the Fundamental Reappraisal of the
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.

March 28, 1967

A Study of the Market for Federal Funds








Maj or Findings

... •

Description of the Market
Interbank Trading
Brokers, Accommodating Banks, and Accommodating and
Correspondent Systems
General Patterns of Funds Activity
Country Banks and the Market.. Growth in Participation.
Sales of Funds
Purchases of Funds
Some District Comments on Funds Trading

• 9
„ H


Federal Funds Vs. Borrowing at Reserve Banks





The Federal Funds Rate



The Market as a Source and Outlet for Federal Funds



Alternate Instruments or Systems of Control....,
Auctions of Federal Funds
Federal Reserve Banks as Clearinghouses for Funds
Transactions of Smaller Banks


Appendix A




Table 1 - Trading in Federal Funds


Table 2 - Purchases of Federal Funds Through Brokers

« . .


Table 3 - Participation of Reserve City and Country Banks in the
Federal Funds Market, 1961 and 1966.


Table 4 - Participation of Small Member Banks in the Federal
Funds Market, 1966


Chart 1 - The Rate on Federal Funds —


New York

Chart 2 - Market Rates on U. S. Three-Month Treasury Bills, Federal
Funds, and Federal Reserve Bank of New York Discount Rate*
Chart 3 - Daily Rate for Federal Funds and Federal Reserve Bank
of New York Discount Rate


Prepared for the Committee for the Fundamental Reappraisal of
the Discount Mechanism.
Author: Parker B. Willis, Federal Reserve Bank of Boston


.... 36


This study has several purposes:

(1) to evaluate the


of the Federal funds market, with emphasis on the participation of
smaller country banks as a source of funds complementary to those
provided by the Federal Reserve discount window; (2) to determine
whether it is feasible and desirable to promote a further development
of this market so as to reduce commercial bank reliance on the discount window; and (3) if such is the case, to recommend the degree,
if any, to which the Federal Reserve should become involved in
that development.

Federal funds are balances on deposit with Federal

Reserve Banks that, together with vault cash, constitute the legal
reserves that member banks of the Federal Reserve System must hold in
a specified ratio to deposits.

Federal funds transactions refer to

the lending (selling) and borrowing (buying) of these balances or
claims on such balances at rates of interest set by the parties to a
This study analyses data on transactions in Federal funds to
determine how the existing market functions and the extent to which
banks of various types can and do operate within it.

Analysis has

been supplemented by interviews with "knowledgeable market participants."

In these interviews probing was directed to assessing the

current nature of these markets with respect to "depth, breadth,
and resiliency," and to ascertaining any changes in these market
qualities over time —

seasonally, cyclically, or secularly.


attempt was also made to determine the underlying causes for any
deficiencies in market operations for the several classes of banks
Some consideration was given to procedures that might improve


market operations.

This related to the problem of Federal Reserve

involvement if the System were to act as a clearinghouse for information about market functioning as a broker for Federal funds,
or were to utilize the Federal funds market as a medium for
controlling open market operations.
From time to time the performance and characteristics of the
Federal funds market have been reviewed in detail by Federal Reserve
System committees and by members of the staffs at the Reserves Banks.
Appendix A contains a list of System pubiications that discuss the
function of the market, variations in patterns of activityf and extent
of member bank participation.

-3II. Major Findings
The market for Federal funds has experienced two periods of marked
development «

the 1920!s and the 1950 ! s,

carried into the 1960fs —

Its development of the 1950fs

confirming and sharpening the structural out-

line of the market and increasing its dimensions.

Throughout the 1920's

banks used Federal funds almost exclusively in adjusting their reserve

While banks continued this method of reserve adjustment in

the later period, the volume of Federal funds acquired increased in
importance both as an outlet for short-term investment of secondary
reserves and directly or indirectly in connection with financing of
U, S. Government securities dealers.

And in the 1960fs an increasing

number of banks sought Federal funds to support expansions of loans
and investments.
Through the early 1950's, the structure of the market changed
somewhat —

shifting from a direct exchange of Federal funds between

banks to an exchange through an intermediary or a broker.

The develop-

ment of facilities for matching the supply of and demand for funds
through a broker was accompanied by an even faster growth in market
activity and in the number of accommodating banks.

At the same time

the market changed from one that was primarily regional and local in
character to one that is strongly national, with its center in New
York City.

With the further growth of accommodating banks outside

New York since I960, and the matching of transactions within
correspondent groups, transactions in the central market are now
largely for the purpose of clearing residual needs,
Currently it is estimated that more than 2,300 country banks,
or more than one out of every three, participate in the market either

-4as buyers or sellers, or both.

Participation rates range from about 17

per cent in the Minneapolis District to 83 per cent in the Boston District.
Five districts report a range of 40 to 50 per cent.

Similarly, virtually

all of the Reserve city and larger country banks are now active in the

The number of country banks using the market has increased more

than fivefold since 1960.
As a rule, country banks are more often sellers than buyers, and
they sell substantially more than they borrow.

The typical movement

of Federal funds is from smaller country banks to smaller city banks to
major city banks.
Country banks supply net to the market about $800 million to $1
billion on a daily average, constituting a fifth to a quarter of the
total volume of trading.

This represents from 12 per cent to 15 per

cent of country bank required reserves.

The increased participation

is reflected in reductions in the ratio of their required reserves
and in the ratios of balances due from banks to total deposits.
Relatively few country banks rely heavily on the Federal funds
market as a source of funds, and the effect of their aggregate
transactions on the market is negligible.

Average daily purchases

do not exceed $300 million, or about 3.7 per cent of their required

In sharp contrast to attitudes of most of the larger banks,

many country banks turn exclusively to the Federal Reserve as their
source of borrowed funds, although they use the Federal funds market
regularly to dispose of funds.
There is still evidence that a good many small banks have no
knowledge of the Federal funds market.

In addition, some small

banks are inately conservative, and they prefer to hold excess reserves rather than run the risk of having to borrow to offset deficits

when they occur.
Transactions in Federal funds are accomplished rapidly and
efficiently in increasing volume for increasing numbers of banks at
nearly uniform rates.

This reflects a high degree of adjustment

between demand and supply and between price and quantity exchanged.
The growth in unity and breadth of the market during the 1960fs
and the increase in its efficiency have strengthened the "links"
among the various divisions of the money market and the links of the
money market with the markets for longer-term credit.

A given volume

of Federal funds now moves through the market with a smaller change
in rates than in earlier years.

Market participants may move back and

forth from one sector to another of the shorter-term money market in
response to shifting rate differentials without causing unacceptable
price changes.
The Federal funds market mechanism now consists of four brokers
and perhaps as many as 70 accommodating banks in principal cities
throughout the nation.

The number of regional accommodating bank

arrangements increased in response to competition from large central
money market banks.

More recently competition among regional banks in

soliciting business over wider areas than previously has forced local
competitors to establish facilities for their own correspondents.
The variety of facilities for trading Federal funds is a product
of the last 10 years.

The new facilities reflect heightened competi-

tion among banks, changes in policies, and more widely diffused
knowledge of the market.

It is now possible for all but the very

small banks to keep most of their funds fully invested.


units have been reduced from $1 million to $200,000 and even $25,000

-6in some instances.
There is no concrete evidence that small banks find it difficult
to gain access to the market.

As needs have grown9 the market mechanism

has been modified to facilitate their transactions.
Participants view the suggestions for a Federal funds auction
with concern.

Auctions would replace completely or radically alter

the present range of facilities which now satisfy efficiently both
sides of the market —

facilities which have evolved over time

bridge" the unit banks.



The sensitive index of pressures within the

banking system provided by the Federal funds rate would be lost*


The money market is made up of institutions that provide a

mechanism for the exchange of cash balances for short-term, interestbearing obligations or for the exchange of such obligations for cash

At present most of these shifts in the form of reserves are

handled through a closely connected nationwide network of arrangements.

Commercial banks are significant participants in the money

market either as buyers or sellers of money market instruments,
largely to maintain their legal reserves at required levels.
the instruments they use are Federal funds.


Purchases or sales of

Federal funds permit adjustment for either a deficit or surplus in a
bank's reserve position at the Federal funds rate and consequently
constitute an important element in the administration of an individual
bank's liquidity.
The market for Federal funds, now almost 50 years old, is a byproduct of Reserve System organization imposed on the American unit
banking structure.
the money market.

It emerged in the early 1920fs as an offshoot of
Normally, transactions in Federal funds are for

overnight, and the rate of interest is negotiated or determined by
the supply and demand in the market.

The market cannot increase or

decrease total member bank reserves but can only redistribute them
and by so doing makes possible a fuller use of bank reserves and resources.
Sometimes banks will deliberately run "short11 on their reserve
positions by lending reserves to other banks —

thus causing or

sometimes increasing a daily deficiency that they expect to cover
later in the reserve period.

On the other hand, some banks depend

on this market as a source of funds for carrying an overinvested
position in loans or securities for short periods.
Facilities for accomplishing Federal funds transactions have
been developed in large part during the last 10 years.

They reflect

the growth of the market, heightened competition among large as well
as many smaller banks, changes in practice and policies of participants, and more widely diffused knowledge of the market.

The market

now provides a way for all but the smallest banks to maintain a more
fully invested position.

A number of the smallest banks are unaware

of the market or have no desire to participate.

Member bank reserve balances are of uniform quality and

can be transferred freely thoughout the United States.

At present

such balances are bought and sold at several points in each Federal
Reserve district, but New York City still occupies the prominent
position and is the central market since half of all transactions
originate in* or are handled by, that city and the brokers and principal accommodating banks are located there.

Local selling points are

intimately connected with the central market and with one another.
They are "linked" in the sense that price differences can bring transactions from one market to another and that some of the competing
buyers and competing sellers carry out transactions in more than one
market within a district or in several districts.

In a real sense

the market is national.
The Federal funds market has experienced two periods of marked
development —

the 1920's and the 1950 f s; its development of the 1950?s

being carried into the 1960fs -- confirming and sharpening the structural

outline of the market and increasing its dimensions.

Throughout the

1920!s banks used Federal funds almost exclusively as a method of
adjusting their reserve positions.

While banks continued this method

of reserve adjustment in the later period, the volume of Federal funds
acquired increased in importance both as an outlet for short-term
investment of secondary reserves and directly or indirectly in connection with financing of U. S. Government securities dealers.


the 1960fs as well, an increasing number of banks sought Federal
funds to support expansion loans and investments.
Through the early 1950's, the structure of the market changed
s o m e w h a t — shifting from a direct exchange of Federal funds between
banks to an exchange through an intermediary or a broker.

The develop-

ment of facilities for matching the supply of and demand for Funds
through a broker was accompanied by an even faster growth of activity
and number of accommodating banks.

At the same time the market changed

from one that was primarily regional and local in character to one
that is strongly national, with its center in New York City.


the further growth of accommodating banks outside New York since 1960,
and the matching of transactions within correspondent groups, transactions in the central market are now more largely for the purpose
of clearing residual needs.

Thus,, the functions of the brokers

changed from principally completing transactions for numbers of
individual banks of differing size to completing transactions to a
greater exlent for the large money market and regional banks.
Interbank Trading.
Federal funds market.

Banks account for most of the activity in the
On the average only about 10 per cent of total

-10activity is with nonbank groups —

chiefly U. S. Government securities

dealers, savings banks, and corporations —
portion may rise to 25 per cent.

but at times, the pro-

In 1966 on an average day $3.5

billion to $3.8 billion shifts from bank to bank, but at times the
total may come close to $5 billion.

The average amount has increased

significantly since the mid-1920fs and had more than tripled by 1960.
And the number of banks participating has risen in each year since 1950.

Table 1


of banks

gross purchases
(in millions
of d o l l a r s ^ _ _



100- 250
350- 450

Partially estimated approximate amounts.
earlier parts of designated periods.
Some 300 member banks
funds market —

Lower limits refer to

are regular participants in the Federal

buying and selling on from one to several occasions in

every reserve period.

These banks hold about 60 per cent of all com-

mercial bank deposits and include practically all banks with $100
million or more of deposits.

The most active participants are found

in Federal Reserve cities, but some 40 of the larger country banks have
substantial regular dealings, and another 350 may trade as often as
A number of nonmember banks and agencies of foreign banks are
also traders — usually on the selling side. The nonmembers include
both small and large banks and may number several hundred.

-1125 times a year.

Estimates place the total number of participants as

high as 2,500 banks.

Many of these will have only one or two trans-

actions during the year and include banks that have deposits of only
$1 million to $2 million.

Usually the transactions of the smaller

banks are sales, which are made possible by excess reserves arising
from seasonal or temporary forces.
Brokers, Accommodating Banks, and Accommodating and Correspondent

Until December 1958, when The Irving Trust Company established

its Federal funds desk,

Garvin Bantel Corporation9 a member of the

New York Stock Exchange, was the only broker in the Federal funds
market, and there were as few as seven or eight accommodating banks,
most of which were in New York City.

Garvin Bantel Corporation had

initiated its interdistrict business in 1948 and had encouraged participation by out-of-town banks.

Participation by such banks became

significant in the early 1950*s, as increasing numbers of banks began
to direct their transactions through that firm.

Garvin Bantel esti-

mates that until about 1953 it handled nearly 80 per cent of all
trading in Federal funds, but as the number of accommodating banks
expanded, this proportion dropped to 50 per cent in 1957 and subsequently fell to one-third.

Since the entry of Mabon, Nugent and Co.*

also a member of the New York Stock Exchange, in the fall of 1963
and George Palumbo & Co., Inc., a money broker, in November 1964, four
firms have shared the volume of Federal funds moved through brokers.
These firms are in daily telephone contact with market participants, and
they act merely as agents in bringing buyers and sellers together.
The Federal funds desk is run separately from Irvingfs transactions in Federal funds for its own account or for accommodation of

-12Although the volume of transactions handled by brokers has increased since 1950? as the number of banks seeking funds has risen,
most of the increase is the result of increased trading by the larger

The number of banks using brokers has failed to grow pro-


There are eight banks in New York City and another

30 or more commercial banks in other parts of the nation •— at least
two in each Federal Reserve district —
business for correspondents.

that perform an accommodating

Accommodating banks differ from brokers

in that they generally deal as principals and often trade on both
sides of the market.

This group of roughly 40 banks constitute the

major accommodators.

During the last 4 years, however, perhaps

another 40 have offered this service in limited degree.
The increase in the number of accommodators in the Midwest,
Southwest, and West in 1964 and 1965 was significant.

With the ex-

ception of the San Francisco area,^ however, most of the important
accommodators are in New Yorks and with the brokers they form the
focal point of the market.

Accommodators outside New York and San

Francisco generally service correspondents on a regional basis and
may cross district lines to a limited extent.
Some accommodators -- 2~way trading banks -- are net buyers,
while others try to maintain balanced positions.

Although all of the

2-way traders are large banks, not all large banks conduct 2-way
Banks in the San Francisco Federal Reserve District accounted for
more than one-sixth of the gross transactions in Federal funds in 1966 a larger fraction than for any other district except New York, Twoway trades amounted to two-thirds of total transactions of banks in the
San Francisco District,


-13Table 2


Amounts (in millions of dollars)

of Banks^



Daily Average



1 A accurate percentage of Funds transactions cleared
through the brokers in relation to total activity cannot be
computed because of double counting. Not'only does the activity of the accommodating banks overstate the net movement
of funds from ultimate supplier to ultimate user within a
given day, but the activity of the brokers will include some
of the same transactions reported by the accommodators.
Hence, in a movement of Funds from Bank X to Bank Y, two
purchases may be reported--the purchase by the accommodating
bank from Bank X, and the purchase by Bank Y. They may be
identical. The Funds may ultimately move to Y from the
accommodating bank through one of the brokers.
Source: Data 1949-1962 supplied by The Garvin Bantel
Corp. - the only broker in the market. Volume data 1963-1966
based on reports of three brokers to the Federal Reserve Bank
of New York. Number of banks estimated.


There are also differences in the use of the market within

a given area, including New York.

Many banks are referred to as

adjusting banks, for they may appear as net buyers or as net sellers
or they may run a balanced position.

The smaller the bank the more

likely it is to be exclusively a seller.
Development of regional accommodating or correspondent systems
facilitated the entrance of smaller banks into the market.


systems have been designed to meet competition offered in regional
markets by the large central money market banks.

More recently,

competition among the regional banks, soliciting business over wider
areas than previously, has forced local competitors to establish
facilities for their own correspondents.


Perhaps more importantly

these arrangements reflect the attempt of the larger banks in interior
parts of the United States to improve the flexibility of their own
reserve positions and to meet marginal needs -- thus helping to
retain and improve their position in influence and size.


of hanks involved in these arrangements range from five or six
to several hundred.

To a considerable extent these networks are

mutually exclusive.
Some leading correspondents have taken an aggressive approach in
developing trading positions in Federal funds to enable them to provide a "new business service" —
their correspondents —

selling or buying funds to or from

while others encourage only sales.

adopted a passive attitude —

A few have

offering to buy or sell only upon

For example, the promotion of trading in Federal funds by large
Dallas banks in 1965-66 forced city banks in Oklahoma to offer trading
services to country banks more willingly, and this has resulted in extensive trading by Oklahoma banks.

-15specific request from the smaller banks and being reluctant to improve
the familiarity of these banks with the market.
Accommodating banks usually operate on both sides of the market
during the same day.

In providing or absorbing funds as a service to

correspondents, the accommodator generally will (1) to the extent
possible, match on its own books ''buy11 and "sell" orders, which it
receives from a correspondent or customer bank; (2) when its own
reserve position is more than adequate, care for the correspondent's
needs out of its own position; (3) when it is not possible to accomplish transactions by means of (1) or (2), use its best effort to
cover a correspondent's needs in the national market.
may even borrow from its Federal Reserve Bank.

At times it

In other cases the

lead correspondent acts only as agent, and he pools sales of a
customer bank with his own.

Funds purchased by smaller banks usually

come from the lead bank's reserves.
All of the accommodating or correspondent arrangements do not
provide the same degree of service, and some may limit their service
only at certain times during the year.

In some cases they may re-

quire a collateral loan agreement of the correspondent.

When the

service provides for purchases of funds by the smaller banks, the
lead bank usually sets up an informal "line of funds.ft

If the

correspondent's needs exceed the level of his credit line, the accommodating bank will refer the request to an officer in charge of the
bank's money position or the representative who regularly calls upon
the particular bank.

Minimum transaction units generally range from

$200,000 down to $25,000 in size.

Some, however, place $200,000

as the minimum and will use $100,000 or less only under pressure.


-16borrowing and lending limits are generally observed, and this requires
in a number of States that sales by smaller State bank correspondents
be secured by U. S, Government securities.
Some lead correspondents charge 1/8 of 1 percentage point on
purchases of less than $1 million, but will sell at the prevailing
rate regardless of the amount.
point on sales.

Other will take 1/8 of a percentage

Some lead correspondents buy and sell at the same

If the bank is acting as agent or if sales are usually com-

bined with those of the lead bank, the correspondent receives the rate
on the combined transaction.

Few if any lead banks view the service

of providing Federal funds as a source of profits.
Probably 85 per cent of the transactions are for overnight and
the rest range from 3 days to 2 weeks, with the rate fixed from day
to day.

In some instances Federal funds remain at the bank's dis-

posal until either party terminates the arrangement or until the rate

There has been a tendency to increase the length of trans-

actions with smaller banks to minimize costs.
General Patterns of Funds Activity.

Trading in the Federal

funds market has shown a very rapid rate of growth since World War II.
This factor, along with the large number of new entrants and the
spreading of knowledge about the market, has tended to blur the cyclical
pattern 6f growth in such trading.

In general,transactions in

Federal funds have grown at a slower rate during periods of restrictive

One typical regional trading system with 124 members collected
income and cost data for a 6-month period. Gross income amounted to
$5,000 and was derived largely from rate spreads. Cost^ without overhead allocation, for overhead expenses exceeded income slightly.

6For more detail see references cited in Appendix A

-17conditions in the money market.

The years 1965 and 1966 were ex-

Those years produced record levels of transactions •—

reflecting increased trading by all banks as policies and practices
changed, as well as a large number of new entrants-

Important factors

in these years were the significant shifts in relationships of interest rates in the money market, which were in part, a result of
monetary policy.
As a general rule, Federal funds activity is highest over the
longer run in periods when the market is neither very firm nor very

This reflects chiefly rate relationships.

When money is tight

and demand strong, the supply tends to dry up because of greater
profitability of other uses of short-term funds.

Under very easy

conditions demand is low, driving rates down to levels where the
increased supply seeks more profitable outlets.
The major cyclical shifts in supply and demand for Federal funds
may be attributed to banks that consistently borrow —

sometimes in

such funds and sometimes at the Reserve Banks -— to maintain their
loan and investment portfolios in periods of heavy credit demands
and monetary restraint.

Although many of these banks remain net

buyers as markets ease, their net purchases are sharply reduced.
Federal funds activity also shows intra-monthly variations in
volume associated in part with float but more importantly with
the ebb and flow of pressures on the large banks caused by the complex of "operating factors'* such as the movement of correspondent
balances, financing needs of U. S, Government securities dealers.
Treasury calls and deposits, and corporate tax and dividend dates.
The generalized pattern presents a sharp rise in activity at

Intra-weekly patterns of activity also exist, but these have
changed in recent years.

Trading is generally a little higher on

Fridays when some banks try to obtain the cumulative effect of transactions over the weekend.

And trading is often heavier toward the

end of the settlement week as banks seek to bring their reserves to
the required level for their reserve computation period.
Smaller country banks as a rule seem to divide their activity
equally more or less among the 12 months.

This is in contrast to

larger banks, which may concentrate their activity during certain
periods of the year or which may shift from sellers to buyers or
vice versa.


As indicated earlier, one purpose of this study was to evaluate

the use of the Federal funds market by country banks as a source
of funds alternate to borrowing from the Federal Reserve Banks.
Growth in Participation.

Participation of the smaller country

banks in the Federal funds market began to accelerate early in the
1960fs and became increasingly widespread after 1962.

Before that,

banks with less than $100 million in deposits seldom traded in that

The standard unit of trading there was $1 million, a rela-

tively large amount for small banks.

Furthermore, it was more than

they would generally have for sale and more than they would need for
reserve adjustment.

The small banks usually carried excess reserves,

and if these amounts were not sufficient to meet their reserve losses,
the banks would borrow at the Federal Reserve or from correspondents
with whom they lodged excess funds, or they would buy Treasury bills.
The forces underlying increased participation by the smaller
banks in the Federal funds market have been present for some time.


basic force was the combination of rising short-term interest rates
and increased banking costs, which provided a strong stimulus,
particularly after 1964.
In 1961 there were probably as many as 400 country banks that
traded funds at one time or another during the year.

(See Table 3.)

These banks generally ranged in size from $75 million to $100 million
or more in deposits.

Today it is estimated that about 2,500 country

banks, or one out of every three, trade at least once during one
reserve period in the year.

This represents a five-fold increase

Table 3



New York
St. Louis
Kansas City
San Francisco

Country Banks

Country Banks
City Banks Total Number
in District^-



Per Cent

City Banks Total Number
in District^















Per Cent









IPercentage of Reserve city banks trading ranged from 50 to 100 per cent in 1961 and from 95 to 100 per
cent in 1966. The smaller percentages apply to Midwest and Southwest Districts.

Data for Boston, Philadelphia, New York, Richmond, Chicago, Minneapolis, and Kansas City Districts derived
from surveys. Other data partially estimated.
3Data are for the beginning of 1966.
Source: Board of Governors of the Federal Reserve System, Federal Reserve. Bulletin, June 1966, pp
and May 1962, pp. 646-47,
~~" "


-21in numbers since 1961 and a doubling since 1964.

These include banks

with deposits of as little as $1 million, and some are found in every
Federal Reserve district.

The greatest growth in participation,

however, has been among banks in the $10 million to $50 million deposit

For banks with deposits of $10 million or less, it is

estimated that between 15 per cent and 72 per cent of the number in the
several districts currently participate (see Table 4 ) . In general,
activity is related to bank size -- with the proportion of banks that
trade increasing with each size class up to the level of $50 million
in deposits.

Participation now includes significant percentages of

banks in the third and fourth size categories, where banks are ranked
by size of deposits into six groups of 1,000 each.

The fifth and

sixth thousand comprise banks of less than $5 million in deposits


found in greatest numbers in the Midwest and South where activity
rates are lowest.
The reduced size of the trading units in correspondent trading
arrangements has not only encouraged small country banks to enter
the market but has increased the frequency of their trades within
reserve periods.

It is no longer necessary to accumulate funds during

a part of the reserve period to meet transaction sizes.
The Minneapolis District has the lowest rate of participation of
any district — probably because of the bank holding companies located
there &nd the large number of very small banks. One large holding
company arranges purchases and sales for its members through the Bank
of America, with appropriate entries to reserve accounts at the Federal
Reserve Bank of Minneapolis. About two-thirds of the trading banks in
the Minneapolis District are members of this bank holding company.
The repeal of Section 6 of the Bank Holding Company Act in July 1966
and concurrent withdrawal of the Federal Reserve Boardfs ruling of 1959
prohibiting trading of Federal funds between bank subsidiaries of a
holding company apparently had had little effect on trading by the end
of 1966. After July 1 subsidiary banks of a holding company were in
effect permitted to deal with each other at arm*s length and were consequently as free to trade Federal funds as are any other banks within
the limits and collateral requirements of Section 23A of the Federal
Reserve Act.


Table 4
Banks with deposits of $10 million or less




Percentage of
Total Country
Banks in Dictrict












New York
St. Louis
Kansas City
San Francisco

Banks Trading Funds
Per Cent
of Total




Based on numbers of banks shown in annual member bank operating
ratios or monthly reviews of the Federal Reserve banks.
Figures for Boston, Philadelphia, New York, Richmond, Chicago,
Minneapolis, and Kansas City Districts derived from surveys. Data
for other districts are partially estimated.

Even so, most of the trading in Federal funds continues to be
concentrated in a relatively small number of large banks in the money
market centers.

About 46 banks, a third of which have deposits of

$1 billion or over, account for three-fourths of all transactions.


is the transactions of these banks that have the greatest impact on
the money market.

The tendency up to the mid-1960fs was toward

increasing concentration, but a small lessening in concentration has
developed with the rise of regional correspondent systems with widespread participation on the part of country banks.

Although the

-23average dollar volume of transactions of most of the country banks is
relatively small in the aggregate and does not have a substantial
impact on the money market, the transactions of these banks play a
continuous role that is marginally important to reserve management of
most participants.
Sales of Funds.

Although country banks of all sizes both buy

and sell Federal funds, they are generally sellers more often than
buyers, and they sell substantially mote than they borrow.


typical movement of Federal funds is from smaller country banks and
smaller city banks to the major city banks.

On balance, country banks

supply net to the market from $800 million to $1 billion on the average
daily, or from one-fifth to one-quarter of the total volume of trading.
This amount represents from 10 per cent to 12 per cent of the required reserves of country banks.

Most of these funds come from

banks with at least $25 million of deposits.
The increased participation of country banks in the market is
reflected in the reduction of the ratio of their excess reserves to
required reserves and in the ratio of demand balances due from banks
to total deposits.

In 1961 these ratios were 8.0 per cent and 7.0

per cent, respectively.

By 1966 they had declined to 3.5 per cent

and 5.4 per cent, respectively —

suggesting that the decline in

excess'reserves is real and not simply a transfer of funds from one
nonearning asset to another.

The growth in sales of Federal funds by

country banks has been greater than the decline in their excess

The fall in the ratio of demand balances due from banks

occurred despite a modest increase in the level of such balances; in
1966 these balances averaged 12 per cent higher than in 1961,

-24whereas* total deposits had risen by 49 per cent.
balances reflected largely operating needs.

The increase in the

Relatively few leading

correspondents are reported to have insisted on larger balances in
return for providing Federal funds.

Some participants are reported

to have made voluntary increases in deposit balances because they
liked the service.
Many smaller country bankers indicate that trading in Federal
funds has reduced their reliance on purchases or sales of Treasury
and other money market instruments as a means of reserve adjustment.
In general, these bankers continue to feel that Treasury bills and
similar instruments involve inconvenience, cost, and exposure to
market loss when used to adjust reserve positions within the
2-week settlement period.

Some indicate that their reluctance

to place liquid reserves in Treasury bills have previously resulted in
manitenance of excess reserves at a higher level than that which
they found desirable since they entered the Federal funds market.
Smaller banks thus have reduced their nonearning assets by selling
Federal funds, and in some cases they have substituted these funds
for other earning assets.

And the larger city banks have bought

Federal funds to facilitate maintenance of a position in loans and
investment with relatively high yield.
Country banks can be net sellers only to the extent that city
banks are buyers.

The eagerness of the larger banks to buy in recent

periods is reflected in the breaking down of large transaction units
into units of $200,000

and less.

An increasing number of larger

country banks are acquiring Federal funds and are then "laying them
off" or arranging "arbitrage" —

in the form of a repurchase agreement

with U. S. Government securities dealers made at a higher rate than
the purchase; or some may put the funds into Treasury bills when the

-23rate on bills is attractive relative to the Federal iunds rate.
Purchases of Funds.

On the buying side, relatively few country

banks rely heavily on the Federal funds market as a source of funds,
and the effect of their aggregate transactions is negligible.
daily purchases probably do not exceed $300 million —
than 3.7 per cent of required reserves.


or not more

And many smaller banks have

no need to borrow from any source.
A bank's appraisal of the advantages and disadvantages of using
the Federal funds market or the discount window or of liquidating
Treasury bills is a major factor in its decision of how to adjust
its deficits.

Frequently, the decision reflects practical considera-

tions of which convenience is seemingly more important than cost.
In sharp contrast to attitudes of most of the larger banks, many
country banks indicate that they seldom obtain funds in the Federal
funds market although they use that market regularly to dispose of
excess funds.

These banks apparently have no hesitancy about borrowing

from the Federal Reserve.

In fact, they prefer to resort to the

discount window rather than attempt to obtain Federal funds or to
liquidate securities, particularly in a declining market or when the
outlook for rates is uncertain.

In this group are banks that never

buy Federal funds and some that buy them only when there is a rate
These banks cite the following advantages of using the Federal
Reserve discount window:

Notes can be prepared in advance and collateral

is already in safekeeping.

This avoids the necessity for

-26trying to locate Federal funds, particularly when they are

Funds can be obtained from the Federal Reserve later

in the day.

In certain cases, the time differences between

New York and the West are very important.

The Federal Reserve is a more dependable source of

funds, and banks can borrow the extra amount, needed; sometimes
this amount may exceed the amount that can be legally borrowed
in the market.

Borrowing at the Federal Reserve is slightly cheaper

when rates are nominally the same because interest is figured
on a 365-day basis instead of the 360 days used in calculating
interest on Federal funds.

Since balances are maintained at

the Federal Reserve Banks, it is argued that some use should
be made of them.

And if banks turn to the correspondent, it is

possible that the correspondent bank would ask that the requesting
bank deposit additional balances, which would tie up more funds
and raise the cost to that bank.
Some District Comments on Funds Trading.

The following comments

by Federal Reserve Banks in several districts reflect the practices
and attitudes of smaller banks toward use of the Federal funds market.


We are reasonably sure that the large Chicago banks do not
encourage their country correspondents to purchase Fed funds,
particularly in the current situation, but some individual
banks can get overnight money this way largely due to competition among large banks for correspondent balances. It is our
impression that the Fed funds available to small banks from
their correspondents ara considered part of the package of

-27correspondent sex vices and that a banker that keeps a good
balance may be able to get Funds if he wants them. But it
seems much more likely that he may prefer to draw down his
balance temporarily when he needs short-term money. We still
find evidence that there are a good many small banks that do
not know anything about Federal funds and some seem unaware
that they can buy as well as sell."
(Underscoring supplied) Letter F.R.B. Chicago, September 19,

"Most banks meet reserve deficiencies in the short run
primarily by buying Federal funds or borrowing from the
Federal Reserve. Large banks tend to incur deficiencies
more frequently tiian small banks and therefore rely more
heavily on both sources of funds. Of the 120 banks in
the survey with deposits of less than $5 million, 4 percent
bought Federal funds and 12 percent borrowed at the discount
window in 1965 but less than 1 percent tapped both sources.
In the next size classification $5~$10 million, only 2 percent of the 129 banks .used both sources while 13 percent
bought Federal funds and 17 percent borrowed from the Federal
Reserve. The proportion using both sources rose rapidly to
8 percent in the $10-$25 million range, 29 percent of the
$50-$100 million banks and 82 per cent of banks with deposits
over $100 million."
"The proportion of banks buying Federal funds but not borrowing at the discount window also rose with bank size up to the
$100 million level, then dropped strongly from 43 percent to
9 percent... The combination of those buying Funds and those
using both sources grew steadily with bank size ranging from
5 percent to 91 percent. Thus, the larger the bank the stronger
the tendency to borrow.11
F.R.B. Richmond, Monthly Review, September 1966, pp. 10,11.


"The results of the survey indicate that only a limited number
of Ninth District member banks made use of the Federal funds
market. Among those that did enter the market, size and frequency of transaction seemed directly related to size of bank,"
"The average frequency of purchase like size of transaction
varied by size of bank: small banks made fewer purchases
than large banks. For example, each of the seven banks with
deposits of between $4 and $8 million that entered the market


on the buying side made an average of 7.6 purchases. On the
other hand, each of the largest-si;ze buyers, $32 million and
over, averaged 48.6 purchases.11
"The average number of sales among banks that were active in
the selling side of the market was somewhat lower, 17.4, than
the number of purchases per bank. Average sales were pulled
down by the behavior of the larger banks those with $16 million
and more in deposits; on the average each of the larger banks
made fewer sales than purchases."
"Several banks, however, returned their questionnaire with
the comment that they had never heard of Federal funds."
"The negative attitude of some city banks (in trading Funds
with smaller correspondents) may be explained by their status
as members of one or another of the several holding companies
that exist in the district... larger city banks that are
members of a holding company (are) legally able to trade funds
with some of the country banks they serve as correspondents
but not with others. Their attitude towards trading with
country banks may reflect a desire to avoid having to discriminate among customers."
(Underscoring supplied) F.R.B. Minneapolis, Monthly Review,
July 1966, pp. 6, 7, 8.

New York
"Second District country member banks as a group entered the
market more often as sellers than as buyers — in accord with
the fact that country banks... hold relatively high levels of

".*• most of the participating banks... with less than $10 million
in total deposits entered the market only as sellers." ... participating banks in the intermediate size range, -$10 million to $25
million in deposits was fairly evenly divided between banks that
just sold funds and banks which acted as both buyers and sellers
while most banks with deposits of $25 million or more traded at
various times on both sides of the market. Even among banks
which both sold and purchased funds, however, the frequency of
transaction on the selling side was substantially greater than
on the purchasing side."
F.R.B. New York, Monthly Review, May 1966, p. 115.

"Some 30 percent of the nonbuyers and 45 percent of the nonsellers suggested that they feel too small to be active in

-29Federal Funds. As would be expected, these banks are indeed almost always very small and typically are located in rural areas.
It should be important, however, that there are many banks as
small or even smaller that are active... The true explanation is,
therefore, that management is either unaware of the opportunities
offered by the market or feels that the potential profit from
Federal funds transactions does not justify the 'trouble* of
entering the market.'1
"... only 15 and 17 percent of the nonsellers and buyers
respectively noted that they were unaware of Federal funds and
most of them are the smaller banks .(Some lead correspondents)
have apparently not been so active (as others) in acquainting
their country correspondents with the Funds market."
"Country member banks which avoided Federal funds because they
preferred other methods of borrowing and lending were frequently
large institutions, frequently situated in urban areas. Rather
than buy they borrow directly from correspondents or at the
discount window.n
(Underscoring supplied) F.R.B. Philadelphia, Monthly Review,
August 1966, pp. 8,9.

Kansas City
"No accurate figures on the number of member banks trading in
Federal funds resulted from the survey. Some guesses are possible, however. Under 10 percent of the member banks with
deposits of less than $5 million trade Federal funds. Approximately 25 percent or less of the banks with deposits of $5-$10
million participate in the market. About. 50 percent of the
member banks in the $10-$50 million size range participate.
Over 90 percent of the over $50 million banks participated
through member correspondents."
"The number of banks participating in the Federal funds market
is apparently largely dependent on awareness and familiarity
with the market and many smaller banks in the District are
unacquainted with Federal funds and the large city banks are
not encouraging familiarity. The number of participating
banks is growing rapidly, however, as knowledge of the market
spreads through other channels."
"Most of the smaller banks that are trading Federal funds are
sellers of funds. The city banks have no explanation of this
except for reference to the traditional aversion of small banks
to borrowing."
Letter, F.R.B. Kansas City, December 16, 1966.

-30San Francisco
"Recent data from District Federal funds reporters indicate
that both California and Pacific Northwest banks have been
selling and purchasing funds from other District Banks, Some
of these transactions have been in small magnitudes — indicating
the probability that the transactions were with relatively small

A check with our Discount Department disclosed no complaints
by banks applying at the discount window about lack of access
to Federal funds market. n
"It would appear, therefore, that small banks in the San Francisco District do have access to the Federal funds market through
their correspondent or other banking relationships. The only
bar would appear to be for the smallest banks which cannot
profitably participate in the market on the sell side because
of the small volume of their lendable funds."
"June 30 call report data... indicate that even banks with less
than $2 million in deposits participated in the Federal funds
market on both the buy and sell side. This confirms interviews
with District banks — which make a market in Federal funds —
that small country banks were actively participating in the
market at times in such small amounts that interest costs probable did not cover the communication cost of the transaction."
Letter, F.R.B. San Francisco, November 11, 1966.


On an average day in the late 1920 f s, Federal funds traded for

all member banks ranged from about 4 per cent to 10 per cent of required reserves.

In the late 1950Ts and early 1960's this ratio

ranged from about 7 per cent to 12 per cent of these requirements.
At the time of this writing, the ratio is close to 25 per cent.


this measure, trading in Federal funds has become of substantially
greater relative importance than in earlier periods.

It should be

noted, however, that the reserve requirement level is about 20 per
cent higher than in the 1920fs.

Meanwhile, trading in Federal funds

has shown a much greater rise; as compared with the lower limit of
the trading range, it has increased 15 times, and as compared with the
upper limit, it has risen about 10 times; as compared with the 1950 f s,
the ranges have more than tripled.
If the daily-average volume of discounts and of trading in
Federal funds are combined, the total at times in the 1920's reached
about 50 per cent of required reserves in contrast to about 12 per
cent in heavy trading days in the 1950fs and 21 per cent in recent

This indicates that borrowings from the Reserve Banks

made.up a substantially larger part of the reserve base in the credit
superstructure of the 192Ofs.
It should also be noted that borrowings from the Reserve Banks
during periods of expansion in the 1950fs and 1960fs averaged about
$100 million less than in the late 1920's.

However, the composition

of total borrowing as suggested by the figures above was reversed;
the ratio of Federal funds to borrowings in the 1920!s was about one
to four; now it is four or five to one.

It may be said that in the


1920fs Federal funds were considered a supplement to discounting but
that in the 1960fs discounting had become a supplement to trading in
Federal funds.

Although transactions in Federal funds relieve the

individual bank from use of the discount window, they do not relieve
the banking system as a whole from reliance on the Federal Reserve.



Except for a period of about 2 years in the late 1920fs and a

similar period beginning in the midautumn of 1964, the Federal funds
rate has fluctuated between the discount rate and a lower limit at
1/8 to 1/2 of a percentage point.

Because of their access to the

discount window at the Reserve Banks, member banks have not usually
been willing to pay more than the discount rate.

The lower limit

of the Federal funds rate is set at the point where banks recover
costs, even though some accommodating banks may absorb some of these
costs in promoting the market.

Chart 1



Average Week y Rota
on Federal Fund
Borrowing* of New York City
Reporting Member Banki

Discount Rate
F.R.B. New York I





' ' . J S


SOURCE: N . Y. Hovald Tribune and Federal R M M V * Bonk of Now York.
Funds Roto Dofa not available in tefitt from prior to April 1928.

Transactions in Federal funds between banks are now quoted in
terms of the effective or prevailing rate —
great bulk of transactions are accomplished.

the level at which the
The quote is considered

representative of rates for the entire market —

New York City and

Quotations above and below the effective rate, when they

occur, merely indicate a range of quotations on a given day.



th e postwar period the quotes have usually changed by 1/4 of a percentage point, but more recently, as in other markets, the change has
frequently been 1/8 of a percentage point -- reflecting extent of
competition within this market and the relation to rates in alternative markets.

Differentials of 1/4 of a percentage point were also

a characteristic of the 1920 f s.
The premiums that were bid on Federal funds during the 1920fs
ranged from 1/8 of a percentage point to more than a full percentage
above the discount rate when the latter was at levels of 4, 4 1/2,
5, and 6 per cent.

Banks1 willingness to pay this rate was attributed

to lack of eligible paper or to fear of criticism at the Reserve Bank
because of loans on stocks.

The premium bid of the mid-1960fs

developed from the efforts of leading banks to obtain a larger volume
of reserves for lending and investing and from fears that they would
be criticized if borrowing from the Federal Reserve were used for
extended or continuous periods.

At times the premium that emerged

was 1 5/8 percentage points above the 4 1/2 percent discount rate,
and on November 2 $ 1966, it was 1 3/4 percentage points.

After the

discount rate was raised to 4 1/2 per cent in December 1965,, it was
not changed and lost touch with market rates.

Under the circum-

stances the premium on Federal funds was undoubtedly larger than it
would have been if the discount rate had been raised to conform with
general increases in market rates.
rate became a discount rate.

In a sense the Federal funds

Discipline exercised at the discount

window insured that Federal Reserve advances were not a steady and
continuous source of supply for any given bank; hence banks had to
obtain reserves from the Federal funds market, and demand forced up


the rate on these funds.

Administration of the discount window in

the 1950fs and 1960fs was more severe than in the 1920's and was substituted for the higher discount rate levels that had prevailed in
the earlier period.

Chart 2


This was particularly true in 1966.

Discount rats
• • » " Federal Fund? (Monthly a«i»je'
Ii?js,iiy HnK 'Monthly aueogf)

In late summer the System

issued a letter dated September 1 calling for cooperation of member
banks in curtailing expansion in loans to business.

The letter indicated

that member banks experiencing deposit losses that made efforts to
reduce loan expansion instead of cutting further into municipals,

would be extended credit for a longer period than usual.

The banks,

however, did not take advantage of this offer to any extent and
made most of their adjustments without the Systemfs assistance,
showing a strong preference for the "privacy" of the Federal funds
Paying more than the discount rate for Federal funds reflects
the elasticity of the demand for these funds.

In fact, the market

may be said to represent a source of marginal demand and supply, one
in which increases in either demand or supply quickly result in higher
or lower interest rates in contrast to some other markets where competition is less perfect.

The rate acts as a sensitive indicator of

shifting pressures in the banking system — particularly when related
to who is supplying the funds, to the volume of the flows, and to the
depth of the demand.

The huge flow of Federal funds during the past

2 years and the widespread participation of banks of all sizes in
the market underscore this characterization of the market.

Chart 3

1 J-X




• 4—4
17 It
31 7
Aupust !


D.icount Rat*




2) 2fl
I September


M 1 iA


« 16 23 30

u' 21 28

-37Transactions are accomplished rapidly and efficiently in increasing
volume for increasing numbers of banks at nearly uniform rates.


reflects a high degree of adjustment between demand and supply and
price and quantity exchanged.

The several markets and several market

rates that may exist at any given time are each the result of forces
of the same general character but of different magnitudes in the several

The rates are not unrelated to each other but they reflect

distinct prices, and the departures from the effective rate merely
reflect a wider range of quotes on a given day.

Lack of perfect ad-

justment and of a uniform rate arises from institutional friction,
the absence of knowledge of the market as a whole, and use of Federal
funds by nonbank groups and others.
The growth in unity and breadth of the Federal funds market and
the increase in its efficiency during the 1960fs have strengthened the
"links" among the various divisions of the money market and the links
of the money market to the longer-term, credit markets.

A given volume

of Federal funds will now move through that market with less change
in rates than was formerly the case, the market participants may move
back and forth from one sector of the money market to another in
response to shifting rate differentials without causing disruptive
price changes.


See Chapter 4, Trading in Federal Funds — Findings of a
Three-Year Survey, by Dorothy M. Nichols, Board of Governors of the
Federal Reserve System, Washington, D. C , September, 1965, for a
detailed discussion of determination of rates and rate structure.
This study provides a detailed analysis of Funds transactions by
250-260 banks that reported to the System between September, 1959,
and September, 1963.


In general, the Federal funds market has encouraged and permitted

banks to reduce their excess reserves and, in addition, has helped
to distribute reserves supplied by the Federal Reserve through open
market operations, the discount window, and reductions in the level
of required reserves.

For all banks the market provides an important

means of adjusting their reserve positions, and the condition or
atmosphere in the market is related to developments in other segments
of the short-term market.
The Federal funds market also represents both a source of and an
outlet for these funds over periods of time.

Deposit swings, however,

force short-run variations in the size of purchases or sales.
fers of reserves from selling banks to buying banks —


in addition to

reducing the excess reserves of the selling banks -— influence the
composition of assets in the banking system.

Net buyers of Federal

funds absorb the obligation of extending credit to a variety of users.
The smaller country banks use the market principally as an investment medium, and their widening use of the market in recent years
has caused them to compute reserve requirements more accurately and to
sell excesses to city banks.

Country banks are much less active on

the buying side, and as was indicated earlier, some of them prefer to
go to the Federal Reserve when the need to borrow arises.

Host of the

country banks that do not participate in the Federal funds market hold
deposits of $5 million or less.

Some of these banks have no familiarity

with the market, but others state that they expect to enter the market
in the future if conditions suit them.

Banks of this size that do

participate are almost exclusively sellers, but a few of them state


that they would borrow if necessary.
With country member banks in the Federal funds market now totaling
more than 2,500

some of which are small banks in terms of their total

deposits, it is doubtful that the dimensions of the funds market will
increase substantially in the future.

There are considerable dif-

ferences in management capability of very small nonparticipating

Furthermore, many of them would.find it too costly to partici-

pate, even as sellers.

This cost is measured in terms of maintaining

statistics on their flows of deposits, following market developments,
and communication.

On the buying side, the question may be raised

whether smaller banks should be encouraged to become borrowers for
the periods of time necessary to support additions to their portfolios
even if the demands by their customers could be met in this way.


same question may be raised about some of the larger city banks, which
may have exploited borrowing sources outside the Federal Reserve.
Considerable skill is necessary to use short-term markets as dependable
sources of reserves.
However, some observers feel that easier access to borrowings in
the Federal funds market should be provided for smaller banks.


the proposals to facilitate this are auctions in Federal funds and
the performance of a brokerage function by the Reserve banks; each
of these proposals is discussed later.
Clearcut evidence of the difficulty of access to the Federal
funds market is lacking, particularly when the growth and development
of the market over the last 5 years are reviewed.

Additional partici-

pation or more continuous participation in the market by the smaller
banks, if desired, can be accomplished by breaking down the innate
conservatism of nonparticipants and by broadening their knowledge of the marke



The Steering Committee, summarizing issues involved in reformula-

tion of the "Discount Mechanism and Concept" has stated that over and
above the considerations as to control mechanisms, there is need to
consider the efficacy of alternative instruments of systems of control
from the broad viewpoint of over-all public policy and the discount
mechanism as a whole.
Auctions of Federal Funds.

One suggested modification is to re-

place the present-purpose constraints with a quantitative limitation
on borrowed reserves through regular auctions of pre-determined
amounts of Federal funds (reserves).

In each reserve-computation

period the banks could bid for Federal funds and pay for them by
tendering their own liabilities -— auctions might be used as the major
source of reserve credit or for particular purposes.
The Steering Committee has also raised the following questions
relating to the possible use of auctions:
operations —

What becomes of open market

as a provider of credit for certain other purposes or

as a supplemental tool to correct errors in the auction process?
What policy measures other than "price" of Federal funds auctioned needed to insure a proper allocation of Reserve Bank credit?
Who should determine how often and what volume of reserves to auction?
How would the funds be auctioned ~

in the Federal funds market; or

by a procedure similar to that for selling Treasury bills; or by a
new method?
In the academic seminar discussing changes in the discount window
Academic Seminar in Changes in the Discount Window, May 11, 1966,
unpublished transcript, Board of Governors of the Federal Reserve System,
pp. 158 ff.

-41suggestion was made that the auction be run on a 13-week cycle, say
$500 million each week.

Unsatisfied demands during a given week would

be met at a penalty rate, that is, at a rate above the auction.
Another suggestion was to hold the auction daily or with some other
regularity «

with arrangements for filling noncompetitive bids at

the average rate in the auction and for providing any additional
amounts needed at a penalty above the average rate.
Advantages advanced for the auction proposal were that it would
broaden the Funds market to the smallest bank in the smallest transaction
stabilize the sum total of System loans -r- the amount of rediscounts
could be fixed forever or can be changed, would provide a market determined rate (as compared with the discount rate), and that the banking
system would never run out of liabilities as a means of payment.
The disadvantages noted were that it would be difficult to determine the amount to be auctioned and that determination of the amount
against projected demand would in effect set the rate -- that is,
the problem of determining the quantity is similar to that of fixing
the rate .
Without additional detail or assumptions a complete analysis
of the effects of the auction proposal on present institutions in the
money market is not possible.

Offhand, however, it would seem that

the proposal, in order to be successful, would have to replace completely, or at least in substantial part, the present range of
facilities, which now satisfy quite efficiently the requirements of
both sides of the Federal funds market —
over time "to bridge11 the unit banks.


Ibid., p. 162,

facilities that have evolved

Such facilities include the


discount window.

The market would be given an official status, and

it would present new problems for the System in necessitating that
more continuous and up-to-date judgments be substituted for those
now made by market participants.
On the assumption that the auctions would be limited to sales
of Federal funds, formulas for awards would have to be determined
in such a way as to prevent cornering of the market and disorderly
trading after the funds had been sold.

Otherwise rate fluctuations

of large amplitude could often be expected.

It is not clear how open

market operations could be used to compensate for errors if too large
a volume of funds were supplied in an auction.
techniques —

Even with present

including reverse repurchase agreements —- open market

operations could not be used with the continuity necessary to complete
the adjustments.
Trading in Federal funds continues throughout the day —
the constantly shifting needs of banks.


The present market mechanism

centralizes buyers and sellers for all practicable purposes at a
single point, and changes in ownership of funds are facilitated by
the willingness of numbers of participants to match demand and
supply —

absorbing or making the residue available at a price.

If the Federal Reserve were to enter this mechanism, the mechanism
would be materially altered, to the extent that the Federal Reserve
became a central point for sales; and the System would be forced to
communicate, directly or through agents, with hundreds of banks


a mechanical problem of some magnitude even with the aid of computers.
It would be difficult to demonstrate that a better allocation of
Federal funds would be achieved or that the efficiency of the market

-43would b-:, improved•

Compensating for errors an the short aide at a

penalty rate (above the auction average) or with additional auctions
suggests the need for precise estimates of needs* and this the
existing data cannot provide.

Setting the penalty rate in the periods

between auctions would offer the problems in determining the Systemwide penalty differential, and rite basis en which it would be applied*
Market expectations could feed on themselves with disturbing affects
on rates if the auctions were frequent End variable in amount, as
would appear to be. necessary.
In this connection there is a risk that in attempting to overcome
these rate fluctuations the System might be obliged to abandon its
auction and establish an administered or pegged rate.

In this event,

changes in this rate would raise problems similar to those associated
with decisions tc change the discount rate.

In tarma of an extreme^

. sales of Federal funds in auctions might liter a time lead t© demands
that the System also purch&it Ftderal funds, resulting in tn tnormously complex operation in which the Syifeist might in fact become the
whole market.
If under the proposal some banki ware &blt to zfzcuxt more Federal
funds than they can in currant m*rkets» a£h@r banka would command a
smaller amount; or within the frfitntwerk of the "adtninistsrsd pricm'*'
they might; h&v$ to pay sort thftn they could conveniently afford,
i§ no m©sn® o£ providing an objtctivt test A S a basis of
for sdmlni§tr&&ivd action, whether daiigmtd to achitva
allocation of Ftdartl funds or a n«w structure of prices that
would encourage reallocstio^ of iund§ among users•
The present market for Federal funds works efficiently9 ,and it

-44is relatively free from frictions that would limit free flows of
funds, as evidenced in the coherent and consistent structure of rates.
Funds rates are now considered an excellent measure of pressures
within the banking system, and they aid in forming a range for other
rates and in strengthening the short-term rate anchor in relation to
rates in the capital market.

The discount rate provides a reference

point, as the sensitive market rates move above and below it.


noted earlier, the widespread participation in the Federal funds
market and the closer links of that market to other parts of the money
market have led to more rate stability and smaller fluctuations in
rates than earlier.
Unless clearcut advantages can be shown for the proposal, it
seems unwise to tamper with the current market mechanism, which
commands confidence.

Changes in money and capital markets that dis-

turb confidence can have disproportionately large effects elsewhere
in the economy.
Federal Reserve Banks as Clearinghouses for Funds Transactions
of Smaller Banks»

The suggestion has been made from time to time that

the Federal Reserve Banks establish facilities for matching the requests for sales and purchases of Federal funds of the smaller banks
in their districts.

This service would be strictly that of a broker.

The Reserve Banks would match demand and supply to the extent possible
and would refer unsatisfied needs to other participants in the market.
Telephone and other communication costs would be absorbed by the
Reserve Banks.

This proposal is less radical than the auction, but

it suggests many of the same problems.

It involves the question of

direct intervention in the market and excites expectations of further

-45With the present high degree of development of the market and the
lack of evidence of unsatisfied needs, there seems to be no justification for further consideration of the proposal at this time.
Available information about the market shows a high degree of participation, especially by large banks.

The market provides ample facilities,

and it is expected that further participation by smaller banks will
come about as need develops.


Board of Governors of the Federal Reserve System, The Federal Funds Market - A Study by a Federal Reserve System Conynittee, Washington,
D. C:
Board of Covernors of the Federal Reserve System, May, 1959.
, "New Serif-; /m f V : o a Funds," Federal Reserve Bulletin,
Washington, D. C :
Board of Governors ol th - Federal Reserve System,
August, 1964.
Carl H. Madden, The Money Side of "The Street", New York:
serve Bank of New York, lc^.a.

Federal Re-

Dorothy M. Nichols, Trading Federal Funds • Findings of: a Three-Year Survey, Washington, V). C.: Board of Governors of the Federal Reserve
System, September, 1965.
Robert V, Roosa, Federal Reserve Operations in the Honey and Government
Securities Markets, New York: Federal Reserve Bank of New York, 1956.
Parker B. Willis, The Federal Funds Market - Its Origin and Development,
Boston, Massachusetts: Federal Reserve Bank of Boston, October, 1964.
Federal Reserve Bank Monthly Review Articles:
New York - William G. Colby, Jr., and Robert B. Platt, "Second District fCountry1 Member Banks in the Federal Funds
Market" (May, 1966).
- "Federal Funds" (March, 1950).
Philadelphia - Nevins D. Baxter, "Country Banks and the Federal Funds
Market" (April, 1966).


"Why Federal Funds?" (August, 1966).

- Jack C. Rothwell, "Federal Funds and the Profits
Squeeze - A New Awareness at Country Banks11 (March,
Cleveland - "Trading in Bank Reserves" (December, 1960; October, 1961).
Richmond - "Federal Funds in the Fifth District" (June, 1961; September, 1966).
- "Reserve Management at Fifth District Member Banks" (September, 1966).
Atlanta - Harry Brandt and Robert R. Wyand, II, "Using a Sharper
Pencil?" (Part; I: November, 1965).

- Paul A. Crowe and Robert R. Wyand, II, ffUsing a Sharper
Pencil?" (Part: II: December, 1965).

-47- Albert A. Hirsch, "Adjusting Reserves through the Federal
Funds Market" (October, 1962).
Chicago - Dorothy M. Nichols, "Marketing Money: How 'Smaller' Banks
Buy and Sell Federal Funds11 (August, 1965).
Minneapolis - J, N. Duprey, "Country Bank Participation in the Federal Funds Market" (July, 1966).
Dallas - William N. Griggs, "Federal Funds Market in the Southwest"
(November, 1961).
San Francisco - "The Role of Twelfth District Banks in the Federal
Funds Market" (June, 1961).

- Jacob Allan Toby, "Fed Funds:
(September, 1966).

The Western Market"

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