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Volume 1


The following report sets forth the conclusions and
recommendations of a System steering committee ap­
pointed to reappraise and, where necessary, recom­
mend redesign of Federal Reserve lending facilities.
This report is the result of a three-year System-wide
study. The proposals for the redesign of the discount
mechanism are the product of a combination of re­
search, experience, and judgment on the part of those
involved in the study.
The Steering Committee, made up of members of
the Board of Governors and Presidents of Federal
Reserve Banks, was chaired by Governor George W.
Mitchell. Other members included Governors Sher­
man J. Maisel and William W. Sherrill and Presidents
Karl R. Bopp of Philadelphia, Edward A. Wayne of
Richmond, Charles J. Scanlon of Chicago, and George
H. Clay of Kansas City. Governor Charles N. Shepardson and President Harry A. Shuford of St. Louis
served as earlier members of the Steering Committee
until their respective retirements from the System, and
William McC. Martin, Jr., Chairman, Board of Gov­
ernors of the Federal Reserve System, served as a
member of the committee, e x o ffic io .
A staff Secretariat had the responsibility for de­
veloping proposals for Steering Committee review,
and implementing the study outline as determined by
the parent committee. This group was chaired by
Mr. Robert C. Holland, Secretary of the Board. Serv­
ing on the Secretariat were Mr. Harold Bilby, Vice
President and Senior Adviser of the New York Re­
serve Bank, Mr. David C. Melnicoff, Vice President
and chief lending officer of the Philadelphia Reserve
Bank, Mr. M. H. Strothman, Jr., First Vice President
of the Minneapolis Bank, Mr. Philip E. Coldwell, now
President of the Dallas Bank, and Mr. A. B. Merritt,


First Vice President of the San Francisco Bank. Rep­
resenting the Board staff were Mr. Howard Hackley,
Assistant to the Board, Mr. John Farrell, Director
of the Division of Bank Operations, and Mr. Frederic
Solomon, Director of the Division of Bank Examina­
tions. Prior to his retirement, Mr. Ralph A. Young,
Senior Adviser to the Board and Director, Division
of International Finance, also served on the Secretar­
Mr. Bernard Shull of the Division of Research
and Statistics was a member of this group and also
served as Director of Research Projects with primary
responsibility for the implementation and coordina­
tion of research activity in connection with the study.
Miss Priscilla Ormsby was Secretary for the Secretar­
iat. Others who contributed to the work of the Com­
mittee were: Mr. George Garvy, New York; Mr. Ed­
ward A. Aff, Philadelphia; Mr. Kyle K. Fossum,
Minneapolis; Mr. T. R. Plant, Dallas; Mr. John B. Wil­
liams, San Francisco; and Mr. Brenton C. Leavitt, Mr.
James C. Smith, Mr. Robert Forrestal, Mr. Walter
Doyle, Mr. John Kiley, and Mr. Robert Gemmill, all
of the Board staff. Special note should be made of
the study of discount mechanisms in other major in­
dustrialized countries, an extensive review of foreign
experience under the direction of Mr. George Garvy.
Several academic scholars also contributed to the
Committee’s deliberations through conferences and
writings. These efforts were organized by Professor
Lester V. Chandler, Chairman, Department of Eco­
nomics, Princeton University, and Academic Con­
sultant to the Discount Study.
The Board is indebted to those named above and
to numerous others who have cooperated in the ac­
tivities of this important and far-reaching study,
culminating in the preparation of the final report.

Library of Congress Catalogue Card Number 70-609110
Copies of this report may be obtained from Publica­
tions Services, Division of Administrative Services,
Board of Governors of the Federal Reserve System,
Washington, D.C., 20551. The price is $3.00 per copy;
in quantities of 10 or more sent to one address, $2.50
each. Remittances should be made payable to the
Board of Governors of the Federal Reserve System in
a form collectible at par in U.S. currency. (Stamps
and coupons not accepted.)

Volume 1



Steering Committee



Bernard Shull







Bernard Shull



Clay J. Anderson

George Garvy



Governor George W. Mitchell, Chairman
Governor Sherman J. Maisel
Governor William W. Sherrill
President Karl R. Bopp, Philadelphia


Edward A. Wayne, Richmond
Charles J. Scanlon, Chicago
George H. Clay, Kansas City
William McC. Martin, ex officio

Members until retirement:
Governor Charles N. Shepardson; President Harry A. Shuford, St. Louis



Summary of the Proposed Redesign of the Discount Window___________________


Background of the Proposed Redesign of the Discount Window_________________ 4


A. Scope of the study
B. Historical summary of the role of the discount window
C. Need for an appropriately redesigned discount window
III. Short-Term Adjustment Credit__________________________________________
A. Basic borrowing privilege
B. Other adjustment credit


IV. Seasonal Credit Accommodation_________________________________________ 15
A. Needs for seasonal credit assistance
B. Seasonal borrowing privilege

Emergency Credit Assistance___________________________________________ 18
A. Emergency lending to member banks
B. The System as “ lender of last resort” to the economy
through nonmember institutions
C. Support of distressed markets through the discount

VI. Discount Rate Policy__________________________________________________ 21
VII. Ancillary Recommendations of the Steering Committee________________________ 23
A. Provisions for coordination of discount administration
B. Changes in reserve regulations to facilitate
end-of-period reserve adjustment
C. On-going studies of means of improving the
shiftability of bank assets and liabilities





The proposed redesign of the discount
mechanism has as its chief objective in­
creased use of the discount window for the
purpose of facilitating short-term adjust­
ments in bank reserve positions. A more
liberal and convenient mechanism should
enable individual member banks to adjust
to changes in fund availability in a more
orderly fashion and, in so doing, should
lessen some of the causes of instability in
financial markets without hampering over­
all monetary control.
Central bank lending operations can pro­
vide funds to individual banks on either of
two bases— continuous or intermittent. In
the first case, banks are always in debt to
the central bank, and the discount rate is
varied in accordance with economic condi­
tions to affect indirectly bank lending terms
and prices. But the bulk of monetary influ­
ence is exercised by the imposition on the
lending policies of commercial banks of such
restrictions as the central bank believes suit­
able to the environment. This system, with
variations, is typical of many foreign coun­
In the United States, on the other hand,
banks in recent decades have not been, and,
in the view of this report, should not be,
permitted to remain continuously in debt
to the Federal Reserve. Given the highly de­
veloped character of the U.S. economy and
its financial structure, open market opera­
tions in Government securities by the cen­
tral bank serve effectively as the preponder­

ant means of secular reserve provision and
the leading edge of monetary policy imple­
mentation. The role of the discount mecha­
nism, on the other hand, is to cushion the
strains of reserve adjustment for individual
member banks and, thereby, for financial
markets. In this context the discount win­
dow can beneficially assume an increased
part of the burdens of intramonthly and
seasonal reserve adjustments which are cur­
rently borne by open market operations.
This increased use should come about both
as credit is provided more liberally to indi­
vidual banks faced with these adjustment
needs and as increased numbers of banks are
led to regard the window as a useful source
of temporary or seasonal funds.
Two major and interrelated changes are
included in the general design of the pro­
posed discount window. These are: (1 ) a
move toward more objectively defined terms
and conditions for discounting; and (2) the
inclusion of several complementary ar­
rangements for borrowing at the window,
each designed to provide credit for a spe­
cific type of need. These changes look for­
ward to a generally higher level of borrow­
ing being done by a rotating sample of
member banks. However, such a higher level
of borrowing would not mean a correspond­
ing increase in total reserves, since increased
borrowing would be expected to be about
offset by correspondingly smaller net System
purchases of securities in the open market.


The first of these changes will be accom­
plished by introducing specific quantity and
frequency limitations on a part of borrow­
ing and by increased reliance on the dis­
count rate. These moves will permit a
clearer and more unequivocal communica­
tion of discounting standards and limita­
tions to member banks and will help to
insure uniformity of window operation
among districts and among banks.
No one of these types of controls can be
expected to bear the entire burden of regu­
lating discount-window use, however. The
rate charged on borrowing, while normally
expected to have a significant influence on
a bank’s use of the window, is not a de­
pendable deterrent to excessive borrowing
under pressure and, at the extreme, may
actually become only a minor considera­
tion. Limitations on the quantity and fre­
quency of borrowing would also prove in­
adequate alone as methods of controlling
borrowing. It would be impossible to con­
struct a matrix of limitations a priori in
such a way that they exactly accommodate,
no more and no less, the varying and often
unforeseeable needs of member banks for
discount credit. For these reasons, the move
toward objectively defined terms and condi­
tions for lending at the window, important
as it is seen to be, cannot be completely
sufficient. Only through the application of
administrative judgment over some part of
the borrowing done at the window can the
System adequately accommodate the widely
differing needs of individual member banks,


while at the same time maintaining the
necessary monetary control.
The proposed redesign contains varied
arrangements for the Federal Reserve to
provide short-term adjustment credit, sea­
sonal credit, and emergency credit. Short­
term adjustment credit is further divided
into the “basic borrowing privilege”—which
provides credit on an automatic basis, within
specified limits on amount and duration, to
all member banks meeting the conditions
specified in Section III—and other adjust­
ment credit. The latter is available, under ad­
ministrative control, to meet needs larger in
amount or longer in duration than can be
accommodated under the basic borrowing
privilege. Seasonal credit will be provided
to accommodate recurring demands over
and above a minimum relative amount, for
such amounts and duration as the applying
member bank is able to demonstrate a need.
The redesigned discount window provides
that the Federal Reserve will continue to
supply liberal help to its member banks in
general or isolated emergency situations. In
addition, the redesigned window recognizes,
and provides for, the necessity that—in its
role as lender of last resort to other sectors
of the economy—the Federal Reserve stand
ready, under extreme conditions, to provide
circumscribed credit assistance to a broader
spectrum of financial institutions than mem­
ber banks.
Each of these various types of credit
accommodation, as well as the issue of dis­
count rate policy, is discussed in some de­
tail in later sections of this report.

A. Scope of the study
the effectiveness of the current discount
The Fundamental Reappraisal of the Dis­ mechanism, an appraisal of the extent to
count Mechanism was launched in mid- which operating rules might need to be
1965. The study has involved a review of altered in view of the changing economic


environment, and the formulation of spe­
cific proposals for implementing such
changes as were found to be desirable.
The study has been under the over-all
direction of a Steering Committee made up
of three members of the Board of Gover­
nors and Presidents of four of the Federal
Reserve Banks. Under this Steering Com­
mittee, a staff Secretariat was responsible
for developing proposals for Steering Com­
mittee review and implementing the study
outline as determined by the parent com­
Over 20 individual research projects
commissioned by the Committee provided
historical perspective and quantitative and
theoretical background for considering
policy alternatives. Most of these projects
were undertaken by members of the re­
search staffs of the Board of Governors and
the Reserve Banks, although several papers
were also prepared by academic economists.
Central bank lending experience was re­
viewed closely, both in the United States and
in other major industrialized countries of
the world. The System also had the benefit
of a survey by the American Bankers Associ­
ation of bank attitudes toward borrowing.
Drawing upon the results of this research,
as well as ideas and suggestions from Sys­
tem personnel, bankers, and academic and
other economists outside the System, the
staff Secretariat formulated specific pro­
posals for the redesign of the discount win­
dow. These proposals, with amendments
and refinements growing out of further
discussion within the Steering Committee
and among other System personnel, are pre­
sented in this document.
B. Historical summary of the role of the
discount window

The Federal Reserve Act in its original
form contemplated use of the discount


mechanism as the principal tool of central
bank policy. In fact, the proportion of total
reserves supplied via discounting never fell
below 37 per cent during the 1920’s and
reached a peak of more than 80 per cent
in 1921. During the 1920’s, however, open
market operations gradually but steadily
began to displace discounting as a means
of supplying reserves to the banking system.
This trend was interrupted in the years
1928-30 and 1932-33, when discounting
was relied upon heavily by many member
banks to assist in their adjustments to the
financial pressures that developed in those
periods. After 1934, borrowing fell to neg­
ligible levels as banks became extremely
liquid, reflecting a number of influences in­
cluding enhanced wariness of indebtedness
in any form, sizable reserve injections from
gold inflows, and the liberal and increas­
ingly sophisticated use of contracyclical
open market operations. Throughout the
1940’s the excess reserves accumulated dur­
ing the middle and late 1930’s and Federal
Reserve purchases of U.S. Government se­
curities at pegged prices provided ample re­
serve funds to meet wartime and postwar
needs, and discounting activity was minimal.
The Treasury-Federal Reserve accord in
March of 1951 freed the Government se­
curities market from pegged rates, at a time
when private demands for credit were
strong. The immediate result was an up­
surge in discounting activity—although still
only to a monthly peak of $1.6 billion, or
about 7 per cent of total reserves, in De­
cember of 1952. This increase was attribut­
able in part to heavy loan demand but
perhaps more significantly to the profita­
bility of borrowing under the provisions of
the excess profits tax temporarily in effect.
In ensuing years credit demands eased, and
the Government securities market con­
tinued to develop to an extent which per­


mitted effective implementation of the bulk
of policy decisions through System purchases
and sales of these assets. At the same time,
most banks held ample supplies of these
liquid securities; such holdings were an
aftermath of war financing and enabled
banks to make most adjustments in their re­
serve positions by selling Government secu­
rities in a generally efficient and flexible
Thus, despite the abandonment of the
open market policy of pegging rates in effect
before the accord, the discount window con­
tinued to serve only a marginal role as a sup­
plier of reserves. It provided banks with
assistance over the peaks of temporary,
emergency, or seasonal needs for funds that
exceeded the dimensions that the banks
themselves were capable of reasonably meet­
ing out of their own resources. To reinforce
a policy of limited bank use of the discount
window, the 1955 revision of Regulation A
was issued, placing chief reliance upon bank
reluctance to borrow, buttressed as and
where necessary by disciplinary contacts by
discount officers. Given this kind of discount
policy, open market operations could be
undertaken with a new degree of vigor and
precision, secure in the knowledge that only
marginal reserve additions would be intro­
duced through the discount window. The
chart on page 5 shows the amounts of
Federal Reserve credit supplied by each of
the three possible means—open market
operations, discounting, and float—over
the years, and Table 1 shows the relative
proportions supplied by each for selected
In the ensuing years, the discount win­
dow has been of less and less day-to-day
significance in the operation of the mone­
tary system, as banks have increasingly
turned elsewhere to meet their short-term
reserve needs. Even in this marginal role,

the window has continued to fill needs which
can be met in no other way. Distributive
mechanisms among both economic and geo­
graphic sectors in the United States are
often imperfect and in some cases clearly in­
adequate. This results in problems of re­
serve distribution which the Federal Reserve
can compensate for only through a tech­
nique such as discounting. The window can
meet the temporary needs of particular
banks directly as they arise, without wait­
ing for the sometimes sluggish distributive
mechanisms to carry credit injected into the
central money market to the point of actual
Discounting can also serve as an impor­
tant adjunct to open market operations in
the implementation of monetary policy. It
is often difficult to determine in advance
the exact degree of stringency which a given
level of open market operations will create
in the banking system as a whole, and virtu­
ally impossible to predict its impact on any
single bank or group of banks. The exist­
ence of the discount mechanism, however,
provides a means for individual banks to
cushion temporarily the impact of such
policy moves and therefore enables the
Trading Desk of the Federal Reserve Bank
of New York to carry out the System’s open
market operations more aggressively than
would otherwise be practicable. In addition,
(Percentage of total)


market Discount­









the level and dispersion of borrowing serves
as a meter of disaggregated market forces
and financial pressures, providing increased
certainty in the implementation of mon­
etary policy.
Apart from these functions of the dis­
count mechanism largely concerned with
reserve creation, the window provides a
unique vehicle for direct communication be­
tween Reserve Banks and member banks.
It has the potential to make an invaluable
contribution to bankers’ understanding of
monetary trends and thus to their apprecia­
tion of and cooperation with Federal Re­
serve policies and actions.
C. Need for an appropriately redesigned
discount window

Short-term and seasonal fluctuations in
loans and deposits are fundamental facts of
commercial banking. They can be relatively

large for individual banks and, in the ab­
sence of readily available and efficient
means of adjustment, can cause problems
not only for individual bank managements
but also for the smooth functioning of the
entire financial system.
Banks’ difficulties in adjusting to such
fluctuations in their funds are compounded
by several factors. The U.S. banking system
is composed of a very large number of indi­
vidual institutions, each of which is subject
to a variety of short-term pressures. In the
net aggregate, these pressures may not nor­
mally appear severe. However, the gross
size and distribution of swings in fund flows
can produce abrupt pressures on individual
banks for which they can prepare only at
the cost of excessive liquidity and a signifi­
cant limitation on the credit resources they
make available to their communities. More­


over, the liquidity instruments used are de­
pendent on financial markets and mechan­
isms which often do not function with suffi­
cient speed and elasticity to guarantee that
a bank can always effect its desired adjust­
ments through these means. And not all
member banks have adequate access to such
In those periods when all banks held
sizable volumes of liquid Government se­
curities, they were able to effect their ad­
justments easily in the highly developed and
almost universally accessible secondary mar­
ket for these assets, and liquidity problems
were of little concern. Since World War II,
however, non-Federal debt has generally
increased far more rapidly than Federal
debt, and bank portfolios have reflected this
trend. The supplies of liquid assets available
for reserve adjustment have been further
curtailed by the rise in the total of public
deposits which must be collateralized by the
hypothecation of specified kinds of assets,
most of which are fairly liquid.
As banks in recent years have placed a
much larger share of their resources into
municipal obligations and into business,
consumer, and mortgage loans, their supply
of readily salable assets has been less and
less of a cushion against unexpected deposit
fluctuations. Part of the answer to this prob­
lem has been found in the sale of such port­
folio assets. Secondary markets for these as­
sets are decidedly inferior to the Government
securities market, however; they range from
the municipal bond market—fairly well de­
veloped at least for the bonds of larger and
better-known municipalities, but subject to
large price fluctuations—to those for con­
ventional mortgages and agricultural paper
—rudimentary or virtually nonexistent.
More striking has been increasing bank
resort to the issuance of short-term liquid

liabilities. This trend can be seen in the
rapid growth of the Federal funds market,
the issuance of marketable certificates of de­
posit and debentures, and the increasingly
heavy reliance of some money market banks
on the Euro-dollar market. All of these latter
devices, by whatever name they are known,
are quite likely to be largely outside the orbit
of the bank’s service area and thus different
from the normal demand and savings de­
posits obtained in that area. Some of the
smaller, more isolated banks do not, and in
considerable measure cannot, effectively tap
these sources of funds. Such banks therefore
tend to hold a sizable proportion of their
assets in liquid form and as a result may be
providing less credit to their communities
than would be desirable.
This increased willingness on the part of
banks to borrow from other sources has not
been accompanied, however, by a parallel
increase in borrowing at the discount win­
dow. A considerable reluctance to borrow
from the central bank has in fact been main­
tained, largely through the application of the
current Regulation A, which emphasizes
that banks should resort to borrowing from
the Federal Reserve only on a short-term
basis when other sources of funds fall short
of their appropriate needs.
Thus the present window continues to
serve well to hold the volume of reserve
additions introduced through borrowing to
a minimum. However, with short-term
reserve needs of individual banks persisting
and in many cases growing, and the his­
torically important methods of meeting
these needs declining in usefulness, very
low totals of borrowing from the Federal
Reserve are no longer consistent with opti­
mum performance of the banking system.
Complicating these problems arising from
the changing financial environment has been
the fact that the current administration of


the discount window has not been well
understood by many commercial bankers.
Failure of the Federal Reserve to commu­
nicate clearly, consistently, and unambigu­
ously with member banks regarding the
availability of discount-window accommo­
dation has caused many of these banks to
view this as an uncertain source of credit. In
addition, occasional Federal Reserve coun­
sel as to what would be regarded as appro­
priate adjustments for borrowing banks has
led many banks to regard the window as
having too great a potential for interfering
with bank management decisions. As a re­
sult, many banks having temporary needs
for funds often make adjustments by more
costly, less efficient avenues than that af­
forded through the discount window, some­
times to the detriment of adequate credit
availability for their local communities.
Furthermore, the design and language of
the current Regulation A, relying as it does
primarily upon bank reluctance to borrow
and, where necessary, administrative actions
by the Federal Reserve, provides consider­



able opportunity for differences in adminis­
tration from one district to another and from
one case to another. Many of the apparent
nonuniformities of administration are con­
sidered justified, since no two borrowing
cases are identical and actions must be
adapted to fit the differing circumstances of
borrowing banks. However, comments of
participants in borrowing transactions and
such objective evidence as can be brought to
bear argue that at times such administrative
differences have been greater than could be
explained by differing circumstances of indi­
vidual banks.
What emerges from this review is a pic­
ture of a Federal Reserve discount mecha­
nism which must be modernized and rede­
signed if it is to play a significant role in the
changing financial environment. It is be­
lieved that the redesign of the discount win­
dow herein proposed can bring the mecha­
nism into closer touch with the prevailing
economic climate and lead to a more effec­
tively functioning member banking system.


The adjustment action initiated by banks
in financial markets in response to tempo­
rary loan and deposit fluctuations can at
times contribute to excessive short-run mar­
ket instability, particularly since the precise
timing and amplitude of temporary swings
are not predictable. In addition, short-run
fluctuations in loans and deposits give rise
to operations that impair to some extent the
efficient operation of the financial system.
The impairment is the result of otherwise
needless transactions which commercial
bank managers must conduct in order to
maintain a margin of liquidity sufficient to
meet unforeseen swings. If the adjustment

alternatives open to the bank are limited in
number and availability, this liquidity mar­
gin may have to be disproportionately large
or costly in terms of foregone yield or poten­
tial capital loss on security sales.
For those reasons, one of the basic func­
tions of the Federal Reserve System has
been to provide temporary additions to
commercial bank reserves through loans to
member banks, in order to cushion the
process of adjustment within the financial
mechanism. Such credit accommodation
undoubtedly leads to somewhat wider shortrun fluctuations in aggregate reserves; but
such movements, usually quickly reversed,


are regarded as less destabilizing than the
fluctuations in pressures on financial mar­
kets and institutions that would otherwise
A. Basic borrowing privilege

A key objective of the proposed redesign of
the discount mechanism is to formalize the
terms of limited and temporary access to
the window through the establishment of a
“basic borrowing privilege” for each mem­
ber bank unless and until otherwise notified.
A basic borrowing privilege is defined as
access to Federal Reserve credit by member
banks upon request through the discount
window within the limits of the law and ac­
cording to precisely stated limits on amounts
and frequency. To some extent, these bor­
rowing privileges represent a formalization
of the existing practice of providing tem­
porary credit over a period of time when­
ever requested by member banks, but under
existing practices neither the amount nor the
duration of such limits is specified in the
Through a basic-borrowing-privilege ar­
rangement, however, the Federal Reserve
would make unambiguously clear to mem­
ber banks the terms of their access to this
type of temporary credit. With clearly de­
fined, precisely stated limits, a high degree
of uniformity of administration of the basic
borrowing privilege should be assured to all
member banks.
The explicit nature of the borrowing priv­
ilege arrangement will enable member banks
to use the Federal Reserve discount window
more readily when they need funds for short­
term adjustment purposes and find no more
convenient alternatives at hand at compara­
ble cost. This facet of the redesigned mecha­
nism should be particularly attractive to the
great majority of small member banks that

currently make no recourse to the discount
The Federal Reserve does not now pro­
vide permanent additions to the loanable
funds of individual banks through the dis­
count window, and the proposal herein ad­
vanced does not alter that fundamental prin­
ciple. Therefore, it is necessary to impose
some limitation on the frequency and dura­
tion of credit provided to a member bank
through a basic borrowing privilege. The
recommended operational objective is for
temporary credit accommodation to be ex­
tended over a long enough period to cushion
short-term fluctuations and permit orderly
adjustment to longer-term movements; but
not for so long as to invite procrastination
in the making of needed adjustments by
individual borrowing banks or to delay un­
duly the response of the banking system to
a change in general monetary policy.
On the basis of extensive review of past
bank balance sheet fluctuations and borrow­
ing patterns, the Steering Committee has
concluded that the above objective is appro­
priately served by the following limitation:
a bank shall not be empowered to draw on
its basic borrowing privilege if such borrow­
ing would cause it to be indebted to its
Federal Reserve Bank (within or in excess
of its basic borrowing privilege, but ex­
cluding any use of its seasonal borrowing
privilege as provided on pages 14-16) in
more than— (6-13) out of the last —(13—
26) reserve periods.1 The—(13-26) period
interval is conceived of as a moving span;
hence, eligibility for temporary adjustment
lrThe ranges indicated here and below extend from
those limitations felt to provide the minimum mean­
ingful assistance to member banks to the maximums
believed compatible with the aims of monetary man­
agement. Final choices of limitations within these
ranges will be made on the basis of experience and
further deliberations.


credit under the basic borrowing privi­
lege in the current reserve period is based
upon adjustment borrowing frequency (both
within a bank’s basic borrowing privilege
and in excess of that amount) during the
immediately preceding— (12-25) periods.
The total amount of credit available to
member banks—through the temporary ad­
justment credit program as well as through
other types of borrowing at the discount win­
dow—must also be controllable if over-all
objectives of monetary policy are to be
achieved. In determining the maximum
credit exposure which could be tolerated,
consideration must be given not only to the
absolute amount of credit provided but also
to the potential fluctuations in borrowing
from reserve period to reserve period. The
recommended operational objective is for
basic borrowing privileges to be large enough
individually to be significant to each mem­
ber bank, and large enough in the aggregate
to cushion a significant part of the swings
in market factors affecting reserves, but not
so large in total as to exceed the capacity of
open market operations to offset any ex­
cessive reserve creation or destruction re­
sulting from the total of coincident bank
drawing on or repayment of their basic
borrowing privileges.
From the point of view of equity and
efficient administration, the distribution
of the sum total of borrowing privileges
among banks needs to be simple and fairly
stable, based on a formula that is easily veri­
fied and related in some reasonable way to
the needs and creditworthiness of the bor­
rowing bank. All things considered, the
most practical method of establishing the
basic borrowing privilege is deemed to be
as a fixed percentage of each bank’s capital
stock and surplus. The combined total of a
bank’s capital stock and surplus is a conven­
tional measure of its ability to service and


repay indebtedness. Furthermore, it is a rela­
tively stable item, and changes therein are
promptly reported to the Reserve Banks in
connection with the required purchases of
Federal Reserve stock. Moreover, use of
capital stock and surplus as a base discrimi­
nates least against newly organized banks in
their access to the basic borrowing privilege.
The distribution of basic-borrowing-privilege access among member banks might, at
first glance, seem to be most equitably ac­
complished by according the same percent­
age of capital stock and surplus to all; how­
ever, the practicalities of a manageable swing
in aggregate credits and of vast differences in
bank size argue for higher percentage limits
on the basic borrowing privilege of small
banks than on that of large banks. A constant
percentage constraint applied to all banks
which would result in a tolerable total
credit exposure would provide so little credit
to small banks that the program would be
of relatively little use to them. If the per­
centage limit were increased uniformly so
as to provide a reasonable amount of credit
to most banks, the aggregate basic borrow­
ing privilege would be excessive and could
jeopardize the ability of the Federal Re­
serve System to meet its monetary policy
Analytical evidence also supports such
a distinction. Studies have confirmed that,
while the largest banks often experience
wide deposit fiuctutaions on a very shorttime basis, small banks tend to face rela­
tively larger fluctuations over periods of
several weeks or longer than do large banks.
This results in the main from their more
limited opportunities for geographic and
functional diversification of depositors.
Though the empirical work done on the asset
side is thus far less extensive, these same
considerations would almost certainly apply


to loan totals. An inverse relationship be­
tween loan and deposit changes may be
traced to the fact that both bank borrowers
and depositors are influenced by common or
related factors.
On the other hand, large banks needing
to borrow funds to meet temporary out­
flows have more ready access to money
market sources here and even abroad. They
generally have more and cheaper alterna­
tives because of their proximity to corpo­
rate, institutional, and governmental lenders
of funds, the continuous information flow
between themselves and these lenders, the
ability and initiative of many of their spe­
cialized money managers, and finally their
ability to tailor liability offerings to the
size and maturity preferences of a wide
range of customers.
These considerations indicate that large
banks have, on the whole, less relative need
for and greater access to external sources
of credit and therefore have less relative
need for assured short-term credit accom­
modation from the Federal Reserve.
Given all these considerations, and after
review of the historical borrowing expe­
rience of various classes of banks, the Steer­
ing Committee recommends granting to
each qualified member bank a basic borrow­
ing privilege, measured by reserve period
averages, equal to the following proportions
of the bank’s total capital stock and
surplus:— (20-40) per cent on the first $1
million; —(10-20) per cent on amounts be­
tween $1 million and $10 million; and
— (10) per cent on amounts in excess of
$10 million.
Although the maximum credit extension
which could currently result under this plan,
again a reserve-period-average basis, is esti­
mated as approximately— ($2.5-$3.8) bil­
lion, the credit actually extended under the

basic borrowing privilege would almost cer­
tainly be significantly less than this figure.
Because of the diversity of fund flows among
banks and the restriction on frequency of
use discussed above, not all banks should be
expected to be making full use of their basic
borrowing privileges in the same reserve
The initial quantitative limitations sug­
gested above may well need to be adjusted
from time to time as experience with the use
of the basic borrowing privilege develops.
It is not intended, however, that such limi­
tations should be changed so frequently as
to disturb orderly bank planning for the
utilization of such privileges in the course
of reserve adjustment operations.
While temporary adjustment credit under
the basic-borrowing-privilege program is to
be generally available upon request, it is
necessary to impose two specific qualifying
conditions in addition to those general con­
ditions arising from statute. First a bank, to
be entitled to use of its basic borrowing priv­
ilege, must be in satisfactory internal condi­
tion. Otherwise access to discount window
credit will be subject to administrative re­
view. In such cases the Reserve Bank will de­
termine the over-all condition of the bank,
taking into consideration capital adequacy,
soundness of loans, liquidity, and quality of
management. If the Reserve Bank, after tak­
ing into account all these factors, judges
that the bank’s over-all condition is too poor
to warrant access to discount credit without
administrative review, that bank’s basic bor­
rowing privilege will be withdrawn until suf­
ficient improvement is shown in its condi­
tion. During that interval, any adjustment
borrowing which the bank undertakes at the
discount window would be immediately sub­
ject to administrative review. Notification of
such withdrawal would be given in timely



fashion, and in the absence of such direct
notification, a bank would be able to rely on
assured access to discount credit so long as it
stayed within the previously defined limits on
amount and frequency.
The second qualifying condition is an ad­
ministrative rule that a bank borrowing
under its basic borrowing privilege refrain
from simultaneously providing net new
funds to the money market—specifically,
aside from possible infrequent transactions
that result from miscalculations or large,
unforeseen movements in the bank’s posi­
tion, it should not be a net seller of Federal
funds in the same reserve period in which it
is borrowing from a Reserve Bank. This re­
striction, a continuation of a policy already
in force, is retained to preclude a large dayto-day retailing operation in Federal Re­
serve credit obtained through the discount
window. It is recognized that banks could
undertake to accomplish much the same pur­
pose by resort to more indirect means, but
currently the funds market is the only ve­
hicle that can handle extensions of credit
among banks on very short notice near the
ends of reserve periods, when banks would
probably be most interested in doing so. If
obvious practices of circuitous transfers of
credit in evasion of this provision should de­
velop, consideration will be given to broad­
ening and strengthening the scope of the
provision commensurately.
The basic-borrowing-privilege program
is both desirable and practical. Its adoption
would serve as a clear communication to
member banks that the discount window is
changed. The program promises to con­
tribute to more effective relations between
member banks and Federal Reserve Banks
while it improves the efficiency of the fi­
nancial system in general by providing a

ready access to at least a measure of tem­
porary adjustment credit for both large and
small member banks.
B. Other adjustment credit

The basic borrowing privilege described
in the previous section would be the normal
method of extending short-term credit to
member banks, but it is not conceived as
adequate to encompass all of the varying
credit needs of banks which justify the use
of temporary adjustment credit. Experience
has shown that circumstances will arise when
adjustment credit is required in larger
amounts or for longer duration than can be
accommodated under the limits of the basic
borrowing privilege. Such supplemental
credit should also be available on as unam­
biguous terms as possible. This credit, it
should be emphasized, is in addition to and
not in substitution for the other types of
credit described in this paper—namely, the
basic borrowing privilege, the seasonal bor­
rowing privilege, and emergency credit.
Borrowing beyond the privilege limits
would be subject to administrative proce­
dures broadly similar to those which have
been progressively developed in recent years
under existing discount arrangements. These
procedures can be thought of as a sequence
of administrative actions ranging from re­
view, which would include informational
concern as to the nature of the borrowing
bank’s portfolio policies and the sources of
its lendable funds, through conferences, dur­
ing which Reserve Bank officials would con­
sult with the management of the borrowing
bank as it endeavors to develop a solution to
its problems, to actual discipline, when the
bank would be asked to begin paying off its
In any case where a member bank, dur­


ing a consecutive — (12-26)-week period,
has received short-term adjustment credit in
any amount in more than — (6-13) weeks
(that is, when the frequency limitation on
the basic borrowing privilege is exceeded),
the Reserve Bank will appraise the situation,
perhaps in consultation with the bank, and
make a determination as to the appropriate­
ness of continued credit extension to that
bank. This determination will be made in
light of any specific indications that a time­
ly forthcoming paydown of Federal Re­
serve indebtedness will occur by reason of
expected inflows of funds or some other
orderly program of balance sheet adjust­
ment. Even if an extension is deemed justi­
fied by the surrounding circumstances, con­
tinuous review will be maintained through­
out the course of the borrowing. Should the
initial or any subsequent analysis indicate
the absence of circumstances warranting a
continued provision of supplemental credit,
the Reserve Bank will initiate action with a
view toward obtaining an appropriate ad­
justment. The precise timing and nature of
such administrative action will, as now, re­
main at the discretion of the Reserve Bank,
taking into account the circumstances in the
individual case.
In actual fact, the basic-borrowing-privilege limitation on amount may be exceeded
more often than the limitation on frequency.
The former event, like the latter, will call for
an internal review of the case. Such borrow­
ing above base will probably occur from
time to time as a result of bank efforts to
cushion sharp temporary drains, and there­
fore, as now, could usually be expected to be
quickly repaid without any need for Reserve
Bank intervention. However, if the balance
sheet of the bank suggested that factors other
than such temporary drains were responsible
for the borrowing, the Reserve Bank could

undertake administrative actions and, if it
were called for, might request an early ad­
justment by the bank. In all cases, the scope
and thrust of the adjustment required would
be related, as it currently is, to all aspects of
the bank’s position and historical borrowing
record and to the desirability of achieving
an orderly program of realignment of bank
assets and liabilities, with the choice among
alternative adjustment procedures continu­
ing to rest with the bank’s own manage­
As this implies, the fact that a bank ex­
ceeds the amount or frequency limitation of
its basic borrowing privilege does not mean
that it is immediately contacted and asked to
reduce its borrowing but only that it loses
its immunity to such contact and administra­
tive review. In contrast to the arrangements
in some foreign countries, where a line of
credit (similar in principle and design to the
basic borrowing privilege) is designed to
control total use of the discount window, the
proposed redesign includes the borrowing
privilege only as a limited source of reserves,
with supplemental borrowing taking place
from time to time as a normal occurrence,
especially on the part of larger banks. There­
fore, member banks can expect to receive
such discount credit as they have a justifiable
need for, in excess of the specific limits on
the basic borrowing privilege.
An adjustment program compatible with
the bank’s situation will be expected of ev­
ery borrower of supplemental credit, al­
though in the case of clearly short-term and
self-reversing fund flows this may require
little or no overt action on the part of the
borrowing bank. Supplemental adjustment
credit should be thought of as temporary,
and increasingly extended use will result in
an increasing probability that the bank will
be asked to work off its debt to the Federal



Reserve. Discount officials should be con­
tinuously informed and should undertake ad­
ministrative discipline promptly in any situa­
tion where it becomes apparent that a bank
is following the practice of using supple­
mental adjustment credit to finance a short­
term position in money market assets.
The guidelines herein set down for the
administrative control of supplemental ad­
justment credit have been general and may
appear to leave too great latitude for the
exercise of discretion by discount officers.


To articulate any more specific rules or
guidelines in this document is neither prac­
tical nor desirable, however. In the light
of case-by-case decisions that would be
made under the proposed procedures and
subject to the underlying principle of equal
treatment for banks in equal circumstances,
standard operating procedures should de­
velop in all discount offices. The final section
of this report recommends arrangements to
foster effective coordination of these pro­
cedures among all Federal Reserve offices.


A. Needs for seasonal credit assistance

Seasonal fluctuations in loans and/or de­
posits create asset-and-liability-management
problems which many smaller banks seem
unable to accommodate without impairing
in one way or another the quality and ade­
quacy of banking service they offer to their
communities. Such recurring pressures, sim­
ilar in nature and origin and probably to
some extent overlapping the short-term fluc­
tuations already discussed, tend to be the
greatest in smaller communities where the
economy is frequently dominated by agri­
culture or by a single industry of relatively
small units. The consequence of such spe­
cialization is that the economic base in the
communities is not sufficiently diversified to
provide a supply of bank funds with ade­
quate flexibility to meet marked seasonal
changes in loan requirements and deposit
positions. While the correspondent banking
system provides a measure of credit to some
of these communities, most often in the form
of overline arrangements for loans exceeding
the lending limit of the local banks, available
evidence clearly indicates the need for more
and in some cases differently structured
credit to meet adequately the seasonal needs

of the communities. Because of size, struc­
ture, and location, banks in small towns are
often at a relative disadvantage in obtaining
credit from other external sources, such as
the issuance of large-denomination certifi­
cates of deposit or participation in the Euro­
dollar or Federal funds markets.
Regulation A currently provides that dis­
count credit may be extended on a short­
term basis to enable a member bank to ad­
just its asset position in cases of seasonal re­
quirements for credit “beyond those which
can reasonably be met by use of the bank’s
own resources.” This policy, articulated in
the revision of Regulation A in 1955, was
adopted against the background of the
heavily liquid positions of almost all banks
during the earlier postwar years and their
consequent ability to meet most seasonal
drains effectively by selling assets.
With the passage of time, however, the
liquidity positions of banks in many of the
smaller communities described have been
markedly reduced by expanding seasonal
and secular demands for credit on the one
hand and lagging community net income
and deposit growth on the other. Particu­
larly in agricultural areas, where credit


needs have been rising very rapidly, such
trends seem likely to continue, progres­
sively narrowing the ability of the local
banks to meet the short-term credit de­
mands in their communities. Despite these
trends, the discount window has continued
to provide only short-range and varying
credit assistance to member banks experi­
encing seasonal fluctuations.
Under these circumstances, it has be­
come appropriate to modify present season­
al lending practices at the discount window
to provide increased assistance to member
banks in accommodating seasonal demands
upon them. The discount window can per­
form this function better than any other
monetary tool, since only through it can the
Federal Reserve make credit available di­
rectly where and when it is needed.
B. Seasonal borrowing privilege

It is proposed that each Federal Reserve
Bank be authorized to establish a “seasonal
borrowing privilege,” renewable from one
year to the next upon submission of ap­
propriate evidence, for any of its member
banks experiencing a seasonal need for
funds of the kind and dimensions outlined
below. The intent of the arrangement is to
provide reasonably assured credit access to
banks with definable and relatively substan­
tial seasonal pressures for the approximate
duration of such pressures, normally ex­
pected to be several months, but possibly
ranging up to as much as 9 months in excep­
tional cases.
The seasonal borrowing privilege at the
discount window is limited to cases in which
the applicant member bank can demon­
strate a probable recurring increase in its
need for funds, arising from expanding de­
mand for regular customer loans or shrink­
ing deposits, or some combination thereof,

which is expected to continue for a period
of more than 4 weeks and is of sufficient
size to be of significance in the asset and
liability management of the bank. Loan
and deposit fluctuations which are relatively
small or which do not continue for as long
as 4 weeks should be accommodated by in­
ternal bank policies or by recourse to ad­
justment credit assistance from the discount
window and are not deemed to qualify a
bank for special seasonal credit accommo­
dation, despite frequency of occurrence.
The size of a bank’s seasonal need for
funds within any 12 months is to be
measured by comparing the net intrayear
changes in levels of deposits and loans to
customers in the bank’s market area. Since
the minimum time period is fixed at four
consecutive weeks, banks might have the op­
tion of using calendar months or, on a more
refined basis, a 4-week moving average on
which to base the estimate of their seasonal
need. Seasonal estimates would be estab­
lished essentially by projecting past years’
experience, adjusted as appropriate to ex­
clude nonrecurring movements.
In order for the bank to qualify for a sea­
sonal borrowing privilege, its projected sea­
sonal need for funds must exceed — (5-10)
per cent of its average deposits subject to re­
serve requirements during the preceding cal­
endar year. Any part of that need in excess
of this limit is eligible for financing through
the discount window subject to the other
conditions described in this section. Use of
such a “deductible” principle is designed
to encourage individual bank maintenance
of some minimum level of liquidity for pur­
poses of flexibility and also to limit the ag­
gregate total of seasonal borrowing priv­
ileges to an amount consistent with the aims
of over-all monetary management.



Figures in Table 2 suggest the nature of
the calculation of a seasonal credit need.
In this illustration the total swing in net
fund availability is $1.0 million, measured
from the peak of $3.0 million in January,
February, and March to the trough of $2.0
million in July, August, and September. As­
suming an average level of deposits subject
to reserve requirements of $5.0 million in
the preceding calendar year, the swing
clearly exceeds the minimum level of — (5—
10) per cent of such deposits and therefore
qualifies the bank for a seasonal borrowing
privilege. The amount of the seasonal bor­
rowing privilege at its maximum would be
— ($750,000-$500,000). Credit actually
outstanding under the seasonal borrowing
privilege would be expected to follow the
pattern of gradual increase to a peak, fol­
lowed by tapering off, as suggested in the
In the negotiation of a seasonal borrow­
ing privilege, the Reserve Bank must have
in its possession evidence demonstrating
that the applying member bank has a sigTABLE 2

base year deposits


Net fund

3.0^ Peak
2. OfTrough


- .5
- .8
- .8
- 1 .0
- 1 .0
- 1 .0
- .5

nificant seasonal need, what amounts of
credit it expects to need, and the expected
profile and duration of such needs. In many
cases the bulk of this evidence will already
be on file with the Reserve Bank. However,
member banks should submit with their ap­
plication any supplemental evidence they
have at hand, especially with regard to
altered seasonal demands which they have
reason to expect. Such information is needed,
preferably somewhat in advance of the ac­
tual takedown of credit, not only for sched­
uling and maintaining internal review over
the seasonal borrowing but also to enable
the System to conduct open market opera­
tions with some foreknowledge of the ap­
proximate volume and timing of seasonal in­
jections of reserves which are expected to
occur at the discount window. This knowl­
edge will help to minimize the degree of un­
expected fluctuation in borrowing which
could make the achievement of monetary
policy objectives more difficult.
Given a demonstrated seasonal need on
the part of a member bank, the Reserve
Bank will arrange to extend credit in the
amount and for the duration needed (with­
in the limits previously defined). Under cur­
rent law, firm arrangements are limited to
90 days duration (except in the case of dis­
count of eligible agricultural paper, for
which the maximum duration is 9 months).
However, in the event that a member bank’s
seasonal needs persist beyond the 90-day
period, the Reserve Bank will consider
sympathetically requests for further exten­
sions of credit in accordance with the initial
seasonal credit arrangement. In no case,
however, would the duration of all seasonal
borrowings under such an arrangement be
permitted to exceed 9 consecutive months.
Under normal circumstances, the amount


of credit requested in the original arrange­
ment should not be revised in midseason.
The intention is that drawings of the sea­
sonal credit, in accordance with projected
needs, would be relatively firm and not sub­
ject to day-to-day or week-to-week fluctua­
tions because of minor unexpected fund
withdrawals or additions or resort to tem­
porarily cheaper financing elsewhere. How­
ever, it is recognized that many factors of an
unpredictable nature can accentuate or di­
minish the seasonal outflows, and the poten­
tials for change, while probably not great in
the aggregate, are sufficient in the case of the
individual bank to make it impractical to bar
all readjustments in the credit arrangement.
The Reserve Bank will periodically re­
view the performance of the borrowing
member bank, and should this review indi­
cate that the seasonal need is not material­
izing as contemplated in the arrangement
or that the bank is failing to operate in line
with the arrangement in some other way,
these factors would have a definite bearing
on the Reserve Bank’s evaluation of future
applications for seasonal credit accommo­
dation on the part of that bank. However,
the Reserve Bank would also retain the
option to curtail an outstanding seasonal
credit arrangement which proves to be un­


Because blocks of borrowed funds ex­
tended under seasonal credit arrangements
will not be generating pressure on the bor­
rowing banks to adjust assets or other lia­
bilities in order to repay promptly (as do
more conventional borrowings), they will be
supplying reserves but will otherwise be nei­
ther adding to nor subtracting from the bite
of general monetary policy. The reserve sup­
ply from takedowns of seasonal borrowing
privileges can be offset to the extent desired
by open market operations; conversely,
these blocks of seasonal credit should prove
sufficiently immune to any moderate changes
in national reserve availability—particu­
larly if the discount rate is kept reasonably
closely in line with market rates—so as not
to offset the latter changes substantially.
Given the other needs for credit at the
smaller rural banks, for developmental cap­
ital as well as for day-to-day working cap­
ital, the more liberal granting of discount
credit for seasonal purposes is regarded as
one of the more important steps the System
can take in this field. The assurance of ade­
quate seasonal access should help to foster
more definitive asset management by small
banks and can also be expected to assist
various larger banks which may qualify for
seasonal credit accommodation.


In its traditional central banking function,
the Federal Reserve System is the ultimate
source of liquidity to the economy. This
role carries with it the responsibility to deal
with emergency situations as they affect
both member banks and the economy gen­
erally. Severe pressures encountered by
banks and other financial institutions with­
in the past few years, involving increasing
illiquidity and interdependence and inter-

action among such institutions, emphasize
the importance of the Federal Reserve’s role
in emergency situations.
The financial system’s liquidity—excessive
in the late 1940’s, more than ample in the
1950’s, and reasonably adequate at the start
of the 1960’s—has sometimes barely covered
requirements in recent years. The asset struc­
ture of commercial banks and savings in­
stitutions reflects this downward trend, as



do increasingly aggressive efforts on the
part of bank management to manipulate
liabilities in pursuit of liquidity. Wide in­
terest rate fluctuations in recent years at­
test to these factors.
Under present conditions, sophisticated
open market operations enable the System
to head off general liquidity crises, but such
operations are less appropriate when the
System is confronted with serious financial
strains among individual firms or special­
ized groups of institutions. At times such
pressures may be inherent in the nature of
monetary restraint, in the sense that mon­
etary policy actions, no matter how imper­
sonally applied, often have, in fact, exces­
sively harsh impacts on particular sectors
of the economy. At other times underlying
economic conditions may change in unfore­
seen ways, to the detriment of a particular
financial substructure. And, of course, the
possibility of local calamities or manage­
ment failure affecting individual institutions
or small groups of institutions is ever-pres­
ent. It is in connection with these limited
crises that the discount window can play
an effective role as “lender of last resort.”
This responsibility is not construed as
placing the Federal Reserve in the position
of maintaining the financial structure in
statu quo. The System should not act to
prevent losses and impairment of capital of
particular financial institutions. If pres­
sures develop against and impair the profit­
ability of institutions whose operations have
become unstable, inappropriate to changing
economic conditions, or competitively dis­
advantaged in the marketplace, it is not the
Federal Reserve’s responsibility to use its
broad monetary powers in a bail-out opera­
tion. Except in the case of member banks,
where its responsibilities are somewhat more
direct, the System should intervene in its
capacity as “lender of last resort” only when

liquidity pressures threaten to engulf whole
classes of financial institutions whose struc­
tures are sound and whose operational im­
pairment would be seriously disruptive to
the economy.
A. Emergency lending to member banks

The Federal Reserve System has a clear
responsibility to lend to member banks in
both isolated and widespread emergency
situations. It is expected that such assist­
ance would often have beneficial effects for
the economy as a whole, but in such cases
the immediate responsibility of the System
is directly to the member bank. This is one
of the benefits of Federal Reserve member­
ship—paid for in a sense by the mainte­
nance of nonearning assets in satisfaction of
reserve requirements—and a basic source of
confidence in the banking system.
Therefore, the Federal Reserve will be
prepared to give prompt and sympathetic
consideration to providing the needed credit
assistance to a troubled member bank, after
having obtained the assurance of the charter­
ing authority that the bank is solvent and
that steps are being taken to find a solution
to its problems. Emergency credit assistance
through the discount window should be pro­
vided to member banks under essentially the
same procedures as those employed in the
case of short-term adjustment credit (in ex­
cess of the basic borrowing privilege). How­
ever, ad hoc exceptions or alterations in
these arrangements—within statutory limi­
tations—will at times be required to deal
effectively with emergency situations.
Any member bank borrowing in an emer­
gency situation will be under extensive ad­
ministrative review. This review will include
a program of coordination with the rele­
vant supervisory and chartering authorities
and will ordinarily take the form of coun­
seling and such other direction as is needed


to work out of the situation. Administrative
discipline may have to be applied in the case
of an emergency caused by mismanage­
ment or dishonesty (at least until the of­
fending management is removed), but Fed­
eral Reserve efforts in an emergency situ­
ation would normally be geared to less dras­
tic means of helping the member bank to
reestablish a viable position. This will, in
most cases, require credit for longer than
would be permissible under the ordinary
administration of temporary credit provi­
sion, but this will be expected and regarded
as appropriate.
B. The System as ‘‘lender of last resort” to
the economy through nonmember institutions

The role of the Federal Reserve as the
“lender of last resort” to other financial sec­
tors of the economy may, under justifiable
circumstances, require loans to institutions
other than member banks. The apparent
general approval of recent instances of lend­
ing and offering to lend to nonmember in­
stitutions has strengthened the belief that the
System’s ability to carry out this function
should be readily available for use when
needed. In contrast to the case of member
banks, however, justification for Federal
Reserve assistance to nonmember institu­
tions must be in terms of the probable im­
pact of failure on the economy’s financial
structure. It would be most unusual for the
failure of a single institution or small group
of institutions to have such significant re­
percussions as to justify Federal Reserve ac­
The Federal Reserve Act places no ex­
plicit limitations on the types of institutions
eligible for direct emergency credit assist-

ance, since it authorizes direct advances to
“any individual, partnership, or corpora­
tion”; but in fact, rather stringent limita­
tions are imposed by the requirement that
these advances be secured by “direct obli­
gations of the United States.” 3 In effect this
means that, in an emergency, credit in any
significant amount could probably be ex­
tended to nonmember, at least nonbank,
institutions only by using a member bank
as a conduit. That is, the Federal Reserve
would lend funds to cooperating member
banks that would in turn make loans to
nonmember institutions. The relevant Fed­
eral agency can also sometimes serve in
the role of a conduit, so long as that agency
has lending authority and assets eligible for
Federal Reserve acquisition. Thus the cur­
rent law is not prohibitive of indirect lend­
ing to nonbank institutions, although it does
involve additional arrangements and costs
over those that would be involved in direct
Decisions as to what types of institutions
will be regarded, under justifiable circum­
stances, as eligible for emergency credit are
best made in the light of the surrounding cir­
cumstances and relative severity of particu­
lar situations. Therefore, no inclusive or ex­
clusive list of the types of institutions to
which emergency credit may be extended
should be established in advance of antici­
pated possible developments. Federal Re­
serve credit would be advanced to nonmem­
ber institutions only after other avenues of
relief have been exhausted. Depositary insti­
tutions, the suppliers and holders of the na­

3In unusual and exigent circumstances the Board
of Governors, by the affirmative vote of at least five
members, may authorize any Federal Reserve Bank
to discount eligible paper for any individual, partner­
2 An exception might be made in a case where the ship, or corporation which is unable to obtain ade­
quate credit accommodation from other banking
Federal Deposit Insurance Corporation requested
institutions. However, in practice this provision is of
Federal Reserve assistance for a nonmember com­
little use, since nonmember institutions typically have
mercial bank while the FDIC carried out a program
only very limited holdings of eligible paper.
to remedy the situation.


tion’s liquidity, are the most likely to en­
counter situations where this is necessary,
and for this reason emergency credit would
be accorded, in all but the most extraordi­
nary circumstances, only to those institutions.
Supervised nonmember financial institu­
tions would be required to obtain the sup­
port and assent of the relevant supervisory
agency to receive Federal Reserve emer­
gency credit. On the other hand, the Fed­
eral Reserve should not be obligated to lend
to nonmembers merely on the request of
their supervisor. While institutions can be
declared insolvent only by the chartering
authority or the courts (and such a declara­
tion would effectively preclude Federal Re­
serve lending), the System should retain the
option to reject requests for assistance even
when the other agency considers the institu­
tions solvent.
When lending to nonmembers, the Sys­
tem will require, in cooperation with the
relevant supervisory agency, that the institu­
tions develop and pursue a workable pro­
gram for alleviating their difficulties and will
follow the progress of the agreed-upon pro­
gram closely. Credit will be provided only at
a significant penalty rate vis-a-vis that
charged member banks. This penalty rate
can be thought of as offsetting, in part, the



cost of maintaining reserves with the System
which is continuously borne by member
C. Support of distressed markets through
the discount window

It is possible that, in periods of severe mon­
etary stringency, markets for certain finan­
cial instruments, such as Federal, State, and
local government securities, corporate se­
curities, and mortgages, may become so dis­
tressed by disappearance of buyer interest,
necessitous selling or “dumping” of issues,
or other influences that a crisis develops
which threatens the entire financial fabric
of the nation. Under such circumstances,
the Federal Reserve will be prepared to take
action in a variety of ways to forestall the
developing crisis.
Action through the Open Market Ac­
count, where possible, is the appropriate
means for dealing with such a widespread
problem. However, in a situation of extreme
emergency, consideration would be given
to making the discount window available to
member banks (and, more remotely, to
nonmember financial institutions) in order
to reduce necessitous sales of these assets
and thus to alleviate crisis pressures in the


The proposed redesign of the discount win­
dow contemplates an increase in the num­
bers of banks regarding the window as a
useful source of funds. One of the major
obstacles acknowledged to exist currently
in this area is the confusion on the part
of member banks as to the terms and
conditions for discounting. The redesign
should substantially reduce banker uncer­
tainty by the specific quantity-and-frequency

limitations regulating the basic borrowing
privilege. But the discount rate also has a
significant role to play in this operation if
the mechanism is to result in an improved
adjustment process.
Achieving maximum effectiveness calls
for maintenance of the discount rate con­
sistently at a level reasonably close to rates
on alternative instruments of reserve adjust­
ment. The exact relationship to market rates


at any time will depend largely on current
monetary conditions and policy objectives,
but it would be expected that related market
rates would move higher relative to the dis­
count rate in periods of restraint and lower
relative to the discount rate during periods
of ease.
The closer linkage of the discount rate to
market rates will probably call for more
frequent changes in the discount rate than
have been made in recent years. It is be­
lieved that such changes can be achieved by
more active communication within the Sys­
tem and will become easier as the pattern
of more frequent discount rate adjustments
tends to reduce the unpredictable announce­
ment effects which often attach to a given
rate change. As banks come to regard the
window as a more liberal and useful source
of funds, with no risk of administrative pres­
sures within the confines of the basic borrow­
ing privilege and a clearer understanding of
the limitations attaching to other borrowing,
price will naturally become a more meaning­
ful factor in their decisions. Thus rates on
alternative means of adjustment will tend to
cluster somewhat more closely around the
discount rate. Because a measure of adminis­
trative review will continue to attach to some
discounting, however, market rates are likely
to be somewhat above the discount rate so
long as reserves are in scarce supply and rate
relationships are allowed to seek their own
There are several limitations on using
rate as the sole or even major instrument
for control of borrowing. Complete rate flex­
ibility is neither practical nor desirable. Un­
der certain circumstances, too frequent or
poorly timed changes could contribute to
instability in the structure of market rates.
This could be particularly true in a period of
tightness when increasing reserve cost could
rapidly escalate market rates.

Because of the Federal Reserve’s role as
the lender of last resort, the demand curve
which it faces may be somewhat different
from that applying to other lenders. Ordi­
narily, this difference should not be very sig­
nificant, but during periods of stringency the
demand for accommodations from the Sys­
tem could conceivably become highly inelas­
tic, particularly in the very short run when
banks may face liquidity or credit demands
(including those from long-valued custom­
ers) without having immediate access to
adequate alternative sources of funds. In
such instances, the exclusive use of price as
the allocator of funds at the discount window
could be severely damaging to the long-run
stability of financial institutions.
There may also be occasions when re­
lationships between U.S. rates and those
abroad, or between bank and market rates
or those being paid at other financial institu­
tions, are so delicately poised that Federal
Reserve discount rate changes may have to
be withheld in order to avoid triggering
highly disadvantageous flows of funds. At
such times, the overriding importance of
other relevant national interests involved
may compel the discount mechanism to op­
erate with greater reliance upon its quantita­
tive and administrative controls and less
upon the impersonal criterion of rate.
These limitations should not, however, be
thought to deprecate the role which the dis­
count rate can play under normal circum­
stances; usually rate can serve as a pervasive,
sensitive, clearly uniform, and flexible con­
trol mechanism. But the limitations men­
tioned demonstrate the impracticality of ex­
clusive reliance on rate. Other controls
—quantity and frequency limitations and,
when necessary, administrative actions—
must be not only available but also in use if
the System is to be sure that discounting



operations do not subvert monetary control
Under the present Regulation A, with the
great bulk of Federal Reserve loans carrying
maturities of 15 days or less, few problems
arise with regard to outstanding loans when
the discount rate is changed. The circum­
stances would become somewhat different,
however, if a seasonal loan were to be out­
standing for as long as 9 months. As an in­
tegral part of the proposal for redesign,
therefore, it is recommended that all dis­
count rate changes be made immediately
applicable to all outstanding loans. The sug­
gested provision would eliminate the tend­
ency for banks to overestimate their sea­
sonal needs in order to “lock in” credit in
anticipation of an expected rate increase.
The automatic rate adjustment would also
be helpful in achieving the objectives of mon­
etary policy, since it would avoid allowing
relatively long-term loans to remain out­
standing at the earlier rate, thereby increas­
ing the lag in the impact of a policy-motivated rate change. Lastly, without this type
of built-in adjustment, banks whose borrow­
ing begins shortly before a rate decrease
would be unfairly penalized or would be
forced to go through the administratively
burdensome procedure of repaying their
loans and reborrowing at the lower rate.
Discount rates will continue to be es­
tablished by the Boards of Directors of the


Reserve Banks, subject to review and deter­
mination by the Board of Governors. This
method of rate-setting carries with it the
possibility of short-term inter-district differ­
ences in the discount rate. Such short-term
differences are not viewed as a problem, and
the proposed redesign contains no special
provisions to prevent them, mainly be­
cause the machinery for achieving uniform­
ity, through use of the requirement of ap­
proval by the Board of Governors, is avail­
able in the event that it is needed. In any
case, it is probably somewhat unrealistic to
contemplate the maintenance of wide inter­
district rate differentials over any period of
time in the highly interdependent economy
of the Nation.
As noted in Section V, emergency credit
to the economy through nonmember institu­
tions should be provided only at a significant
penalty relative to the discount rate. While
the responsibility of the Federal Reserve to
provide lender-of-last-resort credit to the
economy through these institutions is gen­
erally recognized, it remains true that the
benefits of membership in the System must
be maintained and member banks should
therefore receive some measure of prefer­
ential treatment. This penalty rate might be
thought of as offsetting in part the cost of
maintaining reserves with the System, which
is continuously borne by member banks.


A. Provisions for coordination of
discount administration

The increased reliance on the discount rate
and on quantity and frequency limitations to
regulate borrowing behavior, which consti­
tutes an essential part of the redesign of the
discount mechanism, will permit a clear and
unequivocal communication of these facets

of discounting standards and limitations to
member banks and will thereby help to pro­
mote uniformity of window operation among
districts and among banks. However, the re­
tention of a measure of administrative con­
trol is seen as necessary if the System is to
accommodate adequately the widely differ­
ing needs of individual member banks while


at the same time maintaining the necessary
monetary control. It is intended that such
administrative control be applied in the most
uniform and consistent manner possible in
line with the principle of equal treatment for
banks in equal circumstances. Regulation
and machinery to help insure this objective
are therefore regarded as appropriate.
One effective move in this direction will
be the formalization of a practice already
in existence. Recent years have seen a sig­
nificant increase in the level and frequency
of communication among the discount offi­
cers of the 12 Reserve Banks. These offi­
cials now hold an annual conference and
monthly telephone conference calls in addi­
tion to the more informal contacts among
individual districts.
These discussions are devoted in large
part to the exchange of information on the
ways in which individual borrowing cases
are being handled. Out of this exchange
administrative guidelines have been develop­
ing which can be referred to by discount
officers faced with a new or unusual situa­
tion. This development is seen as an evolu­
tionary process, with the character of the
guidelines expected to change somewhat
over time in line with experience and
changes in the surrounding economic cli­
mate. However, the need for machinery for
fostering the development of such guidelines
and maintaining them (that is, currently
existing and perhaps stepped-up contacts
among all discount officers) is recognized,
and such further arrangements as are felt
necessary will be implemented as part of the
redesigned discount window.
B. Changes in reserve regulations to
facilitate end-of-period reserve adjustment

The Steering Committee endorsed the lagged
reserve proposal adopted by the Board

of Governors as an amendment to Regu­
lation D. Under this plan, which will become
effective September 12, 1968, all member
banks have a 1-week reserve accounting
period with required reserves based upon
deposits 2 weeks earlier. Vault cash to be
counted as reserves is also lagged 2 weeks.
Banks are permitted to carry forward to the
next reserve period excess reserves or reserve
deficiencies of up to 2 per cent of required
reserves. This plan, including a number
of other less significant changes, should ease
adjustment problems at the end of reserve
periods and is a move complementary to
the redesign of the discount mechanism fos­
tering a smoother and more effectively func­
tioning member banking system.
C. On-going studies of means of improving
the shiftability of bank assets and liabilities

A possible type of credit accommodation
not provided for in the redesigned window
is long-term credit to meet the needs of
banks servicing perennial credit-deficit areas
or sectors. It was concluded that the solution
to this problem does not properly lie within
the scope of discount-window operations. To
undertake to provide credit for such a pur­
pose would enmesh the System in socio­
economic and political problems beyond its
proper scope and could distort the balance
sheet structure of commercial banking in
some communities by financing the expan­
sion of loan portfolios far beyond the limits
of deposits. More direct and fundamental
answers to the credit-deficit problem are be­
lieved to lie in the improvement of secondary
markets for bank assets and liabilities.
The Steering Committee therefore recom­
mends that ad hoc task forces be established
within the Federal Reserve System—possibly
also drawing on the talents of other agencies


and groups—to pursue detailed studies of
the feasibility of providing long-term credit
assistance through some types of marketperfecting actions. It is recognized that ex­
tensive work has already been done in this
area, with only limited success, but the Steer­
ing Committee nonetheless regards improve­
ment of secondary markets as the most
promising solution to the credit-deficit prob­
lem and feels that further investigation can
be fruitful.
These studies will have to recognize and
evaluate the possibility that the develop­
ment and expansion of such markets may
in itself impose further responsibilities on


the Federal Reserve System in periods of
extreme monetary stringency. As banks are
led to concentrate an increasing portion of
their adjustment efforts in these markets, the
possibilities will increase that conditions in
one or more of them could become so dis­
rupted that it would become necessary to
take action to forestall the developing crisis.
Such action could include making the dis­
count window available to banks to reduce
necessitous sales of these assets, thus alleviat­
ing crisis pressures in such markets. Further
consideration of this possibility is contained
in Section V, “Emergency Credit Assist­


Bernard Shull
Board of Governors of the Federal Reserve System



Evolution of the Current Discount Mechanism_______________________________33
A. Reluctance to borrow as a rationale for
rationing credit
B. Development of concept of appropriate borrowing
C. Activity at the discount window in the 1920’s
D. The “ failures” of the 1920's
III. The Current Discount Mechanism________________________________________ 38
A. The 1955 revision of Regulation A
B. Reliance on the tradition against borrowing
C. Operations since 1955
D. Comparison with foreign experience
IV. Relevant Characteristics of the Financial Environment--------------------------------------- 49
A. Bank motivation
B. The bank adjustment problem
V. Activity at the Discount Window since 1955________________________________ 65
VI. Related System Policies and Alternative Formulations
of the Discount Mechanism__________________________________________ 69
A. The discount mechanism and bank supervision
B. Discount mechanism problems and monetary control
C. Discount study research and well-known proposals
for change in the discount mechanism
VII. Concluding Remarks_________________________________________________ 73
Appendix A. Federal Reserve System Manuscripts and Documents Cited--------------------- 75
1. Member banks borrowing continuously for a year or more
from Reserve Banks------------------------------------------------------------------------------------------ 34
2. Member banks borrowing at Federal Reserve Banks,
1915-35______________________________________________________________________ 38
3. Borrowers and “ counseled” borrowers in five Federal Re­
serve districts, 1965 and 1966_________________________________________________ 43

Contents Cont.

4. Frequency of large relative outflows: Percentage of banks
with fund outflows of 10 per cent or more of net deposits,
by size of bank______________________________________
5. Origin of fund flows: Distribution of member banks and
their net fund flows, by change in IPC deposits and in
6. Total gross fund outflow, by relative outflow at bank____
7. Ratio of bank holdings of U.S. Government securities to
net deposits: Percentage change, June 1961-June 1965
8. Member bank borrowing on eligible paper______________
9. Types of credit available from correspondent banks, 1963
10. Use of correspondent credit by insured commercial banks,
11. Member bank participation in the Federal funds market,
1966: Banks with less than $10 million in deposits______
12. Influence of trend and other factors on ratio of borrowing
to required reserves--------------------------------------------------13. Ratio of member bank borrowing to required reserves:
Federal Reserve Banks compared with all sources_______
14. Percentage change in proportion of country bank borrow­
ing from the Federal Reserve and from all sources, se­
lected periods_______________________________________



1. Discounts and Advances Relative to Total Federal Reserve
Credit and Required Reserves________________________
2. Member Bank Borrowing at Federal Reserve: Ratio of
number of borrowers to all member banks_____________
3. Country Bank Borrowing: Proportion borrowing from Fed­
eral Reserve and others______________________________
4. Member Bank Borrowing at the Discount Window_______






The research effort of the discount study got
under way in the late summer of 1965. The
Steering Committee, under whose guidance
the research program was developed, stated
two related objectives at its first meeting on
August 10 of that year. The first was “to
review operational shortcomings of the
discount function,” with a view to develop­
ing “potential reforms within the scope of
contemporary discount philosophy as to rate
and administrative control.” To this end
the discount study Secretariat was instructed
to develop a plan aimed at throwing “addi­
tional light on the economic, attitudinal and
other factors influencing differing use of
the discount window among districts and by
banks” and to survey “Reserve Bank dis­
count experience.” The second objective was
to reappraise the “discount function as an
instrument of System policy” and to evaluate
“alternative formulations.” This second ob­
jective was considered to require an ex­
tended study, including investigation of the
N o t e .— The author wishes to
acknowledge the
helpful comments of Robert C. Holland, Robert
Lawrence, Emanuel Melichar, and James Pierce of the
Board of Governors, George Garvy of the Federal
Reserve Bank of New York, Lester V. Chandler of
Princeton University, and Ralph A. Young, formerly
Senior Adviser to the Board. He has benefited substan­
tially from continuing discussion, over a period of sev­
eral years, with numerous Reserve Bank officials asso­
ciated with discount operations, and wishes to note, in
particular, the extended colloquy with Harold Bilby
of the Federal Reserve Bank of New York and David
Melnicoff of the Federal Reserve Bank of Phila­
delphia. It should not be inferred that any or all of
those mentioned fully agree with all the views ex­
pressed. This report is republished here as it was ini­
tially prepared for the Steering Committee and pub­
lished in August 1968.

changing problems of banks in different
geographic areas and an analysis of foreign
experience, with a view toward recommend­
ing fundamental changes in current philos­
ophy and practices.
The two objectives were initially kept
separate and, in fact, certain minor recom­
mendations for revision pursuant to the first
objective were made early in the course of
the study.1 However, the research under­
taken for both purposes has, in practice,
blended into a reasonably unified program
aimed at providing information on the
operations of the mechanism by which credit
is provided to member banks through ad­
vances and discounts (hereafter referred to
as the discount mechanism) and on pro­
posals for change. The research program,
which was developed in the last half of
1965, came to fruition in a series of papers
and reports submitted for the most part in
late 1966 and in 1967.2 These papers were
i In particular, recommendations were made with
respect to changes in the maturity and negotiability
requirements of Regulation A. A questionnaire was
sent to the Reserve Banks regarding their discount
operations to meet the Committee’s first objective, but
as described below, it proved to be of substantial value
in meeting the second.
2 Citation of these papers (some unpublished) is by
author, title, and the general reference: “(Discount
Study).” References are to the documents and manu­
scripts that were available when this Report was pre­
pared. Some have undergone substantial editorial re­
vision, including changes in authorship and title.
Results of other staff studies are also presented in the
text, and staff members responsible are indicated in
footnotes. Complete citation of published material is
provided in footnotes. A bibliography of discount
study papers cited in the text and of related unpub­
lished Federal Reserve System documents is provided
in Appendix A.


made throughout to specific papers and
other staff studies. In addition, reference is
made from time to time to the other pub­
lished and unpublished literature on the
issues raised by the study. Several investi­
gations made by the author, not incor­
porated into specific papers, are also dis­
cussed where relevant. It will be observed
that, in a number of cases, gaps in informa­
tion preclude definitive answers, and results
are presented as suggestive rather than con­
In reviewing the research, certain limita­
tions in scope should be noted. First, there
has not been a full evaluation of the relative
roles of open market operations and the
discount mechanism as “tools of monetary
policy.” It became clear early in the study
that there would be no pressing need for this.
While some aspects of open market opera­
tions have been considered, and some de­
ficiencies in supplying reserves through open
market operations are noted below, there
did not seem to be any persuasive reason to
contemplate a drastic change in relative roles
such as took place in the 1930’s and there­
Secondly, a systematic evaluation of
monetary policy, in its theoretical approach
and practical implementation, was not at­
tempted. It was considered important, of
course, to review aggregate borrowing and
the free-reserve variant as measures of mone­
tary restraint and as targets for policy, par­
ticularly in light of some of the findings
reported below. However, for the most part,
3 In addition, Professor Lester V. Chandler, of the discount mechanism was evaluated
Princeton University, was employed as an academic
within the framework of monetary policy
consultant; he helped maintain a liaison with scholarly
effort, which included the holding of a seminar at­
as it currently exists. Recommendations for
tended by a number of prominent contributors to

prepared, for the most part, by the staffs of
the Reserve Banks and the Board, but sev­
eral were undertaken by academic econo­
Over-all, the reappraisal has concentrated
on the current rationale of the discount
mechanism, its operations since the last re­
vision of Regulation A in 1955, and its
effectiveness in serving several types of pur­
poses. These include not only purposes re­
lating to monetary policy but also those
relating to bank supervision and the pro­
vision of credit to individual banks for
adjustment to short-term fluctuations in
reserves. Considerable time and attention
has been given to the development and
evaluation of proposals that could meet de­
ficiencies uncovered. In addition, there has
been a reconsideration and clarification of
the function of the discount mechanism in
providing credit to member banks and other
financial institutions under certain specified
conditions, for example, in emergencies.
The aim of this report is to provide, in
light of the issues of concern, a review and
an evaluation of the research undertaken in
connection with the Federal Reserve Sys­
tem’s reappraisal of its discount mechanism,
and, in particular, to indicate the findings
that have important implications for change
in the mechanism. The nature of the report
is such that a considerable amount of “sift­
ing and winnowing” of the available research
papers has been necessary. Reference is

academic discussion on monetary policy and the dis­
count mechanism. See Priscilla Ormsby, “Summary
of Issues Raised at the Academic Seminar on Changes
in the Discount Window” (Discount Study); and re­
plies from economists to letter from Lester V. Chan­
dler, Spring 1966, “The Federal Reserve Discount
Mechanism and Discount Policies” (Discount Study).

4 In addition, a joint Treasury-Federal Reserve Sys­
tem study of the U.S. Government securities market
began in early 1966. See Board of Governors of the
Federal Reserve System, Fifty-second A nnual Report:
Covering operations fo r the year 1965, p. 217.


change were clearly seen as having impor­
tant implications for monetary policy; and
these implications have been under continu­
ing study.
Finally, it should be noted that no effort
is made in this paper to review in detail the
relationships between the research findings
and the recommendations that have been


developed by the principal committees on
specific aspects of the discount mechanism.
Full evaluation of current policies, judg­
ments as to prospective conditions, and
broader socioeconomic considerations, as
well as the research findings underlying such
recommendations, are developed in the
separate reports of the committees.


The current formulation of the discount
mechanism developed out of a study by the
Federal Reserve System in 1953-54.1 The
principal proposals of the System Commit­
tee on the Discount and Discount Rate
Mechanism were adopted and implemented
in 1955 by a revision of Regulation A .2
However, the rationale of the 1955 revision,
as well as the administrative techniques
adopted, developed out of some of the ear­
liest System experiences. So, for example,
it was noted soon after the revision of 1955
that “the central bank turned back to old
ways of doing things.” 3 In form, this was
true; but in substance, as will be discussed
below, the statement requires modification.
The following review and analysis of the
early development of the discount mech­
anism is meant to provide some perspective
in considering its more recent changes and


Reluctance to borrow as a rationale for
rationing credit

Transformation of the discount mechanism
from the principal instrument of central
System Committee on the Discount and Discount
Rate Mechanism, “Report on the Discount Mecha­
nism,” Mar. 12, 1954 (hereinafter referred to as “Re­
port on Discount Mechanism, 1954”).
2Federal Reserve Bulletin, January 1955, pp. 8, 9.
3Edward C. Simmons, “A Note on the Revival of
Federal Reserve Discount Policy,” The Journal of
Finance, December 1956, p. 415.

bank policy to a coordinate, though seem­
ingly unimportant, tool is a matter of con­
tinuing historical interest.4 This transfor­
mation has been closely associated with the
concept of “reluctance to borrow” as a ra­
tionale for restricting credit flows at the dis­
count window.
Development of coordinated open market
operations in the early 1920’s, and recog­
nition that the “real bills” doctrine was not
a realistic standard for extending credit, ne­
cessitated a reconsideration of the basis for
Reserve Bank credit extension. With com­
mercial banks engaged in a wide variety of
lending functions, eligibility and associated
statutory requirements were inadequate.5
Rationing credit by means of differential
discount rates was evidently viewed as a
potentially effective device in the early
1920’s. But short-lived and misconceived
experiments with rate control and credit
lines quickly disabused the Reserve Banks
4See, for example, A. James Meigs, Free R eserves
(University of Chicago Press,
1962), chapter II; Milton Friedman and Anna
Jacobson Schwartz, A M on etary H istory o f the U nited
States, 1867-1960 (Princeton University Press, 1963),
chapters 5, 6; and Karl Brunner and Allan H. Meltzer, The Federal R eserve’s A ttach m en t to the Free
R eserve Concept, Committee on Banking and Cur­
rency (U.S. Government Printing Office, May 7,
1964), pp. 2-17.
5As distinct from eligibility requirements, there
were attempts in the 1920’s to limit discount credit by
requiring additions to collateral. Clay J. Anderson,
“Evolution of the Role and the Functioning of the Dis­
count Mechanism” (Discount Study).
and the M on ey Supply


that attempted to use them and, it would
seem, the System in general. Hardships
worked by progressive rate formulas on
banks with persistent outflows of funds
proved to be long-remembered experiences.6
A reluctance to be in debt continuously
had evidently been a periodic characteristic
of the commercial banking system during
the preceding decades.7 A System policy was
developed that built upon this characteristic
by maintaining that it was also not tradi­
tional for the central bank to lend continu­
ously.8 Restricting Reserve Bank credit in
this way was, to some degree, successful in
the 1920’s and “helped to make open market
operations rather than rediscounting the
main instrument for quantitative control.” 0
Emphasis on reluctance may be looked
at as a substitute for rationing and distrib­
uting credit by means of the discount rate
or by requirements related to eligible col­
lateral.10 It involved an attempt at persua­
sion by the Federal Reserve as to the degree
of credit restraint at the discount window
that is desirable in light of “sound” commer­
c Three of the four Reserve Banks that established
progressive rates based them on credit lines tied to
the amount of reserves deposited by each bank at the
Reserve Bank. As reserve balances fell, the credit line
contracted and the rate on borrowing could increase
to very high levels. A highly publicized case involved
a rate of 87.5 per cent. Ibid.
7Riefler has noted that “long before the establish­
ment of the reserve system, it was one of the funda­
mental traditions of sound banking practice in this
country, that a bank’s operations should be confined
to the resources which it derived from its stockholders
and depositors, and interbank borrowing was at all
times limited. When it did occur, it was viewed with
such distrust as an evidence of weakness, or at the
least of unsound practice, that various subterfuges
were developed by banks to conceal borrowing in
their published statements.” Winfield Riefler, M on ey
R ates and M on ey M a rk ets in the U n ited States (Har­
per and Bros., 1930), pp. 29, 30. However, such re­
luctance as did exist appears to have weakened con­
siderably from time to time, for example, after World
War I. See Friedman and Schwartz, op. cit., p. 268.
8 See T hirteenth A nn ual R e p o rt o f the Federal R e ­
serve Board: C overin g operation s fo r the yea r 1926;
Riefler, op. cit., p. 29.
9Friedman and Schwartz, op. cit., p. 269.

1 A fuller analysis of “reluctance to borrow,”
viewed in this way, is presented below in Section III.

cial bank operations and effective central
bank policy. Because the desired objective
was a consensus or agreement on these mat­
ters, the approach taken may conveniently
be called “the reluctance convention.” 11
Supporting bank reluctance to borrow
was consistent with both monetary manage­
ment and supervisory objectives. As well
as facilitating the adoption of the “reserve
position” approach to the implementation
of monetary policy,12 “ (i)t established rela­
tions between member banks and Reserve
Banks that facilitated attempts at qualita­
tive control, for example, over the stock
market in 1929”.13 More generally, it pro­
vided a heuristic standard for bank super­
The significance of this standard for bank
supervision was clarified in a series of events
As of—


1925-August 31................... ....................... 593
December 31.............. ....................... 517
1926-December 31.............. ....................... 457
1927-December 31.............. ....................... 303
S o u r c e .—Board of Governors, Federal Reserve System, internal
memoranda on banks that borrowed continuously from Reserve
Banks in 1925, 1926, and 1927.

1 See J. M. Keynes, A T reatise on M o n e y , (Mac­
Millan and Co., London, 1930), vol. 2, p. 239.
Keynes wrote “(t)he history of the Federal Reserve
System since the war has been, first of all, a great
abuse of the latitude thus accorded to the Member
Banks . . . and subsequently a series of efforts by the
Reserve authorities to invent gadgets and conventions
which shall give them a power, more nearly similar to
that which the Bank of England has, without any overt
alteration of the law.”
1 Tenth A nn ual R e p o rt o f Federal R eserve B oard:
C overing operation s fo r the year 1923, pp. 13-16;
Meigs, loc. cit.
1 Friedman and Schwartz, op. cit., p. 269.

1 A discussion of such standards may be found in
Kalman J. Cohen and Frederick S. Hammer, “Linear
Programming and Optimal Bank Asset Management
Decisions,” The Journal o f Finance, May 1967, pp.



beginning in 1925. In that year data were
collected by the Board on the number of
member banks indebted continuously for at
least a year.15 It was found that as of Aug­
ust 31, 1925, 588 member banks had been
borrowing for a year or more from Federal
Reserve Banks.10 Of the 588 continuous bor­
rowers, 239 had been borrowing since 1920;
and 122 had begun borrowing before that.
It was also found that about 150 of the con­
tinuous borrowers were then in an “over­
extended” position.17
In a review of these data, it was noted
that 259 national member banks had failed
since 1920, and a guess was made that at
least 80 per cent had been habitual bor­
rowers prior to their failure.18 In what was
to become an accepted position within the
System, it was stated that . . in borrowing,
. . . the bank uses the best assets it has and
puts him, the depositor, in a less satisfactory
1 The data were requested in a letter from Walter
L. Eddy, Secretary to the Federal Reserve Board, to
all Federal Reserve Agents, dated Sept. 15, 1925.
1 See Table 1. The figure of 593, shown in Table 1,
is a subsequent revision.
1 Overextended banks were defined as “those re­
ported in statement accompanying request for author­
ity to close books of Federal Reserve banks on De­
cember 31, 1925, as having been in an over-extended
condition on November 1.” The data were attached
to a memorandum from Mr. Smead to Mr. Eddy en­
titled “Banks borrowing from the Federal Reserve
Banks continuously for the year ending August 31,
1925,” Jan. 22, 1926.
1 Statement of O. M. W. Sprague, Minutes of Joint
Conference of the Federal Reserve Board with the
Governors and Chairman and Federal Reserve Agents
of the Federal Reserve Banks, Nov. 4-5, 1925, pp.
75ff. The minutes report that Professor Sprague,
who was serving as a consultant to the Board, indi­
cated 888 member banks borrowing continuously, but
in light of the original reports in the records this
must be an error. Sprague severely criticized “ha­
bitual” borrowing, noting that neither eligibility nor
discount rates were “effective agencies for preventing
banks from becoming over extended. . . .” See also the
letter written by John Perrin to the Federal Reserve
Board on “Destructive Effect of Over-Lending to Mem­
ber Banks,” Feb. 26, 1926. It is well to note, how­
ever, that the causal relationship between “overbor­
rowing” and banks getting into difficulty cannot be
viewed as one way. Clearly a bank may borrow large
amounts for long periods because it is in difficulty for
independent reasons, for example, because it has made
bad loans.

position with regard to the additional assets
of the bank, because those rediscounts are
not of as high a quality as the paper which
the bank hypothecates.” 10 Consequently, the
Reserve Bank should carefully investigate
the conditions and behavior of the borrow­
ing bank in order to protect its depositors.20
In subsequent years, additional surveys
of a similar nature were made. In each, the
number of continuous borrowers in an “ex­
tended or unsafe condition” and the number
“likely to liquidate borrowing” during the
coming year were indicated. In addition,
data were gathered on the number of con­
tinuously borrowing banks reported in the
previous survey that had since gone out of
Emphasis on reluctance also reflected a
concern about an “equitable” distribution
of reserves provided by the System. Exces­
sive borrowing by some member banks was
viewed as unfair to other member banks in
that the total pool of reserves was, at the
time, considered limited.2

Development of concept of appropriate

The movement away from rationing credit
by eligibility requirements to rationing by
the “reluctance convention” was accom­
panied by the development of a set of rules
for administering the discount window.23 A
basis for the “surveillance” of borrowing
banks had been established in the early
1920’s. The Board’s Annual Report for
1 Sprague, Minutes of Joint Conference, op. cit., p.
2 Ibid.

-l For example, it was reported that of the 457
continuous borrowers in 1926, 41 had suspended oper­
ations during 1927, while 24 more had liquidated
voluntarily or merged. Memorandum from Mr. Smead
to Federal Reserve Board, “Member banks borrowing
from Federal Reserve Banks continuously during
1927,” May 10, 1928.
“ Anderson, op. cit.
2 Ibid.


1923 had reaffirmed that credit should not
be used for investment or speculative pur­
poses, in accordance with the real-bills doc­
trine.2 While it noted that “(c)redit for
short-term operations in agriculture, indus­
try, and trade . . . is a productive use of
credit,” it also stated that “(t)here are no
automatic devices . . . for determining, when
credit is granted by a Federal reserve bank
. . . whether the . . . extension of credit by
the member bank (is) for non-productive
use.” 2 The same report stated that “(pro­
tection of their credit against speculative
uses requires that the Federal reserve banks
should be acquainted with the loan policies
and credit extensions of their member
banks___ ” 2
Secondly, a restriction on continuous bor­
rowing was developed. The Board’s Annual
Report for 1926, no doubt with the 1925
study of continuous borrowing in the back­
ground, stated:
Even where the paper is unexceptionable in every
respect, the reserve bank must be fully assured in
addition that further credit may be granted to this
member not only “safely and reasonably,” but also
“with due regard for the claims and demands of
other member banks.” This question arises not in­
frequently in cases where a member bank remains
continuously in debt to a reserve bank for a con­
siderable length of time. In such cases, inquiry
may fairly be made as to whether the member
bank’s use of reserve bank credit does not in effect
amount to increasing its own capital out of reserve
bank funds.27

The Report goes on to note that because the
Federal Reserve System represents a “co­
operative pooling of . .. funds” this is unfair
24 A n n u a l R e p o r t, F e d e r a l R e s e r v e B o a r d , 1 9 2 3 ,
p. 33.
2 I b id ., p. 34, 35.
2 Ib id ., p. 35; Reserve Bank surveillance actually
began in the period of “direct pressure” following
World War I. In the spring of 1920, the Board asked
“Reserve Banks to submit a written report of methods
used to keep informed on how member banks were
using Reserve Bank credit.” See Anderson, o p . c it.
2 T h irte e n th A n n u a l R e p o r t o f F e d e r a l R e s e r v e
B o a r d : C o v e r in g o p e r a t io n s f o r th e y e a r 1 9 2 6 , p. 4.

and, moreover, “(i)t may also impair the
ability of the borrowing bank in case of in­
solvency to meet its obligations to depos­
The earlier emphasis on short-term paper
under the real-bill standard was altered to
emphasize short-term borrowing:
. . . the funds of the Federal reserve banks are pri­
marily intended to be used in meeting the seasonal
and temporary requirements of members . . ,28

And finally, the principle that borrowing
should normally be confined to unusual or
adverse circumstances was stated:
In using their influence to discourage member
banks from making continuous use of the lending
facilities of the reserve banks, the operating offi­
cials of the reserve banks are not only protecting
the resources of the Federal reserve system as a
whole, but are also helping individual member
banks to conserve their capacity to borrow at the
reserve bank at times when adverse economic con­
ditions in their localities and among their cus­
tomers may make additional dependence upon the
resources of the reserve system not only justifiable
but necessary.29

The restriction on “borrowing to prof­
it,” 3 with a provision for long-term credit
2 Ib id .
2 I b id ., p. 5.
8 That the issue of “borrowing-to-profit” had not
been resolved by the mid-1920’s is indicated by the




in “unusual circumstances,” was indicated
in the Board’s Annual Report for 1928:
It is a generally recognized principle that reserve
bank credit should not be used for profit, and that
continuous indebtedness at the reserve banks, ex­
cept under unusual circumstances, is an abuse of
reserve bank facilities.31

Absent the explicit limitation on seasonal
borrowing to amounts beyond those “which
can reasonably be met by use of the bank’s
own resources,” all the principles of current
discount administration can be found by
this date.

Activity at the discount window in the

A major proportion of the reserves supplied
fact that in 1925, John Perrin, Chairman of the Board
at the Federal Reserve Bank of San Francisco, felt it
necessary to inquire of the Federal Reserve Board
about the “propriety” of a member bank borrowing
to purchase Government securities. Perrin noted that
he did not think this was in any way wrong. In fact,
he said, “(t)he advance in prices (of governments)
has demonstrated the bank’s soundness in Judgment
(sic) in thus adding to profits at a time of relatively
small earnings.” He indicated, however, that a ques­
tion had been raised by one of the directors of the
Reserve. Bank who was a “competing banker.” [Tele­
grams from John Perrin to Federal Reserve Board,
April 18, 1925, and April 21, 1925] The Board did
not answer the questions directly but requested further
information on the bank in question.
3 F if te e n t h A n n u a l R e p o r t o f F e d e r a l R e s e r v e
B o a r d : C o v e r i n g o p e r a t io n s f o r th e y e a r 1 9 2 8 , p. 8.

by the Federal Reserve in the 1920’s were
provided through borrowing by member
banks. Discounts and advances as a propor­
tion of Federal Reserve credit reached a
peak of about 82 per cent in 1921 and never
fell below 37 per cent during the period
(Chart 1). In addition, the proportion of
member banks borrowing from the Reserve
Banks generally ranged around 60 per cent
during the 1920’s (Table 2). It was not
uncommon, evidently, for hundreds of banks
to be continuously borrowing amounts in
excess of their capital and surplus.3
For the decade as a whole, the proportion
of Federal Reserve credit supplied through
the discount window fluctuated considerably
but showed a clear decline after 1921.
The proportion of member banks borrow­
ing also reached a peak in 1921. This peak
was not reached again until the crisis year
of 1933, by which time the number of
member banks had declined substantially
(Table 2). Reports on continuous borrow­
ers in 1925 and thereafter, reviewed above,
were consistent with an active Board policy to
3 A n n u a l R e p o r t , F e d e r a l R e s e r v e B o a r d , 1 9 2 6 , p. 5.
Interest in this figure stemmed from the fact that prior
to the establishment of the Federal Reserve System,
national banks were not generally permitted to borrow
in excess of their capital and surplus.

. relative to Federal Reserve credit and required reserves







SERVE BANKS, 1915-35

The generally acknowledged successful
conversion from a discount mechanism
based on the “real bills” doctrine to a dis­
count mechanism based on “reluctance to
borrow” in the 1920’s was accompanied by
generally acknowledged unsuccessful at­
tempts to use the discount mechanism in
certain ways to achieve certain purposes.
As mentioned, these “failures” include the
attempt to use the discount rate, credit lines,
and collateral requirements to control the ex­
tension of credit and also attempts to use
preferential or penalty rates and “direct pres­
sure” to influence the final use of credit.3
Such experiences are hardly conclusive in
themselves in precluding certain objectives
or the use of certain techniques today. But
they are of much interest—for example, in
suggesting the difficulties that would be in­
volved in using the discount mechanism for
purposes of selective credit controls.3

Member banks

paper i

number 2






















1 Represents number borrowing one or more times during year;
figures are from annual reports of the Federal Reserve.
2 From Banking and Monetary Statistics, Board of Governors of
the Federal Reserve System, Washington, D.C., 1943.

discourage continuous borrowing.” The num­
ber of member banks borrowing continu­
ously for a year or more was cut in half
between August 1925 and the end of 1927
(Table l) .3
3 The files for 1926-29 include a number of letters
reflecting the efforts of the Board and the Reserve
Banks to eliminate continuous borrowing for such
purposes as carrying Government securities and
operating in the call loan market.
3 It should be noted, however, that in August of


The “failures” of the 1920’s

1925 there existed a policy of mild monetary restraint
induced by the flow of bank credit to the stock market,
while in December 1927 there existed a policy of mild
ease, induced by both international and domestic con­
siderations. See Elmus R. Wicker, F ederal R eserve
M on etary P o lic y , 191 7 -1 9 3 3 (Random House, 1966),
pp. 95-116; and Lester V. Chandler, Benjam in Strong,
C entral Banker (The Brookings Institution, 1958), pp.
435-47. The decline in numbers of continuous bor­
rowers might be attributed in part to the change in
monetary policy as well as to the change in discount
3 Anderson, op. cit.
!0See Lester V. Chandler, “Selective Credit Control”
(Discount Study).


The banking crisis in the early 1930’s led
to liberalization of collateral requirements
for borrowing from Reserve Banks. Em­
phasis was further shifted during this period
from the technical requirements of eligibility
to the requirement that collateral be “satis­
factory.” However, for almost two decades
after 1933—during economic depression,

World War IT, and the early postwar period
—borrowing activity at Reserve Banks re­
mained at very low levels. Discounts and
advances averaged only $11.8 million be­
tween 1934 and 1943, and $253 million
between 1944 and 1951. Little interest was
expressed in the intellectual and operating
characteristics of the discount mechanism.


With the revival of flexible monetary
policy after the “accord” in 1951 there was
also a revival of concern about the possible
“over-extension” of credit through the dis­
count window. Partly as the result of a profit,
incentive to borrowing introduced by the
excess profits tax,1 discounts and advances
increased to more than $1.6 billion in mid1952 and remained over $1 billion during
the first 4 months of 1953.2 “These develop­
ments in particular” according to the System
Committee on the Discount and Discount
Rate Mechanism established in 1953,
“brought under discussion within the Sys­
tem the whole question of the philosophy
and effectiveness of its existing discount
mechanism.” 3

The 1955 revision of Regulation A

The System Committee that had been estab­
lished to study the question recommended
that Regulation A be formulated so as to
place reliance on and give support to the
“tradition against borrowing.” It was ar­
gued that, by doing so, the discount
mechanism would serve both monetary
policy and supervisory purposes. As a re­
sult, discounting could not be used to re­
lieve for long or indefinite periods the
pressure of monetary restraint upon the
banking system and its customers. In addi­
tion, support given to the “tradition against
borrowing” would contribute to the finan­
cial soundness of individual banks and the
banking system. At the same time, it was
argued, the discount window could serve to
meet the “needs” of individual member
banks for credit accommodation to facilitate
'U nder a ruling by the Bureau of Internal Revenue
in 1951, borrowing by banks could be included in their
capital base for the purpose of calculating excess
profits tax liabilities.
8See Bernard Shull, “The Rationale and Objectives
of the 1955 Revision of Regulation A” (Discount
’ “Report on Discount Mechanism, 1954,” p. 22.


short-run adjustments resulting from mone­
tary restraint; that is, it would serve as a
safety valve. More generally, short-term
credit would be available to permit adjust­
ment to unexpected declines in deposit flows
and increases in loan demand; and longerterm credit, to help ameliorate emergency
situations. In addition, it was believed that
this “modernized philosophy” would serve
to eliminate “incompatible interdistrict
differences in discount methods” among the
Reserve Banks.4 This conception of the dis­
count mechanism was essentially adopted in
the 1955 revision of Regulation A. It is most
clearly stated in the “General Principles” of
the Foreword to the Regulation.
While the terminology of the “General
Principles” is almost identical to that used
in the 1920’s, the 1955 revision reflected a
difference in at least one important respect/’
Concern about excessive borrowing in 1952
and 1953 arose when borrowing increased to
over $1 billion. This was not a low dollar fig­
ure by 1920 standards. But in 1952-53, it
represented only about 4 per cent of required
reserves and 3 per cent of Federal Reserve
credit. The revision of Regulation A in this
situation reflected a choice to restrict activity
at the discount window well below even the
lowest relative levels reached in the 1920’s
and to provide almost all reserves by open
4The report states: “(l)ack of a modernized dis­
count philosophy . . . is a factor fostering undesirable
regional differences in discount practices. . . . While
some incompatible interdistrict differences in discount
methods may now exist, the Committee is persuaded
that differences not supported by variations in regional
conditions and needs would be largely eliminated by a
Regulation A reoriented along the lines suggested.”
“Report on Discount Mechanism, 1954,” pp. 23, 34.
5 In addition to the restriction on continuous bor­
rowing the “General Principles” cite three “appro­
priate” purposes for borrowing (to meet “sudden”
deposit withdrawals, seasonal requirements beyond
those that can “reasonably” be met, and emergency
needs resulting from “unusual situations” or “excep­
tional circumstance”) and three “inappropriate” pur­
poses (“principally” to profit from rate differentials,
to obtain a tax advantage, or to extend an “undue”
amount of credit for speculative purposes).


market operations. In qualitative terms, the
1955 revision was essentially a revival and
codification of the rationale and administra­
tive guidelines that had evolved in the
1920’s. In the post-World-War-II environ­
ment, with commercial banks holding large
amounts of liquid Government securities,
it was intended to be far more restrictive
than what had been achieved earlier. The
intervening years in which banks had not
made very much use of the window, in effect,
permitted a major quantitative change, albeit
a relative one, in operations.
The increased degree of restriction was
most clearly expressed in reference to the
issue of credit for seasonal purposes. It was
indicated that the Federal Reserve had re­
sponsibility for responding to the seasonal
swings in reserves that affect the banking
system as a whole, but that member banks
should generally meet foreseeable seasonal
swings out of their own resources.6 Since
seasonals are, by definition, largely foresee­
able, it is reasonable to believe that credit
for such purposes was intended to be re­
stricted to the exceptional case.7 The em­
phasis on temporary borrowing, as indicated
symbolically by a 15-day maximum maturity
in normal circumstances, was intended to
further support the general exclusion of bor­
rowing for seasonal purposes.8
It was argued that this restriction was nec­
essary to make a monetary policy of re­
straint effective. The report stated:
6See “Report on Discount Mechanism, 1954,” pp.
26, 27, and Appendix B.
7“It appears to the Committee that a limitation of
Reserve Bank credit extensions for seasonal require­
ments to those ‘which cannot reasonably be anticipated
and met by the use of the member bank’s own re­
sources’ is a desirable safeguard. . . . there will be
extraordinary seasonal cases, most likely smaller bank
situations, which will require discount acceptance on
the basis of a reasonable evaluation by Reserve Bank
officials of the special considerations giving rise to the
borrowing need.” I b id ., pp. 26, 27.
8 I b id . Compare Section 202.2, note 1, of Regulation
A. 12 CFR 201, as revised effective Feb. 15, 1955, with
Section 2, note 6, of the previous revision in 1937.

If the member banks generally meet their normal
operating responsibilities, use of the System dis­
count facility would ordinarily be limited and
would increase appreciably at times only in re­
sponse to System operations directed at credit

The Committee felt this was both desirable
and practical. It noted that any attempt to
meet the seasonal “needs” of individual
banks could result in a redundancy of credit,
since increases in demand by some banks are
typically accompanied by decreases in de­
mand by others. Reserve Bank credit made
available to individual banks for seasonal
purposes would inevitably have an effect on
general credit conditions through the loan
and investment process. “An oversupply of
reserve funds through the discount window
to meet seasonal needs of individual banks
may thus render more difficult the conduct of
general credit and monetary policy.” 1 The
System would rely on open market opera­
tions to compensate for seasonal (and other
undesired) drains from the banking system
as a whole and would rely on existing insti­
tutions and markets to distribute reserves to
the individual banks experiencing declines
in deposits or increases in loans. The princi­
pal market on which the distribution of
reserves was seen to depend was the Govern­
ment securities market.
By maintaining an adequate portfolio of short­
term Government securities and other money mar­
ket paper which can be sold as needed, individual
member banks in providing for ordinary seasonal
requirements may assure themselves of a s a t i s f a c ­
t o r y a c c e s s t o f u n d s a v a i l a b le in the credit mar­
ket. . . . Nearly all banks hold a considerable
amount of Government securities not only at
periods of seasonal ease but also on a continuing
9I b id .y p. 26.
1 Ib id ., Appendix B, p. 1.
1 I b id .f Appendix B, pp. 10, 11 [italics added]. The
report also noted that “undue seasonal reliance of
some member banks on discounts goes back more to
inadequate holdings of cash assets and short-term
Government securities than to the pressure of strong
seasonal movements in deposits and loans,” p. 12.


In addition, the Committee stated that the
problem, even for the highly seasonal bank,
is generally not unmanageable; “the proporportion of resources that is stable is sub­
stantial. . . 1 Finally, it was suggested that
correspondent banking relationships amelio­
rate the seasonal problem, at least for city
Seasonal movements in interbank loans are not
consistent, and in any event the magnitude of such
loans is small. Interbank deposits (however), are
considerably larger and show considerably larger
fluctuations in dollar amounts over the year. . . .
Thus, city banks actually gain funds at the period
of their peak seasonal need. . . .13


Reliance on the tradition against

As noted, the conception of the discount
mechanism as a strategic instrument of Fed­
eral Reserve policy was to be implemented
through reliance on the tradition against
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 con­
tinuous indebtedness to its Reserve Bank as a re­
source for conducting regular banking operations.
. . . In the severe banking crisis and liquidation in
the early Thirties, adjustment problems of the ag­
gressive, continuous borrowing banks made evi­
dent the hazards to safety of depositor funds. . . .
Because of this costly lesson, it was possible by
the mid-Thirties to speak of an established tradi­
tion against member bank reliance on the discount
facility as a supplement to its resources. . . . F u ­
tu r e d is c o u n t p o lic y . . . s h o u ld b u ild o n th e t r a d i­
t io n a s a k e y s t o n e .14

The tradition against borrowing was to
be supported through the statement of a set
of “General Principles” in Regulation A.
These principles were designed “. . . to guide
1 I b id ., Appendix B, p. 11.
1 Ib id ., Appendix B, pp. 6, 7 [parenthetical material
added]. Presumably, the country bank problem would
be ameliorated by the drawing down of excess cash de­
posited with correspondents during periods of seasonal
1 Ib id ., pp. 10-13 [parenthetical material and italics


Reserve Banks in lending and member
banks in Reserve Bank borrowing.”
It is reasonable to believe that the “Prin­
ciples,” which are now found in the Fore­
word to Regulation A,1 were not intended
to be applied independently of one another
as limits on the supply of borrowed funds.
Rather, they represent a set of terms that
roughly describe the kind of borrowing be­
havior expected of a bank “reluctant to bor­
row.” 1
In combination, they were intended to fa­
cilitate the rationing process, that is, to help
discount officers and committees make a dis­
tinction between sufficiently reluctant (ap­
propriate) and insufficiently reluctant (in­
appropriate) borrowing. It is suggested in
the Committee’s report that the duration of
borrowing was to be used to establish a re­
buttable presumption that borrowing was
for an inappropriate purpose.1 The purposes
that were viewed as inappropriate, such as
borrowing to profit from rate differentials,
were those that implied reliance on borrowed
funds in the “normal” course of business.1
Nevertheless, it was not expected that dif­
ficult rationing decisions would have to be
made very often, or in the case of very many
1 I b id ., p. 23. The “General Principles” suggested
by the “Report on Discount Mechanism, 1954” and the
“General Principles” as finally embodied in the Fore­
word to Regulation A as revised in 1955 are essen­
tially identical.
1 Shull, o p . c it.
1 It was expected that an “initial” request for credit
by a member bank would normally be granted, and
the question of continuous borrowing “. . . would
arise first at the time of the first renewal.” “Report on
Discount Mechanism, 1954,” Appendix C, p. 7. Cer­
tain “objective procedures . . . would facilitate ad­
ministration where findings indicated that developments
other than those stated were responsible.” I b id ., p. 34.
With each successive period in which borrowing oc­
curs, the report noted, “the probability that the bor­
rowing stems from inadvertent causes obviously de­
creases.” Ib id ., Appendix C, p. 10.
1 Much of the analysis in the report relates to
changes affecting individual banks under conditions of
uncertainty. The definition of what, for example, con­
stitutes an “unforeseeable seasonal decline in deposits”
was not rigorously developed.


banks. The Committee’s report suggested
that most banks were sufficiently reluctant
in their borrowing behavior to satisfy the
requirements of monetary policy and bank
supervision and that only a few aggressive
banks borrowed excessively. It was expected
that the revised Regulation, by indicating
the System’s position, would support the
many adhering to the tradition against bor­
rowing, while the work of discount officers
and Reserve Banks would influence the be­
havior of the aggressive few.1
In summary, the administrative procedure
suggested—involving Reserve Bank surveil­
lance and frequent contact with continuous
borrowers—was intended to influence bank
attitudes by promoting the tradition against
borrowing and, thereby, reducing the de­
mand for credit. Where necessary, adminitration provided a device for rationing the
supply of credit.2

Operations since 1955

Information on the manner in which the
“General Principles” of Regulation A have
been and are administered was obtained
through a general questionnaire sent to each
Reserve Bank,2 an additional questionnaire
sent to the discount departments of five
Reserve Banks.2 and a variety of other
sources.2 A reasonably complete picture of
discount-window administration has been
1 “Report on the Discount Mechanism, 1954.” pp.
* lb id .
2 “Questionnaire to Federal Reserve Banks Regard­
ing Discount Operations,” Oct. 1, 1965 (herein­
after referred to as “Questionnaire, 1965”).
~ This questionnaire was part of a review of mem­
ber bank borrowing cases conducted by Kyle E.
Fossum, Federal Reserve Bank of Minneapolis.
2 These include descriptive presentations by several
discount departments of their administrative pro­
cedures, quarterly borrowing reports by each Reserve
Bank to the Board of Governors on problem borrow­
ing cases, and periodic conference calls among the
discount officers of all Reserve Banks and staff mem­
bers of the Board of Governors.

It would appear that “initial” requests
for credit are invariably accommodated
promptly, with little if any discussion and
with little inconvenience to the borrower.2
In most circumstances no real effort is made
to ascertain the purpose of borrowing initi­
ally.2" Beyond this initial accommodation,
the administrative process can, for purposes
of analysis, be broken down into three con­
secutive stages: (1) surveillance of the bor­
rowing bank; (2) a decision with respect to
the “appropriateness” of the borrowing; and
(3) in cases where an “inappropriate”
decision is reached, the undertaking of “ad­
ministrative counseling” or “discipline”
aimed at securing repayment and “educat­
ing” the borrower in the appropriate use of
the discount window.
These three stages may be viewed as ele­
ments in the process of nonprice rationing
and “moral suasion” at the discount window.
It is useful to discuss briefly the substance
of the approach taken, and then to consider
certain related problems that have come to
Nonprice rationing. The administrative
procedures adopted by the Reserve Banks
are essentially identical to the procedures
envisioned in the 1954 Report on the Dis­
count Mechanism. Surveillance takes place
through observation and analysis of data on
the operations of borrowing banks and
through direct inquiries. An initial de­
cision that borrowing which has continued
over some time is “inappropriate” may be
viewed as tentative. It is dependent on a
variety of factors. These include some that
are “given” when credit is extended (the
amount borrowed, the previous borrowing
record of the bank, the stated purpose);
3 By “initial” is meant the first request of a bank
that is not currently subject to surveillance for reason
of previous borrowing.
2 Shull, o p . c it.



some that vary while the credit is outstand­
ing (the borrowing bank’s asset and liability
management); and, of course, “time” itself,
since duration is taken as evidence of “re­
luctance.” These factors may be thought of
as interacting in influencing the initial “appropriate-inappropriate” decision.2
Once the appropriateness of an outstand­
ing debt has been seriously questioned, “ad­
ministrative counseling” or “discipline” is
undertaken. This procedure has been de­
scribed by a Reserve Bank discount officer
as follows:
. . . a Reserve Bank official will promptly write,
phone or arrange a conference with the member
banker whose bank borrowings from the Fed. be­
come frequent or extensive. Whatever form of
communication is used, the Reserve banker’s pur­
pose is the same: to solicit from the borrowing
member additional information about the circum­
stances that are causing his bank to borrow heavily
or frequently; and depending on the nature of
these circumstances, to counsel with the member
bank about whether his bank’s continued use of
the discount window appears appropriate and con­
sistent with principles established by the Board of
Governors and set forth in its Regulation A.

If the “inappropriate” presumption is main­
tained while borrowing continues, “coun­
seling” is “escalated” by meetings between
Reserve Bank and borrowing bank officials
at successively higher levels to “explain”
the standards established by Regulation A,
to request the presentation of a repayment
program, and as a final measure to indicate
that the bank’s request for renewal of credit
will not be honored. This procedure for re­
stricting the duration and amount of credit
is consistent with the view that the objec­
tive is to reach, if possible, a mutual under­
standing and agreement on the standards of
Regulation A.2
A reasonable idea of the extent and quali­
tative significance of nonprice rationing
x ibid.
“ ib id .

was suggested in an analysis of replies to
the questionnaire sent to the discount de­
partments of five Reserve Banks. The ques­
tionnaire requested information on cases in
1965 and 1966 in which the borrowers were
A fairly substantial proportion of bor­
rowing banks were contacted for admin­
istrative purposes during 1965 and 1966.
In both years, over one-quarter of the re­
serve city bank borrowers were “coun­
seled” (Table 3). In 1965 only 8 per cent


Country city | Country
banks banks

Number of member banks. . .





Borrowing at least once:
Percentage borrowing.........













Borrowers counseled:
Percentage o f total bor-

of the country bank borrowers were “coun­
seled,” but the figure rose to 23 per cent
during the period of increased monetary re­
straint in 1966. For 13 of the 48 reported
banks “counseled” in 1965 (the only year
for which data are available), the Reserve
Banks decided conclusively that continued
borrowing would be inappropriate, and they
requested full or partial repayment.
The rise in the number of country banks
counseled in 1966 is indicative of the in­
creased burden imposed on discount ad­
ministration during periods of monetary re­
straint. In part, pressure may be attrib­
uted to restricting the growth of bank re­
serves to a rate below that at which loan
demand was growing. In part, it may be at­


tributed to an increasing differential between
market rates and the discount rate, which
made borrowing at the discount window a
relatively profitable source of reserves.2 In
periods of restraint, the differential between
market rates and the discount rate generally
increases, and in 1966, of course, the dif­
ferential widened substantially.
In qualitative terms the effect on discount
administration was described as follows by
a Reserve Bank discount officer:
. . . there was some tendency for 1966 cases to be
a little stickier than those in 1965. The borrowing
periods involved were somewhat longer than aver­
age; frequently more calls or letters were needed
to accomplish the desired results; and bankers
were generally slower in accepting suggestions in­
volving alternate ways of adjusting their positions.

From the member bank’s point of view,
limitations on future borrowing capacity and
inconvenience involved in negotiations with
Reserve Banks would tend to raise the ac­
tual “cost” of credit once a judgment were
reached that the borrowing is inappropri­
ate.2 Moreover, a considerable degree of
uncertainty must attach to the use of the
discount mechanism. There would be un­
certainty about (1) the duration over which
an initial request for credit will be con­
sidered appropriate; (2) the rate at which
the real cost of credit will rise, in terms of the
inconvenience of being “counseled” and
the implicit reduction in future borrowing
capacity; and specifically (3) the effect of
the past borrowing record on (1) and (2).
When credit is initially extended, the Reserve
Bank is generally not in a position to indicate
2 See Donald R. Hodgman, “Member Bank Borrow­
ing: A Comment,” J o u r n a l o f F in a n c e , March 1961,
pp. 90-93, for a discussion of both causes. Empirical
findings on the responsiveness of the demand for credit
to market and discount rates are discussed below.
2 Since the amount of a loan (relative to bank
size) is taken as one indication of “purpose,” the cost
of borrowing over any extended period of time would
be positively related to the amount, c e t e r is p a rib u s .
Shull, o p . c it.

to the borrowing bank the frequency or dur­
ation over which borrowing will be consid­
ered appropriate.3 Uncertainty surrounding
the terms and conditions on which credit is
available and, in addition, the subjective
aversion of banks to being “counseled”
would also influence the relative attractive­
ness of discount-window accommodation
and of borrowing from other sources.
The “costs” imposed on borrowing banks
by administrative contacts under current
procedures are, in general, indeterminable.
They are difficult, if not impossible, to con­
trol—depending as they do on subjective as
well as objective factors. They are, conse­
quently, susceptible to nonuniformities
among member banks and over time.
In recent
years, questions have arisen about the uni­
formity of discount-window administration
among districts.3 Replies to the question­
naire sent to each Reserve Bank in 1965
provided substantial evidence that under­
standing as to the significance of the re­
strictive terms of the “General Principles”



m Ib id .

3 For example, the report of the Commission on
Money and Credit stated: “Clearly the intent of the
Federal Reserve Board is to have discount adminis­
tration relatively homogeneous among the twelve
Federal Reserve banks, and the commission urges
continued efforts to assure uniform standards of dis­
counting practice. Uniform standards, of course, mean
that like circumstances result in like treatment, at the
same time permitting differences in practice where
regional differences in economic conditions or needs
require.” M o n e y a n d C r e d i t : T h e R e p o r t o f th e C o m ­
m is s io n o n M o n e y a n d C r e d i t (Prentice-Hall, 1961),
p. 66.
More recently a study was undertaken by the
American Bankers Association which has included a
survey of commercial banks on questions relating to
the use of the discount window. The survey question­
naire has included a question asking the bank’s im­
pression as to whether administration of the discount
function varies from one Federal Reserve district to
another. About one-third of those responding felt that
there were differences. See T h e D is c o u n t F u n c t io n ,
The American Bankers Association, New York, 1968,
p. 50. See also David T. Lapkin and Ralph W. Pfouts.
“The Administration of the Discount Function,” T h e
N a t io n a l B a n k in g R e v ie w , December 1965, pp. 179—
86 .


differs in important ways. In consequence,
the Regulation is or could be administered in
substantially different ways among districts.
Differences of importance among Reserve
Banks were identified with respect to bor­
rowing for seasonal purposes, borrowing “to
profit from interest rate differentials,” and
“continuous” borrowing. With respect to
“continuous” borrowing, differences report­
ed involved the duration of “continuous” in
the administrative “rules of thumb” reported,
whether or not one or more groups of banks
(for example, country banks, small rural
banks) were excluded from the general
“rules” and whether or not such “rules” were
in terms of “days” as well as reserve periods
in debt. Information on discount-window ad­
ministration in borrowing cases that involved
conditions not specifically referred to in the
Foreword to Regulation A (such as borrow­
ing while lending to correspondents) was
also obtained from the survey. This informa­
tion also indicated considerable differences
among Reserve Banks and, for the most
part, was consistent with the differences in
interpretation of the three major “Prin­
ciples” indicated above.
The nonuniformities reported in the re­
sponses to the questionnaire should be
clearly distinguished from differences in cir­
cumstances that are, in fact, sanctioned by
the Regulation. The regulatory design leaves
considerable discretion to the Reserve Banks
in deciding, on the basis of all the infor­
mation available, whether a particular bor­
rower is sufficiently reluctant in his borrow­
ing behavior. The differences reported,
however, derive from differences in the def­
inition and interpretation of the “General
Reserve Bank responses to the question­
naire tended to fall into three categories: a
lower, or below average, group with respect


to the extension of credit; an upper group;
and a broad middle range. While these dis­
tinctions are essentially qualitative in nature,
the standards and the interpretations expres­
sed appeared to be more homogeneous with­
in the groupings, particularly the upper and
lower, than between them.3
It is worth noting that there has been no
attempt to translate the “General Principles”
into explicit operational standards and cri­
teria. The individual “Principles” were not
intended to be specified in this way. To de­
fine them more precisely would change the
Regulation from being principally an in­
tended influence on demand to principally
a device for rationing supply; and the basis
for rationing would change from one where
borrowing, if done reluctantly, were appro­
priate to one as yet undefined.3
Relations between Reserve Bank and mem­
ber bank. Responses to the 1965 question­

naire also produced evidence to suggest that
the borrower-lender relationship established
under Regulation A contains elements of
friction not normally found in commercial
borrower-lender relationships. These ap­
parently stem from both the highly restricted
nature of the accommodation and the diffi­
:J The middle group included districts that were, in
fact, in the “middle range” in their administration and
also districts about which there was insufficient infor­
mation to make a judgment. The classification varia­
bles are used in a regression analysis focusing on the
influence of trend, the results of which are provided in
Table 12.
3 In a study of the determinants of borrowing in six
districts for which weekly reporting data for individual
banks were available, it was found that in districts
where relatively large amounts were borrowed from
the Federal Reserve, relatively large amounts were
also borrowed from other sources. (Leslie Alperstein,
“A Reevaluation of the Determinants of Member Bank
Borrowing from the Federal Reserve,” unpublished
doctoral dissertation, University of Pittsburgh, 1967.)
The six districts included five that, on the basis of the
questionnaire responses, had been classified in the
“middle range.” This finding, while suggesting the im­
portance of demand as a determinant of borrowing,
remains consistent with the existence of administrative


culties in communicating the basis on which
credit is extended and restricted.
Most of the Reserve Banks expressed
varying degrees of concern about the ade­
quacy of the discount mechanism in meeting
the kinds of demands for credit arising at
member banks. Several indicated that mem­
ber banks were not obtaining sufficient funds
from the discount window to meet what were
believed to be reasonable demands.3
Some Reserve Banks also reported diffi­
culties in communicating in a satisfactory
way to member banks the basis of appropri­
ate borrowing at the discount window. These
and others reported serious difficulties in de­
termining, in accordance with the “General
Principles,” the purposes for which funds are
borrowed.8 At least one Reserve Bank sug­
gested that rationing under Regulation A
generates resentment among borrowers.
It was noted above that replies to the
questionnaire on borrowing cases in which
“counseling” was undertaken indicated that
in 1965 there were 13 such cases at five
Reserve Banks in which it was decided that
borrowing was inappropriate. In four of
these cases the borrowing bank indicated
that it felt unfairly or inadequately treated.
While it is difficult to know how representa­
tive such a figure is, the direction of the bias
seems clear. One discount officer noted:
I think it is unrealistic to think that you are going
to get any fair appraisal of attitude by asking
member banks whether they agree with Reserve
Banks; I mean it’s like the traffic cop asking
whether you agree with him when you go through
a red light . . . I mean, four banks were honest
enough to indicate some difference of opinion.

significant degree of misunderstanding and/
or dissatisfaction by member banks, they
tend to confirm the other reports mentioned.
Even during the period of severe monetary
restraint in 1966 many large banks chose
not to borrow at the discount window, but
rather to pay considerably higher rates else­
where.3 This policy on the part of potential
borrowers reaffirmed earlier choices that
had resulted in a rise in the Federal funds
rate above the discount rate after many
years in which the latter rate had represented
an upper limit. The aversion of large banks
to borrowing at the discount window has also
been reported by discount officers as an
indication of misunderstanding or dissatis­
faction with administration.3
The effects of discount-window adminis­
tration on large banks is one aspect of cur­
rent relationships that requires considera­
tion. Regardless of the friction, however, most
reserve city banks do borrow from Reserve
Banks at least occasionally during any year.
The proportion of country banks that nor­
mally do not borrow even once a year is, on
the other hand, relatively large—running in
recent years around 75 to 80 per cent (Chart
2). Many nonborrowers in the country bank
classification never borrow from any source
and therefore may be presumed not to have
and/or not to recognize profitable opportu­
nities for borrowing. However, the estimated
proportion borrowing from all credit sources
has been consistently larger than the propor­
tion borrowing at the discount window
(Chart 3). In 1966 about 25 per cent of
country member banks borrowed from the

To the extent that the responses suggest a
M“Questionnaire, 1965.”
8 It also seems clear that a number of Reserve
Banks have adopted more or less arbitrary rules on
amount and frequency of borrowing as proxies for
actual purpose. It is noteworthy that such rules are,
in effect, proxies for a proxy since the purpose restric­
tions were intended to throw light on “reluctance.”

:!6See Dolores P. Lynn, “Reserve Adjustments of the
Eight Major New York City Banks During 1966”
(Discount Study).
* The attitude of some large banks was complicated
in 1966 by the introduction of a special lending pro­
gram at the discount window under the so-called
“September 1 letter.” An inquiry into the impact of
this program was also undertaken.



Member Bank Borrowing at Federal Reserve
Ratio of number of borrowers to all member banks



System, while 41 per cent were estimated to
have borrowed from all sources. Given the
relatively attractive rates on one-day or oneCountry Bank Borrowing
Proportion borrowing from Federal Reserve and others



_______ J_ _




period money at the discount window, and
the absence of any absolute restriction on
borrowing for short periods, it is reasonable
to believe that many nonborrowers also mis­
understand and/or are dissatisfied with the
discount facility.
D. Comparison with foreign experience

In comparing the Federal Reserve’s discount
mechanism with discount mechanisms in in­

dustrial countries abroad, it was found that
“(o)nly a few of the central banks surveyed
base the administration of the discount win­
dow on the assumption that commercial
banks are reluctant to borrow (and to stay
in debt) . ..” 5 In a number of the countries
surveyed “discounting is considered a nor­
mal source of a considerable part of the
banking system’s cash reserves rather than
merely a safety valve, available normally
only for a very short period, pending adjust­
ment of bank assets and liabilities.” 31
Since the conditions that make open mar­
ket operations the monetary instrument of
choice in the United States do not exist in
most other industrial countries, the discount
window has continued to be a principal
tool of monetary policy. “Against the
background of foreign experience, our dis­
count mechanism, no less than our entire
monetary and banking system, appears as a
unique case. . . . ” 4
In recent years, many foreign central
banks have been confronted with the prob­
lem of excess liquidity in the banking sys­
tem resulting from foreign exchange sur­
pluses and, to some degree, Government
deficits. In these countries, efforts have been
made to restrict the growth of the reserve
base, in part by restricting the extension of
credit at the discount window and in part
by developing other means of control. Some
techniques, long used in the United States,
have been introduced abroad—for example,
open market operations, reserve require­
ments, and the use of moral suasion. In addi­
tion, relatively unfamiliar devices have been
used. These include (1) controls aimed at
limiting the expansion of bank credit direct­
:5 George Garvy, “The Discount Mechanism in
Leading Industrial Countries Since World War II”
(Discount Study), Part I [over-all review], Part II
[country studies]. Parenthetical material added.
3 Ibid.
4 Ibid.


ly, for example by means of limits on loans
or permissible rates of increase during speci­
fied time periods; and (2) controls aimed
at limiting the expansion of credit indirectly
through quantitative restrictions on borrow­
ing at the discount window and through use
of various types of penalty rates.
Indirect controls have traditionally in­
cluded the use of the discount rate as a de­
vice to restrict the extension of credit. In
some countries the discount rate has de­
veloped into a structure of rates related to
the size and duration of borrowing, borrow­
ing within or above some specified quota,
and/or borrowing in order to extend credit
for some preferred or nonpreferred purpose
or type of loan.
All the countries surveyed have a multiple
rate structure. But most have not been able
to place exclusive reliance on rate.4 For ex­
ample, in recent years even the United King­
dom, which has traditionally relied heavily
on rate, has also found it necessary to rely to
a significant degree on moral suasion.4
Exclusive reliance on rate has not proved
practicable for a variety of reasons; but it
should be noted that not all of these reasons
are relevant in the economic and institu­
tional environment of the United States.
Attempts to ration credit by rate in coun­
tries where there are automatic linkages
between the discount rate and bank lending
or deposit rates, and in countries where
discount credit accounts for a substantial
proportion of bank reserves, will quickly
result in relatively large interest rate move­
ments throughout credit markets. There has
been considerable concern in the countries
surveyed that such rate fluctuations would be
4 Among other controls should be noted the use of
mandatory liquidity ratios to immobilize assets that
could otherwise be used to borrow at the central bank.
Ib id ., Part II, “France.”
1 I b id ., Part I and Part II, “United Kingdom.”

disruptive to financial markets. In countries
where international capital flows are an im­
portant source of bank reserves, there has
been concern about the offsetting effect of
rate increases that would induce inflows of
funds from abroad.4 In countries where the
use of rate means frequent variation in the
“official” discount rate, there has been con­
cern about “announcement effects.” In Can­
ada the problem of announcing increases in
the discount rate was met, between 1956 and
1962, by tying the discount rate to the Treas­
ury bill rate.4
There appears to have been no effort in
foreign countries to maintain nonrate ration­
ing constant in changing economic circum­
stances, as is the case in the United States.
(This difference may perhaps be attributed
to the fact that the controls over credit exten­
sion elsewhere are aimed principally at serv­
ing the objectives of monetary management
and not, as in the United States, the purposes
of bank supervision as well. If there is no
need to select a standard of “reluctance”
acceptable to the conditions of bank “sound­
ness,” which by its nature cannot be varied
easily, there is no apparent reason to main­
tain an inflexible degree of nonprice ration­
ing.) In addition, it was found that foreign
central banks do not uniformly frown upon,
or penalize relending at a profit.4
“ Ib id ., Part I.
4 Ib id ., Part II, “Canada.”
Ib id ., Part I. In contrast to the discount mecha­
nisms of foreign central banks, which are principally
if not exclusively tools of monetary policy, the ad­
vance mechanism of the Federal Home Loan Bank
System in the United States is principally if not exclu­
sively a tool for facilitating the adjustment and growth
of locally oriented savings and loan associations. The
availability of credit in all maturity ranges, on a large
scale, to relatively small institutions has been accom­
panied, in recent years, by restrictions of a supervisory
nature. The Federal Home Loan Bank Board has im­
posed restrictions aimed at curtailing credit to associa­
tions engaged in “unsound” practices as evidenced by
the growth of “slow assets” (Staff review of Home Loan
Bank System by Lynn Styles, Federal Reserve Bank of
Chicago, and Robert King, Board of Governors.)





The discount mechanism as it was formally
designed in 1955 is built on a number of
hypotheses about the economic environment
in which it was intended to operate. There
was a perceived ecology on whose approxi­
mate existence the usefulness of the mecha­
nism was considered to be dependent. The
hypothesized “outside” conditions may be
contrasted with the “inside” workings of the
mechanism itself discussed above.
Some important issues that arise in evalu­
ating the discount mechanism relate to the
current validity of the environment hypothe­
sized in 1955. The hypotheses themselves
range from views about bank motivation and
behavior to the functioning of financial mar­
kets. In this section these hypotheses will be
elaborated and also evaluated in the contem­
porary environment.
A. Bank motivation

The relative importance of the several values
motivating bankers in their borrowing deci­
sions has been and is a critical issue in
evaluating the current discount mechanism.
As discussed above, if banks are “reluctant”
to borrow and/or remain in debt to an im­
portant degree, then debt can be viewed as
having a uniquely restrictive impact on bank
behavior. Presumably banks would not be
particularly sensitive to differentials between
market rates and the discount rate. If, on the
other hand, banks are not particularly re­
luctant to borrow, then the restraint im­
posed by an increase in the aggregate debt
of the banking system is not automatic, and
emphasis must shift to the restriction im­
posed by nonprice rationing at the several
discount windows.
l . Need versus profit. The theoretical issues
involved in the debate over whether banks

borrow out of “need” or for “profit” appear
largely resolvable.1“Need” may be identified
with a reluctance to borrow, which may be
interpreted as meaning that bankers attach
a negative utility to incurring debt. There is
no theoretical difficulty in incorporating a
disutility attributable to debt into a function,
including profit from borrowing, which
bankers are assumed to maximize.2 As a re­
sult of doing so, however, empirical issues are
raised. In general these relate to the respon­
siveness of borrowing to interest rates, that
is, in the interest elasticity of demand for bor­
rowing;8 and to the effect of past borrowing
behavior (that is, outstanding debt) on cur­
rent borrowing.
The “tradition against borrowing” in System
thought. The “tradition against borrowing”

and related concepts, that is, “reluctance to
borrow” and “reluctance to borrow con­
tinuously,” have, as indicated, dominated
System thinking about the discount mecha­
nism since the mid-1920’s. They have, by
and large, dictated the role ascribed to the
discount rate and the strategy of the System
toward member bank asset and liability
management. It is worth noting, however,
that the issue was never simply whether
banks were, at a given time, reluctant to
borrow, but also whether the “reluctance
1 Anderson, o p . c it.; David M. Jones, “A Review of
Recent Academic Literature on the Discount Mech­
anism” (Discount Study).
2See Murray E. Polakoff, “Reluctance Elastictity,
Least Cost, and Member Bank Borrowing: A Sug­
gested Integration,” J o u r n a l o f F in a n c e , March 1960,
pp. 1-18; Polakoff, “Federal Reserve Discount Policy
and Its Critics,” B a n k in g a n d M o n e t a r y S tu d ie s , edited
by Dean Carson (Richard D. Irwin, Homewood, Illi­
nois, 1963), pp. 190-212; Donald R. Hodgman, lo c .
c it.; Stephen M. Goldfeld and Edward J. Kane, “The
Determinants of Member Bank Borrowing; An Eco­
nometric Study,” J o u r n a l o f F in a n c e , September 1966,
pp. 499-514.
3 Goldfeld and Kane, o p . c it., pp. 502-03.


convention,” as supported by System policy,
was viable over the long run.4
It is reasonable to believe that the current
reconciliation of “need” versus “profit,”
described above, is not alien to the theoreti­
cal views underlying the current discount
mechanism. Reluctance has generally been
presumed to influence the demand for credit
by reducing bank responsiveness to differen­
tials between market rates and the discount
rate. Reluctance to borrow may then be in­
terpreted as an attitude possessing some
value in a system of values that includes
profit; ' the position and slope of the demand
schedule can theoretically be obtained from
the relevant costs and returns on borrowed
funds and the preferences of bankers.
The so-called “reluctance to borrow con­
tinuously” suggests that banks will aim at
zero amounts of long-term borrowing in
managing their assets. Such reluctance would
also tend to reduce the amount borrowed.
Borrowing would be negatively related to
existing debt or, perhaps more generally,
associated with the pattern of borrowing in
the recent past. It has been argued that,
during periods of restraint, reluctance takes
hold when banks begin to be continuous
borrowers, as indicated by the fact that
aggregate borrowing at the discount window
had reached a relatively high level.®
It was clearly recognized, in at least some
System documents, that the slope and posi­
tion of demand schedules for borrowing
4The revision of the discount mechanism in 1955 on
the basis of “reluctance” was not, however, accepted
uncritically throughout the System; this is indicated in
papers and memoranda prepared during the 1953-54
study. See in particular, Karl R. Bopp, “Role of the
Discount Rate,” in Statements of Associate Econo­
mists of the Federal Open Market Committee before
the Conference of Presidents, June 21, 1954, and, in
reply, Winfield Riefler, “Volume of Borrowing vs.
Profitability of Borrowing,” Memorandum to Dis­
count Rate Committee, Aug. 19, 1954.
5Jones, o p . c it.
6 Bopp, o p . c it.

would vary from bank to bank, as preference
systems would vary. However, the belief
implicit in the 1955 revision was that, for
the banking system as a whole, demand is
not very high or elastic,7 and/or could be so
Finally, it appears to have been well un­
derstood that the preference systems of
banks could, and in fact do, change radically
from time to time. The large amounts of
borrowing during the expansion of 1920-21,
and the surveys of continuous borrowing in
1925 and thereafter, clearly indicated that
an acceptable degree of reluctance was
neither an automatic nor inevitable condi­
In the early 1950’s, many in the Sys­
tem no doubt believed that the experience
of the 1930’s had supported the attitude of
reluctance in a substantial way. But, at the
same time, the concern that led to a revision
of Regulation A reflected a belief that re­
luctance was waning. In consequence, it may
be inferred that the relationships among
borrowing, interest rates, and bankers’ pref­
erences were viewed as changing with the
business climate.
In this context, terms such as “tradition
against borrowing” and “borrowing out of
need” may be taken as oversimplifications.
Reluctance to borrow has been viewed as
“traditional” principally in the sense that
economic circumstances encouraging re­
luctance are viewed as traditionally recur­
ring phenomena. The expectations, and
therefore the attitudes, of bankers toward
borrowing have been seen as both deter­
mining and being determined by the current
and past states of the economy. Finally,
“borrowing out of need,” with its real-biUs
overtones, is a misleading term in that it
7 See Riefler, “Volume of Borrowing vs. Profitabil­
ity of Borrowing,” o p . c it.


suggests a bank motivation that is not, in
reality, independent of borrowing aimed at a
better earnings position.

Interest elasticity of demand for borrowed

Empirical studies testing the relation­
ship between market rates and borrowing
have for the most part had available only
highly aggregated data. On the basis of such
data, there have been findings that borrow­
ing is positively related to profitability (for
both reserve city and country banks) and
that elasticities are sufficiently large to reject
the hypothesis that banks are insensitive to
rate spreads.8
One study of borrowing by weekly re­
porting member banks in six Federal
Reserve districts, mentioned above, found
that borrowing activity at the discount win­
dow was related to a number of factors, in­
cluding a measure of bank liquidity, bank
size, the difference between the bill rate and
the discount rate, and the district in which
member banks are located. The measures
of borrowing activity included the propor­
tion of banks borrowing in each district, the
frequency with which the banks borrowed,
and the proportion of deposits borrowed.
A variety of tests were made which tended
to support the findings that holdings of
liquid assets are negatively related to borrow­
ing, that bank size is positively related to
borrowing, and that the difference between
the bill rate and discount rate is positively
related to borrowing. In addition, it was
found that borrowing activity varied signifi­
cantly among districts. Finally, it appeared
that the same determinants explained bor­
rowing from other sources more fully than
they did borrowing from the Federal Re­
These findings are generally in accord
with expectations. They tend to confirm that



op. c it


borrowing from the Federal Reserve is
responsive to relationships between market
rates and the discount rate, and also to in­
ternal portfolio considerations. The fuller
explanation of borrowing from non-Federal
Reserve sources is consistent with the exist­
ence of a more complicated and restrictive
constraint on the supply of funds at the
Federal Reserve; this constraint was not
specified in the model."
Because it has not been possible to specify
precisely the supply function for borrowing
from the Reserve Banks, studies up to now
have not been able to distinguish effectively
between the reluctance of banks to borrow
and what might be thought of as the willing­
ness, in different circumstances, of Reserve
Banks to lend. A failure of banks to respond
to rate differentials might be due to either.
To the extent it is due to the latter, no light
is thrown on the issue of bank reluctance,
though it is evident that borrowing can be
controlled by the Reserve Banks.
Beyond this conceptual issue, it should be
noted that there is relatively little empirical
evidence on the relationship between the
previous pattern of borrowing and current
borrowing.1 Nevertheless, among the large
* Alperstein, op c it See also Stephen Goldfeld.
Comm ercial Bank Behavior and Econom ic A ctivity: A
Structural Study o f M onetary Policy in the Postwar
United States (Amsterdam: North Holland Publish­
ing Co., 1966), pp. 43-50; Goldfeld and Kane, op. cit.,
pp. 503-06; Murray E. Polakoff and William L. Silber,
“Reluctance and Member Bank Borrowing: Additional
Evidence," The Journal o f Finance, March 1967. pp.
1 However, see Frank de Leeuw, “A Model of
Financial Behavior,” in T h e B r o o k in g s Q u a r t e r ly E c o ­
n o m e tric M o d e l o f th e U n it e d S t a t e s , edited by James
S. Duesenberry (Rand McNally & Co., 1965), p. 513.
According to de Leeuw, “the negative influence of
lagged borrowing—banks’ ‘reluctance to borrow’—
is greater when funds are flowing in than when banks
are short of funds.” Also see Goldfeld and Kane,
o p . c it., pp. 505, 506, 511, 512. Goldfeld and Kane
state: “current borrowings will vary positively with
the level of borrowing in previous weeks, with the
influence of past borrowings falling off (and perhaps,
because of surveillance costs, even becoming negative)
as they recede into the more and more distant past”


money market banks at least, there is sub­
stantial evidence from their asset and lia­
bility management that reluctance to borrow
is not an important attitude in restraining
policies. The large New York banks, for ex­
ample, show continuous basic reserve de­
ficiencies of substantial amounts, even
though relatively little borrowing is done at
the discount window.1 As to smaller banks,
it would be difficult to generalize about their
attitudes toward borrowing. But there seems
to have been, in recent years, a growing
acceptance of participation in credit markets
such as the Federal funds market.1

Federal Reserve influence on bank atti­

As indicated above, System views on
bank borrowing imply a belief that there is
an element of reluctance in bank attitudes
toward debt that can be emphasized and
supported by System efforts. The issue
raised by this view cannot be completely
resolved by economic analysis.
It should be noted that the financial condi­
tions that have historically tended strongly to
support a reluctance of banks to borrow
have now largely disappeared. These in­
clude: (1) the close financial interdepend­
ency among banks that existed before the de­
velopment of modem monetary policies and
that tended to make banks cautious about
interbank borrowing; (2) the intimate contudes.

(p. 506). However, the existence of multicollinearity
in the borrowing variables for previous periods made
it difficult to distinguish the effects of successively
earlier debt positions (p. 512). In addition, it has
been argued that as the rate spread widens the rateeffect on borrowing will, after some point, become
negative. Polakoff, “Reluctance Elasticity, Least Cost
and Methber Bank Borrowing—A Suggested Inte­
gration,” o p . c it. In such an event, the rate spread,
which appears to be reflection of an accumulated
indebtedness, would operate in the restrictive manner
envisioned by current monetary policy. However, this
point is still moot and a subject of current contro­
versy in the literature. Goldfeld and Kane, o p . c it.,
pp. 512-14; Polakoff and Silber, o p . c it.
1 Lynn, o p . c it.
“ See Parker Willis, “A Study of the Market for
Federal Funds” (Discount Study).

cern of most depositors with matters such as
the collateral hypothecated by the manage­
ment of their banks, which apparently ex­
isted prior to the introduction of Federal
deposit insurance and modem monetary and
fiscal policies; and (3) high rates of bank
failure (in the 1920’s and early 1930’s) as­
sociated with different economic circum­
stances and earlier views of economic policy.
Little can be said with certainty about
the Federal Reserve’s current influence on
bank attitudes toward borrowing. The most
direct influence would likely be on attitudes
toward borrowing at the discount window.
However, to the extent the discount window
represents a little used source of funds by
relatively few banks, it seems doubtful that
the window can be used effectively to in­
fluence attitudes that are continually being
shaped in a growing variety of credit mar­
kets. Particularly in view of the existence of
other sources of credit and the interbank
markets for excess funds, the attempt to in­
fluence attitudes is more likely to affect the
real cost of credit at the discount window
than the preference systems of banks with
respect to borrowing in general.
B. The bank adjustment problem

The discount mechanism provides a
method by which banks can meet reserve re­
quirements when, for one reason or another,
reserve deficiencies develop toward the end
of reserve periods, and also when large and
more sustained outflows of funds develop
during particular seasons of the year or in
periods of financial emergency. It has been
observed that small, unit banks are generally
less well equipped to handle seasonal and
other adjustment problems through financial
markets than are large branch banks.1 It
1 This note appears on opposite page.



should also be noted that adjustments by
large banks through financial markets can­
not always be managed without substantial
impacts on financial conditions generally,
and without raising serious problems for the
banking system and for monetary policy.1
In periods of financial difficulties, open
market operations constitute an effective
technique for relieving market pressures. But
since reserve drains fall on individual banks,
and because smaller and more remote banks
are not the immediate or certain recipients
of funds provided, the discount facility con­
stitutes a more selective device.
The 1955 revision of Regulation A in­
dicated that Reserve Bank credit would be
available to facilitate bank adjustment. But
it also indicated that only minimal amounts
would be available in the absence of exigent
circumstances. This orientation was based
on the belief that the nonemergency adjust­
ment problems could be substantially ameli­
orated in the then-existing financial environ­
ment, through timely open market purchases
and the market-determined distribution of
reserves thus supplied.
A principal issue raised in the course of
the discount study has been whether this
orientation is reasonable and equitable, par­
ticularly with respect to small unit banks.
(Beyond this, of course, is the question of
whether it is practicable to do anything other
than what was done in 1955.)
It is possible to break out some economic

sub-issues that bear on the general question
raised; and a number of research papers
have developed information on these.






Relatively large fluctuations in deposits and/­
or loans experienced by small, rural, unit
banks apparently derive from their lack of
diversification. It is a well-known proposi­
tion that variability of a bank’s deposits de­
pends, among other things, upon the extent
of geographic and functional diversification
of depositors. Variability, then, would be
related to bank size and also to the geo­
graphic extent of branching organization.1
Unusually large seasonal variations may
also exist because of an inverse relationship
between loan and deposit changes traceable
to bank borrowers and depositors who are
influenced by common or related factors.1
It can be shown that changes in locally
generated demands for bank loans and
deposits will be in opposite directions to the
extent that both changes derive from fluctua­
tions in the expected yield on nonfinancial
investment.1 Since the expected yields on

1 For evidence on the relationship between size and
variability see for example, Lyle E. Gramley, “Deposit
Instability at Individual Banks,” E s s a y s o n C o m m e r ­
c ia l B a n k in g , Federal Reserve Bank of Kansas City,
1962, pp. 43-53; and C. Rangarajan, “Deposit Varia­
bility in Individual Banks,” T h e N a t io n a l B a n k in g R e ­
v ie w , September 1966, pp. 61-71.
Data on intrayear fluctuations in loans and deposits
for all insured banks are presented below. Further
study of seasonal fund flows, using daily deposit and
semimonthly loan data for a selected group of mem­
ber banks, has more recently been undertaken.
“ Robert J. Lawrence, “The Regional Distribution
of Bank Loans” (Discount Study).
1 Lawrence postulates that D — D (r Si r 0, Y ) and
3 See Robert V. Roosa, “Credit Policy at the Dis­ L = L ( n , E , F), where D is the demand for bank de­
count Window: Comment,” Q u a r t e r ly J o u r n a l o f E c o ­
posits in real terms, r s is the interest rate on Government
n o m ic s, May 1959, p. 335; Edward C. Simmons, o p .
securities, r Q is the expected yield on real property, Y is
c it., p. 416; Simmons, “Federal Reserve Discount-Rate
real income, L is the demand for bank loans in real terms,
Policy and Member-Bank Borrowing, 1944-50,” T h e
n is the interest rate on loans, and E is the set of expected
J o u r n a l o f B u s in e s s , January 1952, pp. 20 and 21.
returns from the use of loan proceeds. The interest rate
1 The use of the discount mechanism as a “safety on deposits may be assumed to be zero or constant
throughout. The demand for both loans and deposits is
valve” during periods of monetary restraint is dis­
cussed in Section VI. For a description of the way in
directly related to income. The demand for loans is
which large New York City banks adjusted during
inversely related to r t and directly related to E ; the
the period of financial restraint in 1966, see Lynn,
demand for deposits is inversely related to r s and r g.
o p . c it.
The expected yield on real property and the expected


nonfinancial investment will vary seasonally
in many agricultural areas (as well as
secularly among regions experiencing differ­
ential economic change), the regional dis­
tributions of loan demand and bank de­
posits, at any point in time, may be quite
different.1 So, for example, a bank located
in an area with a highly seasonal economy
that is growing very rapidly may well find
a dearth of locally generated deposits, par­
ticularly at its seasonal peak in loan demand.
Banks requiring additional reserves may
obtain them by selling assets or by borrow­
ing. If all banks have liquid assets such as
Government securities to sell, then each can
obtain additional reserves at approximately
the same market cost, that is, the yield
foregone on the securities.1 If banks do not
have Governments to sell, however, they
must sell other assets or borrow. In selling
other assets, such as municipals, mortgages,
farm loans, etc., secondary market struc­
tures assume particular importance. These
markets range in quality from excellent to
primitive.2 It would appear, however, that
differences in the quality of such markets do
not necessarily constitute a unique problem
for small, unit, rural banks.2
returns on loan proceeds vary directly; however, the
demand for loans is directly related to the expected
return on loan proceeds, whereas the demand for de­
posits is inversely related to the expected yield on
1 Lawrence, o p . c it.
" Ib id .

2 Staff study of secondary markets in municipals,
mortgages, and farm loans was undertaken, respec­
tively, by William Staats, Federal Reserve Bank of
Philadelphia, and J. A. Cacy and Raymond Doll, Fed­
eral Reserve Bank of Kansas City. See Raymond J.
Doll, “An Investigation of the Credit Requirements
and Availability of Credit in Agricultural Areas” (Dis­
count Study), and William F. Staats, “The Secondary
Market for State and Local Government Bonds” (Dis­
count Study).
2 Improvements in secondary markets for assets
held by large numbers of commercial banks could im­
prove the availability and reduce the cost of obtaining
reserves in the absence of Government security hold­
ings. Better secondary markets might have desirable
effects, as well, on the ease with which financial mar-

In borrowing, on the other hand, the dis­
advantages of a unit banking structure
could become more readily apparent.
Smaller banks generally appear to have fewer
alternative creditors and also to suffer from
the high cost of reliable information about
them. The small size of these banks may
preclude systematic participation in some
markets (for example, Federal funds). Ties
to specific correspondents for a variety of
services may discourage, if not preclude,
effective searching for and use of alternative
sources of credit. Lack of information or
lack of ability on the part of managers of
these banks would tend to reduce the number
of alternative credit sources also. Finally, sys­
tematic reliance on time deposits may prove
impossible due to maximum rates permitted
under Regulation Q. (If large, well-known
banks are paying the maximum, smaller
and lesser-known banks cannot hope to rely
on the time deposit market.) In addition,
lack of readily available information about
smaller banks would, in general, tend to
make them higher-risk investments to poten­
tial lenders. In particular, their lack of di­
versification would increase the likelihood of
problems as seen by lenders, without any off­
set that might be warranted by more detailed
but costly investigation. Both a lesser num­
ber of alternative credit sources and the
higher risks involved in lending would, in
themselves, tend to result in a relatively high
cost and lower volume of borrowed re­
The structural disadvantage of smaller
banks was not disregarded by the System
Committee in 1955, but no special provikets adjust to monetary restraint. See Hyman Minsky,
“Financial Instability Revisited: The Economics of
Disaster” (Discount Study).
2 In effect, the demand for funds confronting a po­
tential lender would appear less elastic, and the
volume of funds such a lender would make available
at various rates would be lower.


sions at the discount window were believed
to be necessary because the vast majority of
banks held large amounts of Government
securities.2 The implicit assumption was that
reserves, whether newly injected or already
existing, would be available, and at a reason­
able cost, to banks for any short-run pur­
pose.2 In effect, it was argued that “sound”
banking requires the holding of Government
securities, and that the holdings of Govern­
ment securities give all banks access to re­
serves, whenever the banks demand them, at
a market price more or less determined by
the Federal Reserve.

Regardless of the volume of Governments
held by commercial banks, the disadvantage
of structure to the customers of small, unit,
rural banks would exist. There are costs as­
sociated with operating under these con­
ditions, and these costs presumably are
passed on to local customers. To the extent
that disadvantaged banks compete directly
with more favored banks, the latter would
tend to grow larger and the former smaller.
However, if local customers of smaller banks
can only obtain credit elsewhere from higher
rate financial institutions or at higher rates
that include a risk premium associated with
their distance and the high cost of infor­
mation about them, they too would incur the
There are, consequently, several general
implications that also warrant consideration.
First, geographic extension of competition
for bank customers will tend to injure
smaller and more specialized banks. Sec“ It should be added that unit banks in rural areas
have also had an advantage in obtaining funds in their
local areas. Limited numbers of competitors and high
regulatory barriers to entry have permitted these
banks, at least until very recently, to obtain deposits
at rates well below those paid in major metropolitan
“ The emphasis on short- or possibly intermediateterm adjustment stems from the restriction on con­
tinuous borrowing reviewed above.


ondly, while some customers would benefit
from such competition, others—particularly
small and locally limited customers—would
probably not and could suffer as a result.
Whether or not extra-local competition de­
velops, the problems associated with small
size would tend to result in an undesirable
allocation of bank credit.
Finally, the responsibility assumed by the
System in providing reserves through open
market operations in response to seasonal
and other fluctuations to facilitate bank ad­
justment is made more difficult in a bank­
ing system that relies on credit markets. The
difficulties faced by small banks, among
other things, create conditions such that the
reserves provided through open market pur­
chases will not necessarily be distributed
among banks in proportion to losses in re­
serves they are intended to replace.2
Magnitude of the problem. An evaluation of
current discount policy with respect to the
provison of credit for bank adjustment pur­
poses was approached by considering the
magnitudes of intrayear fluctuations faced
by banks in different size groups and eco­
nomic situations, and by examining the ways
in which adjustments currently may be
handled. In considering alternative methods
of adjustment, recent developments in bank
holdings of Government securities were re­
viewed, as was evidence on credit flows
through the correspondent system and the
markets for Federal funds and certificates of
I n t r a y e a r F l u c t u a t i o n s . As noted above,
deposit variability at the individual bank
level is related to the economic diversifica­
tion of bank customers. Loan demand varia­
bility would seem to be directly related to
the economic diversification of borrowers.
2 On the reserve distribution problem, see Gold­
feld, o p . c it., p. 153.


Such variability in deposits and loan demand
may tend to be reinforcing rather than off­
setting in producing variability in the de­
mand for reserves, at least over some periods
of time.
A rough attempt was made to determine
the magnitudes of intrayear fluctuations at
individual banks by looking at their quar­
terly and semiannual outflows (or inflows)
defined as the change in the deposits of
individuals, partnerships, and corporations
(IPC) minus the change in nonfinancial
loans, after both were “adjusted for trend.”2
The only comprehensive data available for
banks of all sizes were from condition re­
ports. Semiannual and quarterly changes
were computed for the period July 1962June 1963, and semiannual changes for the
period July 1965-June 1966, these being
the only periods for which data were avail­
able. The analysis was based on data for all
insured commercial banks.
The inflows and outflows of funds, as cal­
culated, include both random and seasonal
movements. In addition, there is little like­
lihood that the maximum variation in either
type of movement (or the net of the two)
has been accurately calculated, since the
dates upon which the calculations are based
are not necessarily analytically meaningful.
(However, the half-year periods July-December may approximate the period of max­
imum fund outflow in many agricultural
areas.) It should also be noted that the cal­
culation makes no distinction between loans
and deposits as claims on bank resources.
Thus in the case of pressure on a bank’s re­
serve position, where loans are liquidated to
meet deposit losses, the calculated outflow of
funds would be reduced; and the outflow fig­
ure would not be comparable with the case
2 An exact definition of the fund flow calculated
may be found in Emanuel Melichar, “Intra-year Fund
Flows at Commercial Banks” (Discount Study).

in which pressure on reserves is met by sales
of liquid assets.
Results of the analysis based on these
data are generally consistent, however, with
expectations and may be viewed as provid­
ing some notion of the quantitative signifi­
cance of the fluctuations experienced. Data
for all member and all insured banks sug­
gest that the likelihood of a bank experi­
encing a “large” intrayear outflow (defined
as 10 per cent or more of deposits) is in­
versely related to size (Table 4). Thus, in
the first half of 1966, for example, 27 per
cent of member banks with deposits of under
$2.5 million had “large” fund outflows, com­
pared with 6 per cent of banks with deposits
of $25 million to $100 million. Substantially
identical results were obtained for the first
half of 1963. Quarterly data for 1962-63
and data for all insured banks also are con­
sistent with the conclusion.2
For a number of banks, fund outflows re­
sulted from a combination of deposit de­
clines and loan increases during the same
period. For example, during the second
quarter of 1963, 42 per cent of member
banks had simultaneous increases in loans
and declines in deposits. These combined
to cause an outflow of $2.75 billion at these
banks.2 During the first half of 1966, 46
per cent had increases in loans and declines
in deposits, with a resulting outflow of $5.5
billion (Table 5).
The dollar amounts involved in intrayear
fund outflows of banks with “large” outflows
were, as might be expected, a relatively small
portion of total outflows. For example, in
the first quarter of 1963, the aggregate out­
flow for all member banks experiencing out­
flows was $5.7 billion. Of this amount, the
aggregate outflow for banks with an outflow
2 Ibid.
2 Ibid.




Percentage of Banks with Fund Outflows of 10 Per Cent or More of Net Deposits, by Size of Bank
Net deposits (millions of dollars)

Net deposits (millions of dollars)










Member banks

Jan.-June 1966.
Jan.-June 1963.









July-Sept. 1962.
Oct.-Dec. 1962.


Jan.-Mar. 1963.
Apr.-June 1963.






1 Less than one-half of 1 per cent.


















Member and insured nonmember banks


July-Dee. 1965.
July-Dee. 1962.












S o u r c e .—Emanuel Melichar, “Intra-Year Flows of Funds” (Dis­
count Study).

Distribution of Member Banks and Their Net Fund Flows, by Change in IPC Deposits and in Loans 1
Deposits down




Deposits down

Deposits up


Percentage distribution of banks




Deposits up


Net fund outflow, ( —) ; 1r inflow, ( + ) (in millions of dollars)

July-Dee. 1965........
July-Dee. 1962........







-3 8

-3 2 4

+ 4,844


Jan.-June 1966.........
Jan.-June 1963........






-8 ,2 3 7
-7 ,1 0 8

-3 ,1 8 0
-2 ,5 8 3

-5 ,5 2 5
-4 ,8 4 4



July-Sept. 1962........
Oct.-Dec. 1962........







-4 8 8
-1 0 6

-1 ,2 9 3
-4 4 4



Jan.-Mar. 1963........
Apr.-June 1963........






-4 ,6 4 8

-3 ,2 9 5

-2 ,1 0 0
-2 ,7 4 7



1 IPC deposits are those of individuals, partnerships, and corpora­
tions. Loans exclude those to financial institutions and those for
purchasing or carrying securities.

S o u r c e .—Emanuel Melichar, “Intra-Year Flows of Funds.” (Dis­
count Study).

of over 5 per cent of deposits was $2.9 bil­
lion; for banks with an outflow of over 10
per cent, it was only $700 million. Similar
results were obtained for the 1965-66 pe­
riod2 (Table 6).
Finally, as expected, changes in holdings
of U.S. Government securities and in bal­
ances held with other domestic banks ap-

peared to be related to the magnitude of the
outflow. And as also expected, the adjust­
ment in these assets made by nonmember
banks in response to a given magnitude of
outflow was larger than for member banks.3
b. B a n k A d j u s t m e n t in A g r i c u l t u r a l A r e a s .
Because of State branching laws and re­
gional economic conditions, small, unit,

2 Ib id .



(In billions of dollars)
Fund outflow as percentage of net deposits






15.0 I 20.0
to ' to


Fund outflow as percentage of net deposits

Member banks







Jan.-June 1966.
Jan.-June 1963.









July-Sept. 1962...........
Oct.-Dec. 1962............





Jan.-Mar. 1963...........
Apr.-June 1963...........






















i Less than $50 million.

rural banks tend to be concentrated in the
southern and middle western portions of the
United States, that is, in the sixth, seventh,
eighth, ninth, tenth, and eleventh Federal
Reserve districts. Close to 4,000 member
banks, about 65 per cent of all members, are
located in these six districts. About 6,000
of the 7,300 nonmember banks are also in
these districts.
Over the last 15-20 years there have been
persistent increases in demands for credit
in many such areas derived from an expan­
sion of the optimum-size farm and a sub­
stitution of capital for labor in farming.3
Total farm debt to banks and other credit
institutions has increased substantially. The
increase at banks was 213 per cent in the
1946-56 period and 126 per cent in the
1956-66 period.3 In the tenth Federal Re­
8 Staff study of credit demands in agricultural
areas was undertaken by a task force headed by
Raymond J. Doll, Federal Reserve Bank of Kansas
City. See Doll, op . cit .
^Emanuel Melichar, “Bank Financing of Agri­
culture/’ Federal Reserve B ulletin , June 1967, p. 928.
Farm credit provided by other institutions, such as
Farmers Home Administration, Federal intermediate
credit banks, production credit associations, and Fed­
eral land banks, has also increased substantially.




15.0 ! 20.0
to J to


Member and insured nonmember banks

July-Dee. 1965.
July-Dee. 1962.


j Under |




























S o u r c e .—Emanuel Melichar, “Intra-Year Flows of Funds.” (Discount Study).

serve district (Kansas City), for example,
total loans at rural banks increased about
180 per cent between 1950 and 1965.
Income and deposits in rural areas have
increased much more slowly. Deposits at
country banks in 20 farm States increased
about 29 per cent in the 1946-56 period
and 66 per cent in the 1956-66 period.3
The secular growth of credit demands
and the slower growth of income and depos­
its in rural areas would presumably tend to
aggravate the traditional short-term adjust­
ment problems for rural banks. Other things
being equal, intrayear outflows of funds
would become larger in both dollar and rela­
tive terms. Historical data, however, are not
available to investigate this hypothesis, and
it should be noted that this tendency might
well be offset by diversification among cus­
tomers of rural banks. To the extent that
farmers diversify and reduce their own sea­
sonal movements in income and credit de­
mands, rural banks would similarly obtain
the benefits of diversification.
3 Ibid.




Percentage Change, June 1961-June 1965
Qass of bank,
and deposit size
(millions of dollars)
Reserve city:
25 and under............
Over 100..................






Atlanta Chicago






- 4 9 .0

- 2 9 .6
-3 2 .0

- 2 1 .0
-2 1 .1
- 3 3 .9

- 4 1 .5
- 3 8 .4

- 4 3 .4
- 6 2 .0
- 4 7 .2

-6 0 .2
- 3 1 .3
- 2 8 .8

- 1 2 .2
- 3 8 .9
-3 5 .3

- 6 3 .2
- 3 4 .4

-5 2 .1
- 1 8 .3
-4 4 .9


- 5 4 .7

-3 5 .3

25 and under..
Over 100........


-1 7 .3
- 3 1 .6
-3 8 .7




- 2 5 .2

-2 0 .1
-2 7 .5
- 4 2 .7

-2 1 .0
- 2 9 .0
- 2 1 .7

-1 6 .1
- 2 7 .5
- 3 0 .8

-1 7 .8
-3 1 .1

-1 6 .1
- 2 2 .5

- 1 8 .5
-3 5 .2
-3 3 .5

-2 5 .7
- 2 7 .6
-3 1 .5

-1 8 .5
- 3 5 .2
- 3 6 .9

Nonmember insured:
25 and under.. . .
Over 100............


-2 1 .1
- 2 2 .3
- 4 3 .0

- 1 4 .7
- 2 3 .5
- 1 7 .3

- 1 1 .9
-3 2 .3
- 4 8 .4

-1 6 .1
- 2 9 .0
-3 1 .7

-1 5 .6
-1 0 .3

-7 .4
-2 4 .7

- 1 4 .7
- 3 1 .8
+ 11.0

- 8 .7

-1 3 .1

- 2 3 .8
- 1 4 .0

- 2 3 .3
-3 0 .1
- 3 8 .3

Source.—Board of Governors of the Federal Reserve System.

C. Holdings of Government Securities. In the
last two decades rapidly rising demands for
credit in the private and non-Federal Gov­
ernment sectors have substantially raised the
returns on bank assets such as loans, and
thereby the cost of holding Government
securities. In consequence, there have been
substantial reductions in the proportion of
assets and deposits held by banks in Govern­
ment securities.
At the end of 1954, about 40 per cent
of net deposits of member banks were held
in U.S. Government securities. At reserve
city banks the proportion was 39 per cent

Face value of paper
presented and analyzed
(millions of dollars)


All member
All member except reserve
city banks in
N.Y. district













and at country banks about 42 per cent. By
the end of 1967, the proportion held in Gov­
ernments had declined for all members to
about 16 per cent, with reserve city banks
holding 13 per cent and country banks 20
per cent. Data for the period 1961-65 sug­
gest that declines in holdings of U.S. Gov­
ernment securities have been consistent
across different geographic areas. On the
average, small, medium-sized, and large re­
serve city, country, and nonmember insured
banks in each district have experienced sub­
stantial declines (Table 7).3
In rural areas some banks’ holdings of
Government securities were still found to be
quite high. For example, in the Kansas City
District it was reported that a number of
rural banks have more funds invested in
3 At the discount window, in the last several years,
this trend has been reflected in the substantial in­
crease in borrowing collateralized by eligible paper in
contrast to Government securities. The face amount
of eligible paper presented and analyzed at Federal
Reserve Banks increased from about $150 million in
1959 to over $20 billion in 1966 (Table 8). In some
banks, the Government securities that are held are
pledged largely as collateral for public deposits. It is
estimated that around half of the more than $50 bil­
lion in U.S. Government securities held by banks are
pledged. See Charles F. Haywood, T h e P le d g in g o f
B a n k A s s e ts , A Study Prepared for the Trustees of
the Banking Research Fund, Association of Reserve
City Bankers, p. 5.


Government securities than in loans. Staff
study found that banks maintaining rela­
tively high ratios of Government securities
were not infrequently found in communities
where other banks had reduced their hold­
ings of Governments substantially. The find­
ing suggests that profitable opportunities in
acquiring alternative assets may well exist
even where banks maintain large volumes of
Government securities.3
Credit Flows Through the Correspondent
Banking System. There is evidence that corre­
spondent relationships result “. . . in a sub­
stantial net flow of funds fro m smaller local­
ities, where credit availability is relatively
low and interest rates are high, to larger
localities where availability is high and rates
are low.” 3 However, many different kinds
of services are obtained by small banks from
large correspondents and are paid for prin­
cipally with deposit balances. In conse­
quence, the implications of this “perverse”
deposit flow for credit availability from
large correspondents are not completely
The best data currently available on credit
flows through the correspondent banking
system were obtained in a 1963 survey for
the Committee on Banking and Currency of
the House of Representatives.3 Analysis of
3 To some undetermined degree, the decline in hold­
ings of Government securities by banks has probably
been restrained by Federal Reserve System policies.
For example, the Federal Reserve Bank of New York
developed an examinations procedure designed to eval­
uate the operations of banks by the standards of
current Regulation A. The procedure is directed par­
ticularly at finding out whether or not banks are
maintaining sufficient liquidity to meet seasonal pres­
sures. Benjamin Stackhouse, “Discount Policy and
Bank Supervision” (Discount Study).
3 Jack M. Guttentag and Edward S. Herman,
B a n k in g S t r u c t u r e a n d P e r f o r m a n c e , Institute of Fi­
nance, New York University, February 1967, pp.
3 See Ira Scott, Jr., A R e p o r t o n th e C o r r e s p o n d e n t
B a n k in g S y s t e m , Subcommittee on Domestic Finance
of the Committee on Banking and Currency of the
U.S. House of Representatives, Washington, 1964.

these data suggests that the correspondent
system does generate a substantial amount
of credit.3 In the fall of 1963, the estimated
volume for all commercial banks aggregated
roughly $5.5 billion. Of this total, a rela­
tively small amount, about $500 million,
was in the form of direct borrowing under
credit lines or similar arrangements, or
through asset sales. The preponderance was
in the form of loan participations (Table


(In millions of dollars)

Type of credit

All insured

Banks with
deposits less
than $100 million

Participation loans—amount held
by correspondent: 1
Commercial and industrial.......
Non-real-estate farm.................



Total participation credit___







Borrowing under lines of credit 2..
Sales of assets to correspondents 3

1 Outstanding as of survey date.
2 Largest amount reported to have been borrowed within 12 months
previous to survey.
3 Mortgages, State and local government securities, and consumer
loans sold in 12 months previous to survey.
Source .—Estimates based on data from 1963 survey of the Banking
and Currency Committee of the U.S. House of Representatives.

However, much of the volume represented
an exchange of credit among relatively large
banks; $3.8 billion was obtained by banks
with deposits over $100 million. Only some
portion of the remainder can be thought
of as credit that might conceivably be avail­
able to small banks for adjustment pur­
3 Staff study of correspondent banking was under­
taken by a task force headed by Ernest Baughman
and Dorothy Nichols, Federal Reserve Bank of
S9As can be seen in Table 9, of the $1.7 billion
that can be identified as going to banks with less than
$100 million in deposits, $1.4 billion was in the form



About two-thirds of all insured banks with
deposits of less than $100 million reported
some sort of credit arrangement with cor­
respondents in 1963. However, the propor­
tion of banks reporting actual credit trans­
actions in that year was considerably less.
This was particularly true for small banks—
banks with deposits of less than $5 million
(Table 10).
(Pei* cent of all insured banks)
Size of insured bank (total
deposits, in millions of dollars)
Type of credit reported

Any credit arrangements with
Measurable credit on date of
Participation loans on date of
Borrowing under lines of credit.
Sales of assets..............................
Number of banks—total.............
















N o t e .—In some cases the correspondent’s share of a participation
loan was retired prior to the survey date. In consequence, the pro­
portion reporting measurable credit is slightly lower in some instances
than the proportion reporting participation loans.
S o u r c e . —Estimates based on data from 1963 survey of Banking
and Currency Committee of the U.S. House of Representatives.

Among member unit banks with under
$25 million in deposits, outstanding corre­
spondent credit in late 1963 amounted to
about $313 million, that is, about $204,000
per bank. The average was about $ 160,000
for banks with less than $5 million in de­
posits.4 Relatively few commercial banks
(about 6 per cent) with under $100 million
of loan participations. It should be noted that these
figures are not comparable with figures on credit made
available at the discount window, since the latter are
typically on a daily-average basis. The estimate of
aggregate volume passing through the correspondent
systems includes participations outstanding as of the
survey date, the largest amount borrowed under lines
of credit in the previous 12 months, and sales of
mortgages, municipals, and consumer loans in the
previous 12 months.

in deposits used correspondent credit in ex­
cess of 10 per cent of their loans.
There is evidence that the amount of credit
provided by correspondents to rural banks,
though still modest in dollar totals, has in­
creased substantially over the last decade.
Data for 1956 and 1966 indicate that farm
participation loans increased 618 per cent,
or at an average annual rate of 22 per cent.
A check on this “long-term” trend with data
for 1963 indicated that roughly the same
annual rate of increase had occurred in re­
cent years.4
It would appear then that correspondent
credit, at least in some moderate amounts,
has been and is available to relatively small
banks. This does not mean, however, that
the credit generally available is suited to
meeting the problems of bank adjustment.
The preponderant type of accommodation
is the participation loan, and a substantial
proportion of the participations are appar­
ently overlines, that is, loans that exceed the
lending limit of the smaller bank. The over­
line participation loan, at least, represents a
relatively inflexible type of credit.
Perhaps even more importantly, there is
reason to believe that the cost of participa­
tion and overline credit is quite high, even
though the maintenance of a balance by
smaller banks and the package of services
offered by the large correspondents in re­
turn effectively preclude accurate cost es­
timates. The availability of credit generally
depends on the profitability of the long-run
balance supplied by the borrowing bank.
When credit is extended in the form of a par­
ticipation, the borrowing bank is also fre­
quently asked to increase its balance at least
4 Among nonmember unit banks, the per-bank
average was $178,000 for banks with under $25 mil­
lion in deposits and $87,000 for banks with less than
$5 million.
n Emanuel Melichar, “Bank Financing of Agricul­
ture,” o p . c it., p. 937.


by as much as that which the customer
would be expected to maintain if he had
obtained the loan directly from the corre­
spondent. Finally, the participating bank
receives the interest paid by the customer
on the share of the loan taken.
A relatively high cost for participation
credit should not be unexpected. Funds are
made available without a long-term rela­
tionship with the ultimate customer; conse­
quently the loan would normally be viewed
as a relatively undesirable use of funds by
the lending bank. From the point of view of
the borrowing bank, credit is solicited, par­
ticularly in case of overlines, in order to
keep a long-term relationship with a cus­
tomer who might otherwise be immediately
and irrevocably lost, and often with some
feeling that the solicitation of overline credit
from a larger bank is dangerous because the
customer may be ultimately lost in the proc­
ess anyway. Both supply and demand factors
would, therefore, tend to result in high
“prices”; and the expansion of correspondent
credit in recent years may simply reflect the
still higher cost of alternative methods of ad­
A comparison between fund flows in a
unit-correspondent banking system and in a
branch banking system is useful. There is
considerable evidence to the effect that the
potential and actual fund flows in a branch
banking system are substantially greater.4
This must reflect both the greater avail­
42 It should be noted that variability in interbank
deposit balances is not a reasonable measure of the
correspondent banking contribution to meeting ad­
justment problems, at least for small, unit banks. As
in the case of Government securities, such balances
have declined substantially in recent years as a per­
centage of deposits, from about 9 per cent to 5.5 per
4 Staff study of fund flows within branch banking
systems was undertaken by Verle Johnson, Federal
Reserve Bank of San Francisco; Harmon Haymes.
Federal Reserve Bank of Richmond; and Margaret
Beekel, Federal Reserve Bank of Cleveland.

ability and the lower “cost” of additional
reserves to an office that is part of a single
banking organization with many branches.
The branch office would benefit in obtaining
“credit” not only from a less severe liquidity
constraint but also from the financial market
position of its larger organization, the geo­
graphic diversification of other offices in the
system, and, most probably, a better in­
formed management.
Credit Flows Through the Federal Funds
Market. Since the early 1960’s, there have
been highly important changes in the nature
of the Federal funds market. These include
a rapid expansion in the number of small
banks participating, either as sellers or buy­
ers, or both. In 1961 about 400 country
banks, generally larger than $75 million in
deposits, traded in Federal funds; their par­
ticipation was probably infrequent. The
standard unit of trading at that time was $1
million; and this was a larger amount than
would be efficient for banks of much less
than $100 million in deposit size. In con­
trast, in 1966 it was estimated that over
2,000 country banks traded, at least occa­
sionally. These included banks with less than
$10 million in deposits; the standard unit of
trading had declined to $200,000, with con­
siderably smaller amounts being traded from
time to time.4 There has been a rapid de­
velopment of participation by small and geo­
graphically dispersed banks. The proportion
of banks with less than $10 million in de­
posits that traded Federal funds was about
22 per cent in 1966. In the Boston District,
the proportion was 72 per cent but in all
others was considerably lower (Table 11).
The growth of small bank participation in
the Federal funds market is traceable in large
part to the efforts of large, money market
4 Parker Willis, “A Study of the Market for Fed­
eral Funds,” o p . c i t .



Banks with Less Than $10 Million in Deposits
Banks in district


number i


New York..........................




Kansas City.......................
San Francisco....................








1 Based on numbers of banks shown in annual member bank oper­
ating ratio reports or monthly reviews of the Federal Reserve Banks.
2 Figures for traders in the Boston, Philadelphia, New York,
Richmond, Chicago, Minneapolis, and Kansas City Districts were
derived from surveys. Data for other districts are estimated.
S o u r c e .—Parker Willis, “A Study of the Market for Federal Funds”
(Discount Study).

banks, particularly in New York City. The
objective has been to secure a dependable
source of continuous credit to support larger
portfolios than would otherwise be possible.
The provision of an investment service by
these large banks to small banks in outlying
areas for short-term money has evidently
put competitive pressure on large regional
banks to provide a similar service. It is esti­
mated that by 1966 there were 70 accommo­
dating correspondent banks, that is, banks
that trade for themselves and other banks,
with mutually exclusive networks ranging
from 5 or 6 to several hundred smaller
banks.4 On an average day, $3.5 billion to
$4 billion has been traded in the market;
and considerably more on some days. In con­
trast, borrowing at the discount window
rarely exceeds $1.5 billion to $2 billion on
any day, and normally is well below that.
The Federal funds market is probably
4 Ibid.

still in flux, though there is doubt that large
numbers of additional small banks will be
incorporated into it in the near future.4 The
principal impact of the change has been to
reduce the volume of excess reserves carried
by smaller banks and to weaken reliance on
the discount window by larger banks, if not
smaller ones.
The initial objective of the correspondentaccommodating system was, as noted, to fa­
cilitate reserve adjustment for larger banks,
not smaller ones. Nevertheless, the system
has developed competitively to serve addi­
tional purposes. Indeed, “(m)any smaller
country banks indicate that trading in Fed­
eral funds has reduced their reliance on pur­
chases or sales of Treasury and other money
market instruments as a means of reserve
adjustment.” 4
Most of the smaller banks involved are,
however, typically sellers, not purchasers. In
1966, the smaller banks supplied from
$800 million to $1 billion net on average
each day. Their average daily purchases
probably did not exceed $300 million.4
Moreover, there is considerable doubt as to
whether heavy buying by smaller banks is
feasible. It was found that at least some
smaller banks fear that turning to the corre­
spondent will lead to a demand for addi­
tional balances.4 But the extent to which
smaller banks can “buy” probably varies
from group to group,5 and as noted above,
about three-quarters of the banks with less
than $10 million in deposits still do not par­
ticipate. Finally, the credit involved is still,
essentially, “1-day” money, though some

4 Ibid. This includes the purchases of all banks in
the country bank classification.
4 Ibid.
5 Ibid.


longer-term arrangements are made from
time to time.5
In sum, smaller, unit banks probably can­
not view the Federal funds market, even in
its current high state of development, as a
dependable substitute for holdings of Gov­
ernment securities or excess reserves for ad­
justment purposes. They may well view it
as an outlet for excess reserves and an occa­
sional source of credit to meet unexpected
and very short-run reserve losses. The larger
banks that have initiated its development,
on the other hand, evidently do view it as
a source of reserves for both intermediateand longer-term adjustment.
One additional implication of these changes
in the Federal funds market should be noted.
The behavior of neither the large banks nor
the small banks is consistent with the ra­
tionale of Regulation A as originally con­
ceived. Continued reliance on borrowed
funds by the larger banks indicates an in­
sufficiently reluctant behavior that requires
some degree of “administrative discipline”
when and if they borrow at the discount
window. The frequent sale of Federal funds
by smaller banks would seem also to reflect
an “undue” sensitivity to market rates of in­
terest under current discount standards.
Such sales to large money market banks can
become particularly important during peri­
ods of monetary restraint when the objective
of Federal Reserve policy is to force asset
The Markets for Certificates of Deposit.
The extent to which small banks in rural
areas are at a disadvantage in purchasing re­
serves outside their local market areas is only
indirectly suggested by differential rates on
prime and off-prime CD’s of commercial
banks. While the differential varies with eco­
nomic conditions, it was noted that off11Ibid.

prime CD’s when issued and traded require
a higher rate than CD’s of prime name
banks in New York.5 “In this sense,” it was
reported, “buyers discriminate against certifi­
cates of smaller, less well-known banks.” 5
The prime (and “lesser-prime”) banks cur­
rently constitute less than 100 in number,
however, and include only very large institu­
tions, with deposits of $500 million or
more.5 The “off-prime” banks whose certifi­
cates trade in the secondary market still in­
clude only large institutions by comparison
with the vast majority of banks. While
smaller banks can frequently sell certificates
at favorable rates in local or regional mar­
kets, these do not normally trade at all.5
The designations of “prime” and “offprime” reflect relative marketability. Mar­
ketability depends on the degree to which a
bank is “known.” 5 An inability on the part
of smaller banks to sell CD’s outside local
market areas or to have their CD’s traded
cannot moreover be completely attributed to
differences in the actual risk involved in
lending to them or, for that matter, even to
the cost of gathering information about
them. Many small banks are no doubt ex­
tremely safe institutions. And while informa­
tion on their operations is typically collected
by supervisory authorities, it is not normally
disclosed to potential lenders. Policies asso­
ciated with releasing information, not the
cost of gathering it, have established a level
of risk that is not necessarily an accurate
reflection of what exists.
Conclusions. The available information
supports the view that small rural banks,
concentrated in the sixth through the elev°3Parker Willis, “The Secondary Market for Ne­
gotiable Certificates of Deposit” (Discount Study).
5 Ibid.
“ Ibid.
5 Ibid.
“ Ibid.



enth Federal Reserve districts, have serious
disadvantages relating to their organizational
structure. In many cases the prohibition of
branching precludes growth to large size.
This restriction on growth and geographic
expansion frequently results in a high de­
gree of deposit and asset specialization that
promotes variability in deposits and loans.
Such variability may be accommodated by
holding relatively large volumes of liquid as­
sets or by borrowing. If liquid assets are
relied on, substantial portions of bank assets
may be unavailable for local loans and the
cost of lending will be correspondingly
In recent years, the opportunity costs of
holding liquid assets have risen considerably
and many banks have increasingly relied on
credit for adjustment purposes. When at­
tempting to obtain credit, smaller banks are
apparently at a disadvantage and probably


pay relatively high rates when such credit
is available.
The volume of credit available to small
banks via the correspondent banking system
is still relatively small. However, the amount
of credit passing through the correspondent
banking system in recent years, in partici­
pations and Federal funds, has apparently
been growing. Competition among large cor­
respondents shows some signs of providing
increased benefits to small banks. Never­
theless, the “correspondent market” in which
small banks attempt to obtain credit is still
highly imperfect. It is characterized by
large bank-small bank bargaining relation­
ships, traditional and multiservice arrange­
ments that probably tie small banks rather
firmly to particular large banks, and a dearth
of information on the real costs of the in­
dividual services being provided.


As noted above, the implicit change in the
formulation of the discount mechanism in
1955 was a more restrictive interpretation
of “appropriate” borrowing than in the
1920’s. In large measure the broad aim of
restricting the provision of Reserve Bank
credit through the discount window has been
met over the last 13 years. As can be seen
in Chart 1, in comparison with the 1920’s
a very small proportion of Federal Reserve
credit has been provided at the discount
window since 1955. On a quarterly basis,
the ratio of borrowing to required reserves
has ranged from less than 1 per cent to a
little over 5 per cent; the proportion of mem­
ber banks borrowing from the Federal Re­
serve has ranged between 9 and 22 per cent.
(Chart 4).1
1 It should be noted that the proportions of mem­
ber banks borrowing from the Federal Reserve on a

As would be expected under the current
discount mechanism, there have been cycli­
cal changes in borrowing activity. There ap­
pears also to have been a downward trend
which, while widely appreciated within the
Federal Reserve System, is not obvious from
aggregate borrowing figures alone. In Table
12, the results of a multiple regression analy­
sis are presented, relating a trend variable,
among others, to ratios of borrowing to re­
quired reserves. Holding constant the bill
rate, discount rate, required-to-total re­
serves, offices-to-banks, and indicated ad­
ministrative standards among groups of dis­
tricts, a linear trend variable was significant
and explained a considerable proportion of
quarterly and on an annual basis are not comparable.
To the extent different banks borrow in each quarter,
the proportion borrowing on an annual basis would
be higher.


Member Bank Borrowing
at the Discount Window

Quarterly data.

the variation in borrowing over time.2 This
was true of reserve city and country banks.
These results suggest a decline of close to
1 percentage point per year in the ratio of
borrowing to required reserves for reserve
city banks; and a decline of V2 percentage
point per year for country banks. Given bor­
rowing ratios that range between 1 and 5 per
cent, the importance of such a decline is evi­
dent. The equations suggest that the borrow­
ing ratios have, in fact, been maintained be­
cause of increases in required-to-total re­
serves and, for city banks, by the rise in
market rates relative to the discount rate.
2 The variable, bank offices-to-banks in each district,
is based on the hypothesis that branch banking affords
greater stability of deposits and loans and, therefore,
the extent of branching is, other things equal, inversely
related to supply and demand for credit at the discount

The reduction in activity has been ac­
companied by an expansion in estimated
borrowing from other sources and in no
way should be taken as evidence of a strong
reluctance to borrow as the term has been
defined above. While the proportion of re­
quired reserves borrowed by member banks
from the Federal Reserve declined by 30
per cent between 1959 and 1966, the esti­
mated proportion of required reserves bor­
rowed from all suppliers or sources of credit
increased by 124 per cent (Table 13).3
Since 1959, the proportion of reserve city
banks borrowing from Federal Reserve
Banks has changed very little, but the pro­
portion of reserves they have borrowed from
the Reserve Banks has declined. In contrast,
the proportion of reserves borrowed from
all sources has increased substantially.
The borrowing behavior of country banks
since 1959 is equally, if not more, indica­
tive of the movement from borrowing at
Reserve Banks to borrowing from other
sources. Table 14 shows by Reserve District
the percentage changes in country bank bor­
rowing at the discount window and borrow­
ing from all sources for the recent period
(with alternative initial and terminal dates:
1959-66; 1959-65; 1960-66). In each
comparison of the proportion of reserves
borrowed from the Federal Reserve and
from all sources, the contrasting directions
of change are generally evident. For ex­
ample, between 1959 and 1966 the propor­
tion of banks borrowing from the Federal
Reserve declined in 8 out of 12 dis­
tricts; the proportion borrowing from all
sources increased in 11 out of 12 districts.
3 The 1959-66 period is one for which detailed
borrowing data are available and, in comparing per­
centage changes, is advantageous in that both 1959
and 1966 were years of monetary restraint. Alteration
in initial and terminal dates, so that the period runs
from 1960 to 1966 or from 1959 to 1965, does not
alter the conclusions.




Regression Coefficients for 1955-65
Independent variable




-.3 3 *

- .1 2


- .3 5 *


Excluding “central reserve city” ..

- .0 8
0 . 12)


Reserve city:
Including “central reserve city” ..


age of
to total


Class of bank



- . 22 *

Ratio of

( . 12)


District classification1

of multiple
tion R 2



-.9 1 *





(. 68)

-.9 4 *



( . 10)




- .5 0 *


-.2 6
( . 21)



( . 10)

* Significant at the 5 per cent level.
1 For discussion of classification, see p. 15.
for borrowing to required reserves are based on

annual aggregates for each district. The statistical procedures involved
a pooled cross section (by district), time-series analysis for yearly dataStandard errors in parentheses.

The actual changes themselves, even when
in the same direction, generally suggest a
differential influence at work. So, for ex­
ample, the proportion of country banks bor­
rowing from the Federal Reserve in the
Philadelphia District declined 41 per cent
between 1959 and 1965; in the Richmond

District, the decline was about 40 per cent;
in St. Louis about 65 per cent; and in At­
lanta about 22 per cent. Declines in the
proportions borrowing from all sources were,
respectively, — .2 per cent, — .9 per cent,
— 4.8 per cent, and — 6.8 per cent. Similar
examples can be found by examining the
There are, no doubt, a number of related
reasons for a downward trend in borrow­
ing at the discount window. These would in­
clude the general prohibition of credit for
normal operating purposes, the gradual im­
plementation of the revision of Regulation
A after 1955, and development of other
markets for credit.
In the kind of financial environment that
has been developing, a related reason
may also be considered. To potential bor­
rowers who do not conform to the rough
regulatory image of a “sufficiently reluctant”
borrower, described in the General Prin­
ciples of Regulation A, the discount mecha­
nism represents an uncertain source of funds.
There would be, for such borrowers, sub­
stantial nonmonetary costs associated with

N o t e . —Ratios

Federal Reserve Banks Compared with All Sources
Federal Reserve Banks

All sources

member city Country member city Country
banks banks banks
banks banks banks


4 .0




















1 959-66....

- 3 0 .0

-3 9 .1

- 2 6 .3

+ 124.2 +106.7

+ 46.2

N o t e .—Figures for “all sources” are estimates of borrowing from
all suppliers of credit obtained by capitalizing the interest paid on
borrowed funds, shown in earnings and dividends reports, at the
discount rate through 1965, and at the average effective Federal funds
rate in 1966.








Atlanta Chicago






+ 7 .6
+ 78.8

-2 3 .9
+ 75.0

Change from 1959 to 1966
Proportion borrowing
Federal Reserve.............
All sources.....................

- 6 .5

- 8 .0
+ 1 .7

- 2 2 .4
+ 22.1

- 4 5 .7
- 7 .3

- 2 0 .2
+ 10.8

+ 21.7
+ 9 .2

+ 15.2
+ 4 4 .4

- 1 5 .3
+ 30.6

- 1 .9
+ 36.3

+ 3 .0
+ 18.4

Proportion of required re­
serves borrowed from:
Federal Reserve............. - 3 3 .3
All sources.....................
-8 .9

+ 11.9
+ 90.2

- 4 8 .6
+ 64.7

-6 6 .7
+ 7 1.4

- 5 5 .8 +281.8
+ 19.4 + 10.2

+ 8 8 .4

- 4 6 .2
+ 31.6

-5 6 .1
+ 42.9

-2 6 .1
- 5 3 .8
- 4 8 .4
+ 8 .6 + 136.4 +184.6

Change from 1959 to 1965
Proportion borrowing
Federal Reserve.............
All sources.....................

- 3 0 .7

-3 2 .6

- 4 0 .7

+ 10.6

- 11.8


Proportion of required re­
serves borrowed from:
Federal Reserve............. - 7 3 .7
All sources..................... - 1 9 .6

- 4 7 .6
+ 4 7.6

- 6 8 .6
+ 29.4

- 6 9 .8
-1 9 .6

- 3 9 .6
- .9

- 2 2 .4
- 6 .8

- 3 0 .9
+ 6 .2

- 6 5 .3
-4 .8

-3 0 .7
+ 8 .0

- 2 7 .9
- 5 .1

- 5 3 .3
+ 38.0

-7 2 .5
+ 65.8

- 8 7 .5
+ 34.3

- 7 8 .8
- 2 4 .2

- 1 .0

- 6 5 .5
+ 16.3

-7 3 .1
+ 2 .6

-6 5 .9
+ 16.3

- 5 9 .4
+ 14.3

- 6 0 .9
+ 69.7

- 5 3 .8

Change from 1960 to 1965
Proportion borrowing
Federal Reserve.............
All sources.....................

+ 2 .3

- 2 9 .6
- 6 .7

- 3 7 .6
- .8

- 6 5 .3
- 1 4 .9

-6 3 .9

- 4 7 .7

- 11.0

-4 0 .5
- 7 .4

- 6 6 .9
- 1 4 .9

- 2 8 .4
+ 4 .5

-2 4 .5
- 2 .8

- 6 2 .3
+ 16.7

-7 3 .6
+ 21.7

Proportion of required re­
serves borrowed from:
Federal Reserve.............
All sources......................


+ 29.4
+ 95.2

- 6 6 .7
+ 2 0 .0

- 7 8 .6
+ 38.2

- 6 9 .4
-2 1 .7

+ 75.0
+ 9 .0

- 5 0 .0

-6 1 .1
- 9 .3

- 5 1 .7
+ 11.8

-4 3 .5

- 6 9 .0
+ 2 4 .4

- 6 0 .0
+ 68.3

+ 2.2

uncertainty and administrative inconveni­
ence. If the estimates of interest elasticity
developed in recent econometric studies and
the developments in the Federal funds mar­
ket described above provide an even closeto-accurate indication of the state of mind of
increasingly large numbers of member
banks, then it seems likely that growing
numbers would not normally conform to
the acceptable regulatory image. In conse­
quence, growing numbers of banks would
either approach the discount window in full
awareness of the restrictive surveillance to
which they would be subjecting therr.selves,
or not approach the window at all. In either
case, the amount of credit extended at the

discount window would tend to decline—by
administrative control over supply or by the
behavior of banks who feel that the cost is
likely to be too high.
At an extreme (for example in 1966),
abstention from borrowing at the discount
window because of high or rising nonmone­
tary costs is not a completely convincing ex­
planation. During 1966 the rate differential
was highly favorable to such borrowing, and
it is reasonable to believe that it would have
been clear to potential borrowers that non­
monetary costs for at least some borrowing
would not be prohibitive. Nevertheless, bor­
rowing from Reserve Banks remained at very



low levels. In this case, noneconomic ex­
planations should probably be considered.
One possible explanation is that the discount
window was rejected by potential borrowers
as a “legitimate” source of credit.4 W this

would occur warrants careful consideration
but will not be discussed in detail here.5

5 Legitimacy may be viewed as functionally related to
a number of qualitative nonlinear “variables” that ex­
hibit discontinuities. Boulding, op. cit. While a “legiti­
macy cliff” may have developed in 1966, movement
toward the cliff may be traceable to much earlier de­
4 On the concept of “legitimacy,” see Kenneth velopments. This possibility is supported by the Re­
serve Bank reports on dissatisfaction and/or resent­
Boulding, “The Legitimacy of Central Banks” (Dis­
count Study).
ment on the part of borrowers.


The existing discount mechanism reflects, in
mechanism. Those proposals are principally
large measure, constraints derived from aimed at changes in the techniques and/or
other Federal Reserve System responsibil­ targets of monetary policy. Such proposals
ities, particularly those of over-all monetary
have, for the most part, been viewed as be­
control and bank supervision. Its operations
yond the scope of the present study. How­
were intended to be integrated with policies
ever, their relationship to the focus of the
designed to meet these other responsibilities.
present study is also reviewed briefly below.
In recognition of these relationships, the
A. The discount mechanism and
current study has focused on the extent to
bank supervision
which other policies provide “elbow room”
With respect to bank supervision, the cur­
for changes in discount operations designed
to overcome shortcomings in rationale, ob­ rent rationale of the discount mechanism
and its implementation is, in the existing
jectives, administration, and borrowing be­
financial environment, clearly an oversim­
havior that have come to light. It has become
plification. With the advent of deposit in­
reasonably clear that there is some range of
surance, the vast majority of depositors are
practicable alternatives to the existing for­
no longer concerned with the quality of
mulation within the current framework of
paper banks hypothecate in borrowing.
monetary policy and bank supervision.1
The relationship between borrowing and the
It has also been noted that the problems
likelihood of failure is by no means simple
uncovered in the course of the study have
and, to the extent that the “reluctance con­
importance not only for the effective opera­
vention” implies opposition to borrowing in
tions of the discount mechanism, per se, but
the normal course of business, it may impede
also for related policies. Implications of the
banks from making a full contribution to
findings for bank supervision and within the
their communities, and thereby simply en­
current framework of monetary control are
courage the establishment of competitive
reviewed below.
Problems of monetary control have been financial institutions. Current discount stand­
ards, therefore, would not appear to be an
widely discussed, and there are certain wellaccurate reflection of modem objectives in
known proposals for fundamental change
bank supervision.
that involve alteration in the discount
'On monetary policy, see Paul Meek, “Discount
Policy and Open Market Operations” (Discount
Study). On bank supervision, see Examinations De­
partment, Federal Reserve Bank of New York, op.cit.

B. Discount mechanism problems and
monetary control

Within the current framework of monetary


policy, the discount mechanism provides one
of a number of operational guides to the de­
gree of monetary restraint in financial mar­
kets, that guide being the aggregate level
of member bank borrowing. Reserve Bank
credit is also intended to provide a “safety
valve” against the build-up of undesirable
levels of pressure at individual institutions
and in financial markets. Finally, changes in
the cost of Reserve Bank credit, that is, the
discount rate, are, from time to time, in­
tended to signal changes in central bank
policy. These monetary policy aspects of the
discount mechanism are, of course, comple­
mented by operational aspects of open mar­
ket policies, whereby reserves are provided
or withdrawn to meet secular, seasonal, and
shorter-term variations in demand.
As noted, the view that the aggregate level
of member bank borrowing (or the free re­
serve variant) is a reliable, though provi­
sional, measure of monetary restraint is
based in part on the belief that banks are
reluctant to borrow. If banks are reluctant,
and open market operations force them into
debt, they would presumably make asset
adjustments (in order to repay borrowing)
of the sort desired. However, as also noted
above, the largest banks do not appear re­
luctant to borrow; smaller banks appear to
be growing less reluctant to borrow. While
pressure toward asset adjustment may still
be imposed by administration at the dis­
count window, the availablity of credit from
other sources, particularly for large banks,
permits relief from such pressure. Total
bank reserves may thus be controlled within
the desired range, but interest rates in short­
term credit markets can, as a result, fluctuate
One consequence of recent developments
in credit markets and bank behavior is that

the aggregate level of borrowing from the
Federal Reserve tends not to be a compara­
ble measure of monetary pressure over time.
It was clear in 1966, for example, that the
relatively low level of borrowing from the
Federal Reserve did not adequately reflect
the high level of pressure in financial mar­
kets, and it was not comparable in this re­
spect to relatively low levels of borrowing in
previous periods.
Variability in administrative pressure at
Reserve Banks also makes interpretation of
borrowing figures difficult. It has long been
recognized that the impact of any level of
aggregate borrowing would depend on its
distribution among banks, at least partly
because “reluctance” among different groups
of banks might differ and partly because the
impact on financial markets would depend
on the extent to which such borrowing were
concentrated in banks in differing condi­
tions. Findings on nonuniformity of admin­
istration suggest an additional reason why
the impact of any given level of aggregate
borrowing would depend on how such bor­
rowing were distributed.
The decline in reluctance (and, in the
current financial environment, little likeli­
hood that it could be revived), the develop­
ment of new markets for short-term credit,
and changes in attitudes toward borrowing
at the discount window, for whatever reason,
all make the monetary policy interpretation
of borrowings data difficult. These same de­
velopments likewise lead to a conclusion that
the discount mechanism has not functioned
as intended as a “safety valve.” 2 During pe­
2 Whether the growth of aggregate borrowing dur­
ing a period of restraint is viewed as an “escape
hatch” or a “safety valve” seems to some degree a
matter of semantics. If the money supply is the only
target of significance to the monetary authority, then
an increase in borrowing may be viewed as an “escape
hatch.” However, if one or more additional targets
are considered, including interest rate targets, it is not



riods of monetary restraint, the growth of
borrowing generally permits values and rates
in financial markets to change more slowly
than they otherwise would. Tobin has
. . . suppose there is a boom which increases de­
mands for bank loans. Under the present system
the availability of loans at a fixed discount rate at
the Fed permits the banks to meet some of these
demands, and limits the rise in interest rates. . . .
(T)he safety valve of discounting is probably
good. It gives the Fed time to react to events,
whether the events are its own policies or external

And Samuelson has said:
Now in particular, when you are squeezing the
market tight there is an adversary procedure going
on between you and the . . . banks. This is where
the discretionary versus nondiscretionary use of the
mechanism comes in. I suppose you are actually
making a discretionary use of it and exercising a
certain degree of rationing. Then, if you have over­
done it just a bit, they come in with blood in their
eyes and very self-righteously protesting, causing
you to ease up and change the degree of rationing.
But then gradually you do later pull in on the rope
and bring them to heel.4

When there is little borrowing from the
Federal Reserve, adjustments during a
period of restraint, such as in 1966, are
more precipitous and involve more rapidly
rising interest rates than otherwise would be
the case. If, to paraphrase Samuelson, bank­
ers do not come in with blood in their eyes,
but stay away with blood in their eyes, the
discount window will not, of course, func­
tion as a safety valve. Borrowing from nonFederal Reserve sources cannot, of course,
provide a substitute, in this respect, for credit
extended at the discount window.
The effects of a change in the discount
necessary to interpret the growth of borrowing during
a period of restraint as such.
3 See replies from economists [Tobin] to letter from
Lester V. Chandler, o p . c it.
4Statement of Paul Samuelson at Academic Semi­
nar on Changes in the Discount Window, May 11,

rate on market expectations as to future in­
terest rates, and therefore on the level and
structure of current rates, has been discussed
in detail both within and outside the Federal
Reserve System. It has long been recognized
that changes in the discount rate may have
a significance that is independent of the
measureable change in the cost of borrowing
at the Federal Reserve.5 It has also been
generally recognized that such effects, to the
extent they exist, are not easily predicted
or controlled.
In the 1954 Report on the Discount
Mechanism it was indicated that periodic
revisions in the discount rate would have to
be made in order to adjust the cost of bor­
rowing to changes in market rates.6 It was
also recognized that changes in the discount
rate could “serve as an objective indication
to the business and financial community of
System credit policy.” 7
Nevertheless, it has proved difficult in
practice to separate “announcement effect”
changes in the discount rate from “technical
adjustments.” The result has been to support
the tendency for a widening discount ratemarket rate differential during periods of re­
straint, such as in 1966. As a result, a
serious burden is placed on nonprice ration­
ing at the discount window. As discussed
above, there is clearly no danger that reserve
creation might become excessive. But the
standards of the Regulation are not well
suited to extensive nonprice rationing.
C. Discount study research and well-known
proposals for change in the discount

There have been numerous proposals for
5 The idea of an “announcement effect” was con­
sidered in A n n u a l R e p o r t , F e d e r a l R e s e r v e B o a r d ,
1 9 2 3 , p. 11. See also Jones, o p . c it., for a summary
of recent literature on the subject.
6 “Report on the Discount Mechanism, 1954,” o p .
c it., p. 43.
7 Ib id .


change in the discount mechanism. Many
are not fully motivated, or may not neces­
sarily be motivated at all, by the considera­
tions reviewed in this report. Some have
emanated from the Federal Reserve System
and some from non-System sources.8
The research effort of the discount study
has not had as one of its principal objectives
the full evaluation of each responsible pro­
posal on its own merits. Rather, an attempt
has been made to consider proposals likely
to meet the problems uncovered. Neverthe­
less, it is useful to relate certain well-known
proposals to this frame of reference.
Neither the proposal to pay interest on
excess reserves at the discount rate, and to
reinstitute explicit interest on demand de­
posits9 nor the proposal to abolish the dis­
count mechanism1 were given the attention
they might warrant in a fuller reappraisal
of the entire monetary mechanism. However,
proposals to tie the discount rate to some
market rate and permit banks free access at
the discount window received more con­
sideration. Such proposals were suggested
and viewed as a technique that might elimi­
nate the problems associated with nonprice
rationing at the discount window, the differ­
ential costs of reserve acquisition attributable
to structural conditions, and the announcement-effect barrier to raising the discount
rate during the periods of monetary re­
straint.1 It was also recognized that a tied
rate could, at the same time, tighten the

8 See replies from economists to letter from Lester
V. Chandler, op. cit.; Jones, op. cit.; and Doll, op. cit.
“James Tobin, “Toward Improving the Efficiency
of the Monetary Mechanism,” Review of Economics
and Statistics, August 1960, pp. 276-79.
10 Milton Friedman, A Program for Monetary
Stability, Fordham University Press, 1960, p. 38.
"However, it should be noted that the withdrawal
of Canada from a tied-rate system removes the ex­
ample that evidently initially suggested this kind of
proposal. See Garvy, op. cit., Part II, Canada.

linkages among open market operations, the
money supply, and interest rates, by stabiliz­
ing aggregate borrowing from the Federal
Reserve over the cycle.
Even if success in accomplishing these
ends were unquestioned, the desirability of
the result would not be completely clear. The
stabilization of borrowing, either at zero by
abolishing the discount window, or at some
positive figure, would change the current
monetary mechanism which incorporates a
safety valve independent of open market
operations. Experience in 1966 has suggest­
ed that market rates of interest for short­
term funds can rise very rapidly and to
very high levels during periods of economic
expansion if borrowings are not permitted to
increase. Tying the discount rate to a market
rate might not establish tighter linkages with­
out causing unacceptable swings in interest
rates.1 Moreover, tying the discount rate and
opening the window would break the one
existing direct link for communications be­
tween the Federal Reserve, in its monetary
policy function, and individual member
banks. While current relationships through
this channel may be less than satisfactory,
there is no inherent reason why they have to
be. Finally, it also seems reasonable to be
cautious about giving up instruments that
are at least potentially useful, such as the
discretionary setting of the discount rate.
The proposal to tie the discount rate to a
market rate also raised questions about what
market rate should be used, the premium to
be maintained, and the possibility of having
a schedule of rates related to the amount
borrowed by each bank, or possibly the
volume of borrowing in aggregate. While at
first these seemed merely practical issues, as
matters turned out they raised important
12 See replies from economists [Tobin] to letter
from Lester V. Chandler, op. cit.


technical and conceptual considerations.1
The importance of the unanswered ques­
tions about proposals to tie the discount rate
to a market rate by no means implies that
the discount rate cannot be used more ef­
fectively to ration credit than is currently
the case. But such questions as have been
raised clearly suggest the need for further

This paper has attempted to provide a re­
view and evaluation of a major portion of
the research undertaken in connection with
the Federal Reserve’s reappraisal of the dis­
count mechanism. As noted in the Introduc­
tion, materials have been covered with par­
ticular reference to specific issues raised by
the Steering Committee and the Secretariat.
(The principal recommendations for change
in the discount mechanism have also been
under study, but this aspect of the research
has not been systematically reviewed here.)
A number of findings have been made on
the issues discussed. These may be sum­
marized briefly:
It seems doubtful that the Federal Re­
serve’s support of the “tradition against bor­
rowing,” through the discount mechanism,
has much influence currently on the aggre­
gate demand for credit by banks. Commer­
cial bank behavior in credit markets appears
increasingly to reflect only moderate if not
minimal degrees of reluctance toward bor­
As a result of recent developments in
interbank borrowing and in other credit
markets, along with relatively permissive
1 For a review of discussion on these matters at
the academic seminar on discounting in 1966, see
Ormsby, op. cit.
1 In this connection see the recent paper by Franco
Modigliani, “Some Proposals for Reform of the Dis­
count Mechanism” (Discount Study).


bank attitudes toward borrowing, the “Gen­
eral Principles” of Regulation A have, of
necessity, assumed substantial importance as
a standard for rationing credit at the dis­
count window. This circumstance, well over
a decade after the 1955 revision of Regula­
tion A, must be considered contrary to the
intent of the revision and to the expectations
expressed at the time it was implemented.
The “General Principles” of Regulation A
are not well suited as a standard for ration­
ing credit. The credit-restrictive terms are
not easily understood or unambiguously ap­
plied. Problems in interpretation and admin­
istration appear to have contributed substan­
tially to an undue degree of difference in ad­
ministration among districts and to a high
degree of friction between member bank
borrowers and Reserve Banks. Looking at
the matter another way, nonprice rationing
at the discount window may be viewed as
imposing both objective and subjective non­
monetary costs on the banks that borrow;
but the “costs” imposed cannot be readily
controlled by the lender nor clearly com­
municated to the borrower.
Lower levels of borrowing were a clearly
intended result of the 1955 revision of Regu­
lation A, but it appears that there has been
an even more restrictive effect than intended.
It is likely that the use of the “General Prin­
ciples” as a standard for rationing credit has
contributed to this downward trend in bor­
rowing activity at the window. This is pos­
sible because, as mentioned, the nonmone­
tary costs imposed at the discount window
are not subject to sufficiently precise control.
Since 1955 there have been substantial
declines in the relative importance of Gov­
ernment securities in bank portfolios. Re­
duced holdings by large money market
banks, coupled with greater activity in pri­


vate credit markets, resulted in asset and
liability adjustments during the period of
restraint in 1966 that involved rapidly rising
rates of interest and a tendency toward dis­
ruption in some financial markets. The dis­
count mechanism, at least recently, has not
functioned in the way contemplated as a
safety valve.
Many small rural banks have traditionally
difficult adjustment problems. In some rural
areas there have been rapid increases in de­
mand for credit associated with the changing
nature of agricultural production; holdings
of Government securities by smaller banks
have also declined. To some degree credit
is available through correspondent relation­
ships and in the Federal funds market for
many banks. However, small banks are at
a disadvantage relative to larger urban banks
in obtaining credit; such credit as is avail­
able is probably at a relatively high price.
Under these circumstances, the geographic

distribution of bank reserves and bank cred­
it, as envisioned in the 1955 revision of
Regulation A, seems unlikely.
These findings suggest that the current
discount mechanism has been defective in
achieving the objectives for which it was in­
tended. In large measure and in perspective,
these findings may simply reflect the fact
that the underlying rationale of the current
mechanism developed out of an era far
different from that which exists today—a
period of relatively free entry in banking,
of large numbers of very small banks, of
distress in agricultural areas, of widespread
bank failure, particularly in agricultural
areas, and prior to Federal deposit insurance
and modern economic policy. Given the farreaching economic and financial changes
since the 1920’s, and even since 1955, such
problems as have been discussed should not
be considered extraordinary.



Documents Prepared for the Discount Study,

Anderson, Clay J., “Evolution of the Role and
the Functioning of the Discount Mechanism.”
Bank Examinations Department, Federal Re­
serve Bank of New York, “Discount Policy
and Bank Supervision.”
Boulding, Kenneth, “The Legitimacy of Central
Chandler, Lester V., “Selective Credit Control.”
Doll, Raymond J., “An Investigation of the
Credit Requirements and Availability of
Credit in Agricultural Areas.”
Garvy, George, “The Discount Mechanism in
Leading Industrial Countries Since World
War II.”
Jones, David M., “A Review of Recent Aca­
demic Literature on the Discount Mecha­
Lawrence, Robert, “The Regional Distribu­
tion of Bank Loans.”
Lynn, Dolores P., “Reserve Adjustments of the
Eight Major New York City Banks During
Melichar, Emanuel, “Intra-Year Fund Flows at
Commercial Banks.”
Meek, Paul, “Discount Policy and Open Mar­
ket Operations.”
Minsky, Hyman, “Financial Instability Revis­
ited: The Economics of Disaster.”
Modigliani, Franco, “Some Proposals for a Re­
form of the Discount Mechanism.”
Ormsby, Priscilla, “Summary of Issues Raised
at the Academic Seminar on Discounting.”
Questionnaire to Federal Reserve Banks Re­
garding Discount Operations (mailed under
letter from Governor George W. Mitchell to
Presidents of Federal Reserve Banks, dated
October 1, 1965).
Replies from economists to letter from Lester
V. Chandler “The Federal Reserve Discount
Mechanism and Discount Policies,” Spring

Staats, William F., “The Secondary Market for
State and Local Government Bonds.”
Shull, Bernard, “The Rationale and Objectives
of the 1955 Revision of Regulation A.”
Willis, Parker, “The Secondary Market for Ne­
gotiable Certificates of Deposit.”
Willis, Parker, “A Study of the Market for Fed­
eral Funds.”
Other Documents (Unpublished)

Federal Reserve Board memoranda, “Banks
Borrowing ‘Continuously’ from the Federal
Reserve Banks,” 1925, 1926, and 1927.
Federal Reserve Board and Reserve Bank re­
search personnel, “The Discount and Dis­
count Rate Mechanism,” group of special
Hackley, Howard H., “A History of the Lend­
ing Functions of the Federal Reserve Banks.”
Letter from Walter L. Eddy to all Federal Re­
serve Agents, September 15, 1925.
Letter from John Perrin to the Federal Reserve
Board, “Destructive Effects of Over-Lending
to Member Banks,” February 26, 1926.
Minutes of Joint Conference of the Federal Re­
serve Board with Governors and Chairmen
and Federal Reserve Agents of the Federal
Reserve Banks, November 4-5, 1925.
Riefler, Winfield, “Volume of Borrowing vs.
Profitability of Borrowing,” memorandum to
Discount Rate Committee, August 19, 1954.
“Statements on the Discount and Discount Rate
Mechanism of Associate Economists of the
Federal Open Market Committee before the
Conference of Presidents,” June 21, 1954.
System Committee on the Discount and Dis­
count Rate Mechanism, “Report on the Dis­
count Mechanism,” March 12, 1954.
Telegrams from John Perrin to the Federal
Reserve Board, April 18 and April 21, 1925.



Evolution of the role and the functioning of the discount mechanism
Clay J. Anderson


A review of recent academic literature on the discount mechanism
David M. Jones


Summary of issues raised at the academic seminar on discounting
Priscilla Ormsby


Financial instability revisited: The economics of disaster
Hyman P. Minsky
The secondary mortgage market
J. A. Cacy
The discount mechanism in leading industrial countries since World War II
George Garvy
Capital and credit requirements of agriculture, and proposals to increase
availability of bank credit
Emanuel Melichar and Raymond J. Doll
A study of the market for Federal funds
Parker Willis
The secondary market for State and local government bonds
William F. Staats
Discount policy and bank supervision
Benjamin Stackhouse
The secondary market for negotiable certificates of deposit
Parker Willis
Overseas branch balances in the reserve management practices of
large money market banks
Fred H. Klopstock
An evaluation of some determinants of member bank borrowing
Leslie M. Alperstein
Discount policy and open market operations
Paul Meek
The legitimacy of central banks
Kenneth E. Boulding
Intrayear fund flows at commercial banks
Emanuel Melichar
Some proposals for a reform of the discount window
Franco Modigliani





To assist the Steering Committee in its Fun­
damental Reappraisal of the Discount
Mechanism, a number of research papers
were commissioned. Transmittal memo­
randa, which are reproduced on the follow­
ing pages, were prepared by the Secretariat
to accompany the papers as they were sub­
mitted to the Steering Committee. In most
cases the memoranda contain a very brief
summary of the paper, but their major
function was to point out the significance of
the paper for the redesign of the discount
mechanism and, in some instances, suggest
conflicting Secretariat views on issues.
The memoranda were written as Com­
mittee documents and reflect the collective
judgment of the individuals of the Secretar­
iat. However, they do not necessarily reflect
the views of any single member of the
group, of the higher-level Steering Commit­
tee, or of the staffs of the Board of Gover­
nors of the Federal Reserve System or of the
Federal Reserve Banks.
The papers for which memoranda were
written do not coincide with the papers
published in the series on the discount

mechanism. Some memoranda are included
for papers that, for a variety of reasons,
were not carried through to the publication
stage. On the other hand, some papers were
written later in the course of the study and
sent to the Steering Committee without
transmittal memoranda. Even when both
the paper and its memorandum are being
published, the paper has undergone edi­
torial, and perhaps substantive, revisions
since it served as the basis for the memo­
randum; as a result there may be inconsis­
tencies in content.
The memoranda are presented in the
chronological order in which they were sent
to the Steering Committee. Thus the reader
has some sense of the development of a
proposed redesign of the discount mecha­
nism in the collective mind of the Secretar­
iat. While the memoranda do not report di­
rectly on that development, they contain
almost without exception comments on the
stage of development that prevailed on the
indicated date. Therefore, the memoranda
reflect to a limited extent the development
of the proposed redesign.




MARCH 1, 1967

Clay J. Anderson
Federal Reserve Bank of Philadelphia

The paper, “Evolution of the Role and the
Functioning of the Discount Mechanism,”
attempts to describe the continuous fusion
of ideas and conditions that resulted in the
original formulation of the discount mecha­
nism and its subsequent evolution as
shaped by experience, discovery, and ad­
justment to changing economic and finan­
cial conditions. The judgments expressed in
the paper focus on the decade of the 1920’s
and do not generally reflect the important
and different post-1955 experiences. These
earlier experiences can and should offer
guidance for the current reformulation of
the discount mechanism, but it is worth­
while noting that care must be exercised in
generalizing from the results of actions
taken in circumstances that were in many
ways very different from those existing
today. In the remainder of this memoran­
dum, the nine main points that the Secre­
tariat believes to be important are briefly
summarized, and the current judgment of
the Secretariat as to the key implications
for the design of the future discount mecha­
nism is expressed.
1. Narrow purpose and eligibility

Mr. Anderson’s paper gives further support
to the idea that the type of narrow “dollar
tracing” purpose control of discounting as­
sociated with the real bills doctrine has not
proved to be practical. It also strengthens
the view that eligibility requirements not
only are impractical, but are illogical and

in fact constitute a positive handicap in the
operation of the discount window. This idea
was of course actually accepted with the
rejection of the real bills doctrine, but the
eligibility requirements have persisted, and
Mr. Anderson’s findings add support to the
eligible paper bill presently before Con­
2. Direct pressure

The paper also makes clear that direct pres­
sure, as practiced in the 1920’s, was not a
feasible method of control. Even then a
moderate proportion of all banks were bor­
rowing from the Federal Reserve at any
one time, and even among those that were
borrowing it was difficult to tell if a bank
were lending too much in one area until it
had built up a fairly substantial portfolio.
Direct pressure can, of course, have some
initial impact on all banks, though only
through moral suasion on nonborrowers.
However, this impact usually is progres­
sively eroded as nonbank institutions move
into the relevant loans and moral suasion
loses its bite. For direct pressure to retain
some effectiveness over time, the area sub­
ject to it must constantly be broadened.
Direct pressure can be applied either for
its monetary effects or for its sound bank­
ing effects. However, in the thinking of the
1920’s, these two objectives were tied: if
through direct pressure the Federal Reserve
could limit reserve credit to productive
uses, the proper quantity of reserves could
then be supplied with little effort.


The issue of direct pressure is one to
which the above warning about generaliza­
tion is especially pertinent. During the
1920’s the discount window was the pri­
mary source of reserves. Thus the Federal
Reserve could not demand that the banking
system repay all or even a large part of its
discount credit, regardless of the use it
might be making of this credit. To do so
would have left the banks with patently in­
adequate reserve balances. In addition, the
classification of loans was not well specified
in the 1920’s, making it difficult to single
out proper and improper uses of reserve
credit. For instance, it was almost impossi­
ble to differentiate between a loan for spec­
ulative dealings in securities and a perfectly
legitimate loan for the purchase of securi­
ties to support industry. Last, one of the
most frequent problems, at least in the mid­
dle and late 1920’s, was stock market
credit. However, to treat such loans too
harshly would probably have hastened the
collapse of the market. There was also the
consideration here that stock market loans
were not bad per se; it was rather the in­
flated condition of the market that was bad.
Thus the Federal Reserve was faced with a
number of circumstances in the 1920’s
that are not currently pertinent, and the
use of direct pressure as applied in the
1920’s must be evaluated with an aware­
ness of these circumstances.
3. Progressive discount rate

The well-documented failure of progressive
discount rates as a control mechanism in
the early 1920’s must also be examined
with close attention to the environment in
which it occurred. There were at least three
obvious weaknesses in the arrangements
used. First, in the case of three of the four
Reserve Banks employing the arrange­
ments, the rate schedule was hinged to a
member bank’s reserve balance plus capital

in the Reserve Bank. The fourth Bank tied
it to the member bank’s capital plus sur­
plus. This supposedly gave each bank its
“fair share,” as its rate schedule was related
to its contribution to the earning capacity
of the Reserve Bank. This was illogical in
view of the Reserve Bank’s function as a
creator of reserves and bore little or no re­
lation to a member bank’s reserve need. In
fact, when a bank suffered a deposit out­
flow and presumably needed more help
than usual from the discount window, its
reserve balance, and thus its basic line, de­
clined. The second and a related weakness
was that no ceiling was established beyond
which rates would not be allowed to rise.
Such a ceiling would have prevented cases
such as the one when a bank paid 87.5 per
cent for its marginal borrowing.
The third weakness was that only four
Reserve Banks instituted the progressive
rate system. Thus member banks could cir­
cumvent the higher rates by borrowing
from correspondents outside the affected
districts. This weakness might have been
avoided if all districts adopted the progres­
sive rate schedules, although the possibility
would still exist of borrowing from a corre­
spondent that had not used up its basic
line. These weaknesses provide lessons in
themselves, and the experience of the
1920’s should be examined in light of them.
It might be noted that progressive rate sys­
tems employed by several foreign central
banks have avoided these weaknesses and
have achieved a more rational and success­
ful operation, although of course almost all
of them have their own weaknesses of vary­
ing degrees of seriousness that should be
4. Effect on customer rates

Mr. Anderson’s work indicates that, at least
in the 1920’s, changes in the discount rate
were generally not carried forward directly



into customer rates. Rather, a change in the
discount rate signaled a change in the avail­
ability of credit and thus influenced over-all
monetary conditions. This is probably
equally true today (except possibly on
some loans and credits to borrowers with
easy access to the money market) and
might always be true in the absence of the
tied arrangements in effect in some foreign
5. Rates related to collateral

The paper also indicates that preferential
discount rates of the type used, based on
collateral, were shown during the condi­
tions prevailing in the 1920’s to be imprac­
tical as a control device. So long as it was
available, banks would naturally offer the
collateral with the lower rate, and the pref­
erential rate would thus become the effec­
tive rate.
6. Reluctance to borrow

Mr. Anderson’s paper provides support for
the idea that there are at least two kinds of
reluctance to borrow that should be distin­
guished. One is a basic reluctance of a
bank to pile up debt to anyone; if carried
too far its solvency might be endangered.
The second is a reluctance to be in debt to
the central bank in view of its limiting rules
and the kind of administrative discipline to
which a borrowing bank might be subject.
This is at least partly an artificial reluctance
stemming from the rules, statements, and
actions of the Federal Reserve.
The Secretariat believes that there is per­
haps a subcategory of the first type of re­
luctance worth citing as a third category.
This is a reluctance to show borrowings be­
cause of presumed customer and investor
attitudes. Such reluctance is, as indicated,
akin to the first type, but it has a somewhat
different rationale and accounts for situa­
tions such as often occur around statement
dates, when banks borrow very heavily at

the discount window on the day previous so
that they can show an average or lower
level of borrowing on their statement.
The paper suggests that, while all three
types of reluctance to borrow might be be­
coming progressively less viable as an auto­
matic and self-enforcing control of borrow­
ing, the first and third types—reluctance to
borrow from any source and to show bor­
rowing—would be very difficult to eradi­
cate quickly or fully. In fact, to eradicate
this reluctance as it applies to substantial
borrowing, in contrast to incidental, would
not be desirable because of the adverse ef­
fects this might have on bank liquidity posi­
tions. Convincing banks to use the discount
window more freely (that is, to increase the
share of their borrowing done at the Fed­
eral Reserve) is quite possible, but that
would take time. However, so long as either
the first or the second form of reluctance to
borrow—from any source or specifically
from the central bank—persists to an im­
portant degree, it will be impracticable to
achieve large contracyclical changes in the
volume of borrowed reserves, and thereby
in the total quantity of reserves. However,
the Federal Reserve has other tools, notably
open market operations, which can exercise
this contracyclical influence on reserve to­
tals, and it seems likely it will have to con­
tinue to rely on them in the foreseeable fu­
7. Value of administrative discretion

The paper also points up the real value of a
certain amount of administrative discretion.
Many of the problems of the past could
have been dealt with more successfully if
the Federal Reserve had had some ability
to vary mechanical rules quickly and flexi­
bly. This is particularly true when these
rules prove to be inappropriate to meet the
varying circumstances within the banking


8. Attempts to influence uses of credit

9. Changing objectives of discount policy

The history related in the paper demon­
strates that, in the past, the specification of
a qualitative use of credit to be encouraged
or discouraged by the discount window has
always given way to direct action in which
the window became a threat. This history
should at least be recognized in designing
any future use of the window.

Last, the paper indicates that over the years
the objectives of discount policy have
evolved and been adapted or modified as
the implementing rules have proved un­
workable in changing circumstances. In
the past, experience with the discount
policy has been to a large extent a learning

MARCH 27, 1967

David M. Jones
Federal Reserve Bank of New York

Priscilla Ormsby
Board of Governors, Federal Reserve System

The paper, “A Review of Recent Academic
Literature on the Discount Mechanism,”
examines academic literature of the decade
following the 1951 Treasury-Federal Re­
serve accord and presents the major argu­
ments that pertain to discounting in that
literature. It concentrates on literature that
bears directly on the implications of dis­
counting for monetary control.
The literature examined was all pub­
lished prior to the experiences of 1966, and
therefore some of the arguments presented
may be at least partially overcome by
events. However, it is the opinion of the
Secretariat that few academics will undergo
any substantial changes in attitude as they
look at 1966. Rightly or wrongly, they will
probably view those events as strengthening
the opinions they have held in the past. In
any event, it will probably be some time be­

fore academic reaction to 1966 is reflected
to any great extent in published literature.
This being the case, this paper is valuable
in reflecting most of the relevant and fairly
recent academic thinking available.
The paper, “Summary of Issues Raised at
the Academic Seminar on Discounting,”
was prepared in connection with the semi­
nar held at the Board on May 11, 1966. It
reflects the expression of the more recent
thinking of a number of influential aca­
demic economists and may therefore be
thought of as modifying to a certain extent
some of the ideas presented in Mr. Jones’
paper. However, even this paper was based
on discussion held prior to many of the im­
portant developments of 1966 and there­
fore suffers from the same handicap.
The paper, “Financial Instability Revis­
ited: The Economics of Disaster,” prepared


for the discount study by Professor Hyman
P. Minsky and submitted to the Steering
Committee separately, does represent one
academic economist’s reaction to the events
of 1966. However, it seems most unlikely
that many academics will emerge from an
examination of these events with Minsky’s
In the remainder of this memorandum,
the five main points in the Jones and Ormsby papers that the Secretariat believes to
be important are briefly summarized, and
the current judgment of the Secretariat as
to the key implications for the design of the
future discount mechanism is expressed.
1. General dissatisfaction with the discount

Most of the academic economists consulted
seem to regard the discount mechanism, as
currently constructed, as being antagonistic
to the Federal Reserve’s primary task of
monetary management. They point out that
the initiative for borrowing rests with the
member banks, that borrowing adds to total
reserves, and that the level of borrowing
varies procyclically.
These contentions are answered by some
academics and by others with the nowfamiliar arguments outlined below. The
Secretariat generally supports the following
arguments, with the caveats noted in the
While the borrowing of an individual
member bank is at its own initiative, the
aggregate level of borrowing can be con­
trolled by the Federal Reserve. One of a
variety of operational targets employed in
open market operations is the level of free
reserves, and since excess reserves generally
remain fairly stable in toto (although there
may be wide fluctuations in the distribution
of those excess reserves) the effective target
is often aggregate borrowings. This control
is obtainable in principle, but it is less than


perfect in practice. The fall of 1966 offered
striking evidence that borrowing can be ex­
tremely inelastic vis-a-vis interest rates and
at times the efforts of the Trading Desk to
achieve a given level of borrowing can be
largely frustrated by the nonmonetary costs
that banks attach to borrowing.
However, the Federal Reserve retains at
least a general control over aggregate bor­
rowing levels, and, what is perhaps more
important, has the ability to make fairly ac­
curate predictions of those levels, even
when it might not choose them. The Secre­
tariat in its deliberations has given and con­
tinues to give close attention to the proba­
ble effects of various changes on the
predictability of borrowing. It has also rec­
ognized that the likely response of the
banking system to a given level of borrow­
ing is not invariant, but may depend on
such things as where in their borrowing
spans the indebted banks may be (that is,
how close they are to the threshold of ad­
ministrative discipline). Thus, the Secretar­
iat considers the predictability of this re­
sponse even more meaningful than the
predictability of borrowing levels.
The arguments that borrowing adds to
total reserves and that the level of borrow­
ing varies procyclically cannot be refuted
in and of themselves. However, the signifi­
cance of these arguments can be questioned.
Borrowed reserves have long been argued
as having less expansive implications than
unborrowed reserves because of the bank
adjustment efforts they make necessary. It
is also true that the existence of the dis­
count window to serve as a safety valve
makes possible more vigorous open market
operations than could otherwise take place.
2. Determinants of borrowing

Mr. Jones’s paper sketches the still partially
unresolved debate over whether banks bor­
row out of need or to obtain a profit. It

notes that empirical evidence on this ques­
tion remains small and inconclusive. How­
ever, it suggests at least one reconciliation
of the profit motive and the reluctance to
borrow. This is that banks are, on the
whole, reluctant to borrow, but that, given
a reserve deficiency—and therefore a need
to borrow, whether they come to the dis­
count window or turn to some other short­
term source of funds will depend on rela­
tive cost considerations.
The academic literature still does not
seem to have produced a satisfactory recon­
ciliation between reluctance to borrow and
the administrative discipline exercised by
discount officers. The Secretariat notes,
however, that this question was dealt with
in its memorandum of March 1, 1967, ac­
companying the paper, “Evolution of the
Role and the Functioning of the Discount
Mechanism.” At that time it suggested that
there are two basic sorts of reluctance to
borrow—one an innate reluctance to be in
debt based largely on a concern for the liq­
uidity and solvency of the institution, and
the other an acquired reluctance to be in
debt to the central bank growing out of the
actions, regulations, and statements of that
central bank. The Secretariat also notes the
widespread and in some respects impressive
breakdown in recent years of at least the
first type of reluctance to borrow. The in­
creased willingness of banks to issue short­
term, liquid liabilities is apparent in the
Federal funds market, the CD market, and
the Euro-dollar market.
3. Nondiscretionary control

Most of the academic economists consulted
are strongly opposed to the use of adminis­
trative discipline by discount officials,
which has been the major factor in creating
the second type of reluctance to borrow dis­
cussed above. They would propose com­
plete reliance upon nondiscretionary control

of the window, which they almost unani­
mously equate with interest rate control.
The most frequent proposal is for a tied
rate system, where the discount rate would
be set above and would vary with some
market rate. This proposal generally leaves
unspecified the questions of the appropriate
market rate to be used as the peg—a diffi­
cult one for a diverse and fragmented bank­
ing system employing a variety of reserve
adjustment procedures—and of the rate
Largely ignored by the academic litera­
ture is the interest rate instability that a tied
discount rate might introduce into the finan­
cial structure. This problem was probably
an important factor in Canada’s abandon­
ing the system in 1962.
It also might be noted that, even with a
tied discount rate, the Federal Reserve
would probably find it necessary to admin­
ister the rate spread at times, as well as to
influence the level of market rates, to bring
about desired responses. A completely auto­
matic control over discounting at all times
does not seem to be compatible with discre­
tionary monetary policy.
A system of control based on rate alone,
with an administratively determined rate,
would also pose serious problems. It would
result in a loss of control over reserve crea­
tion in the short run, and would make the
setting of the discount rate probably the
most important decision made by the cen­
tral bank. A mistake in that decision could
have very serious implications for monetary
conditions. Therefore, the Secretariat sees a
need, in the future as in the past, for some
kind of other, nonprice constraints on dis­
count window use.
4. Announcement effects

Academic economists are almost unani­
mous in considering the announcement ef­
fects of changes in the discount rate to be


unclear, unnecessary, and often perverse.
The Secretariat also has reservations, but is
not convinced that the announcement ef­
fects cannot serve a constructive purpose
both domestically and internationally. Sev­
eral academics recognize the value of an­
nouncement effects, given the attention ac­
corded discount rate changes in interna­
tional financial markets.
Academic economists suggest eliminating
the announcement effects through a tied
rate system or minimizing it by instituting a
frequent and regular schedule of smaller
discount rate changes. Possibly the second
alternative merits further consideration.
It seems possible that much of the dis­
cussion by academics and by others gives
undue importance to the announcement ef­
fects. These rate changes are only one of a
variety of factors influencing the decisions
of borrowers and lenders. While they do
have some real significance and perhaps ex­
ercise more influence than this real signifi-


cance should justify, those closest to the is­
sues may be attributing to them more
power than they actually possess.
5. Reserve redistribution

An important, although probably second­
ary, topic in the academic literature is that
of reserve redistribution. On this issue, the
academics seem rather satisfied with the
status quo. They prefer to see this realloca­
tion done by other agencies with the Fed­
eral Reserve role limited to that of lender
of last resort.

In sum, the Secretariat often finds itself
considerably at variance with academic atti­
tudes on discounting. Nonetheless, it feels
that indexing these attitudes is worthwhile
and has noted a number of areas in the
foregoing discussion where academic econo­
mists offer constructive criticism and sug­

MARCH 27, 1967

Hyman P. Minsky
Washington University

The paper, “Financial Instability Revisited:
The Economics of Disaster,” is unusual and
out of the main stream of academic thought
in that it deals basically with the role of the
Federal Reserve as a lender of last resort
and less with its function on monetary man­
agement. It also deals with the dynamics of
domestic financial flows, in contrast to the
static approach adopted by most academic
The paper draws much of its evidence
from the experiences of 1966 and might be
regarded as a lesson in economic brink­
In the remainder of this memorandum,

the 14 main points that the Secretariat be­
lieves to be important are briefly summa­
1. The “banking theory” for all units

Firms and households can be thought of as
balancing their expected cash inflows and
outflows, holding portfolio assets to bridge
any prospective cash shortfalls with suffi­
cient provision of liquidity to guard against
2. Initial effects of euphoria

When continuing economic prosperity gen­
erates euphoric attitudes, expectations as to

future income and asset values are esca­
lated, and expected cash needs to guard
against shortfalls and uncertainty are scaled
down; as a result, firms and households are
led to become more illiquid—and the
greater the euphoria, the greater this shift
toward illiquidity.
3. The discounting of protection

This change in attitudes can lead to liquida­
tion pressures and higher interest rates on
the safest and most liquid assets, as increas­
ing confidence causes holders to shift to­
ward higher-yielding even though riskier
4. The impact on financial institutions

Such holder adjustments affect particularly
banks and other financial intermediaries
that had earlier benefited from the public’s
cautious attitudes by issuing liquid liabili­
ties and holding less liquid assets—and, of
course, the greater this disparity and the
more that adjustments are constrained by
regulatory limitations for a particular group
of institutions, the tighter the pinch.
5. Public policy to counteract euphoria

Counterinflationary public policy—what­
ever the mix between monetary and fiscal
policy—has to endeavor to moderate the
euphoric expectations that cumulative ex­
pansion generates, but in so doing it risks
the kind of financial squeeze outlined
above, which can assume crisis proportions
if the deflation of euphoria is abrupt, as it
can easily be if the preceding euphoria had
been strong and widely held.
6. Failures to meet euphoric expectations

This pinch on financial intermediaries and
on markets for safe assets can
pounded by a second kind of liq
sure, as firms and households expt v

shortfalls in cash flows from their euphoric
expectations, and are led (a) to try to bor­
row or otherwise raise cash to cover their
shortfalls, and (b) to adopt a more con­
servative portfolio and cash flow posture.
7. Role of the central bank

Consequently, the central bank, as the only
ultimate source of liquidity, needs to be
prepared to perform as a liberal lender of
last resort to ameliorate the deflationary
swing back toward a greater desire for li­
8. Scope of central bank actions

Central bank provision of liquidity at such
times should extend to all financial institu­
tions and secondary markets for major
types of liquid and/or safe assets on which
pressures are likely to concentrate. This
raises the broad policy issue as to whether
such central bank action would not be
more effective if the central bank had regu­
lar contact with and participation in the
markets in question, particularly in the
form of financing assistance for dealers in
these markets. However, the Secretariat
feels that this should not go so far as to in­
volve the Federal Reserve in a commitment
to these markets.
9. Early public policy actions

Because the risk of financial crisis seems
higher the greater and more prolonged the
preceding euphoria, the paper implicitly
places some premium on early public policy
actions to curtail the development of eu­
phoric attitudes. This points up the need for
coordination among the various supervisory

Limits on monetary restraint

premium is also placed on a careful and
owledgeable weighing by the central



bank of how far it can go with counterinflationary monetary restraint before needing
to step in with lender-of-last-resort-type
ameliorative actions.
11. Cash flow analysis

Both for this purpose and for more effective
bank supervision for other purposes, exami­
nations should introduce cash flow analysis
of the position of each financing institution,
based upon empirically validated (or simu­
lated) probable consequences of various al­
ternative economic environments that could
conceivably develop.
12. Regional pressures

The authorities will also need to stay aware
of potential regional concentration of finan­
cial crisis pressures (for example, Califor­
nia, or other areas of heavy capital im­

13. Discretion on the part of the
Federal Reserve

To respond effectively to the changing finan­
cial conditions, the central bank must main­
tain a substantial amount of discretion and
flexibility in choosing the policy tools to be
used and in the application of these tools.
The adequacy of tools now available should
be re-examined from the point of view of
the above analysis.
14. Direct relevance for the
discount study

The Secretariat regards these views as inter­
esting and worthy of further consideration.
They seem to argue for more liberal and
flexible use of the discount window at all
times, both to forestall crises and to facili­
tate handling of those crises that may de­

JULY 5, 1967

J. A. Cacy
Federal Reserve Bank of Kansas City

The main points in the paper, “The Sec­
ondary Mortgage Market,” that the
Secretariat believes to be important are
briefly summarized as follows:
A secondary market for mortgages is
all but nonexistent.
The Federal National Mortgage Associa­
tion buys and sells only Government-under­
written home mortgages. Moreover, its op­
erations on the buy side are best
characterized as primary market transac­
tions. Most of its purchases are from originator-servicers, who, in effect, are mortgage
No private organizations exist that make
a market for seasoned mortgages by acting
continuously as brokers and/or dealers; nor

are “open market” price quotations avail­
able on a continuous basis.
A number of serious obstacles have
impeded the development of secondary mar­
ket facilities.
First, the cost of providing the kind of
information necessary to secondary market
operations is prohibitive. Mortgage loans
are small in size and heterogeneous in na­
ture, and under present arrangements it is
necessary to have detailed knowledge of the
property and borrower characteristics of
each loan.
Second, the mortgage market tends to be
fragmented into a number of submarkets, a
fact which discourages market making. The


tendency for principal lenders to specialize
in particular sectors of the market is en­
couraged by the heterogeneous nature of
mortgage loans and by various legal ar­
rangements such as geographic lending re­
strictions, restrictions on asset composition,
and policies affecting competition for sav­
Finally, for various reasons, including
the existence of customer relationships and
the absence of secondary markets, mortgage
lenders have adopted the attitude that mort­
gages, once acquired, are not to be sold.
Hence there is no attempt, when originating
mortgages, to tailor them to the require­
ments of a larger market.
The development of a secondary
market would be desirable.
For one thing, such a market would en­
hance the shiftability of assets and intro­
duce greater flexibility into the financial
structure. This greater flexibility, in turn,
would tend to encourage flows of funds into
areas and sectors of greatest need, thereby
contributing to improved allocation of re­
Also, a secondary market should increase
the sensitivity of mortgage rates to general
monetary conditions. To the extent that
flows of funds into the mortgages are influ­
enced by differential rates of return be­
tween mortgages and bonds, this should en­
courage stability in the housing industry
and should reduce the differential impact of
monetary policy on residential construction.
In the Secretariat’s view the Cacy paper
has the following implications for the rede­
sign of the discount mechanism:
1. It would not be wise or feasible to at­
tempt to divert flows of funds into the
mortgage market via the discount mecha­
2. The discount mechanism should not
be redesigned so as to paper over institu­

tional inadequacies in the mortgage market.
Rather the System should encourage desira­
ble changes in both the primary and the
secondary markets.
The Secretariat believes a number of the
recommendations contained in the Cacy
paper for improvements in the secondary
market to be worthy of further considera­
tion. These include: (1) removing barriers
that limit the speed or extent to which
mortgage rates are able to fluctuate with
market rates; (2) restructuring FNMA to
perform a full-fledged dealer operation in
Government-underwritten mortgages, main­
taining its portfolio within narrow limits by
adjusting its buying and selling prices; (3)
taking steps to reduce the heterogeneity of
conventional loans by encouraging uniform­
ity in origination procedures, lending prac­
tices, and State mortgage laws; and (4) re­
moving legal or other obstacles that prevent
responsible financial institutions from com­
peting on an equal footing with other insti­
tutions for conventional mortgage loans on
a nationwide basis.
The proposal in the Cacy paper that the
System perform a stabilizing role in the sec­
ondary mortgage market in time of stress
by undertaking open market operations in
completely insured mortgages is not looked
upon with favor by the Secretariat.
The Secretariat recognizes that promo­
tion of a secondary mortgage market and
encouragement of appropriate changes in
the institutional structure of the primary
market are not direct System responsibil­
ities. Nevertheless, the Secretariat believes
that a useful purpose might be served if the
System were to cooperate and work closely
with the various agencies associated with
the mortgage markets, perhaps through a
mortgage subcommittee of a System task
force charged with the general responsibil­
ity of looking into market-perfecting de­



3. An effective secondary mortgage mar­
ket would provide banks with another
alternative to the discount window in mak­
ing reserve adjustments. What the interrela­
tionships would be would obviously depend
on the kind of window that is ultimately
adopted and on the nature of the new sec­
ondary market. This points up the need for
continuing adaptation of the discount
mechanism as the financial system changes.
It would be unrealistic to hope that the win­
dow can be redesigned once and for all.
4. It might be necessary for the Federal
Reserve to exercise a lender-of-last-resort
function in connection with an improved

secondary market for mortgages. Conceiva­
bly, there could be widespread unloading
during periods of monetary restraint, in
which case it might be necessary for the
System to provide credit in some fashion to
central lenders in order to prevent disor­
derly conditions. On the other hand, freer
and better secondary markets, while not
dealing with the fundamental problems en­
countered in 1966, might moderate some of
the adjustment difficulties faced then. More
sensitive mortgage rates and improved com­
petitive relationships among financial insti­
tutions would tend to prevent sudden shift­
ing of funds out of the mortgage market.

JU LY 5, 1967

George Garvy
Federal Reserve Bank of New York

The paper, “The Discount Mechanism in
Leading Industrial Countries since World
War II,” represents a general survey of dis­
count policies in these countries and does
not attempt to evaluate the policies or
apply them to the specific proposal for a
redesigned discount window being devel­
oped by the Secretariat. This study was ini­
tiated with the thought that central bank
experience in the advanced industrial coun­
tries would: (a) offer significant insights
into the relationship of the discount mecha­
nism to other tools of monetary policy; (b)
show the way in which various policy tools
interact; and (c) suggest problems and ad­
vantages associated with specific techniques
that might be considered in redesigning the
discount window in the United States.
In order to bring out the various possibil­
ities and limitations that should be consid­
ered in relating foreign experience to our

problems and strikingly different conditions,
this paper focuses on the policy environ­
ment and institutional factors that have
shaped the discount mechanism in the indi­
vidual countries studied.
The paper clearly shows that there is no
uniform “foreign experience” that can be
compared with ours, but, rather, there is a
variety of examples of adapting the oldest
tool of monetary policy to specific but
changing conditions in each given country.
Indeed, the paper did not aim at a compre­
hensive comparative study of the discount
mechanism of the countries covered, or at
assessing its effectiveness in each individual
In the remainder of this memorandum,
the main points in the research report that
the Secretariat believes to be important are
briefly summarized.
1. Discounting remains a principal tool


of monetary management in most of the ad­
vanced industrial countries. One reason for
the continuing importance of the discount
mechanism has been the survival of com­
mercial bills as a main instrument of bank
lending in most of these countries. Another
factor is the lack of alternative means for
controlling bank liquidity in the short run.
In several countries this reflects the unde­
veloped state of the money market and, in
particular, of the market for Government
2. In contrast to the United States, in
most foreign countries foreign exchange
surpluses have provided the banking system
with adequate (or more than adequate) li­
quidity, and as a result the need for using
the discount window has diminished con­
siderably in recent years. In these countries,
the main problem of monetary management
has been to adjust discount policies to ef­
fects on reserves of fluctuations in the bal­
ance of payments (and in some cases, of
Treasury operations) over which the central
bank has no direct control—in particular,
in the short run.
3. Foreign experience shows that for a
variety of reasons exclusive reliance on rate
for controlling domestic credit conditions as
well as for maintaining international equi­
librium is impractical. As a result, opera­
tions of the discount window have been
supplemented by other means of monetary
a. In several countries, open market
operations and various techniques to con­
trol the effect of fluctuations of exchange
holdings on bank reserves have been devel­
oped to supplement the discount mecha­
nism. Reserve requirements have been in­
troduced in several countries.
b. By and large, however, quantitative
controls to limit permissible expansion of
bank credit or to regulate access to the dis­

count window have been introduced to
cope with excess liquidity, mostly generated
by balance of payments surpluses and/or
Government deficits. Controls at the win­
dow may be direct or indirect, by immobi­
lizing (through liquidity ratios) specified
quantities of discountable assets in bank
c. Moral suasion has been introduced
to reinforce general monetary controls in a
number of countries. The form of moral
suasion varies: it may consist of formal
expression of the central bank’s wishes
(as in the case of Governor’s Letters in the
United Kingdom), gentlemen’s agreements
with regard to the rate of bank credit ex­
pansion (as in the Netherlands), or de­
tailed tutelage (as under the “window guid­
ance” system in Japan).
Quantitative regulation imposes on the
monetary authorities responsibility for de­
termining the appropriate rate of increase
in bank credit (or related monetary magni­
tudes)—a responsibility that, in fact, we
have recognized ourselves in recent years.
4. The discount rate has gradually
evolved into a structure of rates. This oc­
curred in part to ration central bank credit
by imposing a higher cost for successive
tranches of borrowing, or for borrowing ex­
ceeding stipulated periods, and in small
part because the discount mechanism has
been used as a means of selective credit
control. Also, the link between the princi­
pal official rate and subsidiary rates has
gradually become more flexible.
5. In several of the countries surveyed,
discounting provides at least a part of the
permanent additions to the reserve base.
While for a generation the Federal Reserve
System has been using open market opera­
tions in U.S. Government securities for this
purpose, foreign experience suggests the
possibility that in the future some part of
the growth in the reserve base could possi­



bly be supported through the discount
6. Operations at the discount window
have been simplified and made more flexi­
ble in several countries by shifting the em­
phasis to advances and to repurchase agree­
ments. Depending on the country, advances
are either a normal substitute for discounts
(substantially identical rate and terms
applying to both operations) or a means of
obtaining additional central bank accom­
modation under more stringent conditions,
for short periods but at a higher cost.
7. Foreign experience offers numerous
examples of window use for (a) encourag­
ing specific activities (or by designated sec­
tors) through preferential rates, special
credit lines, access to the window outside of

quotas, and other means; and (b) for re­
stricting extension of credit for purposes, or
to areas, of low priority. It offers, however,
only scant guidance for possible aggressive
use of the discount window in deflationary
Some of the techniques discussed in the
paper were tried in the United States in the
1920’s; others are novel to American expe­
rience. In many cases, such techniques were
shaped by the particular characteristics of
each national financial system.
While the underlying conditions in
the United States are considerably different
in several respects from those existing in
the countries covered by this paper, a few
of the techniques developed abroad recom­
mend themselves for further study.

JU LY 5, 1967

Emanuel Melichar and Raymond J. Doll
Board of Governors and Federal Reserve Bank of Kansas City

The paper, “Capital and Credit Require­
ments of Agriculture, and Proposals to In­
crease Availability of Bank Credit,”
investigates: (1) potential credit require­
ments of the agricultural industry; (2)
availability of credit in rural areas; (3)
mobility of credit flows between rural
and other sectors of the economy; (4)
unique problems confronting rural banks;
and (5) proposals for altering prevailing
mechanisms or for providing supplementary
mechanisms that will help alleviate difficul­
ties that may occur.
The main points in this paper that the
Secretariat believes to be important are
briefly summarized, and the current judg­

ment of the Secretariat as to the key impli­
cations for the design of the future discount
mechanism is expressed.
1. Credit needs of agricultural areas and
the role of commercial banks

The paper concludes that, up to the present
time, agriculture has been able to meet its
rapidly growing credit needs; the bulk of
production credit has come from commer­
cial banks, but other institutions such as the
Federal intermediate credit banks have as­
sumed increasing importance. The credit
needs of agriculture are expected to con­
tinue to increase at a rapid pace, however,
and it is questionable whether commercial


banks will be able to maintain their com­
petitive position in this area. Since deposit
growth in these banks is closely related
to income growth and credit needs grow
largely out of a changing capitalization
ratio rather than an expanding industry, the
local banks will probably find it more and
more difficult to mobilize sufficient funds to
make these loans. The trend is aggravated
by declines in country bank holdings of liq­
uid assets and by their very limited access
to the central money market.
The Secretariat would not suggest that a
deliberate attempt be made to perpetuate
the banks in their current share of the mar­
ket. But it would support the principle that
the Federal Reserve should attempt to in­
sure that banks have an equal opportunity
to compete for agricultural business and are
not handicapped by imperfections in the
flows of funds.
2. Role of the discount window

The Secretariat is opposed to the provision
of long-term credit through the discount
window, including that to banks in agricul­
tural areas. It feels that such credit would
probably enmesh the System in socioeco­
nomic and political problems beyond its
scope and competence, and that it could re­
sult in a pyramiding of debt on the part of
individual banks that could become danger­
ous from the supervisory point of view.
However, a contribution to the credit
needs of agricultural areas can be made
through more liberal provision of seasonal
credit. In addition to meeting certain agri­
cultural credit needs directly, this and any
other liberalization of the discount window
should result in the freeing of a limited
amount of funds, currently held in highly
liquid forms as secondary reserves, for
longer-term lending. This liberalization
might even go further than its direct effects
and act as a catalyst, spurring local growth

and an increasing supply of locally gener­
ated funds.
3. Ultimate solution— market perfection

Despite the limited contributions that the
redesign of the discount window may make
to the filling of agricultural needs, the Sec­
retariat feels that the only long-run solution
lies in the perfection of secondary markets
for bank assets and liabilities. What might
appear to be a preferred position presently
occupied by the large banks results essen­
tially from their ready ability to sell their
instruments—both earning assets and liabili­
ties—in the market place. Small rural banks
will be able to compete for funds on an
equal footing only to the extent that they
have a similar ability to market their instru­
4. Ad hoc System committee

The issue of market perfection lies largely
outside the scope of the discount study, and
the Secretariat therefore recommends estab­
lishment of an ad hoc System committee to
investigate and develop suitable means of
perfecting market performance and improv­
ing credit flows. Since this study would be
independent of the discount study and
would probably continue for some time
past its conclusion, the Secretariat will not
try to outline specifically the areas of con­
cern or actions of this group. It does sug­
gest, however, that such a committee study
encompass the whole broad panoply of sec­
ondary markets, and that it establish special
subcommittees to concentrate in those mar­
kets that seem to have the greatest difficul­
ties and/or hold out the greatest hope for
improvement (for example, the mortgage
market and the market for agricultural
paper). The newly created committee
should also determine the extent of its in­
volvement with other interested Federal



JULY 5, 1967

Parker Willis
Federal Reserve Bank of Boston

The paper, “A Study of the Market for
Federal Funds,” describes and analyzes the
growth and development of the Federal
funds market, emphasizing those changes
that have occurred in the postwar period.
The paper notes that the market has be­
come broader, deeper, and more efficient in
recent years. As a result, the linkages have
been strengthened within the various divi­
sions of the money market and also be­
tween the money market and longer-term
credit markets.
Improved brokerage facilities and in­
creased services provided by accommodat­
ing banks have given the market an increas­
ingly national character. While a handful of
banks account for most of the dollar
volume of trading, the market has ex­
panded to include a relatively large number
of smaller banks. Many of these indicate
that trading in funds has reduced their reli­
ance on transactions in Treasury bills and
other money market instruments as a means
of reserve adjustment. Most small partici­
pating banks, however, use the market pri­
marily as a means of disposing of excess
The Secretariat believes that the follow­
ing points should be kept in mind in re­
designing the discount mechanism.
The Federal funds market is working
quite efficiently for large and medium-sized
banks. For small banks, however, the mar­
ket is not now, nor does it seem likely to
become, a dependable source of funds, in
part because many large institutions are ap­
parently reluctant to sell funds, at least on
a relatively sizable or extended basis, to
their smaller correspondents. This seems to

be particularly true in periods of tight
money, when the large banks are keenly in­
terested in retaining funds to finance their
own lending activities.
2. The adoption of the lagged reserves
and reserve carry-forward proposals will
probably tend to reduce the need of smaller
banks for 1-day money and may also tend
to reduce small-bank participation on the
selling side of the funds market. This fol­
lows from the likelihood that banks under
the new plan will be able to carry over
small misses into the next reserve period.
3. It is questionable whether or not
small banks should be encouraged to use
the Federal funds market to support addi­
tions to portfolios, since considerable skill
is required in the use of this day-to-day
market as a dependable source of reserves.
There is also some question as to the desir­
ability of larger banks using the market for
this purpose to the extent they have. This is
an additional reason for believing that the
development of new and improved liquidity
standards for banks should be given high
4. On the whole, the Federal funds mar­
ket has worked very well in recent years
and has demonstrated its ability to respond
quickly and appropriately to changing
needs and conditions. The adaptability of
this market, the implementation of the
lagged-reserve proposal, and the possibility
of a discount window redesigned in such a
way as to permit more ready access by
smaller banks argue against adoption of
such drastic proposals as a Federal funds
auction or even the milder proposal that the
Federal Reserve act as a clearinghouse for


funds transactions of smaller banks. The
Secretariat has a strong preference for
avoiding any action that would tend to dis­
courage the development or improvement
of private market facilities that have a rea­
sonable chance of developing adequately on
their own.

The Federal Reserve might, however,
consider changing its rules so as to permit
wire transfers in uneven amounts without
penalty. This should provide a minor stimu­
lus to further broadening of the market
since it would permit interest on Federal
funds to be included in the return wire.

JU LY 19, 1967

William F. Staats
Federal Reserve Bank of Philadelphia

The paper, “The Secondary Market for
State and Local Government Bonds,” eval­
uates the municipal bond market on the ba­
sis of its performance during 1966 against
three widely recognized criteria of a good
securities market.
It concludes that the market passes the
first test—that there should be free interplay
between the largest possible number of buy­
ers and sellers who have available to them
a maximum amount of information perti­
nent to the market—moderately well but
there remains room for improvement. The
breadth of the market is reduced to some
extent by the tax-exempt feature, which
tends to limit the market to those institu­
tions and individuals able to benefit from
the special tax advantage. Also, bonds that
carry exemption of State and local taxes
tend to be restricted in their market to
fairly small geographic areas. Perhaps the
most critical shortcoming is the existence of
a huge number of heterogeneous bonds,
making it difficult and costly for market
participants to secure sufficient information
to make an optimal decision.
The second test, that buyers and sellers
be brought together at minimum cost
through an efficient institutional structure,
is passed with a high score by those dealers

located in major financial centers who
make a market in the issues of large, wellknown governmental units. There is some
evidence that investors trading with smaller
dealers in the local or regional sectors of
the market may pay higher costs than neces­
sary, but additional research would be
needed to prove this point.
Under normal conditions the market
passes the third test of being able to adjust
readily to temporary disturbances in sup­
ply/demand relationships, thereby main­
taining price continuity. During the peak of
the cyclical pressures in 1966, however, the
performance of the market deteriorated
sharply, largely because of the abrupt shift
of commercial banks from the buy side to
the sell side of the market. Only a handful
of dealers continued to make markets in
municipals and some of these bid very low
so as to minimize the likelihood of taking
on additional bonds. Under these circum­
stances, wide differences occurred in the
prices of two consecutive trades in the same
bond on the same day.
The Secretariat recognizes the following
implications of the paper for the redesign of
the window:
Considering the extreme nature of the
pressure placed on the municipals market in


1966, this paper can be accepted as docu­
mentary evidence that the secondary mar­
ket performs very well under normal cir­
cumstances and can survive even the most
trying circumstances. This does not rule out
the possibility of improvement, and the Sec­
retariat recommends that the performance
of this market be reviewed from time to
time by System study groups in order to
stay abreast of its developing characteristics
and to be able to recommend changes that
would moderate the disproportionate im­
pact of monetary restraint on small, rela­
tively unknown governmental units and
would enable the market to operate better
during periods of unusual stress.
The growing importance of municipal
securities in the portfolios of commercial
banks and the increased willingness, espe­
cially of large banks, to sell these securities
in the market have added a new dimension
to the reserve adjustment mechanism. The


secondary market for municipal securities
could become an increasingly important al­
ternative to discount accommodation.
The Secretariat has a strong prefer­
ence for giving private market facilities free
rein to develop and adapt to changing con­
ditions, if they seem to have the capacity.
The rapid development and the generally
good performance of the secondary market
in municipals make unnecessary the adop­
tion at this time of any of the more drastic
possibilities listed in the paper. No need is
seen at present to use open market opera­
tions to stabilize prices of muncipals or to
have a Government agency act as broker. It
could be necessary, however, for the Fed­
eral Reserve to exercise a lender-of-lastresort function in connection with the mu­
nicipals market in periods of unusual stress.
The Secretariat looks forward to municipal
securities being made eligible for discount
on passage of proposed legislation.

JU LY 19, 1967

Benjamin Stackhouse
Federal Reserve Bank of New York

The paper, “Discount Policy and Bank Su­
pervision,” sets forth the various examina­
tion approaches to liquidity under the pres­
ent framework for borrowing specified in
Regulation A. It recognizes that recent
banking changes have altered the tradi­
tional concept of bank liquidity and that a
substantive change in the rules governing
discounting could alter that concept still
further and necessitate a revised approach
to liquidity measurement. While the paper
does not attempt to spell out any such new
approach, it is nonetheless valuable as a
summary of approaches in use under the
present rules of the game.

The remainder of this memorandum
summarizes the main points of the paper
and sets forth its implications for the rede­
sign of the discount window, as the Secre­
tariat sees them.
1. Postwar changes in liquidity and in the
meaning of liquidity standards

Bank liquidity, defined as the ability of a
bank to meet known and foreseeable de­
mands for money that may be made upon
it, has become a subject of increasing con­
cern in recent years. Not only has liquidity
declined to quite low levels according to the
traditional liquidity measures, but the use­


fulness of these measures has been impaired
to some extent by the growing tendency for
banks to adjust positions by manipulating
their liabilities. Borrowing from various
sources—in the Federal funds market,
through sales of securities under repurchase
agreements, and more recently through the
Euro-dollar market—and what might be
termed “quasi-borrowing” through issuing
negotiable certificates of deposit have all
provided funds to meet other deposit with­
drawals and credit demands. Borrowed
funds, however, cannot be regarded as un­
conditional sources of liquidity, since short­
term borrowing itself establishes a need for
liquid funds in the very near future for pur­
poses of refinancing or repayment. The
foregoing changes that have occurred in
banking practices in recent years make nec­
essary the formulation of new and im­
proved liquidity standards. Contemplated
changes in the discount mechanism add a
new note of urgency to this endeavor.
2. Liquidity standards under the new

Bank liquidity standards will not be less im­
portant if the discount window is opened
wider and made a more certain source of
funds. They will, however, need to be
somewhat different. Assurance of being
able to meet a larger portion of seasonal
and random needs through discount accom­
modation, for example, would reduce the
need for banks to hold as large a volume of
short-term, highly liquid assets as secondary
reserves. Precise liquidity standards cannot
be developed before the details of the new
window are known, but assuming a some­
what more liberal window, examiners
would probably tend to regard a relatively
lower level of bank liquidity (as currently
defined) as adequate, while placing corre­
spondingly greater emphasis on the quality

and soundness of longer-term assets, on the
adequacy of capital, on the adequacy of
earnings to cover the costs of borrowing,
and on flow of funds analysis.
3. Cooperation between bank examination
and discount administration

The redesign of the discount window will
require some readjustment in the approach
to liquidity employed by bank examiners.
Within reasonable limits, this can be ac­
complished without affecting the quality of
their supervision.
The window redesign will probably also
result in increased attention to a bank’s
over-all liquidity position on the part of dis­
counting authorities. This will make it all
the more desirable for administrators of the
window and bank examiners to utilize the
same methods for analyzing that liquidity
position. While bank examination should
continue to have primary responsibility for
enforcing liquidity standards, the Secretar­
iat recognizes the need for complementary
discipline in connection with discount ad­
ministration. The precise nature of the role
assigned to each function will depend, of
course, on the kind of discount mechanism
that is ultimately adopted. But in any case,
there should be a free and regular flow of
information and a close coordination of ac­
tions between the two functions. Presuma­
bly, the examination department would con­
duct an intensive analysis of a bank’s
liquidity position at the time of each exami­
nation, while the discount department
would make repeated but less detailed re­
views of current positions in connection
with occasional discount accommodation
during the course of the year. Both func­
tions may also need to be supported by a
more regular and frequent flow of pertinent
data from each member bank than is re­
ported under existing arrangements.



AUGUST 1, 1967

Parker Willis
Federal Reserve Bank of Boston

The paper, “The Secondary Market for Ne­
gotiable Certificates of Deposit,” describes
and analyzes the growth and development
of the secondary CD market, emphasizing
those changes that occurred in the period
from 1961 through 1966. Because second­
ary market trading takes place almost exclu­
sively in large-denomination CD’s of fairly
well-known banks, which are issued primar­
ily to nationally known concerns, the paper,
of necessity, focuses on the kind of CD that
has implications for large banking institu­
The secondary market during this
1961-66 period experienced ups and downs
in activity, primarily in response to differ­
ing relationships between money market
rates and Regulation Q ceilings. Secondary
market activity tended to expand as long as
banks were forbidden to pay more than 1
per cent for 30- to 89-day money. This
forced a downward-sloping yield curve on
the market and permitted both dealers and
investors to profit from riding the curve.
Under such circumstances dealers were
willing to hold fairly large inventories. Dur­
ing the period from 1961 through 1964,
the market grew steadily, dealer inventories
rose, and the volume of trading expanded
significantly. The increased liquidity of the
CD instrument provided further incentive
for growth in the volume of CD’s outstand­
Activity in the secondary market de­
clined following a change in Regulation Q
in November 1964 that permitted issuers to
pay as much as 4 per cent on maturities of
less than 3 months. Activity declined fur­

ther with the establishment of uniform rates
on all maturities of CD’s in December 1965
and the rapid escalation of market rates in
1966. With the flattening of the yield curve,
an important source of profit was elimi­
nated. Furthermore, dealer positions be­
came exposed to undercutting from primary
issuers who extended the maximum rates to
shorter and shorter maturities. As a result
dealers reduced their inventories sharply
and trading activity declined to very low
Despite the gyrations of the secondary
CD market during the period under review,
participants seemed pleased with the mar­
ket’s performance. In rating the various
short-term markets, they described the mar­
ket for Treasury bills as excellent and ac­
corded a “good” rating to the market for
bankers’ acceptances and CD’s. This is a
quite remarkable tribute to the speedy evo­
lution of the-CD market in view of the fact
that the acceptance market is an old estab­
lished market in which the Federal Reserve
has participated as a buyer and seller for
many years. While the secondary CD mar­
ket still has limited “depth, breadth, and re­
siliency,” in view of its rapid development
and its performance during trying times,
continued improvement can be expected
with the passage of time.
The paper catalogues a number of pro­
posals designed to improve the marketabil­
ity of certificates. Implementation of some
of the proposals could presumably be left
entirely to the market and would require no
action on the part of any governmental
unit. These proposals include: (1) the issu­


ance of certificates on a discount basis, (2)
dealer endorsement of certificates for a fee
as in the case of acceptances, and (3) the
marketing of certificates of smaller banks
through a firm that would be recognized by
a consortium of banks as the leading dealer
in their certificates in the secondary market.
None of these apparently show much prom­
ise. The practice of issuing certificates on a
yield-to-maturity basis is now firmly estab­
lished, dealers do not want to assume the
obligation of certifying the credits of issuing
banks, and an attempt by a large commer­
cial paper house in early 1966 to market
CD’s for a consortium of regional banks
met with an unenthusiastic reception.
Several other proposals for improving
marketability of certificates would require
action on the part of one or more Federal
agencies. These suggestions include: (1)
enhancing the homogeneity of the CD in­
strument by granting complete FDIC insur­
ance coverage; (2) permitting the Federal
Reserve to purchase certificates for the Sys­
tem Open Market Account and/or enter
into repurchase agreements with certificate
dealers; (3) allowing Federal Reserve
Banks to act as brokers in smaller-bank
CD’s, arranging contacts between banks
needing funds and wishing to issue CD’s
and other banks with surplus funds that
might be interested in buying CD’s; and
(4) permitting greater market freedom
with respect to CD rates. The author seems
to have very little enthusiasm for any of
these proposals except the last.
The Secretariat sees the following impli­
cations of the secondary negotiable CD
market for the redesign of the discount win­

1. To some extent the secondary market
provides an alternative means of reserve ad­
justment. Banks hold some CD’s issued by
other banks that can be sold in the market.
Also, dealers have been known to acquire
CD’s directly from issuing banks. More im­
portantly, the existence of the secondary
market imparts a fairly high degree of li­
quidity to the CD instrument, thereby en­
couraging the growth of the primary mar­
ket. This, in turn, makes it possible for
banks, under normal circumstances, to at­
tract funds by creating new instruments, a
fact that has implications for a discount
window designed to accommodate seasonal
needs. For a significant number of banks,
issuance of CD’s may be a reasonable alter­
native to reliance on a seasonal discount
2. There does not seem to be a pressing
need for the Federal Reserve to encour­
age further development of the market for
large-bank CD’s. This market arose in the
first instance in response to particular needs
of an important group of large banks, and
in the main, the market can be relied upon
to adapt itself to the changing needs of
these banks. Because it believes that the CD
market as presently constituted is primarily
suited to the needs of big banks, the Secre­
tariat is unwilling to endorse any specific
recommendations designed to expand the
market to include a larger number of
smaller institutions. The Secretariat holds
this view because of the hazards to which
relatively small and undiversified institu­
tions with managements unskilled in money
market matters could expose themselves by
aggressive CD sales to other than their reg­
ular customers.



AUGUST 23, 1967

Fred H. Klopstock
Federal Reserve Bank of New York

The Secretariat recognizes the following im­
plications of the paper, “Overseas Branch
Balances in the Reserve Management Prac­
tices of Large Money Market Banks,” for
the redesign of the discount window:
1. Borrowings from foreign branches
can, under certain circumstances, be an im­
portant alternative to borrowings in the
U.S. market or from the discount window
for the small group of large banks that have
branches abroad. Although only a dozen
banks are presently involved, they account
for as much as 47 per cent of the business
loans made by weekly reporting member
banks, and their share in deposits and total
assets of the same group of banks is about
2. Money market banks as a group do
not obtain corresponding additions to their
reserve balances as a result of borrowing of
Euro-dollars through foreign branches, as—
for example— they do whenever they borrow
Federal funds net from nonmoney market
banks. This is because borrowings by U.S.
banks of foreign-owned funds through for­
eign branches reduce the supplies of these
funds invested directly by foreigners in the
U.S. money market, either through deposits
in U.S. banks or through purchases of
money market instruments.1 Shifts out of
these latter assets would typically have a
considerably adverse impact on the money
1 This is the case even when a foreign investor
moves from a foreign-currency investment to a dollar
investment, since the foreign central bank that loses
reserves in the process will have to reduce its invest­
ments in U.S. money market assets.

market banks. Therefore, the existence of a
growing volume of Euro-dollar borrowing
through the foreign branches does not mean
that the money market banks as a group
might not need to use the discount window
as an important adjunct to money market
borrowing when making reserve adjust­
But the ability to borrow through
their foreign branches does give those
money market banks with branches abroad
a competitive edge over the other money
market banks. Banks with foreign branches
may have a better opportunity to develop
customer relationships with foreign busi­
nesses and investors than do banks that op­
erate only in the United States or through
correspondent banks abroad. Moreover,
banks with branches are able to bid for de­
posits without the actual or potential con­
straints impused by the existence of Regula­
tion Q ceilings.
The advantages of borrowing through
branches are probably least where the U.S.
head office is seeking funds for day-to-day
adjustments; this is because time-zone dif­
ferences, incomplete information, and vari­
ations in market practice make it difficult
for U.S. banks to make last-minute adjust­
ments by having their branches bid for
funds abroad.
The added measure of flexibility that the
banks with foreign branches obtain ap­
pears, in the first instance, to be only at the
expense of other money market banks. But
how the effects of an increase in borrowing
from branches are ultimately distributed

will depend on the extent to which the
banks that lose foreign deposits turn to
other market sources of funds or to the
discount window.
In any event, the wide variety of ways
in which large banks have proved able to
supplement their liquidity positions— in­
cluding, in those cases where foreign
branches exist, not only increased liabilities
to those branches, but also the sale of assets

to the branches (usually, but not neces­
sarily always with repurchase agreements)
— argues against reliance on any narrow or
pat definition of liabilities for purposes of
either bank supervision or discount window
administration. The extensive range of al­
ternative sources of funds available to such
banks requires a close analysis and evalua­
tion in any appraisal of the liquidity of
these institutions.


Leslie M. Alperstein
Board of Governors, Federal Reserve System

The paper, “An Evaluation of Some Deter­
minants of Member Bank Borrowing,” is a
statistical study of factors affecting the like­
lihood, volume, and frequency of member
bank borrowing from the Federal Reserve
and from other sources. Most previous
studies of this nature have used aggregative
information, a fact that has limited their
usefulness. One important contribution
made by this paper is the basing of analysis
on data relating to 143 individual banks in
six Federal Reserve districts.
The paper relates borrowing, defined in
various ways, to five independent variables
— a liquidity ratio, bank size, Federal Re­
serve district, reserve classification, and the
differential between the discount rate and
the 3-month Treasury bill rate.
The paper provides confirming evidence
of some of the relationships which one
would have expected a priori and which are
fairly obvious. It concludes, for example,
that borrowing is inversely related to bank
liquidity; that banks, if they have to bor­
row, tend to borrow from the least expen­
sive source; and that borrowing, especially

from sources other than the Federal Re­
serve, is a positive function of the size of the
Because of limitations of data and tech­
nique, however, the conclusions of the
paper should be regarded as highly tenta­
tive. Individual bank borrowing data were
not available for the most recent period of
restraint and the analysis is therefore lim­
ited to 1959-61. This time span is an edi­
fying one, but it should be noted that, in
contrast to the 1966 period, the Federal
funds rate remained below the discount
rate. It is difficult to predict how much this
change in rate structures might have influ­
enced the results.
The meaningfulness of the results is also
limited by the choice of districts used. Five
of the six districts included fall in the mid­
dle group when all districts are classified
into three groups by the degree of restric­
tiveness of their discount administration.
On the basis of such a sample, it is not sur­
prising that the study failed to uncover any
evidence of significant interdistrict differ­


Within the bounds imposed by these lim­
itations, the finding most relevant to the
redesign of the discount window is the evi­
dence that interest rate differentials are im­
portant determinants of sources of member


bank borrowing. This suggests that careful
attention should be accorded the possibili­
ties for more active use of the discount rate
as a device for controlling the volume of
member bank borrowing.

FEBRUARY 23y 1968

Paul Meek
Federal Reserve Bank of New York

The paper, “Discount Policy and Open
Market Operations,” undertakes to review
the current operating relationships between
discounting and open market operations, as
seen from the vantage point of the Trading
Desk, and to outline the considerations that
should be taken into account in making any
changes in the discount mechanism in order
to maintain the effective functioning of
open market operations.
On the basis of its study and discussion
of this document, the Secretariat regards
the following points as the main implica­
tions of open market policy considerations
for the redesign of the discount mechanism.
1. Open market operations and the dis­
count window need to function together
harmoniously to achieve a climate of re­
serve availability that serves the current
objectives of monetary policy.
2. For a variety of reasons, open market
operations have become, and should, for
the foreseeable future, continue to be, the
predominant means of affecting the supply
of reserves to the banking system. Reserves
required for seasonal purposes may, over
time, come to be furnished increasingly
through the discount window, however.
3. Under current procedures, the aggre­
gate level of member bank borrowing
serves as one of the practical operational
targets for open market operations. Its

value for this purpose stems from its two
key functions: (a) it is where otherwise unprovided-for changes in the economy’s re­
serve demands show up for accommoda­
tion; and (b) in due course it imposes
certain pressures upon borrowing banks to
readjust their assets and liabilities, thereby
exercising an influence over the growth and
relative availability of bank credit and the
behavior of interest rates.
Thus, a move toward more restrictive
open market operations— or an expansion
of credit demands— generally results in
greater bank borrowing at the discount win­
dow. This is followed by some tightening of
credit market conditions and moderation of
bank credit availability as borrowing banks
endeavor to liquidate assets or borrow
funds elsewhere in order to retire their in­
debtedness to Reserve Banks in accord with
current discounting practices. Conversely, a
move toward more liberal open market op­
erations— or a slackening of credit de­
mands— generally produces a reduction in
bank borrowing at the discount window,
followed by some easing of credit market
conditions and enhancement of bank credit
availability as erstwhile borrowing banks
are freed of the pressure to contract their
earning assets or borrow funds elsewhere in
order to conform to the current rules with
respect to the use of the discount window.


5. The present discount mechanism en­
deavors to limit the volume and timing of
reserves provided through the window by
confining appropriate borrowing essentially
to marginal and temporary purposes; this
is accomplished by both fostering bank re­
luctance to borrow and applying active ad­
ministrative discipline.
6. The present discount mechanism en­
deavors to achieve a reasonable degree of
predictability in the response of a borrowing
bank to its discipline (in terms of the bal­
ance sheet and interest rate changes in­
duced) by holding the conditions of discount
accommodation—apart from the discount
rate, which is varied contracyclically—as
uniform as practicable (a) over time and
(b) as among banks in similar circum­
7. However, no form of discount mecha­
nism that is designed to provide funds at
the initiative of member banks can comply
ideally with the objectives cited in para­
graphs 5 and 6. The present mechanism falls
short by the extent to which variations in
credit demands or reserve flows produce
sharp and uneven concentrations of mem­
ber bank borrowings. It also falls short in
the degree to which differing bank adjust­
ments result from any given aggregate level
or change in borrowing, depending upon
differences among borrowing banks in (a)
their reluctance to borrow, whether inher­
ent or induced; (b) their closeness to the
thresholds of administrative disciplinary ac­
tions; (c) the kinds of administrative pres­
sure received from their Reserve Banks;
and (d) their sensitivity to administrative
discipline when encountered; and also de­
pending upon the variations in all these fac­
tors over time, because of changes in bank
management, administrative rules, and the
surrounding economic and financial envi­

8. There is scope for liberalization in the
amount of member bank borrowing to be
permitted without serious detriment (and
perhaps even with some benefit) to the
efficacy of open market operations, pro­
vided that the volume of reserves borrowed
under any new rules is not so large, and
does not change with such rapidity and un­
predictability, as to exceed the capacity of
the Trading Desk to offset it with open
market operations whenever and to what­
ever extent they result in over-all reserve
availability incompatible with current mon­
etary policy.
9. The ability of the Federal Open Mar­
ket Committee and the Trading Desk to
perceive and make use of borrowing
changes and consequent bank responses
should be enhanced to the extent that bank
borrowing practices can be made more uni­
form and bank responses to borrowing can
be regularized. Changes that would make
bank borrowing and its consequences more
predictable should enable open market op­
erations to generate desired money and
credit market conditions with a higher
order of reliability.
10. Any changes made in the discount
mechanism to achieve these purposes
should be reasonably long-lived. Frequent
changes in the “rules of the game” could
keep the patterns of borrowing and their ef­
fects in continuous flux, and thereby make
it difficult for open market operations to be
conducted with any assurance of the need
for or effects of such actions.
11. From an operational point of view,
the most convenient time to introduce any
major changes in the discount mechanism
would be in a period of monetary ease,
when borrowing would be minimal and
both banks and System authorities could
grow gradually accustomed to the new
framework within which reserves would be
supplied. It is possible, however, that the


shortcomings in the current system could
become so troublesome under the stresses
of a period of monetary restraint as to war-


rant a prompt introduction of some reme­
dial changes in discounting rules, even at
the cost of transitional operating difficulties.

FEBRUARY 27, 1968

Kenneth E. Boulding
University of Colorado

The paper, “The Legitimacy of Central
Banks,” looks at the Federal Reserve from
a lofty vantage point. In a highly abstract,
multidisciplinary view, the details of dayto-day operations and tactics are obscured,
and the System is revealed as one of many
interrelated nodes of activity in a large and
complex social system. Boulding is inter­
ested in the factors which give “legitimacy”
to the central bank and its role. He has not
commented specifically—and was not asked
to comment—on the discount mechanism.
Any lessons for the window in his paper
must be inferred.
By “legitimacy” Boulding means to
imply a degree of acceptance and approval
sufficient to induce other social role-occupants to serve the institution with “inputs.”
He sees legitimacy as a part of the social
cement that holds the elements of society
together and makes possible a continuity of
operations. Without “legitimacy,” Boulding
has said elsewhere, relations among individ­
uals and institutions would become “oneshot jobs, single acts of violence or even of
exchange, without any continuing pattern.”
For a particular institution, a loss of legiti­
macy will lead to an erosion of its viability
and to its ultimate demise. The letter of the
law and the police power of the State may
not be sufficient to counter such a loss.
Six sources of legitimacy are delineated
by Boulding. The first is familiar and, in a
sense, obvious. It is the ability of an institu-

tion, in its exchanges with other elements of
society, to yield “payoffs” that are greater
than the social costs of its operation—as
though it had a heavy positive balance in a
comprehensive cost-benefit analysis.
Good “payoffs” are often not sufficient,
however. They are best accompanied by
some combination of the five other legiti­
macy factors, which he labels “Sacrifice,”
“Age,” “Mystery,” “Ritual,” and “Alli­
ances.” In describing these, Boulding seems
at first glance to be dealing, half-seriously,
with trivialities. The terminology is strange
in this context, but Boulding is using it
quite seriously; and, as one becomes accus­
tomed to his mode of expression, it is ap­
parent that he is attempting to take into
consideration some very powerful social
forces that the mechanics of formal eco­
nomic or political analysis often overlook.
“Sacrifice” he defines as a one-way trans­
fer from one decision unit to another, by
contrast with exchange, which is a two-way
transfer. His second social force is “Age,”
the simple act of surviving over time.
Third, he refers to “Mystery,” something
that is not understood but is dimly
perceived by the public as something grand
or deeply significant. “Ritual,” the fourth
social force, he describes as artificial order,
stemming from regularly repeated rituals,
liturgies, and human law. Last, Boulding
discusses “Alliances,” the identification of a
new and nonlegitimate institution with


other institutions that already possess a
great deal of legitimacy. These are the five
classifications into which Boulding fits real
events and processes in order to describe
their impact on institutions and to evaluate
their contribution to a social equilibrium
that is constantly upset and re-established as
intentions and consequences collide.
This interpretation attributes a function­
alist view of society to Boulding, which
may be unjustified. His paper, after all, is
not intended to state more than a fragment
of a theory, and one should not extrapolate
from it. It provides sufficient grounds, how­
ever, for Boulding to find the Federal Re­
serve System “for its time, an optimum so­
lution for the maximization of legitimacy,”
which faces no major threats. His reasons
are somewhat different from those found in
the standard texts. They include elements of
Sacrifice (on the part of member banks),
Age, Mystery, and Ritual (including move­
ments of the discount rate). At the mo­
ment, the System’s necessary alliance with
Government enhances the former’s legiti­
macy, although he believes that at some fu­
ture time that relationship could be re­

What this paper contributes to a study
of the discount mechanism is highly infer­
ential. It emphasizes that the most de­
pendable basis for an institution’s viability
is its real payoffs to society. This places a
high premium on recognition of social
priorities and a lower value on doctrine. It
suggests that it is better to keep the finan­
cial mechanism running smoothly and
effectively than it is to keep its traditional
principles inviolate. The consequent pain of
inflation may qualify as Sacrifice. It is bet­
ter to look at the real consequences of a
particular configuration of the discount
mechanism than to be preoccupied with the
logic of its construction. Boulding would
admit, however, that in the performance of
central banking functions, a little Mystery
is a good thing. And the Ritual of the dis­
count rate change in itself has a value.
Boulding does not imply that the Federal
Reserve System should be run by a public
opinion poll. He is a pragmatist, not a con­
formist. In his view of human endeavor, the
System should lead as well as follow, but
preferably in directions that subsequent
public evaluation will regard as socially

MAY 13, 1968

Emanuel Melichar
Board of Governors, Federal Reserve System

The study, “Intrayear Fund Flows at Com­
mercial Banks,” was undertaken to help ex­
plore the feasibility of permitting individual
member banks to meet a larger portion of
their seasonal needs through discounting. A
basic need for such a study was to obtain
data on seasonal flows of funds at indi­
vidual banks, as opposed to the generally
available data on aggregate net flows at

large groups of banks. The magnitude and
duration of individual flows, as well as their
distribution among different types and sizes
of banks, could affect the advisability of
liberalizing borrowing for seasonal pur­
poses. A primary objective of the study was
to provide appropriate data of that kind.
The data in the study were obtained
from the periodic reports of condition re­


quired from all insured banks. Two 12month time frames—June 1962-June 1963
and June 1965-June 1966—were exam­
ined; detailed call report data were avail­
able approximately quarterly for the first
of these, but only semiannual data were
available in computer language for the
second. Fund flows were defined as the net
changes in deposits and nonfinancial loans
of individuals, partnerships, and corpora­
tions. Because of the short duration of the
periods being examined, the normal statisti­
cal method of extracting changes due to
secular and cyclical influences could not be
applied. However, allowance for “trend” in
each item was achieved by calculating the
June-to-June change and then subtracting
one-fourth of this value from each observed
quarterly change and one-half of the value
from each observed semiannual change.
The calculation of fund flows in each pe­
riod was performed separately for each in­
sured bank; aggregate fund flows for groups
of banks were then computed by summing
the flows at the individual banks. Gross
outflows or gross inflows were computed by
summing individual flows only at banks
with outflow or with inflow, respectively.
The aggregate net fund flow for a group of
banks was obtained by summing their in­
dividual fund flows irrespective of direction.
The use of call report data is recognized
as having obvious drawbacks. It is unlikely
that these specific dates coincide precisely
with the peaks and troughs of seasonal
credit swings, and so results are probably
biased downward somewhat. In addition,
the data contain a random element which
results in a bias of indeterminate direction.
Last, using call report data makes it likely
that the balance sheets on which the data
were based had undergone some window
dressing; the specific data used are not,
however, normally subject to significant
window dressing. It should also be kept in


mind that any empirical measures of cur­
rent seasonal movements of loans and de­
posits cannot take into account those cases
where banks have curtailed loans because
of deposit outflows and lack of ready
sources of seasonal credit assistance. Thus
true seasonal pressures, which it is expected
would be the appropriate measure of the
need for increased discount window assist­
ance, are undoubtedly somewhat larger
than indicated by these data.
The net effect of these considerations is
almost certainly a downward bias of the
data. In recognition of the statistical short­
comings of call report data, the Secretariat
undertook several projects to develop some
independent indication of seasonal credit
needs in individual districts. These projects
encountered even greater difficulties in de­
fining and measuring these needs and in no
case did they produce clear and unambig­
uous or even usable results. However, the
over-all impression gained from the pilot
studies is a confirmation of the expected
downward bias in the call report data.
Despite these drawbacks in data, the
study carried out by Mr. Melichar repre­
sents the only comprehensive treatment of
the probable demands that would be made
on a liberalized discount window for sea­
sonal credit and makes a useful contribu­
tion to the examination of this possibility.
The remainder of this memorandum sum­
marizes and comments on some of the
paper’s more important findings for the re­
design of the discount window.
1. Fund flows at large and small banks

According to Mr. Melichar’s results, the
fund flow at a large and primarily urban
bank arises mainly through seasonal
changes in deposits, with less trend-adjusted
change in loan volume on a half-year basis.
At some small rural banks, on the other


hand, loan volume undergoes a substantial
intrayear change because of the very high
dependence of the bank and the community
on a single industry with a marked seasonal
movement in its funds needs. For the same
reason, such smaller banks also exhibit
greater relative intrayear change in depos­
Relative to its deposits, the large bank
generally finds small changes in U.S. Gov­
ernment securities and in balances with
other banks to be sufficient to cope with its
fund flow. In contrast, some smaller banks
often have to make relatively large changes
in these items to meet their loan and de­
posit flows. On a relative basis, their portfo­
lio adjustment problems loom much larger
than those of the larger bank. During part
of the year, relatively large amounts of
funds have to be kept idle or invested in
securities that can be readily liquidated to
meet the coming seasonal fund outflow.
These results support the view that a
substantial need exists among some small
banks, although not necessarily among
large banks, for increased assistance in
meeting the seasonal demands upon them if
they are to serve effectively the over-all
credit needs of their communities.
2. Aggregate fund outflows

On the basis of semiannual call report data,
22 per cent of member banks had outflows
of funds during the second half of 1965, to­
taling $0.9 billion or 1.7 per cent of net de­
posits at these banks. In the first half of
1966, 78 per cent of member banks had
outflows, which totaled $9.1 billion and
amounted to 4.7 per cent of net deposits at
such banks. Both semiannual and quarterly
data for 1962-63 exhibited approximately
the same relationships.
3. Fund outflows at individual banks

Only a minority of banks had large out­
flows during any period studied; even in the
period of greatest outflow, the first half of

the year, one-half of all member banks ei­
ther experienced fund inflow or had outflow
of less than $250,000. In each period, how­
ever, large individual outflows accounted
for the bulk of the total outflow. The 18
per cent of member banks with outflows of
$1 million or more in the first half, for in­
stance, had 86 per cent of the total gross
outflow of that period.
As a general rule for the period exam­
ined, the proportion of banks with outflows
did not vary greatly by size of bank, and
the direction of total net fund flow in a
given period was the same for different size
groups. As expected, large banks accounted
for much of the total outflows in most peri­
In each period studied, outflows at most
banks were limited to less than 10 per cent
of deposits. In fact, during each semiannual
period, about one-half of the banks with
outflows experienced outflows amounting to
less than 5 per cent of their net deposits,
and during each quarter over three-fifths of
the banks with outflow were within this
figure. The bulk of the total outflow oc­
curred at these banks with small or moder­
ate individual outflows. But in each period
some banks had relatively large outflows,
and the percentage of banks in this situa­
tion differed considerably among the peri­
ods examined.
4. Potential seasonal borrowing by banks
with large relative outflow

Only a minor part of total fund outflow
in most periods occurred at small banks,
a minor part of each period’s outflow oc­
curred at banks with large relative outflows,
and, as these facts would imply, large
relative outflows occurred much more fre­
quently among smaller banks than among
larger institutions.
These findings have several implications
for design of a program that permits more
seasonal borrowing by member banks. They
are as follows:


a. “If the program were limited to banks
with the larger relative outflows, which now
have to make large portfolio adjustments,
the total amount of funds likely to be sup­
plied under such discounting would consti­
tute a very small proportion of total re­
serves in the banking system, which would
be consistent with the System’s general de­
sire to continue to supply the bulk of mem­
ber bank reserves through open market op­
b. “The small banks that constitute the
majority of banks eligible for the program
are likely to be operating at a disadvantage
in present financial markets commonly em­
ployed for portfolio adjustment purposes.
The discount route for seasonal funds
should therefore be a relatively attractive
one for such banks.”
c. “Many of the small banks with large
relative seasonal flows are probably heavily
involved in financing agriculture, a sector
that in recent decades has been generating
credit demands in excess of its contribution
to the growth of country banking resources.
The seasonal discount program would pro­
vide a net addition to the lending resources
of such banks that currently find it difficult
to meet total local farm credit demands.”
While again emphasizing its serious re­
servations about basing any decisions on
these data alone, the Secretariat would gen­
erally endorse these implications.
5. Outflows exceeding specified relative

In each period studied, the proportion of
banks with the large relative outflows was
greater among the smaller banks. During
periods in which some large banks did have
large relative outflow, however, such banks
accounted for a substantial share of the
total outflow. Also, because of the size of
these banks, the total outflow was much
larger during these periods than at other
The amount of outflow exceeding a spec­


ified percentage of deposits at each bank
can be regarded as an estimate of potential
borrowing from the Federal Reserve under
a regulation permitting banks to borrow to
meet only those fund outflows that exceed
the specified relative level. Under a 5 per
cent “deductible” provision, potential firsthalf borrowings are estimated at $2 billion,
with just over one-half of the sum going to
banks with deposits of $100 million and
over. Potential first-half borrowings under
the 10 per cent deductible plan are esti­
mated at $400 million, with perhaps twofifths of the total being borrowed by the
large banks.
These figures emphasize the substantial
differences in potential borrowing under
different percentage deductible levels. Mr.
Melichar suggests that, on the basis of these
data, the 10 per cent level appears to be
rather restrictive unless it should prove that
many banks have in fact been forced to
limit seasonal lending significantly in recent
years. On the other hand, he suggests that
the 5 per cent deductible, under which
two-fifths of member banks were estimated
to be eligible for first-half borrowing, might
be considered to violate the goal of limiting
the program to banks with relative outflows
significantly above average. He therefore
has undertaken the same calculations for
intervening percentages and determined
that approximately half the credit exposure
is eliminated in the move from 5 to 7 per
cent with progressively smaller decreases as
one approaches 10 per cent.
This study provides the most useful
available data on fund flows, which have
been helpful to the Secretariat and should
continue to exert an influence on the ulti­
mate design and specification of the sea­
sonal borrowing privilege. However, the
Secretariat does not feel justified in making
a definitive recommendation for the per­
centage deductible plan to be adopted on
this basis.


NOVEMBER 13, 1968

Franco Modigliani
Massachusetts Institute of Technology

The paper, “Some Proposals for a Reform
of the Discount Window,” represents an ex­
perimental effort by a leading academic
scholar to design a system whereby the vol­
ume of member bank borrowing can be
controlled by the discount rate alone, an
innovation long recommended, although
usually in more general terms, by many ac­
Professor Modigliani identifies as one of
the major goals of his proposals a reduction
of the slippage between nonborrowed re­
serves and the supply of demand deposits
and a consequent improvement in the con­
trol that the Federal Reserve exercises over
the money supply. He cites free reserves as
the main source of the slippage and seeks
to minimize variations in the level of free
reserves by minimizing fluctuations in the
volume of borrowing at the discount win­
Other major goals set include the follow­
ing: to eliminate or reduce the discretion
and, at times, caprice that the author pres­
ently sees in discount window operation; to
give smaller banks more equitable access to
funds vis-a-vis large banks; and to improve
the spatial allocation of funds. In addition,
Professor Modigliani foresees two desirable
side effects that would result from his pro­
posal. These are the elimination of an­
nouncement effects of discount rate changes
and increased attractiveness of membership
in the Federal Reserve System, further im­
proving the System’s monetary control.
Under the proposal put forth in the
paper, all banks meeting prescribed stand­
ards of creditworthiness would have un­

questioned access to the discount window
up to a predetermined and stated amount.
The rate charged on this credit would be
tied to, and significantly in excess of, a
short-term market rate. Professor Modigli­
ani recognizes the problems inherent in the
choice of such a rate, but after this recogni­
tion largely sets them aside and uses the
Treasury bill rate as a peg for the purposes
of exposition. Borrowing at this “regular”
discount window would be on a 1-day basis,
but would be automatically renewable at the
option of the borrower.
By setting the discount rate significantly
higher than the base market rate, Professor
Modigliani proposes to minimize the level
of borrowing at the window while still
maintaining the Federal Reserve’s function
as a lender of last resort. Based on this
design and certain other assumptions as to
linkages in financial markets,1 the paper
proceeds to show analytically that, follow­
ing any disturbance in financial equilib­
rium, free reserves would, in his model,
tend to return to their initial levels unless
the Federal Reserve took specific action to
counteract this tendency.
Professor Modigliani also explains why,
in his model, the choice of the differential
between the discount rate and the base rate
would be of major consequence only in de­
termining the character of the short-run,
semi-autonomous response of the banking
system to a persistent disturbance while the
Federal Reserve made a decision as to
1 Professor Modigliani cites the various articles on
the Federal Reserve-MIT econometric model for fur­
ther elaboration of these assumptions.


whether and in what way it should act in
response to that disturbance. The greater
the differential the more heavily the initial
response will be concentrated in variations
in short-term interest rates as opposed to
variations in the money supply. While not
advocating any specific appropriate size of
the differential, Professor Modigliani sug­
gests the possibility of a variable differential
between the discount rate and the base
market rate that would increase with the
volume of aggregate borrowing above a
specified amount. Such a system would pre­
serve the usefulness of the window as a
cushion for day-to-day bank needs, but
would avoid an excessive injection of re­
serves in response to a major disturbance
before the Federal Reserve could make a
determination as to its appropriate counter­
action, if any.
In addition to the “regular” discount
window described above, Professor Modigli­
ani proposes a “special” discount window
aimed specifically at the smaller banks lack­
ing adequate access to the Federal funds
market. This window could be open only to
banks of a given size or could be limited to
loans up to a given absolute amount. The
rate charged would be tied to but somewhat
in excess of the Federal funds rate. The
same general considerations regarding the
interaction of the window with market
forces would apply to this “special” window
as were outlined for the “regular” window,
although the equilibrium level of borrowing
would be expected to be higher, relative to
the aggregate size of eligible banks or
loans, since the “special” window would
serve as a day-to-day substitute for the Fed­
eral funds market for some banks.
Professor Modigliani makes a number of
other suggestions to improve the stability of
free reserves within his model. These in­
clude the payment of interest on excess


reserves and additional reforms in reserve
accounting procedures—chiefly the intro­
duction of staggered settlement periods.
In a further proposal, which he sees as
largely independent of the two described
above, Modigliani suggests a third discount
window, which he calls the “term” window.
This would provide credit of intermediate
but fixed maturity (for example, 3 months)
to any bank willing to pay the price, again
up to some limit determined by a credit­
worthiness standard. The rate charged
would be reset at frequent intervals and
would be tied to a short-term market rate
with a flexible differential, again increasing
with the aggregate volume of borrowing.
The design of this window would not be
such as to minimize borrowing, since it
would be viewed as a substitute for an in­
terbank loan market or, alternatively, as a
device to extend to smaller banks facilities
analogous to those provided by the market
for certificates of deposit.
The Secretariat views exclusive reliance
on the discount rate to control the volume
of borrowing at the discount window as un­
workable in the U.S. economy for a variety
of reasons. It therefore does not endorse
Professor Modigliani’s proposal. However,
one cannot help but be impressed by the
striking similarities that appear between this
proposal and that actually being recom­
mended by the discount study, once allow­
ance is made for the idealized and simpli­
fied world deliberately assumed in the
Modigliani model in contrast to the practi­
cal constraints recognized in the Steering
Committee report. There are, of course, also
significant differences in basic approach
and operational detail, but the fact remains
that two proposals emanating from people
with different backgrounds and experience
have much in common.



Table 1— Member Banks: Number, and Number Borrowing, 1959-68, by Class


Table 2— Borrowings and Required Reserves of Member Banks, 1959-68, by Class


Table 3— Collateral for Member Bank Borrowing at Federal Reserve Banks





Number (at year-end)





,2 1



Number borrowing (during year)
At least once from
Federal Reserve

From all sources




















Averages of daily figures, in millions of dollars
Borrowing from—


Federal Reserve Banks

Required reserves
All sources












3 ,50§.0















A. Under Sections 13 and 13a
Number of banks borrowing

Number of pieces



















Face amount (in millions of dollars)














TABLE 3 (Cont.)

B. Under Section 10b
Number of banks


Type of collateral (face amount, in millions of dollars)

























2.8 0


Municipal bonds






























Bernard Shull
Board of Governors of the Federal Reserve System

I. Introduction______________________________
II. The Current Regulation: Objectives and Techniques
A. Objectives in revising Regulation A
B. General Principles
C. Contemplated administration of Regulation A
ill. Administration of Regulation A_______________
IV. 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
V. Summary and Conclusions__________________






The 1955 revision of the Federal Reserve
System’s Regulation A governing discounts
and advances developed out of a study by a
System Committee in 1953 and 1954. The
principal change recommended in the re­
port issued by the Committee was adopted,
that is, a set of General Principles to guide
borrowing and lending at the discount win­
dow.1 The report’s recommendations were
deeply rooted in the development of the dis­
count mechanism during the 1920’s, and
also in the System decision to rely princi­
pally on open market operations in the con­
duct of monetary policy once flexibility was
1 System Committee on the Discount and Discount
Rate Mechanism, “Report on the Discount Mecha­
nism,” Mar. 12, 1954, unpublished document (herein­
after referred to as “Report on the Discount Mecha­
nism,” 1954).


re-established after the Treasury-Federal
Reserve accord in 1951.
This paper reviews and evaluates the ra­
tionale and objectives of the 1955 revision
of Regulation A—in particular as they re­
late to the mechanisms for rationing credit
established by the General Principles. The
analysis is based principally on the 1954
System Committee report on the discount
mechanism and is supplemented by re­
sponses to a questionnaire on discount op­
erations sent to each Reserve Bank in 1965.
The historical development of the discount
mechanism in the 1920’s and the principal
changes represented by the 1955 revision
are discussed elsewhere.2
2 See Bernard Shull, “Report on Research Under­
taken in Connection with a System Study,” pp. 31-75.


The 1953-54 study of discounting was in­
stituted as a result of concern about the
possible “overextension” of Federal Reserve
credit through the discount window. In
mid-1952 discounts and advances had in­
creased to over $1.6 billion; after that they
had declined somewhat but throughout the
first half of 1953, they still exceeded $1
This upsurge in the volume of funds bor3 This note appears on p. 120.

rowed from the discount window developed
after almost 20 years of low levels of activ­
ity. Between 1934 and 1943, discounts and
advances averaged $11.8 million per year;
between 1944 and 1951 they averaged
$253 million. Only in the early postWorld-War-I period (1918-21) and in the
late 1920’s (1928 and 1929) did discounts
and advances approximate in dollar amount
the levels in 1952 and early 1953.4
4 This note appears on p. 120.


A. Objectives in revising Regulation A

In developing and recommending a reformu­
lation of Regulation A, the System Com­
mittee emphasized several objectives. These
may be summarized as follows:
(1) The discount mechanism should not serve
to relieve for long or indefinite periods the pres­
sure of monetary restraint upon the banking sys­
tem and its customers.5
3 According to the “Report on the Discount Mech­
anism,” 1954, p. 22: “In part the rapid rise in bor­
rowing 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 sup­
plement operating resources in order to accommodate
the active credit demands being generated by infla­
tionary 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 Regula­
tion A were also described in the Annual Report of
the Boatd of Governors of the Federal Reserve Sys­
tem 1957, p. 9: “In 1952-53 as credit demands ex­


panded and Federal Reserve policy limited the
amount of reserves made available through open
market operations, pressure on bank reserves in­
creased, and member bank borrowing from the Re­
serve Banks rose rapidly. During this initial revival
of the discount mechanism after a generation of dis­
use numerous problems arose, including uncertainty
among many member banks about what was an ap­
propriate use of the discount privilege. . . . As one
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 ap­
propriate and sound and also in the light of statutory
provisions . . . , the Board of Governors revised its
Regulation A.”
4 In the 1918-21 period discounts and advances av­
eraged $1,840 million; in 1928 and 1929 they aver­
aged $886 million. However, it should be noted that
in the 1918-21 period discounts and advances aver­
aged close to 70 per cent of total Federal Reserve
credit outstanding. In 1928 and 1929 they represented
about 60 per cent of such credit. At the peak of dis­
count activity in December 1952, discount credit rep­
resented only 6 per cent of Federal Reserve credit
outstanding. “Member Bank Reserves and Related
Items,” Supplement to Banking and Monetary Statis­
tics, Section 10, 1962, pp. 14-19.
5 “(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 Sys­
tem . . . (T)he discount facility [can] serve as a

(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 the risk of
their insolvency and/or illiquidity.6 Furthermore,
increases in the risk of insolvency and illiquidity
for individual banks, aside from being undesirable
per se, endanger the stability of the financial sys­
tem and militate against the effective operations of
monetary policy.7
(3) That member banks are generally reluctant to
borrow is, for the reasons stated above, in the
public interest. In order to prevent a weakening
of this attitude, it is necessary that Regulation
A be formulated so as to give support to the
extant “tradition against borrowing.” 8
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.” “Re­
port on the Discount Mechanism,” 1954, pp. 9 and
1 2 ‘

6 “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 continuous in­
debtedness to its Reserve Bank as a resource for con­
ducting 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 sta­
tus ahead of deposit liabilities.” Ibid., pp. 10, 11.
7 “Chronically indebted banks risk depositor pres­
sure in the event that economic conditions turn ad­
verse and the fact of their difficulties in a closely
interdependent banking community can make other
banks, even those in a strong position, highly sensi­
tive about their own liquidity needs. This kind of
banking climate can set the stage for a period of ir­
rational bank credit liquidation. As Federal Reserve
experience in at least one important period illus­
trates, constructive credit and monetary policy to
cushion economic recession and foster revival can be
rendered substantially ineffectual by persistent de­
pendence on the discount facility developed by some
banks in a prior phase of economic boom.” Ibid., pp.
12 and 13.
8 “Because of this costly lesson [during the 1930’s],
it was possible by the mid-thirties to speak of an es­
tablished 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 tradi­
tion permits the discount facility to serve as a safety
valve. . . . From the standpoint of strong and re­
sponsive banking conditions, the tradition against


With the achievement of these objectives,
the Committee believed the discount mech­
anism 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
degree of monetary restraint and to meet
“unexpected” changes in deposit flows or
loan demand and to ameliorate emergency
situations.9 In this role, discounting would
complement open market purchases and
sales in achieving the desired degree of
monetary restraint.
The Committee also expressed the belief
that formulation of Regulation A to meet
the objectives cited would serve to elimi­
nate “incompatible inter-district differences
in discount methods” among the Reserve
B. General Principles

To achieve these objectives, the “Report on
the Discount Mechanism” recommended a
set of General Principles to be incorpo­
rated into Regulation A.1 These were de­
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 continuous 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.] [How­
ever] (t)he tradition against large and continuous
borrowing, being without adequate regulative sup­
port, is subject to the risk of weakening in periods of
credit tightness. . . .” Ibid., pp. 11-13, 22 and 23.
9 “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.
10 The “lack of a modernized System discount phi­
losophy . . . is a factor fostering undesirable regional
differences in discount practices. . . . While some in­
compatible inter-district differences in discount meth­
ods may now exist, the Committee is persuaded that
the differences not supported by variations in re­
gional conditions and needs would be largely elimi­
nated by a Regulation A re-oriented along the lines
suggested.” Ibid., pp. 23 and 24.
11 Ibid., Appendix D.


signed “. . . to guide Reserve Banks in
lending and member banks in Reserve
Bank borrowing,” and “. . . to give clear
and full expression to the discount obliga­
tions of the Reserve Banks as they are
stated in, or implied by, present law.” 1
The Committee indicated that “(a) key
premise underlying the . . . suggested revi­
sion of Regulation A is that explicit stand­
ards for use of the discount facility would
reinforce the member bank tradition against
borrowing by providing a frame of refer­
ence for evaluating undue reliance on dis­
counting by aggressive member banks... .”1
The majority of banks who were viewed
as “reluctant to borrow” would, presuma­
bly, receive support from the position taken
by the Federal Reserve and the observed
change in behavior on the part of the “ag­
gressive” few.1 The relatively few “aggres­
sive” borrowers, it was expected, could be
persuaded to shape their demands for credit
to the standards of reluctance established by
the regulation.
The Report noted that “(i)f the discount
standards advanced should . . . be applied
too inflexibly by Reserve Banks . . . then
the regulation could tend increasingly to
supplant tradition.” 1 The principles ad5
12 Ibid., pp. 23 and 24.
13 Since relatively few banks ever borrowed at all,
it was inferred that the majority were “reluctant to
borrow.” The System Committee indicated that a pos­
sible objection to its suggested revision was that the
System’s discount mechanism problem was mainly
one of relatively few insistent borrowers. Ibid., pp. 36
and 37. The Committee stated that: “(t)he majority
of member banks are now administering their affairs
in line with the philosophy of the suggested revi­
sion.” 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.
14 “The majority of member banks . . . now ad­
ministering 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 con­
formity.” “Report on the Discount Mechanism,” 1954.
is Ibid., p. 36.


vanced, the Committee stated, were
. .
intended to be general guides and standards
and not precise administrative instructions
inflexibly applicable to all cases.” 1 Never­
theless, the principles were not intended to
vary with cyclical changes in monetary pol­
icy, though the amount of credit flowing
through the discount window would vary.1
The General Principles as finally em­
bodied 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 substan­
tive change.1 The General Principles of
the current regulation may be viewed as
the device designed to achieve the objec­
tives developed in the System Committee
16 Ibid., pp. 24 and 25.
17 The Report indicated that “(w)hile the Commit­
tee 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,” Ibid.,
p. 32.
18 The revision suggested by the System Committee
Report incorporated the suggested General Princi­
ples in Section 1 of the regulation. An introduction
indicated the basic objectives underlying Federal Re­
serve credit policy, the methods utilized to achieve
these objectives, the effect of borrowing on the sup­
ply of reserves, and, consequently, the need for
“guiding principles” in extending credit by discount­
ing. It indicated also that “(a)ccess to the credit fa­
cilities 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 abbreviated form, as follows:
“(1) 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 mem­
ber 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 con­
tinuous use of Federal Reserve credit . . . would not

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 “pur­
poses” for which the type of credit de­
scribed may or 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 of 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 avail­
able, but only in exigent situations; that is, for
certain “purposes.”)
2. Appropriate and inappropriate purposes.
The appropriateness of any given request for
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’; and the
acceptance of paper offered for rediscount or as col­
lateral . . . must be determined in the best judgment
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 perti­
nent.” Ibid., Appendix D, pp. 1-5.
With the exceptions of (7) and (8), the Princi­
ples suggested by the System Committee were incor­
porated 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 Principles 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.



short-term credit is dependent on the purpose
for which the credit is requested. Short-term
credit may be appropriately extended to meet a
“sudden withdrawal of deposits or seasonal re­
quirements beyond those which can reasonably
be met by use of the bank’s own resources.”
A credit request is not appropriate if the funds
are to be used to obtain “a tax advantage,” to
profit “from interest rate differentials,” or for
the “undue” extension of credit for speculative
purposes. Long-term credit, as mentioned, is
available for certain “purposes.” 19
General supervisory considerations. A Re­
serve Bank will, in extending credit, give “due
regard . . . to its probable effects upon the main­
tenance of sound credit conditions, both as to
the individual institution and the econom y gen­
erally. It keeps informed of and takes into ac­
count 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 was 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,” 2 as they presumably would
if access to the discount window were
granted as a “right.”
C. Contemplated administration of
Regulation A

The 1954 “Report on the Discount Mecha­
nism” discussed how Regulation A, if re­
vised as recommended, would be adminis­
tered. It also suggested how the restrictions
on credit (in the General Principles) would
It was evidently expected that an “ini19 “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 par­
ticular member banks.” Regulation A, 12 CFR 201.
20 The Federal Reserve System: Purposes and Func­
tions, Board of Governors, Washington, D.C., 1963,
p. 42.

tial” request for credit by a member bank
would normally be granted. The Report
notes that “. . . promptness of discount ac­
tion would require reliance in the first in­
stance on a member bank’s own statement
of purpose”; 2 and the question of continu­
ous borrowing “. . . would arise first at the
time of the first renewal.” 2 In determining
the appropriateness of borrowing thereafter,
the restrictions on continuity and purpose
would, presumably, operate in a coordi­
nated fashion, since all the “principles . . .
are closely interrelated.” 2
The intended relationship between the
“purpose” and “continuous borrowing” re­
strictions, however, is not obvious; nor for
that matter are the relationships among the
“purpose” restrictions themselves. The two
major types of restrictions and the intended
relationships require further consideration.

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 in­
terpret the restriction in this fashion, there
is good reason to believe that such was not
intended. It seems more likely that the in­
tent 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 de­
gree of frequency, is to be taken as progres­
sively more persuasive prima-facie evidence
that the credit extension is not for an ap­
propriate purpose.
“With each successive period in which borrowing
occurs . . . the probability that the borrowing

21 “Report on the Discount Mechanism,” 1954, p.
22 Ibid., Appendix C, p. 7.
23 Ibid., p. 24.


stems from inadvertent causes obviously de­
creases. . . . Consequently, if a bank borrows at
least once in each of a number of consecutive
reserve periods, there exists a 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.” 24

Consistent with this view of the
restriction, the “Report on the Discount
Mechanism” refrains from a specific defini­
tion of “continuous” borrowing, though the
Committee went into some detail on the
issue.2 It noted that it is “. . . necessary
[to develop] some reasonable empirical
standard for judging the number of reserve
periods that a bank may borrow succes­
sively before it is to be considered a con­
tinuous borrower.”2 But the Report states,
“(t)he specific guideposts for identifying
such borrowing can be established only on
the broad discount experience of individual
Reserve Banks and discussion among the
Reserve Banks.” 2
Given that the “continuous borrowing”
restriction was intended to represent evi­
dence that would help illuminate the “pur­
pose” of borrowing, it follows that borrow­
ing for an “appropriate purpose” (for ex­
ample, “the result of chance factors,” or to
meet extraordinarily large deviations from
21 Ibid., p. 10. It is conceivable that some specific
duration of indebtedness (in terms of number of pe­
riods or frequency over a period of time) might
have been chosen as establishing a conclusive pre­
sumption that the borrowing is for an “inappropriate
purpose.” Continuous borrowing would then be suffi­
cient to restrict credit, but still only as a proxy for
“purpose.” However, the author has been informed
by one reviewer, intimately familiar with the deliber­
ations during the period, that there was a Systemwide consensus that the definition of continuous bor­
rowing should not be pushed further.
25 The Report does indicate that both extendedrepetitive borrowing; that is, cases in which banks are
in and out of debt “over nearly successive reserve
periods,” and extended-uninterrupted borrowing; that
is, borrowing over successive periods, should be in­
cluded under the definition of “continuous borrowing.”
26 Ibid., Appendix C, p. 9.
27 Ibid., p. 11.

usual seasonal developments, or for “emer­
gency” reasons) would not, in principle, be
limited in duration by the restriction on con­
tinuity. Rather, most “appropriate” purposes
would be such as to involve only short-term
“Purpose” 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 atten­
tion to the purpose of member bank bor­
rowing” and that certain “. . . objective
procedures . . . would facilitate administra­
tion where findings indicated developments
other than those stated [by the member
bank] were responsible . . . ” 2
However, the Report does not provide
specific definitions of the three “appropri­
ate” purposes cited in the General Prin­
ciples (borrowing to meet sudden with­
drawals, seasonal requirements beyond
those that can reasonably be met, and emer­
gency needs resulting from unusual situa­
tions 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
28 So, for example, the provision of Regulation A
permitting long-term credit in emergency situations
could be thought of as establishing not a separate
category of “emergency” loans but rather a separate
“purpose” for which extended credit is “appropriate.”
29 “Report on the Discount Mechanism,” 1954,
p. 34. The Report also stated that a Reserve Bank
would “. . . engage in analyses of changes in the bal­
ance sheet items of its member banks and of the sea­
sonal 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 bor­
rowing. The methods applicable would not present
too difficult technical problems.”


undue amount of credit for speculative pur­
poses). 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 be­
lieved such mutually exclusive categories
were indeed intended. Moreover, the “pur­
pose” terms themselves are closely inter-re­
lated. So, for example, in defining a word
such as “reasonably” in the phrase that lim­
its the extension of credit for seasonal pur­
poses, the definitions of the three “inappro-



priate” purposes cited in the regulation
are, of necessity, qualified. The General
Principles can be confusing because, taken
literally, borrowing could seem to be simul­
taneously for both an “appropriate” and an
“inappropriate” purpose.
Because they are so closely related, the
credit-restrictive terms of the General Prin­
ciples warrant further analysis. An attempt
will be made below to explain this “related­
ness.” It will be helpful, however, to con­
sider first some aspects of the way in which
the regulation is administered.


Information on the manner in which the
standards incorporated in the General Prin­
ciples of Regulation A are being adminis­
tered was obtained through a questionnaire
sent to the Reserve Banks.3 It would ap­
pear that “initial” requests for credit are
invariably accommodated promptly, with
little if any discussion and with little in­
convenience to the borrower.3 The infor­
mation requested by the Reserve Banks on
application for credit suggests that in most
circumstances no substantial effort is made
to ascertain the “purpose” of such an initial
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 appropriate­
ness of the borrowing; and (3) in cases in
which the borrowing is judged “inappro­
priate,” the undertaking of “administrative
counseling” or “discipline” aimed at secur3° “Questionnaire to Federal Reserve Banks Re­
garding Discount Operations,” October 1965 (herein­
after referred to as “Reserve Bank Questionnaire,
31 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.

ing repayment and “educating” the bor­
rower in the appropriate use of the discount
window. These stages may be viewed as
elements in the process of nonprice ration­
ing and moral suasion at the discount win­
The “counseling” and “discipline” proce­
dures are quite similar at each Reserve
Bank. They typically involve contact with
the borrowing bank, generally first by tele­
phone, and inquiries on the “purpose” of
borrowing and about the presumed plans of
the bank to “work out of” its debt. If a de­
finitive judgment is reached that the borrow­
ing is inappropriate, the Reserve Bank esca­
lates its efforts. Such “escalation” involves
contacts between officials of the Reserve
Bank and those of the borrowing bank at
increasingly higher levels, meetings with
Bank 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 re­
flect an attempt to persuade borrowers that
further borrowing is not in their own best


interest.3 If a mutual understanding cannot
be reached, the Reserve Banks are in a po­
sition to deny credit and to curtail the bor­
rowing privilege in the future. Replies to
the 1965 Questionnaire provided evidence,
however, that there were important differ-

ences in understanding among Reserve dis­
tricts as to the significance of the restrictive
terms of the General Principles. In conse­
quence, it appeared that the regulation
could be and was administered in substan­
tially different ways.3

32 For further discussion of this point, with refer­
ence to experience in the 1920’s, see pp. 33-38.

33 For a statement as to the kinds of differences
found, see pp. 44 and 45.



The principal intention of the 1955 revision
of Regulation A was to limit the flow of
credit through the discount window, partic­
ularly during the periods of monetary re­
straint, and to develop an acceptable ra­
tionale for doing so. However, the
regulation itself does not, of course, spell
out in detail under what economic condi­
tions the credit limitations would be im­
posed. 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 of that realized.
A. General Principles and demand
for credit

It may be recalled that the System Commit­
tee 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 to­
ward borrowing. There is much in the Re­
port—particularly in the General Princi­
ples—and in the way the regulation

operates to suggest that the principal re­
striction on credit was intended to operate
through what might be called “moral sua­
sion,” on the demand for Reserve Bank
When the purpose and continuous bor­
rowing restrictions of the General Princi­
ples 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 restrictions
on borrowing—for purposes such as profit­
ing from interest rate differentials, accom­
modating seasonal demands for commercial
or agricultural credit, and compensating for
expected withdrawals of deposits—may be
thought of as reflecting a somewhat impres­
sionistic regulatory image of the behavior
that could be expected of a bank that, to
some degree, was “reluctant to borrow.”
For such a bank, being in debt would entail
some nonmonetary “cost.” Consequently,
the bank would not borrow simply because
borrowing was profitable in money terms.
At equal, and perhaps even at somewhat
higher costs, it would prefer to obtain re­
serves 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 con­
junction with other information, would rep­
resent evidence of the “purpose” of borrow­
ing, 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; that is, whether there really is a
“reluctance” on the part of the borrower.
“Surveillance” of borrowing banks and pe­
riodic conversations on the “purpose” of
borrowing presumably provide the Federal
Reserve with an opportunity to influence
bank behavior and, by persuasion, bank at­
titudes. Such persuasion, of course, is
backed by the mutual understanding that
credit can be curtailed and that further bor­
rowing capacity at the Federal Reserve can
be impaired. Presumably these discussions
would, at a minimum, provide an incentive
for member banks to conduct their business
as “reluctant borrowers” would.
It is not easy to draw an exact line be­
tween the influence of administration on
bank attitudes, and therefore on the de­
mand for credit, and nonprice rationing of
the supply of credit. It seems clear, how­
ever, that a principal intent of the regula­
tion was to provide a mechanism whereby
member banks would be persuaded to limit
—on their own—their demands for Reserve
Bank credit. To summarize the evidence
provided thus far: (1) The 1954 “Report
on the Discount Mechanism” indicated that
one of the principal purposes of revising
Regulation A was to give regulatory sup­
port to the “tradition against borrowing.”
(2) The General Principles can be con­
sidered a reasonable 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 con­
straint on supply because they do not estab­
lish mutually exclusive categories of “ap­
propriate” and “inappropriate” borrowing.
And (3) the administrative procedure asso­
ciated with the current regulation is con­
sistent with this interpretation and is diffi­
cult to understand otherwise. A decision to
retire an outstanding debt is generally in­
tended to reflect agreement between the Re­
serve Bank and the borrowing bank—al­
though the latter may be quite reluctant to
terminate his borrowing. Such an agree­
ment, reached after considerable persuasive
discourse, strongly suggests a process de­
signed to influence bank attitudes and fu­
ture bank behavior.
B. General Principles and the discount

Flexible use of the discount rate, as a
principal device to ration credit, was re­
jected by the System Committee in 1954.
However, the Committee did consider
briefly the role of the rate under its pro­
posed revision. Its view tends to confirm the
conclusion 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 profit­
able, the discount rate would need to be ad­
justed 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 ordinary discounting to meeting
temporary needs pending other adjustments, how­
ever, the sensitiveness o f their borrowing to the
spread between the discount rate and market
rates would be less marked. The need for fre­
quent change in the discount rate to keep borrow­
ing from appearing profitable, therefore, would be
diminished . . ,34

34 “Report on the Discount Mechanism,” 1954,
p. 43.


C. General Principles and the supply of

Consistent with the intention to restrict the
demand for Federal Reserve credit by sup­
porting the “tradition against borrowing,”
the General Principles of Regulation A
also appear to represent an attempt to facil­
itate the distinction between borrowing that
is in accordance with the “tradition” (suffi­
ciently reluctant) and borrowing that is not
(insufficiently reluctant). But, as indicated,
the distinctions that the Reserve Banks
have drawn in practice are not, and cannot
be, clear cut. Typically, an “initial” borrow­
ing request is assumed to be “appropriate,”
(that is, sufficiently reluctant) and is ac­
commodated at the going discount rate.3
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,” coun­
seling or disciplinary action is undertaken.
The ultimate step in this “disciplinary” pro­
cedure 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 pass before such a
step were taken; and in fact, it appears that
final recourse to credit rationing in this
strict sense seldom occurs.
Short of explicitly denying the continued
extension of credit, the “disciplinary” pro­
cedure is perhaps 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. This “surcharge” is not easily
translated into specific money terms.
Since the threat to future borrowing and
the “inconvenience” imposed by negotia­
tions increase progressively once a judg­
ment is reached that the borrowing is for
an “inappropriate purpose,” the actual
“cost” of credit to the bank would rise over
time.3 Since the Federal Reserve has al­
most complete discretion in making and re­
newing 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) would be considered “appropri­
ate” would depend on a variety of factors.
These include some that are stated 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 bank’s portfolio and liability
management); and “time” itself, since the
length of time the credit is outstanding is
presumed to provide evidence of
“purpose.” 3 These factors may be con­

36 Since the amount of a loan (relative to bank
size) is taken as one indication of “purpose,” the
cost of borrowing over an extended period of time
would be positively related to its amount ceteris par­
ibus. 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 suc­
cession of chance developments.” Ibid., Appendix C,
p. 11. The amount borrowed currently appears to be
treated in this way by the Reserve Banks.
37 Even a loan that was initially “appropriate” be­
cause it was to meet a sudden deposit withdrawal
would not be “appropriate” indefinitely since the
35 No doubt there is some limit on the amount bank is expected to adjust its portfolio within a rea­
sonably brief period of time if the funds do not re­
that a Reserve Bank would lend to an individual in­
turn. Moreover, a succession of “sudden” deposit
stitution. However, there is no explicit limit (either
withdrawals would not be “sudden” under the terms
in absolute or relative terms) in Regulation A or in
of the regulation over any extended period of time.
the Federal Reserve Act.



ceived of as interacting in influencing the
inappropriate” decision.3
From 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. There would be un­
certainty about: (1) the duration over
which an initial request for credit for a par­
ticular purpose is considered appropriate;
(2) the rate at which the cost of credit
rises once it is decided that the borrowing is
for an “inappropriate purpose”; 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 (as­
sumed “appropriate”) is granted, the Re­
serve Bank is generally not in a position to
indicate to the borrowing bank how often or
how long borrowing will be considered ap­
propriate. The rise in the “cost” of credit—
once a decision as to inappropriateness is
reached—is, by its nature, a matter of much
uncertainty also. The effect of “inappro­
priate” borrowing behavior in the past on
the availability and “cost” of credit cur­
rently cannot be indicated except in a very
general manner. To take an extreme exam­
ple: If, after an extended period of borrow­
ing, credit to a bank is denied, how
long should the discount privilege be
withheld? 3 As previously mentioned, such
A nd extended borrowing to meet these withdrawals
would presumably not be “appropriate.”
38 They m ay be thought of as independent variables
in a joint functional relationship with the “appropriate-inappropriate” decision. The value of the inde­
pendent variable “tim e,” at the point at which the
decision is reached that the loan is not for an appro­
priate purpose, would give the duration over which
the “cost” of credit would equal the discount rate.
39 One Reserve Bank indicated that after the ulti­
m ate step in disciplinary procedure is reached, the
borrowing bank receives reassurance about the avail­
ability of credit for initial requests. “In no event
would a banker be told that the borrowing privilege
was being perm anently curtailed but only for the rel­
atively short run; it would be m ade plain that truly
emergency needs of the m em ber bank would always
receive appropriate consideration.”

extreme cases are rare. But the “threat” to
future borrowing capacity is, of necessity,
implicit at all stages in the disciplinary pro­
cedure, not simply the final stage of credit
Consequently, similar questions arise in
all such cases. Specifically, these are: (1)
how soon will a credit request be honored
after the bank has been disciplined and it
has repaid its loan; and (2) to what extent
will the previous borrowing record shorten
the period over which the loan is “as­
sumed” and/or “judged” appropriate. 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.” However, as is well
understood, the appropriate duration for a
new loan is influenced by the previous bor­
rowing record of the bank.4
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 borrow­
ing.” The intention was to keep demand for
Federal Reserve credit relatively low and
inelastic with respect to the differentials be­
tween 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 in­
corporated in disciplinary procedures and,
to some degree, in the physical inconveni­
ence of negotiations instituted while credit
is outstanding. Such conditions impose real
40 A t 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 .”


costs on the borrowing bank. However, un­
certainty surrounding the threat to future
borrowing capacity, together with the trou­
blesomeness 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.” The
administrative procedures under Regulation
A would, for such banks, imply an even
greater limitation on their demand for Fed­
eral Reserve credit than is suggested by a
rising supply schedule, or by the intent to
support or alter bank attitudes toward bor­
It might be argued that uncertainties
concerning the duration of the time period
over which no questions are asked, the
vigor of “disciplinary action” once ques­
tions are raised, and the effects of “discipli­
nary action” on subsequent borrowing exist,
for the most part, in those relatively rare
cases of “extended borrowing” 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 for the
most part are sufficiently “reluctant to bor­
row” that they will generally conform to the
rough regulatory image described in the
purpose restrictions of Regulation A as ad­
If such is not the case— that is, to the ex­
tent that banks are less reluctant to borrow
than deemed appropriate— there would be
more certainty of action in the extreme
than in the normal run of cases. For exam­
ple, banks that borrow heavily so as to be
able 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 (and also to earn a
profit) would have to determine in each in­
stance the duration of the time period over
which the holding of such investments
would be considered appropriate and the
“costs” incurred in exceeding this duration.


The intention of the 1955 revision of Regu­
lation A was to limit the amount of credit
available at the discount window, particu­
larly during periods of monetary restraint.
Both demand and supply limitations were
envisioned. The General Principles in the
Foreword to the revised regulation appear
to describe roughly the kind of borrowing
behavior expected of a bank that was reluc­
tant to borrow. They were principally in­
tended to support the attitudes of the large
majority of banks considered to be reluc­
tant borrowers. In this sense, they repre­
sented a form of moral suasion designed to
limit the demand for credit.

The General Principles also seem in­
tended to facilitate a distinction that dis­
count officers and committees would, from
time to time, be required to make between
borrowing behavior that was sufficiently re­
luctant ( “appropriate”) and borrowing be­
havior that was insufficiently reluctant ( “in­
appropriate”). However, it was not thought
that it would be necessary to make this
distinction often. In those instances where
such nonprice rationing proved necessary, it
was believed such rationing would have a
remedial effect.
The current mechanism clearly provides
for adequate control over the volume of


credit available at the discount window. In
fact, it appears to create a degree of uncer­
tainty about the terms and conditions of
credit that would tend to limit borrowing
more than intended. 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,


primarily 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 suffi­
ciently 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 administra­
tion among Federal Reserve districts may
be viewed as a reflection of difficulties in
implementing the current regulation.


Clay J. Anderson
Federal Reserve Bank of Philadelphia

Introduction__________ __ _____________________________________________________________________


Summary of Findings________________________________________________________________________


Regulating use of bank credit
Allocation among banks
Appropriate borrowing
The discount rate
Concluding remarks
Evolution of the Discount Function: Episodes of Current Significance____________________ 140

Reasons member banks borrow
Attempts to regulate final use of bank credit
Allocation among banks
Appropriate and inappropriate use
Disuse and revival
Elimination of eligibility requirements
Discount rate policy
Bibliography__________________________________________________________________________ 162



the four policy-making groups prior to 1935
— conferences of the Governors of the
Federal Reserve Banks; conferences of the
Chairmen and Federal Reserve Agents of
the Federal Reserve Banks; the joint con­
ferences of these groups with the Federal
Reserve Board; and minutes of the Open
Market Investment Committee.
Other unpublished material of the Sys­
tem included special studies, such as the re­
port of the ad hoc Committee on the Dis­
count Mechanism in 1954, and the
excellent “A History of the Lending Func­
tions of the Federal Reserve Banks,” by
Howard H. Hackley, which includes all
amendments to the Federal Reserve Act re­
lating to the discount function and revisions
of Regulation A.
Published material, including works
of the better-known academic economists
(prior to World War II); Annual Reports
of the Federal Reserve Board (Board of
Governors of the Federal Reserve System
since 1934); and congressional hearings,
particularly the “Agricultural Inquiry,”
Joint Commission of Agricultural Inquiry in
1921 and “Operations of the National and
Federal Reserve Banking System” (U.S.
Senate) in 1931.
It should be noted that the bulk of the
material to be covered in this study ap­
1 It should be noted that academic literature since
World War II is included in David M. Jones, “A Re­
peared prior to the Great Depression. The
view of Recent Academic Literature on the Discount
discount function fell into disuse following
Mechanism,” vol. 2 of this series.

There are two major aspects of the discount
function, both of which exercise some influ­
ence on the volume of reserves supplied via
the discount window.
Discount policy (administration of the
discount window) influences the total vol­
ume of borrowing. It also affects the alloca­
tion of Reserve Bank credit among member
banks and indirectly it may influence the al­
location of member bank credit among final
uses. The discount rate affects the cost of
member bank borrowing. But discount
policy is not considered an effective means
of influencing specific uses of credit.
A complete history of the evolution of
the discount function— philosophy, princi­
ples, and policies embraced in administra­
tion of the discount window and in discount
rate policy— as recorded in the literature
within the System and by outside econo­
mists would be a weighty document. Much
of the material, however, is of historical in­
terest only. This paper is limited to infor­
mation and experiments that might be help­
ful in determining what the role of the
discount function should be.1
The principal sources of material used
Unpublished material available within
the System, especially the Proceedings of


the Great Depression and did not become a
significant policy instrument again until
after the Treasury-Federal Reserve accord in
March 1951. Within the System, policy dis­
cussions since the accord, except for the
study in 1953 -5 4 and this one, have dealt
largely with open market operations.
The paper is divided into two main parts.
The first is a brief summary of the evolu­
tion of the discount function; the second
deals in more detail with the principal con-

cepts and philosophies embraced in discount
and discount rate policies and some experi­
ments that appear of relevance in determin­
ing the current role of the discount mecha­
nism. Evaluation, other than that made in
the literature covered, is often unnecessary.
No attempt has been made to cover each
amendment affecting the discount function
or each revision of Regulation A. Nor are
the V-loan and Section 13b-loan programs

Evolution of the discount function during
the past half-century reflects the influence
of economic thought and economic events.
The underlying philosophy of the discount
provisions of the Federal Reserve Act was
the “real bills” doctrine that bank credit
should be confined to short-term productive
uses. This view strongly conditioned the ev­
olution of the discount function in the first
two decades of the System. It even led to
efforts, at times, to use discount policy to
curb the use of bank credit for certain pur­
Economic events, however, soon created
doubts as to the validity of this doctrine,
both in principle and in practice. Confining
credit to “productive uses” would not nec­
essarily automatically result in the proper
total quantity of bank credit. During an in­
flation boom, total bank credit expansion
resulting from lending for so-called “pro­
ductive uses” could be excessive; hence it
was necessary to regulate the total quantity
of bank credit in the interest of sustained
over-all stability.
These two views had significant implica­
tions for the discount function. For selec­
tive regulation, such as confining bank
credit to certain uses, discount policy was
considered a more useful instrument; the

discount rate was regarded as a more effec­
tive instrument for regulating the total
quantity of bank credit.
Regulating use of bank credit

The philosophy embodied in the Federal
Reserve Act contemplated that Reserve
Bank credit should be extended for a short
term only and that it should be confined to
financing the production and the distribu­
tion of goods from producer to consumer.
It should not be used to finance investments
or speculative activity of any kind— securi­
ties, commodities, or real estate. Confining
bank credit to productive purposes, it was
believed, would result in an automatic re­
sponse of supply to the expanding and con­
tracting needs of commerce, industry, and
The implications of this real bills doc­
trine for Federal Reserve policy were two­
fold: (1 ) use of Federal Reserve credit to
finance unproductive activities should be
prevented, and (2 ) System officials should
pursue a passive policy allowing the supply
of credit to respond to changing demands
of “legitimate” business and agriculture.
At first, eligibility requirements were
considered the principal method of confin­
ing Reserve Bank credit to productive uses;


however, experience soon demonstrated
that the kind of paper offered for discount
was no indication of the uses made of the
bank credit extended on the basis of the
Following World War I, emphasis shifted
to “direct pressure” as a means of confining
bank credit to appropriate uses. Even
though Reserve Bank officials might not be
able to identify the specific uses made of
the proceeds of a discount, they could and
should keep informed of the loan and in­
vestment policies of their member banks.
Reserve Bank credit should be denied those
banks using it for unproductive purposes.
Most System officials were sympathetic
with the ultimate goals of direct pressure,
but there was growing opposition to the
policy in the 1920’s. One of the major
points of opposition was that it was im­
practical. It was impossible to confine
credit to productive uses through adminis­
tration of the discount window. A member
bank discounts or borrows to replenish a
reserve already deficient— a deficiency that
usually results from a number of transac­
tions. Moreover, reserves created by loans
to banks making only “productive” loans
might flow to banks extending credit for
speculative and nonessential purposes. Sec­
ondly, a substantial number of banks do
not borrow from the Federal Reserve Banks
and hence are not subject to direct pres­
sure. Finally, there was increasing doubt
that confining credit to productive uses
would result in the proper total quantity of
credit. The total quantity of credit, even
under a productive-use criterion, may ex­
pand more rapidly than ability to produce
goods and services to match it. Discount
policy by itself was not considered an effec­
tive means of regulating the total quantity
of bank credit.
The controversy over direct pressure in­
tensified in the latter part of the 1920’s as


an increasing flow of bank credit went into
the stock market. With business operating
below capacity and prices tending down­
ward, the situation called for selective con­
trol to curtail credit for speculation without
making credit scarcer or more expensive for
business and agricultural purposes. Those
favoring direct pressure instead of an in­
crease in the discount rate thought the lat­
ter would have little effect on speculative
use of bank credit but would work a hard­
ship on business and agriculture. Others,
however, thought the policy of direct pres­
sure could not be implemented effectively.
Some loans against securities might be for
speculation but others were for productive
purposes. They favored an increase in the
discount rate.
The Great Depression brought to a close
attempts to implement the real bills doc­
trine as a means of achieving business sta­
bility. The quantity of eligible short-term
commercial paper dwindled, and eligibility
requirements handicapped the Reserve
Banks in providing adequate assistance to
some member banks. Then, too, emphasis
continued to shift from selective control to
regulating the total quantity of bank credit
and the money supply.
Allocation among1

Preventing excessive borrowing by individ­
ual member banks has always been a prob­
lem, especially in the earlier years of the
Federal Reserve System. System officials
thought that too much borrowing was un­
sound banking policy because experience
had shown that banks heavily indebted to
the Reserve Banks were among the first to
fail. Excessive borrowing was also consid­
ered inconsistent with the spirit of the Fed­
eral Reserve Act, which authorized Reserve
Banks to administer the discount window
so that each member bank would be able to
get its fair share of Reserve Bank credit.


The problem here involved allocation of
Reserve Bank credit among member banks
instead of allocation of member bank credit
among uses.
One of the early experiments in attempt­
ing to prevent excessive borrowing by some
member banks was the establishment of
progressive discount rates by four Reserve
Banks. Progressive rates would penalize ex­
cessive borrowers without making borrow­
ing more expensive for member banks not
abusing the privilege.
The four Reserve Banks establishing pro­
gressive rates soon abandoned them. A fun­
damental weakness was that the penalty
was based entirely on quantity of borrowing
in excess of a basic line, which in turn was
computed in an illogical manner. The de­
vice worked a hardship on banks suffering
unusually large seasonal or other types of
deposit drains, and exceptionally high rates
paid by a few banks aroused widespread
criticism and subjected the System to politi­
cal attack. The consensus of Federal Re­
serve officials seemed to be that excessive
borrowing could be better controlled by dis­
cretionary discount policy than by a rigid,
mechanical formula such as progressive dis­
count rates.
The burden of preventing excessive bor­
rowing by individual banks fell mainly on
administration of the discount window. Re­
serve Bank officials soon began to keep
closer tab on member banks that were bor­
rowing either unusually large amounts or
continuously. In the case of problem banks
the usual investigation was supplemented by
conferences with officers or directors of the
borrowing bank. Reserve Bank officials also
used various contacts and methods to try to
educate member banks on proper use of the
discount window.
Appropriate borrowing

Another aspect of discount policy discussed
in the 1920’s was appropriate uses of the

discount window. There seemed to be gen­
eral agreement that borrowing from the
Federal Reserve should be short term to
meet temporary needs, that habitual bor­
rowing was unsound and undesirable, and
that banks should not borrow to profit from
higher rates.
The discount window was not used much
from about the m id-1930’s until 1951 be­
cause of the large volume of excess reserves
generated by gold imports and of the ready
availability of reserves under the policy of
supporting the prices of U.S. Government
securities. With the return to a flexible
monetary policy, System officials launched
studies in order to reappraise use of both
the discount window and open market op­
erations in the new environment.
The studies and the revision of
Regulation A in 1955 were concerned pri­
marily with appropriate and inappropriate
types of borrowing from the Reserve Banks.
The principles adopted were largely a reaf­
firmation and refinement of principles that
had evolved, mainly in the 1920’s.
Appropriate uses of the discount window
were principally twofold: (1 ) short-term
advances to meet temporary reserve drains,
such as from a deposit loss, and seasonal
requirements that could not reasonably be
anticipated; and (2 ) advances for longer
periods if necessary to enable member
banks to meet unusual and emergency situ­
Inappropriate uses included continuous
borrowing to supplement a bank’s own re­
sources, borrowing for speculative purposes,
and borrowing to profit from interest rate
differentials or to obtain a tax advantage.
The philosophy embodied in the revision
of Regulation A contemplated only a lim­
ited use of the discount window. Except in
emergency situations, advances are to help
meet temporary reserve drains that a wellmanaged bank ordinarily would not be in a
position to meet out of its own resources.


Borrowing is to afford time for a more or­
derly adjustment of assets and/or lending
The discount rate

The Federal Reserve Act contained little
guidance for discount rate policy. Section
14 stated that rates should be established
“with a view of accommodating commerce
and business.”
Initially, there was little crystallized
thinking among System officials either as to
the role of the discount rate or as to criteria
that would be useful in determining the
timing of rate changes. The penalty-rate
concept was widely accepted in principle
but considered impractical in the United
Several factors influenced the role of the
discount rate in the 1920’s. Emphasis on
the use of discount policy for selective
credit regulation, and a consensus among
System officials that the discount rate was
ineffective for preventing excessive borrow­
ing by an individual member bank, tended
to relegate the discount rate to a secondary
role. On the other hand, belief by some of­
ficials that “direct pressure” was impracti­
cal, and increasing emphasis on the need to
regulate the total quantity of credit, favored
a more important role for the discount rate.
Discovery of the value of open market op­
erations in the early 1920’s gave System
officials two quantitative tools. The discount
rate and open market operations soon came
to be regarded as the “twin instruments” of
Federal Reserve policy.
System officials devoted considerable at­
tention to guides that might be useful in de­
termining the timing of changes in the
discount rate. The dominant view that
emerged was that no simple rule or formula
would suffice. Instead, decisions should be
made on the basis of a wide range of rele­
vant information on current credit and
business conditions. Perhaps the most


widely accepted principle was that the dis­
count rate should be raised when there was
evidence that bank credit expansion was be­
coming excessive in relation to the volume
of business activity, and that the rate
should be lowered in periods of depression
to encourage expansion.
Studies were also initiated to determine
the effects of discount rate action. Surveys,
including questionnaires and calls on mem­
ber banks by field men, indicated that
changes in the discount rate had little effect
on bank loan rates to customers. Excep­
tions were loans that were closely related to
market rates, such as call loans, and busi­
ness loans of the larger banks in financial
Even though most member banks indi­
cated that changes in the discount rate had
little effect on customer loan rates, some
System officials thought that the effect of a
change on the cost of borrowed reserves
had a significant influence on the total vol­
ume of bank credit.
Although open market operations have
been the major policy instrument since
1951, a new proposal regarding the dis­
count rate advanced in academic literature
is that the discount rate should be tied to
some relevant market rate.
Concluding remarks

The evolution of the discount function,
even though interrupted by a long period of
quiescence in both implementation and
thought, has some significant implications
for discount policy. On the basis of past ex­
perience the principal implications, in the
opinion of the author, are the following:
Administration of the discount win­
dow has been neither an equitable nor an
effective instrument for implementing a pol­
icy of selective credit control. At best, it
has reached only a minority of commercial
banks (a large number of member banks as
well as many nonmember banks do not use


the discount window) and an even smaller
fraction of all lenders. Discount officers can
ordinarily identify “misuse” only after it
shows up in bank condition reports— a fait
accompli. Moreover, banks denied access to
the discount window because of noncompli­
ance may have an inflow of reserves from
banks that do borrow from the Reserve
Banks, or they may acquire reserves in the

sistent with the maintenance of sound credit
conditions. Second, progressive rates hit
especially hard member banks that are sub­
ject to erratic and pronounced seasonal and
other temporary reserve drains.
Preferential discount rates, used only
briefly except in war financing, proved to
be discriminatory and ineffective. The pref­
erential rate soon became the effective rate.
One of the lessons of experience is that
courageous and well-informed discount
The use of mechanical devices in ad­
officers have been more effective in imple­
ministering discount policy has never been a
menting discount policy than any rule or
satisfactory substitute for discretion.
mechanical formula yet developed.
The experiment with progressive discount
3. Eligibility requirements have been
rates in 1920 was soon abandoned. Some
more of a handicap than a help in imple­
of the shortcomings were the result of the
menting policy. They never achieved the
particular type of plan adopted. But even
purpose for which they were intended, and
more serious weaknesses are inherent in
the philosophy underlying the requirements
progressive rates. First, no logical basis has
has been inappropriate for the economic
thus far been proposed for computing a
environment that has prevailed for many
basic line. Any basic line, regardless of how
years. This is mainly why the System has
computed, implies that quantity is the pri­
mary determinant of validity of borrowing
recommended to the Congress their elimina­
tion from the Federal Reserve Act.
from a Reserve Bank. Borrowing in excess
of some arbitrary basic line is automatically
4. Experience has demonstrated that the
discount function has been useful in rein­
penalized regardless of the reasons for the
forcing anticyclical monetary policy— forc­
borrowing. This view is the antithesis of the
ing banks to the discount window and rais­
concept (and the spirit of Section 4 of the
ing the discount rate when desirable in
Act) that, in deciding whether to extend
implementing a restrictive policy, and low­
credit to a member bank, Reserve Bank
ering the discount rate and using open mar­
officials should take into consideration the
condition and policies of the applicant bank
ket operations to take member banks out of
debt in periods of monetary ease.
and whether the proposed borrowing is con­

This section is devoted primarily to issues
and episodes believed to be of some rele­
vance in the current reappraisal of the dis­
count function. It attempts to summarize
the dominant views expressed within the
System and in academic literature prior to
World War II.

The principal topics covered are as fol­
lows: the reasons member banks borrow;
attempts to regulate the final use of bank
credit; techniques of allocating Reserve
Bank credit among member banks; appro­
priate and inappropriate borrowing; and the
discount rate.



Reasons member banks borrow

Soon after the System began operations,
Reserve Bank officials became concerned
over the general attitude of member banks
toward borrowing from the Reserve Banks.
Many banks thought of borrowing from the
Reserve Bank in the same way as borrow­
ing from a correspondent— a source of
funds to lean on when their own resources
were short. Hence, Reserve Bank officials
tried to inculcate in bankers the philosophy
that Reserve Banks should be regarded as a
lender of last resort.
In the 1920’s two divergent views
emerged (most of the analyses being in ac­
ademic literature) as to why member banks
borrow. One view was that member banks
borrow only when in need of additional
funds; the other put more emphasis on
profit motivation. These views had signifi­
cant policy implications, especially for the
role of the discount rate.
Need theory. One view that emerged in
the early 1920’s and still prevails is that
member bank borrowing is motivated pri­
marily by need rather than by profit.2 In
essence, the doctrine was that member
banks are reluctant to borrow from the Re­
serve Banks; they generally borrow only to
meet a reserve deficiency; and they repay
indebtedness to the Reserve Bank as soon
as practicable. In repaying, however, banks
usually withdraw funds from the money
market and shift the reserve deficiency to
other banks.
It is obvious that need is substantially in­
fluenced by open market policy. If sufficient
reserves are supplied through open market
purchases, there is little need to borrow; if,
however, insufficient reserves are supplied
through open market operations, member
2 For example, see Winfield W. Riefler, M oney
Rates and M oney M arkets in the United States, pp.
19-32. Riefler was a leading advocate of the need

banks may be compelled to turn to the dis­
count window.
Experience was used to support the need
motivation for borrowing. A substantial
spread between the discount rate and mar­
ket rates was not unusual. Hence, it was al­
leged that if member banks borrow primar­
ily for profit, market rates could not long
remain above the discount rate. Borrowing
to take advantage of higher market rates
would soon eliminate the spread. Neither
could market rates remain much below the
discount rate so long as there was any ap­
preciable volume of member bank indebt­
edness to the Reserve Banks.
A significant implication of the need
theory is that the discount rate is not a
major determinant of the volume of mem­
ber bank borrowing. Exponents of the doc­
trine thought the volume of member bank
borrowing had a greater influence on mar­
ket rates than changes in the discount rate.
The discount window, although only a mar­
ginal source of funds, had an important in­
fluence on market supply and hence on
market rates. Evidence cited was that mar­
ket rates moved closely with the volume of
member bank borrowing, and changes in
the volume of borrowing usually preceded
changes in rates.
The discount rate had some influence on
market rates, however. If the discount rate
is above market rates, banks may turn to
call loans or other market sources for re­
serves instead of to the discount window.
But if the discount rate is below market
rates, the tendency would be for banks in
need of funds to turn to the discount win­
Profit theory. The profit theory, simply
stated, is that member bank borrowing
from the Reserve Bank is motivated pri­
marily by profit. Member banks tend to
3 For example, see Riefler, op. cit.


borrow when it is profitable. Profitability of
discounting or borrowing from the Reserve
Banks is a major determinant of the volume
of member bank borrowing.
The profit theory, although not expressly
stated and developed, is implicit in a sub­
stantial part of System material dealing
with discount rate policy since World War
I. Proceedings of policy discussions prior to
the Great Depression frequently reveal gen­
eral acceptance of the principle that the dis­
count rate should be a penalty rate in order
to discourage borrowing for a profit; it was
agreed, however, that implementation was
impracticable in the United States because
of the wide variation in interest rates re­
gionally and by type of loan.4
A more sophisticated version of the
profit theory is that member banks, faced
with a reserve deficiency, will tend to select
the lower cost among alternative reserve
adjustment media.5 When the discount rate
is above market rates on assets available for
readjustment— so-called secondary reserve
assets— banks tend to turn to the market
instead of borrowing from the Reserve
Banks to cover reserve deficiencies. Banks
are encouraged to borrow from the Reserve
Banks when the discount rate is below mar­
ket rates on these assets. The view widely
accepted since revival of the discount func­
tion in the post-World-War-II period— that
the discount rate should be equal to or
above market rates on commonly used alter­
native assets for reserve adjustment, espe­
cially in periods of restraint— implies ac­
ceptance of this version of the profit theory.
Synthesis and evaluation. The need and
profit doctrines came under close scrutiny
4 For example, see the following (for description
of conferences, see p. 163): Conference (1), Oct.
25-28, 1921 (p. 20 et passim ); Conference (2),
Nov. 19-21, 1919 (pp. 59-73 et passim ), and Apr.
12-15, 1921, vol. 1 (et passim ).
5 For example, see Robert C. Turner, M em berBank Borrowing, pp. 92-97.

in the m id-1930’s, especially by Robert
Turner who attempted to test the two theo­
ries, both analytically and empirically.
A critical weakness of the need theory is
the nebulous nature of the basic concept.
Advocates of the doctrine did not give a
clear definition of need— usually referring
to seasonal drains and temporary reserve
deficiencies arising from market factors
such as deposit flows. Need in this sense,
however, should have little effect on the
total volume of member bank borrowing.
Seasonal drains and other market flows
shift reserves among banks but do not af­
fect significantly reserve needs of the bank­
ing system. If, on the other hand, need is
defined to embrace all types of reserve defi­
ciencies, reserve “needs” resulting from
loan and deposit expansion, including lend­
ing and investing to take advantage of a
rate spread, would be included.6
Turner points out that a spread between
market rates and the discount rate does not
prove that member banks do not borrow
for profit, only that they do not borrow in
sufficient volume to bring market rates into
line with the discount rate. Banks may bor­
row to re-lend or invest at a profit, but lim­
its imposed by discount policy and the tra­
dition against borrowing may prevent a
volume sufficient to eliminate the rate
Turner, using available statistical data,
attempted to test the validity of the profit
theory. His findings may be summarized as
There was no correlation (1 ) between
the volume of member bank borrowing and
the profit spread between the discount rate
and bank customer loan rates, or (2 ) be­
tween borrowing and the profit spread be­
tween the discount rate and bond rates. In
other words, banks try to take care of their
6 For an explanation and evaluation of the two
doctrines, see Turner, op. cit., chapters IV, V, and VI.


customers regardless of whether they are
able to borrow from the Reserve Banks at a
profit. And apparently they do not borrow
from the Reserve Banks to invest in bonds
even when the return affords a profit.
2. There was a fairly close correlation
between the volume of member bank bor­
rowing and the profit spread for three types
of open market paper: call loans to brok­
ers, time loans to brokers, and commercial
paper. There was also close correlation be­
tween the volume of borrowing and the
profit spread between the discount rate and
the average of these three market rates.
3. Changes in the profit spread for open
market paper appeared to be an important
determinant of changes in the volume of
member bank borrowing in the period
1922-30, but the correlation was not so
close for the period 1931-36.
On the basis of his research and analysis,
Turner concluded that the profit theory is
not a complete explanation of the volume
of member bank borrowing but that it is a
significant one. The volume of borrowing
tends to increase as the profit spread wid­
ens, but because of the tradition against
borrowing there is a point beyond which
widening of the spread has gradually less
effect. There is an observable tendency for
changes in the profit spread either to lead
or to occur at the same time as changes in
the volume of borrowing. A negative profit
spread is associated with a low volume of
borrowing, but it appeared not to be so im­
portant in determining changes in the vol­
ume of borrowing. Finally, a general theory
of member bank borrowing must embrace
consideration of factors influencing reserve
positions as well as the profit theory.
Turner’s conclusions are valid. Bank
loan and investment policies are not di­
rected toward taking advantage of every
profit spread between their earning assets
and the discount rate. The tradition against


borrowing, as well as administration of the
discount window, inhibits such actions.
Nevertheless, a profit spread may induce
some banks, especially the more aggressive
ones, to pursue more liberal lending and in­
vesting policies; and the relation of the dis­
count rate to rates on alternative reserve
adjustment media surely influences banks in
their choice of the source of funds to cover
reserve deficiencies.
Attempts to regulate final use of bank credit

The general philosophy underlying the dis­
count provisions of the Federal Reserve Act
was that Reserve Bank credit should be
confined to productive uses in industry,
commerce, and agriculture. It should not be
used to finance speculative activity of any
kind— securities, real estate, or commodi­
ties— or to finance investments other than
Government securities.7
This philosophy of the discount function
was expanded and refined in the 1920’s. A
view prevalent inside and outside the Sys­
tem was that confining bank credit to
short-term productive purposes was the real
pathway to economic stability. Productive
purposes included financing of an orderly
flow of goods from producer to consumer,
but not the building up of inventories in an­
ticipation of higher prices. For example, the
Federal Reserve Board’s Annual Report for
7 Materials concerning the discount function in the
period prior to the mid-1930’s were taken principally
from the following sources, all within the System:
(a) minutes of conferences of the Governors of the
Federal Reserve Banks; (b) minutes of conferences
of the Governors and the Chairmen and Federal Re­
serve Agents of the Federal Reserve Banks with the
Federal Reserve Board; (c) minutes of meetings of
the Open Market Investment Committee; and (d)
Annual Reports of the Federal Reserve Board. The
minutes of the annual conferences of the Federal Re­
serve Board with the Governors and Chairmen of
the Federal Reserve Banks, usually held in October
or November, in the first part of the 1920’s were es­
pecially useful because the meetings were devoted en­
tirely to papers and discussions of Federal Reserve


1923 stated, “the economic use of credit is
to facilitate the production and orderly
marketing of goods and not to finance the
speculative holding of excessive stocks of
materials and merchandise.” 8 Confining
bank credit to productive uses, as here de­
fined, would automatically result in the ap­
propriate quantity of credit. This point was
also well stated in the 1923 Annual Re­
It is the belief of the Board that there will be
little danger that the credit created and contrib­
uted by the Federal reserve banks will be in
excessive volume if restricted to productive uses.
. . . Administratively, therefore, the solution of
the economic problem of keeping the volume of
credit issuing from the Federal reserve banks
from becoming either excessive or deficient is
found in maintaining it in due relation to the
volume of credit needs as these needs are derived
from the operating requirements of agriculture,
industry, and trade, and the prevention of the
uses of Federal reserve credit for purposes not
warranted by the terms or the spirit of the Fed­
eral Reserve Act.9
Eligibility requirements. The initial view
was that confining bank credit to produc­
tive uses could be implemented by eligibil­
ity requirements. The original Federal Re­
serve Act limited access to the discount
window primarily to short-term paper aris­
ing from, or the proceeds of which were to
be used in the financing of, industrial, com­
mercial, and agricultural activities. Except
for a minimum gold reserve requirement of
40 per cent, eligible commercial paper
could also be pledged as collateral against
the issue of Federal Reserve notes. Thus, ac­
cess to the discount window and to a large
extent the issuance of Federal Reserve
notes were directly related to holdings of el­
igible commercial paper. As a result, it was
expected that Reserve Bank credit and Fed­
eral Reserve notes would automatically re­
8 Tenth A nn ual R eport of the Federal Reserve
Board: C overing operations for the year 1923, p. 5.
9 Ibid., pp. 34 and 35.

spond to the changing needs of production
and trade.
Events and experience soon demon­
strated that eligibility requirements were
not an effective method of regulating use of
credit. To facilitate financing the large de­
fense expenditures incurred in World War
I, the Reserve Banks were given authority
to make loans to member banks against
U.S. Government securities. More signifi­
cant, however, experience soon demon­
strated that the kind of paper offered for
discount or put up as collateral for loans
afforded no indication whatever of the use
a member bank was to make of the proceeds. In fact, member banks came to the
discount window to cover a reserve defi­
ciency that had already occurred and that
usually reflected the combined effects of a
large number of transactions.
Preferential discount rates. Another early
experiment in trying to influence the use of
credit was the preferential discount rate. In
1915, a preferential rate was established on
trade acceptances to encourage development
of a market for acceptances and broaden
the use of this type of paper. A broader
market for acceptances would tend to stim­
ulate U.S. exports and increase the liquidity
of member banks. In the same year a pref­
erential rate was established on paper based
on some staple commodities to facilitate
seasonal financing of the marketing of agri­
cultural products.
In World War I and World War II, Sys­
tem officials established preferential rates on
discounts and advances “collateralled” by
Government securities in order to facilitate
the financing of large wartime expenditures.
The preferential rate in World War II ap­
plied to member bank borrowing “collater­
alled” by short-term Government securities.
Experiments with preferential discount
rates, except against Government securities


in wartime, were short-lived. There were
two serious disadvantages. One was that
banks in need of funds offered for discount
the type of paper with the lower discount
rate. The preferential rate was the effective
discount rate. Second, preferential rates
were discriminatory. Member banks hold­
ing the types of paper with preferential
rates could borrow more cheaply than
banks not holding such paper. Except for
Government paper in wartime, System
officials— especially Reserve Bank officials
— were strongly opposed to preferential dis­
count rates; they thought that all types of
eligible paper should carry a uniform rate.
Preferential discount rates (or a penalty
rate) have been proposed occasionally
other than in wartime since the early exper­
iments. In 1928 the System had been fol­
lowing a policy of moderate restraint in
order to curb speculative use of bank
credit, but there was no need to curtail
bank credit for business and agricultural
purposes. A member of the Federal Reserve
Board recommended establishing a special
preferential discount rate for paper drawn
to finance the marketing of agricultural
products and a preferential buying rate for
bankers’ acceptances drawn for the purpose
of seasonal crop movement. The intention
was to ease the impact of restraint on the
marketing of agricultural products. The
proposal, which was presented to the Open
Market Investment Committee, was op­
posed by the Reserve Bank Governors.
They opposed preferential rates as a matter
of principle and also on the basis that such
rates would not result in lower rates to
In the fall of 1928, Professor O. M. W.
Sprague proposed a penalty discount rate
for member banks making stock exchange
loans. For example, he stated:


To curb the demand of brokers for credit, it is
necessary to destroy the confident belief that
additional funds will always be forthcoming in
response to an advance in rates. This can be
readily accomplished by the addition of a simple
provision to the Federal Reserve act, authorizing,
or perhaps directing, the Reserve Banks to impose
a rate 1 per cent higher than the call renewal
rate upon rediscounts for member banks that are
lending on the Exchange at the time the accom­
modation is secured. If need be also a minimum
borrowing period of seven days might be estab­

Serious objections were raised to the
Sprague proposal. In addition to the usual
objections, it would be difficult to imple­
ment such discretionary power wisely. Bank
credit was needed to facilitate distribution
of new corporate securities, which in turn
were needed at times to encourage business
recovery. It would not be easy to determine
when securities loans were excessive. Pas­
sage of such legislation might also imply
that securities loans are objectionable per
Direct pressure. Ineffectiveness of eligibil­
ity requirements along with immobilization
of discount rate policy following World
War I because of Treasury financing re­
quirements resulted in a shift of emphasis
to “direct pressure” via the discount win­
dow. There was substantial support within
the System to use direct pressure both to
regulate the final use of bank credit and to
prevent excessive member bank borrowing
from the Reserve Banks.
In the spring of 1920 the Federal Re­
serve Board asked the Reserve Banks to
submit a written report of methods used to
keep informed on how member banks were
using Reserve Bank credit. Some members
of the Federal Reserve Board were ardent
advocates of using discount policy to bring

11 O. M. W. Sprague, “A New Device for Reserve
Bank Control of Brokers’ Loan Inflation,” p. 599.
10 Minutes of the Open Market Investment Com­
12 For example, see Harold L. Reed, Federal R e mittee, Aug. 13, 1928.
serve Policy 1921-1930, pp. 183 and 184.


pressure on member banks to curtail credit
for nonessential uses. According to this
view, Reserve Bank officials should keep in­
formed on member bank lending and in­
vesting policies and should deny access to
the discount window to those extending
credit for speculative and other nonessential
In general, Reserve Bank officials did try
to keep informed of their member banks’
loans and investments through regular re­
ports, bank examination reports, and inter­
views with officials of problem banks. Most
of the Reserve Banks, through circular let­
ters and other methods, urged member
banks not to make loans for speculative ac­
tivities, such as in securities or to enable
borrowers to hold commodities for higher
prices. The Governor of one of the Reserve
Banks stated that borrowing to buy auto­
mobiles was one of the most extravagant
things they had to cope with and that peo­
ple were buying cars who could not afford
them. One Reserve Bank refused to dis­
count paper arising from the sale of pleas­
ure automobiles, on the basis that the in­
dustry was overextended. The policy was
soon abandoned, however. Some Reserve
Banks, upon receiving a request for dis­
count accommodation from member banks
making speculative loans, followed the
policy of asking the banks to liquidate such
loans instead of borrowing from the Reserve
There was considerable sentiment that it
was impractical to try to distinguish be­
tween essential and nonessential uses of
bank credit in peacetime; however, discre­
tionary discount policy could have benefi­
cial results. Knowledge that Reserve Bank
officials were scrutinizing their loans and
lines of credit would cause member bank
officials to be more selective in extending
their credit. This attitude of member bank

officials would in turn cause borrowers to
be more careful in their applications for
credit. A potential borrower contemplating
purchasing some luxury that he would “be
better off without,” for example, would
likely decide not to buy if the appropriate­
ness of such borrowing were questioned.1
Strong support for direct pressure to in­
fluence allocation of member bank credit
emerged again in the latter part of the
1920’s. System officials became concerned
as early as the m id-1920’s about the flow of
credit into the stock market. The growing
volume of bank credit being absorbed for
speculation in securities confronted System
officials with a dilemma. The excessive flow
of bank credit into the stock market called
for a policy of restraint; a margin of unused
resources and declining prices called for a
policy of ease.
Actions to curtail the total quantity of
bank credit and to make it more expensive
in order to curb speculation would have
harmful effects on legitimate business. The
solution, according to some officials, was to
use discount policy to prevent member
banks from making speculative loans. The
Federal Reserve Board, convinced that an
increase in the discount rate would not be
effective in curbing speculation, sent a letter
to the Reserve Banks on February 2, 1929,
calling attention to the large volume of
speculative loans and to the fact that use of
Reserve Bank credit to support such loans
is contrary to the spirit of the Federal Re­
serve Act. For example, the letter stated:
The Federal reserve act does not, in the opinion
of the Federal Reserve Board, contemplate the
use of the resources of the Federal reserve banks
for the creation or extension of speculative credit.
A member bank is not within its reasonable
claims for rediscount facilities at its Federal re­
13 See Conference (2), Apr. 10, 1920, especially
pp. 515 and 516 et passim.


serve bank when it borrows either for the pur­
pose of making speculative loans or for the pur­
pose of maintaining speculative loans.14

The Board also stated that it had no inten­
tion of interfering with the loan practices of
member banks so long as those practices
did not involve the Federal Reserve Banks.
But the Board did have a responsibility
when member banks were maintaining spec­
ulative securities loans with the aid of Fed­
eral Reserve credit.
From the very beginning, there was
strong opposition to the policy of trying to
use administration of the discount window
as a tool of selective bank credit control.
For example, the Governors of the Reserve
Banks were unanimous that it was not
practical to try to distinguish between es­
sential and nonessential uses of credit in
peacetime.1 The principal objections to a
policy of direct pressure were as follows:
1. It is impossible to determine the spe­
cific use a member bank makes of the pro­
ceeds of a loan from a Reserve Bank. The
loan is to replenish reserves already im­
paired, usually by a large number of trans­
2. Even if Reserve Bank credit should
be denied to member banks making specu­
lative loans or for other purposes not con­
sidered desirable, reserves created by loans
to other member banks may be transferred
through ordinary commercial and financial
transactions to member banks making such
14 See “Review of the Month,” Federal Reserve


3. Direct pressure cannot be applied to
the large number of banks not borrowing
from a Reserve Bank.
4. Direct pressure, at best, is feasible
only for preventing excessive borrowing by
the individual bank; it is impossible for Re­
serve Bank officials, in passing on loan ap­
plications of member banks, to determine
what the total volume of reserves at the dis­
posal of the banking system should be.
5. The Federal Reserve Act does not
give either the Federal Reserve Board or a
Reserve Bank control over the loan policy
of a member bank. A Reserve Bank cannot
compel a member bank to make a loan that
it does not want to make nor restrain a
member bank from making a loan that it
wishes to make.16
Another aspect of the policy of direct
pressure was discussed in the early 1920’s.
There was considerable concern that some
member banks might be investing too heav­
ily in bonds and that some of the smaller
banks especially were being induced by
salesmen to buy bonds of poor quality. One
of the questions discussed by the Governors
was whether, when a member bank comes
in to borrow, Reserve Bank officials should
go over its statement and try to tell the
bank what its investment policy should be;
also whether the bank should be advised to
sell some of its bonds before the Reserve
Bank would lend to it. Although discussed
at some length, there was vigorous opposi­
tion to advising member banks on their in­
vestment policy because it would be undue
interference in member bank management.

Bulletin, Feb. 1929, vol. 15, p. 94. Another good

source of information on pros and cons of direct
pressure is U. S. Senate, Subcommittee of the Com­
mittee on Banking and Currency, Hearings S. 71,
“Operation of the National and Federal Reserve Bank­
ing Systems,” especially the statements of A. C. Miller
of the Federal Reserve Board and George L. Harrison,
Governor of the Federal Reserve Bank of New York.
15 See Conference (2), Apr. 8, 1920, pp. 287-90.

16 See Eighth A nnual R eport o f the Federal R e­
serve Board: Covering operations fo r the year
1921, pp. 95 and 96. A good statement of the objec­
tions to a discount policy of direct pressure is given
in Interpretations of Federal Reserve Policy in the
Speeches and Writings o f Benjam in Strong, pp.
126-33 and 190-93.


No action was taken toward trying to im­
plement such a policy.17
A leading academic economist stated
that the experiment of attempting to use
discount policy to regulate use of bank
credit was a failure. Attempts to curtail the
use of bank credit for speculation also af­
fected the use of such credit for business
and agricultural purposes. At best, it might
have held down total Reserve Bank credit
somewhat, with little effect on the alloca­
tion of member bank credit among particu­
lar uses. In his opinion, a real effort to carry
out the doctrine would have required: de­
nying Reserve Bank credit to member
banks making loans on the stock market;
extending liberal loan privileges at low
rates to member banks not making such
loans; and open market sales of securities
as necessary to mop up any excess reserves
created in the process.1
Amendments in the early 1930’s. Additional
authority for selective regulation just about
coincided with the termination of attempts
to use the discount window as a means of
influencing final use of bank credit. Legisla­
tion in the Great Depression, in addition to
giving the Federal Reserve Board authority
to fix margin requirements on loans for
purchasing or carrying securities registered
on a national exchange (excluding U.S.
Government securities), also conferred ad­
ditional powers to regulate member bank
loans for speculation in securities.1 Section
l l ( m ) of the Federal Reserve Act was
amended to provide that the Board on an

17 See Conference (3), Oct. 10 and 11, 1922, pp.
18 See Charles O. Hardy, Credit Policies o f the
Federal Reserve System , pp. 140-46.
19 For a complete statement of legislation in the
early 1930’s affecting the discount function, see How­
ard H. Hackley, “A History of the Lending Func­
tions of the Federal Reserve Banks,” chapters 8-11.

affirmative vote of six members could estab­
lish for each district the percentage of each
member bank’s capital and surplus that
could be represented by loans secured by
stock and bond collateral, the percentage to
be fixed “with a view of preventing the
undue use of bank loans for the speculative
carrying of securities.” Under an amend­
ment to Section 13, if any member bank,
while indebted to a Reserve Bank and de­
spite warning from a Reserve Bank or the
Board of Governors, increases its collateral
loans or loans to securities dealers for the
purpose of purchasing or carrying securities
(other than U.S. Government securities),
its note to the Reserve Bank shall be imme­
diately due and payable, and the member
bank will be ineligible to borrow for a pe­
riod to be determined by the Board of Gov­
The financial crisis accompanying the
Great Depression revealed a serious weak­
ness in trying to tie Reserve Bank credit too
closely to narrowly defined eligible com­
mercial paper. Eligibility requirements
handicapped the System in meeting member
bank needs in two ways. First, some banks
did not have enough eligible paper and
Government securities so that they could
borrow adequate amounts to meet reserve
drains, especially if subjected to heavy de­
posit withdrawals. Second, System open
market purchases of Government securities
to help check deflation resulted in a reduc­
tion in member bank indebtedness and the
supply of eligible paper available to be put
up as collateral for the issue of Federal Re­
serve notes. As a result, ability to issue
Federal Reserve notes was declining at the
same time public demand for currency was
soaring. Some of the Reserve Bank Gover­
nors became concerned over this situation
as early as 1930.
The Federal Reserve Act was amended



to remove these handicaps. The Reserve
Banks were given authority to lend against
any satisfactory asset under rules and regu­
lations prescribed by the Board of Gover­
nors but at a penalty rate V2 per cent above
the discount rate on eligible assets. The Re­
serve Banks were also given authority for
the first time to extend credit directly to in­
dividuals, partnerships, and corporations
(which included nonmember banks) for a
period not to exceed 90 days against U.S.
Government securities as collateral, under
rules and regulations prescribed by the
Board. U.S. Government securities were
also made eligible as collateral for the issue
of Federal Reserve notes.
Regulation A was revised effective in Oc­
tober 1937. The revision was concerned
primarily with bringing the regulation into
conformity with amendments to the Federal
Reserve Act; however, there was a state­
ment of General Principles in a preface to
the regulation. The General Principles may
be summarized as follows:
1. The guiding principle underlying dis­
count policy is advancement of the public
interest; hence, the effect that the granting
or withholding of credit by a Reserve Bank
may have on a member bank, on its deposi­
tors, and on the community is of primary
2. Reserve Banks are expected to con­
sider not only the quality of paper offered
for discount but also whether it is in the
public interest to put additional funds at
the disposal of member banks.
3. Reserve Banks, in accordance with
the provisions of the Banking Act of 1933,
are to keep informed on the loans and in­
vestments of member banks and on whether
funds are being used for speculative pur­
poses, fixed investment, and so forth.
4. In determining its discount policy, a
Reserve Bank is to take into consideration

the general business situation as well as the
general conduct and management of the
applying bank.20
Allocation among banks

Another objective in implementing the dis­
count function, especially in the early
1920’s, was an appropriate allocation of
Reserve Bank credit among member banks.
Section 4 of the Federal Reserve Act di­
rected that the affairs of each Reserve Bank
shall be administered “fairly and impar­
tially” as among member banks and that
each member bank should be extended such
discounts and advances “as may be safely
and reasonably made with due regard for
the claims and demands of other member
Little use was made of the discount win­
dow prior to World War I because most
banks had ample reserves, and many banks
still preferred to borrow from their corre­
spondents as formerly. During the war,
Federal Reserve policy was directed toward
facilitating war financing, and member
bank borrowing on Government securities
rose sharply. Discounts and advances to
member banks continued to soar during the
postwar boom and then plummeted in the
depression. One of the problems confront­
ing System officials after the depression was
a substantial number of habitual borrowers.
A study revealed that in mid-1925 nearly
900 member banks had been borrowing
steadily for over a year. More than 250 na­
tional banks had failed since 1920, and
more than four-fifths of these banks were
habitual borrowers from the Federal Re­
serve prior to failure. A large number of
the habitual borrowers still confronted

20 See “Regulation on Discounts by Federal Re­
serve Banks,” Federal Reserve Bulletin, Oct. 1937,
p. 977.


problems that had their origin in the war
and early postwar periods.2
Banking policy, in contrast to credit pol­
icy, was directed toward maintaining the
sound financial condition of individual
member banks. This policy was considered
to be the joint responsibility of the discount
function and supervisory authorities. Here
we are concerned only with the discount
One of the problems confronting the Sys­
tem’s discount officials was preventing indi­
vidual member banks from making exces­
sive use of Reserve Bank credit both with
respect to what is sound banking policy and
the member bank’s fair share relative to the
needs and demands of other member banks.
The discount rate could not be relied on to
prevent excessive borrowing, as already
mentioned, because a penalty rate was con­
sidered impracticable in our type of bank­
ing system.
Additional collateral. One device used by
several Reserve Banks to prevent excessive
borrowing was to require additional
collateral.2 With use of the discount rate
immobilized until early 1920 because of
Treasury financing requirements, System of­
ficials were pressed to seek other methods
of trying to deal with excessive borrowing.
Some of the Reserve Banks required a mar­
gin of collateral, in addition to the usual
amount, for member banks borrowing more
than they considered appropriate.23
Additional collateral was usually re­
quired when a member bank borrowed in

21 See the report on member bank borrowing by
Professor O. M. W. Sprague in Conference (1),
Nov. 4 and 5, 1925, pp. 72-86.
22 In the early post-World-War-I period, additional
collateral was frequently required also for purposes
of safety.
23 See the following: Conference (3); Conference
(2), July 1 and 2, 1918, Mar. 20-22, 1919, and Apr.
7-10, 1920; U.S. Congress, Joint Commission of Ag­
ricultural Inquiry, Hearings, “Agricultural Inquiry,”
vol. 2, p. 157.

excess of a certain amount, such as its capi­
tal and surplus, or a basic line computed
for each member bank by the Reserve
Bank. In extreme cases, one Reserve Bank
compelled such member banks to put up
extra collateral in order to reduce their
holdings of eligible paper and hence their
capacity to discount or borrow from the
Reserve Bank.
Even though the device apparently was
not widely used, it aroused criticism. John
Skelton Williams, formerly Comptroller of
the Currency and ex officio member of the
Federal Reserve Board, stated that some­
times the large additional margin— as much
as 50 or even 100 per cent— made it im­
practical for country banks to get credit.2
Additional margins of collateral of this
magnitude, however, were apparently infre­
Progressive discount rates. In 1918 the
Federal Reserve Board proposed for discus­
sion the establishment of progressive dis­
count rates on brackets of borrowing above
a member bank’s normal or basic line. The
purpose was to prevent some banks from
borrowing more than their proportionate
share of Reserve Bank credit.
Several objections were raised against the
proposal, especially by the Governors of the
Reserve Banks, and it was decided that ag­
gressive borrowers could probably be better
dealt with by moral suasion. The proposal
was made again in 1919. The Federal Re­
serve Act was amended in April 1920, on
the recommendation of the Federal Reserve
Board, providing authority for the estab­
lishment of progressive discount rates.
There were two principal reasons for the
request for authority to establish progres­
sive rates. One purpose was to prevent ex­
cessive borrowing by relatively few member
banks without penalizing those that bor24 See U.S. Congress, op. cit., p. 157.


rowed infrequently and only moderate
amounts. A second purpose was to achieve
a better allocation of Reserve Bank credit
among member banks in accordance with
the provisions of the Federal Reserve Act
that credit should be extended “with due
regard for the claims and demands of other
member banks.” In some districts borrow­
ing was concentrated in a small number
of large banks, which in turn extended
credit to their smaller correspondents. Most
large banks wanted to continue to serve
their correspondents instead of having them
borrow directly from the Reserve Bank.
Four Reserve Banks (Kansas City, Dal­
las, St. Louis, and Atlanta) established pro­
gressive discount rates in April and May
1920. The schedule for the four Banks pro­
vided that for each 25 per cent by which a
member bank’s borrowing from the Reserve
Bank exceeded its basic line, a “super rate”
of Vi percentage point was added to the
regular discount rate.
The key part of the plan was establish­
ment of a basic line for each member bank.
The consensus of the Governors of the Re­
serve Banks was that the basic line should
represent the member bank’s contribution
to the lending resources of the Reserve
Bank. The latter, it was agreed, consisted
of a member bank’s reserve deposit and its
paid-in capital to the Reserve Bank. The
Kansas City, St. Louis, and Atlanta Re­
serve Banks adopted as a basic line a figure
2V2 times a sum equal to 65 per cent of the
reserve balance maintained or required to
be maintained by the member bank plus its
paid-in subscription to the capital stock of
the Reserve Bank. The Dallas Bank estab­
lished as the basic line an amount equal to
the combined capital and surplus of each
member bank. Advances to member banks
“collateralled” by U.S. Government securi­
ties were excluded from progressive rates in
order not to affect adversely the market


prices of such securities or to work a hard­
ship on those still carrying a large part of
the Liberty Bonds acquired on original
The experiment with progressive discount
rates lasted only a short time. One Reserve
Bank terminated progressive rates in the
latter part of 1920, and the other three in
1921. Only a small percentage of the mem­
ber banks paid a rate of 10 per cent or
more— 44 in the Atlanta District, 49 in St.
Louis, 114 in Kansas City, and 20 in
Dallas.26 Great publicity was given to the
fact that a member bank in the South paid
a discount rate of 87.5 per cent. The bank
had experienced a large outflow of deposits
and its reserve balance dropped to $86,
drastically reducing its basic line. The 87.5
per cent, of course, applied only to the
upper bracket of its total borrowing.
Progressive discount rates resulted in
widespread criticism, especially in political
circles. It was alleged that progressive rates
resulted in member banks charging their
customers exorbitant rates; also that pro­
gressive rates put great pressure on member
banks to reduce their borrowings, which in
turn caused the banks to put pressure on
their customers to repay their loans. Avail­
able evidence, however, did not support the
charge that progressive rates resulted in
member banks charging excessive rates to
their customers. Instead, data revealed that
there was no difference in the rates charged
by member banks borrowing from the Re­
serve Banks and those not borrowing. In
view of the criticism about exorbitant rates,
the Atlanta and Kansas City Reserve Banks
25 For example, see the Seventh A nnual R ep o rt of
the F ederal R eserve Board: C overin g operations for
the year 1920, pp. 58 and 59.
26 See Robert F. Wallace, “The Use of the Pro­
gressive Discount Rate by the Federal Reserve Sys­
tem,” p. 61. Good outside sources on progressive dis­
count rates are Wallace, op. cit., pp. 59-68, and
Benjamin Haggott Beckhart, The D iscoun t P olicy of
the Federal R eserve System , pp. 367-77, 405-10.


rebated all interest paid by member banks
in excess of a 12 per cent rate.
One of the principal beneficial results
claimed for progressive discount rates was a
better distribution of Reserve Bank credit
among member banks. Progressive rates
discouraged large borrowings by city banks
in order to re-lend to smaller correspond­
ents and resulted in more of these smaller
banks borrowing directly from the Reserve
There was strong opposition to progres­
sive discount rates both within and outside
the System. First, member banks experienc­
ing strong seasonal pressures and aggressive
banks extending credit to meet the needs of
their communities were likely to be penal­
ized. Second, as applied by the four Re­
serve Banks, a hardship was imposed on
banks in rural areas that were experiencing
an outflow of funds as a result of the de­
pression. Reserve drains reduced the basic
line and resulted in higher super rates.
Third, politicians and demagogues seized
upon the relatively few instances of member
banks paying unusually high discount rates
to criticize and ridicule the System. Fourth,
a rigid, automatic rule was substituted for
discretion in administration of the discount
window. Finally, with only four Reserve
Banks using progressive rates, banks could
evade the penalty by borrowing from a cor­
respondent in a Federal Reserve district
that did not have progressive rates.
Some of the weaknesses of the progres­
sive rate experiment in 1920 resulted from
the type of plan adopted. The basic line,
above which penalty rates were applied, re­
flected an attempt to relate a member
bank’s fair share of borrowing to its contri­
bution to the lending resources of the Re­
serve Bank. This was an erroneous idea,
and there was no logical reason why a bank
borrowing in excess of such a basic line
should be required to pay a higher discount

rate. Moreover, adoption of progressive
rates by all Reserve Banks would eliminate
the problem of avoidance by borrowing
from correspondents in districts without
such rates.
But there are serious weaknesses inherent
in progressive rates, regardless of how the
basic line is computed. Borrowing beyond a
certain amount is assumed to be unwar­
ranted and hence should be discouraged by
a penalty rate. Progressive rates are applied
on the basis of amount without regard to
reasons for borrowing. The effect is to dis­
criminate against member banks subject to
large reserve drains, regardless of circum­
stances or how well the banks are managed.
A member of the Federal Reserve Board,
discussing progressive rates, stated that he
hoped few Reserve Banks would resort to
“the mechanical and bureaucratic device of
that kind in order to control a situation that
ought to be controlled through firm, dis­
criminating governing.” 2
Progressive rates apparently were not
effective in restricting member bank bor­
rowing. One Reserve Bank official stated
that member banks were not discouraged so
much by progressive rates as by the fear
that they might not be able to borrow from
a Reserve Bank. The Federal Reserve
Board conceded that progressive rates ap­
parently were not so effective as the flat 7
per cent rate adopted by some other R e­
serve Banks.
Preferential rate. One of the staff papers

in the discount study of 1953-54 dealt with
a preferential discount rate on noncontinuous borrowing.28 One suggestion was to
charge a preferential rate on member bank
borrowing against Government securities
for 15 days or less provided the bank had
27 See Conference (2), Apr. 10, 1920, p. 523.
28 William J. Abbott, Jr., “A Preferential Rate on
Noncontinuous Member Bank Borrowing,” in “The
Discount and Discount Rate Mechanism,” May 1953.



not borrowed for at least a 15-day period.
But other bases for applying a preferential
rate to encourage noncontinuous borrowing
could be used.
Some of the alleged advantages that
might result from such a preferential rate
were as follows:
1. It would penalize the continuous use
of Reserve Bank credit and strengthen the
sagging tradition against borrowing.
2. The device would have considerable
flexibility as the spread between the prefer­
ential and the regular discount rate could
be varied over time and among Reserve dis­
3. The preferential rate could be
changed without the psychological impact
of a change in the regular discount rate.
4. An increase in borrowing at the regu­
lar discount rate would be an indication of
growing tightness.
5. It would assist in policing the dis­
count window and encourage member
banks to maintain greater liquidity.
But the proposal had serious disadvan­
tages. It would discriminate against member
banks that had heavy seasonal demands for
loans and that might have to borrow in sev­
eral reserve periods, even after liquidating
securities and aaking other asset adjust­
ments. In trying to solve one problem it
would create another—that of preventing
one member bank from borrowing at the
preferential rate in order to re-lend to an­
other that could borrow only at the regular
discount rate. Finally, the public relations
impact of a preferential rate might be
harmful. The conclusion was that continu­
ous borrowing could probably be prevented
more effectively through discretionary ad­
ministration of the discount window than
by some mechanical device such as a pref­
erential rate.
A similar proposal was made by a mem­

ber of the Board of Governors in 1957. He
suggested, however, a penalty discount rate
for continuous borrowers; for example,
banks borrowing for the third or possibly
the fifth successive reserve period.2
Appropriate and inappropriate use

Even though two major considerations in
discount administration in the 1920’s were
influencing the final use of bank credit and
a fair allocation of Reserve Bank credit
among member banks, appropriate uses in
the modern sense of the term were also dis­
One of the problems was the attitude of
member banks toward borrowing from the
new central bank. In general, member
banks thought of borrowing from a Reserve
Bank in the same way as borrowing from a
correspondent. The widespread misunder­
standing of the discount function among
member banks focused attention on educat­
ing them as to the proper uses of the dis­
count window.
The procedure followed by most Reserve
Banks in administering the discount win­
dow varied somewhat according to the
borrowing record and condition of the
member bank. Well-managed banks that
borrowed only infrequently were given only
a routine investigation—determining eligi­
bility of the paper offered for discount or as
collateral, and analysis of readily available
data on the bank’s condition. Continuous
and frequent borrowers, banks borrowing
unduly large amounts, and banks with un­
sound policies or in poor condition were
given much more careful scrutiny. Problem
borrowers were typically subjected to much
more careful analysis, covering such points
as the character of the bank’s loans and its
lending policies; behavior of its deposits; its
29 See Minutes of Federal Open Market Committee,
May 7, 1957.


borrowing record from the Reserve Bank;
examination reports on its condition; and
perhaps discussion with bank examination
officials as to the quality of the bank’s man­
agement. Such internal analysis and investi­
gation were often supplemented by inter­
views with the borrowing bank’s officers or
Provisions of the Federal Reserve Act
were often referred to for guidance as to
appropriate uses of the discount window. In
general, member banks should use the dis­
count window for only short terms to meet
seasonal, emergency, and other temporary
credit needs. With respect to member banks
in poor condition, a Reserve Bank should
take a reasonable risk to prevent a member
bank from failing, but it should not make
advances on worthless paper or paper that
would result in loss.
More attention was devoted apparently
to inappropriate uses of the discount win­
dow. First, Reserve Bank credit should not
be used for either speculative purposes or
investments. The Annual Report of the
Federal Reserve Board for 1923 stated:
T is not a system of credit for either investment
or speculative purposes. . . . The exclusion of
the use of Federal reserve credit for speculative
and investment purposes and its limitation to
agricultural, industrial, or commercial purposes
thus clearly indicates the nature of the tests
which are appropriate as guides in the extension
of Federal Reserve credit.3

Second, member banks should not bor­
row to take advantage of a differential be­
tween the discount rate and the bank’s own
30 Minutes of meetings of practically all of the
policy-making groups in the 1920’s contained some
discussion of discount policy and administration of
the discount window. For example, see the follow­
ing: Conference (1), Nov. 12-16, 1923, especially pp.
102-36, and Nov. 4 and 5, 1925; Conference (4),
Nov. 4-10, 1926, pp. 503-25; and Conference (3)>
Mar. 22-24, 1926, pp. 43-59, and Nov. 8-10, 1926,
pp. 28-53.
31 Annual R eport, F ederal R eserve Board, 1923,

p. 33.

lending rates. The Annual Report of the
Federal Reserve Board for 1928 stated: “It
is a generally recognized principle that re­
serve bank credit should not be used for
profit, . . 3
Third, continuous borrowing from a Re­
serve Bank was inappropriate for several
reasons. It was inconsistent with the spirit
of the Federal Reserve Act in two respects:
Borrowing should be only for short term,
and according to the principles in Section
4 the discount window should be admin­
istered impartially and with due regard to
the claims and demands of other member
banks. Continuous borrowing was also un­
sound banking policy. The Annual Report
of the Federal Reserve Board for 1926
stated that continuous borrowing “would
not be in accordance with the spirit of the
Federal reserve act and would not be fair
to the other member banks which may be
active competitors of the borrowing bank.
It may also impair the ability of the bor­
rowing bank in case of insolvency to meet
its obligations to depositors.” 3 Discussion
at policy meetings identified three types of
continuous borrowers: banks in an overex­
tended position; those using Federal Re­
serve credit as a means of enlarging their
own operations; and banks borrowing to
profit from a differential between the dis­
count rate and their own lending rates.
Other instances of inappropriate dis­
counting or advances to member banks
were cited in System discussions. For exam­
ple, a Reserve Bank should not discount or
make advances to member banks when the
effect is to perpetuate unsound policies and
poor management. Illustrations of the latter
were when 60 per cent of a member bank’s
32F ifteenth A nnual R eport of the Federal R eserve
Board: C overin g operations fo r the year 1928 , p. 8.
33 Thirteenth A nnual R eport of the Federal R e ­
serve Board: C overin g operations fo r the year 1926,

p. 4.



2. To assist member banks in providing
short-term and, to a limited extent, seasonal
credit to facilitate production and the
movement of goods through the productive
process from raw material to the ultimate
consumer. According to the foreword to
Regulation A, Federal Reserve credit may
be extended to cover “seasonal require­
ments for credit beyond those which can
reasonably be met by use of the bank’s own
Permitting member banks to use the dis­
count window to meet all of their seasonal
Disuse and revival
reserve needs was considered undesirable
From the Great Depression until the Treas­ because such a policy would probably re­
sult in the creation of excess reserves for
ury-Federal Reserve accord in March
1951, the discount function fell largely into
the banking system as a whole and interfere
disuse, and problems other than discount
with appropriate monetary policy. More­
policy were of concern to System officials.
over, such a policy would not contribute to
Discount rate policy also received relatively
sound banking practice. Member banks
little consideration.
should manage their assets so as to be in a
Restoration of a flexible monetary policy
position to meet normal or expected sea­
and revival of the discount function focused sonal fluctuations.3
attention once again on the role of discount
3. Borrowing for longer periods is ap­
policy. A System Committee was established
propriate, according to the foreword to the
in 1953 to make a study of the discount
regulation, “when necessary in order to as­
mechanism and its role in the new environ­ sist member banks in meeting unusual situ­
ment. Several staff studies were made, and
ations, such as may result from national, re­
the committee submitted its report in
gional, or local difficulties or from excep­
March 1954. Regulation A was revised in
tional circumstances involving only par­
ticular member banks.” In other words,
The revision of Regulation A largely re­ borrowing for longer periods may be appro­
affirmed the guiding principles for discount
priate to enable member banks to meet sit­
policy that had been developed earlier. Ap­ uations arising out of adverse economic
propriate uses of the discount window,
conditions, money panics, or other eco­
stated in the form of general principles in nomic crises that threaten maintenance of
the foreword of the revised regulation, were
sound banking and credit policies or the
analyzed in more detail in the staff papers
public interest.
and committee report.
Inappropriate uses of the discount win­
Appropriate uses of the discount window dow included:
may be summarized as follows:
To help finance speculative activities
To assist member banks in making whether in securities, real estate, or com­
very short-term reserve adjustments re­
34 See System Committee on the Discount and Dis­
quired by a temporary loss of deposits or
count Rate Mechanism, “Report on the Discount
impairment of liquidity.
Mechanism,” Appendix D.

assets consisted of loans to officers and
directors, or when an increase in borrowing
from the Reserve Bank was accompanied
by a persistent decline in the bank’s depos­
its. In such cases, a Reserve Bank should
make advances only when it appears the
member bank can be salvaged, and only
after a plan is agreed on for eliminating the
unsound policies and practices; otherwise,
extension of Federal Reserve credit enables
some depositors to be paid at the expense
of other depositors.


modities or to enable a member bank to in­
crease its investments (except to assist in
the secondary distribution of U.S. Govern­
ment and other securities).
2. Borrowing to take advantage of a rate
differential or for tax avoidance.
3. Borrowing for a purpose that is in­
consistent with the objectives of sound
credit policy or the public interest.
4. Continuous borrowing—in effect us­
ing Reserve Bank credit to supplement a
bank’s own resources.
The committee report offered several
objections to continuous borrowing. First,
such borrowing would convert the discount
window from a source of temporary and
emergency assistance to one of semiperma­
nent investment for a relatively small num­
ber of member banks. Second, a small
number of banks would probably get an
undue proportion of the reserves that
should be made available through the dis­
count window consistent with an appropri­
ate monetary policy. Third, large and con­
tinuous indebtedness would contribute to
an unsound banking practice, create sub­
stantial claims prior to that of depositors,
and could threaten the stability of the
banking system. And fourth, a policy of
permitting continuous borrowing might re­
sult in the injection of more reserves than
would be desirable for monetary policy.3
Perhaps it should be pointed out that in
the staff studies, the committee report, and
the revision of Regulation A no sentiment
was expressed for using discount policy to
influence the final use of bank credit, ex­
cept that borrowing to support speculative
activities and investments was considered
Elimination of eligibility requirements

The System Committee on Eligible Paper,
in its report of May 1962, recommended
35 Ibid.

that present eligibility requirements be re­
pealed and that the Reserve Banks be au­
thorized to make advances to member
banks on their own notes secured to the sat­
isfaction of the Reserve Banks, subject to
rules and regulations prescribed by the
Board of Governors. The recommendation
was approved by System officials, and the
Chairman of the Board of Governors in a
letter to the Chairmen of the Senate and
House Banking and Currency Committees
of August 21, 1963, recommended legisla­
tion to achieve these results. A draft of a
proposed bill accompanied the letter.
There were several reasons for the rec­
ommendation to eliminate present eligibility
requirements and broaden access to the dis­
count window. First, drastic changes in the
economy since 1914 have resulted in
marked changes in commercial bank assets.
A marked trend toward loans of longer ma­
turity and an increase in investments in the
past three decades have resulted in a sub­
stantial decline in the proportion of bank
assets eligible for discounting. In the post­
war period there has also been a downward
trend in bank holdings of U.S. Government
securities. In view of the basic changes that
have occurred, elimination of eligibility re­
quirements is desirable in order that the
Reserve Banks, “will always be in a posi­
tion to perform promptly and efficiently one
of their principal responsibilities—the ex­
tension of appropriate credit assistance to
member banks to enable the latter to meet
the legitimate credit needs of the
economy.” 3
A second important reason for the rec­
ommendation is that the narrowly defined
eligibility requirements serve no useful pur­
pose. Initially, it was expected that the re­
quirements would result in Reserve Bank
36 Letter from Chairman William McC. Martin,
Jr., to the Chairmen of the Senate and House Bank­
ing and Currency Committees, Aug. 21, 1963.


credit, including Federal Reserve notes, au­
tomatically responding to changing needs of
business. Experience soon proved these ex­
pectations unjustified. Departures from the
principle that Reserve Bank credit should
be extended only on the basis of short-term,
self-liquidating commercial paper began in
1916 when the Reserve Banks were author­
ized to make advances up to 15 days on
U.S. Government securities. As already
pointed out, even more significant depar­
tures were made in the early 1930’s.
Inasmuch as present eligibility require­
ments serve no useful purpose, and at some
future time might seriously handicap the
Reserve Banks in meeting legitimate mem­
ber bank reserve needs, the emphasis
should be on “the soundness of the paper
offered as security for advances and the ap­
propriateness of the purposes for which
member banks borrow.” 3
Discount rate policy

A thorough analysis and review of the evo­
lution of academic and System thinking
about the discount rate as an integral part
of monetary policy is outside the scope of
this study. The focus of the study is di­
rected primarily to the role of the discount
rate as a part of the discount mechanism,
particularly the aspects of significance for
current appraisal of the discount function
as a whole. Thus there is no attempt to give
a complete chronological evolution of the
discount rate’s role in monetary policy. Ac­
cordingly, this section deals with the
broader course of thinking on the function
of the discount rate, with guides for deter­
mining changes in the discount rate, and
with the effects of changes in the discount
rate. The bulk of the material covered deals
with the period prior to the Great Depres­

37 Ibid.


Role of the discount rate. The role of the
discount rate depends largely on the reli­
ance that monetary authorities put on dis­
count policy and other instruments, such as
open market operations and changes in re­
serve requirements. A widespread belief
that frequent borrowing is a sign of weak­
ness and unsound banking policy, a consen­
sus that a penalty discount rate relative to
customer loan rates is impractical, a belief
that the Reserve Banks should be lenders of
last resort, and reliance on open market op­
erations as the principal tool of monetary
policy have all tended to relegate the dis­
count rate to a minor role.
There was little in the way of a theory or
philosophy of discount rate policy prior to
the 1920’s. System officials had had no ex­
perience in central banking, and initially
there was a wide range of views on the
principles that should be followed in estab­
lishing discount rates—some being relevant
for a central bank while others reflected
thinking more appropriate for a commercial
bank. There were two main views: one that
the discount rate should be above bank
lending rates in order to discourage dis­
counting for a profit, and the other that the
discount rate should be low enough to en­
courage use of the resources of the new Re­
serve Banks.
Conditions prior to World War I were
not favorable to the development of a dis­
count rate philosophy. Lower reserve re­
quirements provided in the Federal Reserve
Act and an inflow of gold supplied banks
with ample reserves, so there was little need
to borrow or discount at the Reserve
Banks. During the war and the postwar pe­
riod prior to 1920, discount rate policy was
directed toward assisting the Treasury in
financing the war and the large volume of
expenditures that continued into the post­
war period.
The marked change in economic envi­
ronment from the prewar period and the


postwar boom and depression emphasized
the need for serious study and consideration
of the objectives and instruments of Federal
Reserve policy. In the first part of the
1920’s annual meetings attended by mem­
bers of the Federal Reserve Board, and the
Governors and Chairmen of the Federal
Reserve Banks were devoted entirely to
Federal Reserve policy. The consensus was
that policy should be directed primarily to­
ward maintaining sound credit conditions
and business stability.
There was a sharp difference of opinion
within the System on the discount function,
as already mentioned. Some favored direct
pressure to regulate the use of credit; others
thought more reliance should be placed on
the discount rate. The latter thought the
discount rate had several advantages over
direct pressure as a means of credit control:
it was impersonal, and it applied to all bor­
rowers alike; it was suitable for regulating
the total volume of bank credit, whereas di­
rect pressure was effective only in regulat­
ing borrowing of individual banks; and rate
changes did affect willingness of individual
banks to borrow. It was not necessary for
the discount rate to be above bank lending
rates to have some restraining influence.3
A modern, forward-looking type of phi­
losophy regarding discount rate policy
began to emerge in the early 1920’s. Dis­
count rate policy should be directed toward
mitigating the upward and downward
swings of the business cycle. In order to
achieve this objective the discount rate
should lead market rates on the upswing to
prevent or at least mitigate inflation; it
should lead market rates on the downswing
38 Some of the better sources of information on
the discount rate in the 1920’s are: Conference (1),
Oct. 25-28, 1921, Oct. 10-13, 1922, and Nov. 12-16,
1923; Conference (4) Oct. 25-28, 1921; Conference
(3), Nov. 2-5, 1925; and “The Discount and Dis­
count Rate Mechanism,” statements (June 21, 1954).

to prevent liquidation from becoming a
strait jacket of deflation. Most System of­
ficials believed there was little danger that
a low discount rate in depression would
stimulate borrowing for inappropriate pur­
poses, as some feared. Business firms do not
borrow merely because credit is cheap.
This type of discount rate policy was
considered consistent with the provision in
the Federal Reserve Act that the rate
should be established with a view to accom­
modating commerce and business. The dis­
count rate should be low in depression pe­
. . you do not accommodate com­
merce and business by high rates when four
million men are out of employment and
business is sick for lack of markets and
markets are lacking because the world is
more or less in commercial chaos.” 3 A re­
duction in rates when business is in a slump
can have a considerable effect in accelerat­
ing business revival; an increase when busi­
ness is booming can do much to restrain,
if not prevent, inflation. In implementing
this type of discount rate policy, however,
“(t)imeliness of action is of the essence of
successful Federal reserve action.” 4
The role of the discount rate was influ­
enced significantly by two developments
that emerged in the 1920’s. First, open
market operations began to be used in the
early 1920’s as an instrument of monetary
policy. This diminished reliance on the dis­
count rate and raised the problem of coor­
dinating the two instruments. Second, there
was growing support for using Federal
Reserve tools to regulate the total quantity
of bank credit instead of its quality or use.
The shifting emphasis toward regulating
quantity instead of quality of bank credit
was accompanied by greater reliance on the
discount rate and less on discount policy.
30 See Conference (1), Oct. 25-28, 1921, p. 160.
* ° I b id ., p. 156.


Discount rate policy was of relatively lit­
tle significance during the long period from
the mid-1930’s until the accord of March
1951, for reasons already given. Studies of
the discount mechanism in 1953 and the
System Committee’s report in 1954 dealt
mainly with discount policy. Consideration
of the discount rate was largely in terms of
coordination with open market operations.
Discussion of discount rate policy, espe­
cially in the 1920’s, dealt largely with
guides and effects of rate changes and coor­
dination of the discount rate with open
market operations.
Guides to discount rate action. Prior to the
1920’s the reserve ratio was frequently
mentioned as a guide for determining
changes in the discount rate, but proceed­
ings of policy discussions indicate that it
was rarely, if ever, a major reason for a
rate change. A much more important con­
sideration was the relation of the discount
rate to market rates—usually the market
rate on prime commercial paper prior to
the Great Depression and the market rate
on 3-month Treasury bills since World War
II. As already mentioned, the penalty rate
was generally accepted in principle but was
considered impractical in terms of bank
lending rates.
There was a consensus that the discount
rate should lead market rates up in a period
of expansion; a discount rate below market
rates would likely encourage speculative ac­
tivity and borrowing to invest at a profit.
Keeping the discount rate generally above
market rates in a period of expansion
would discourage development of a specu­
lative boom and misuse of the discount
There was a difference of opinion as to
the proper relationship in a downswing.
One school of thought was that the dis­
count rate should lead market rates down
in a period of declining business activity.


Encouraging a decline in interest rates
would relieve some of the pressure for liq­
uidation and help to stimulate a revival in
business activity. There would be no dan­
ger, according to this view, of stimulating
speculation and other improper uses of
credit. Another school of thought, however,
was that on the downswing the discount
rate should follow market rates down. The
discount rate should not be lowered until
an accumulation of funds had brought a de­
cline in market rates. Leading market rates
down involved the danger of encouraging
speculative borrowing, and the lower rate
would not stimulate borrowing for produc­
tive purposes.
The objective of trying to maintain eco­
nomic stability and a growing belief that
this required regulation of the total quantity
of bank credit shifted attention from main­
taining a certain relationship to market
rates to a much broader range of informa­
tion. The Federal Reserve Board in its An­
nual Report for 1923 stated: “Broadly
stated, an effective Federal reserve discount
rate will be one that gives effective support
to a Federal reserve bank’s credit and dis­
count policy. The objective in Federal re­
serve discount policy is the constant exer­
cise of a steadying influence on credit
conditions.” In deciding whether to change
the discount rate, officials should look to
the total flow of credit and general business
and financial conditions. In 1931, a System
official stated, “(I)f central banking au­
thorities see and have reason to believe in
view of the statistics available to them that
the total volume of credit of the country is
expanding at a rate and volume faster than
any normal growth of business could jus­
tify, it is incumbent upon the central bank­
ing authorities to put pressure or restraint
on that growth by an increase in the redis­
count rate.” 41
41 U.S. Senate,

o p . c it.,

pp. 67-68.


Discretion based on a large amount of
business and financial information instead
of a few guides was needed for sound deci­
sions in making discount rate changes. This
view was well stated in the Board’s Annual
Report for 1923:
No statistical mechanism alone, however carefully
contrived, can furnish an adequate guide to credit
administration. Credit is an intensely human
institution and as such reflects the moods and
impulses of the community— its hopes, its fears,
its expectations. The business and credit situation
at any particular time is weighted and charged
with these invisible factors. They are elusive and
can not be fitted into any mechanical formula,
but the fact that they are refractory to methods
of the statistical laboratory makes them neither
nonexistent nor nonimportant. They are factors
which must always patiently and skillfully be
evaluated as best they may and dealt with in
any banking administration that is animated by
a desire to secure to the community the results
of an efficient credit system. In its ultimate anal­
ysis credit administration is not a matter of
mechanical rules, but is and must be a matter of
judgment— of judgment concerning each specific
credit situation at the particular moment of time
when it has arisen or is developing.42

The view that policy actions should be
based on informed judgment instead of
rules or a few statistical guides still prevails.
Effect of rate changes. The effect of dis­
count rate changes was also the subject of
considerable study in the early 1920’s.
Many System officials thought the discount
rate had little influence on the volume of
member bank borrowing. The principal rea­
son was that it was impractical to keep the
discount rate above bank lending rates,
with the result that banks could usually em­
ploy profitably funds borrowed from a Re­
serve Bank.
Some officials disagreed. They thought
the cost effect of rate changes influenced
willingness to obtain additional reserves by
borrowing even though the discount rate
might be below bank lending rates.

A nnual R e p o rt, F ederal R eserve B oard, 1923, p.

There were two linkages whereby a
change in the discount rate might influence
the volume of bank credit. First, an in­
crease in the discount rate made borrowed
reserves more expensive and caused mem­
ber banks to scrutinize their loan policies
more carefully. Second, the discount rate
served as a signal to the public of Federal
Reserve policy intentions. An increase in
the rate was interpreted as an indication
that credit was likely to be less readily
available as well as more expensive. As a
result, business enterprises were less willing
to enter into future commitments in antici­
pation of higher prices or for other reasons.
Attempts were made to determine
whether changes in the discount rate af­
fected the rates that banks charged their
own customers. Surveys and discussions
with bankers indicated there was little effect
on the lending rates of smaller banks; how­
ever, there was some effect on rates charged
by the larger banks in financial centers.
Large borrowers with alternative credit
sources would often use a reduction in the
discount rate as a bargaining point for
lower rates. The discount rate also had
some effect on loan rates tied more closely
to market rates, such as brokers’ loans and
bankers’ acceptances.
Academic economists apparently had
more confidence in the effectiveness of the
discount rate than most System officials.
Leading economists thought that low dis­
count rates were largely responsible for
credit expansion and rising prices after
World War I and that increases in the dis­
count rate in 1920 had been a major factor
in checking the expansion. They, too,
thought that increases in the discount rate
caused banks to be more careful about
loans and induced some of them to raise
their own lending rates. An increase was
also interpreted by the public as a signal of
more expensive and tighter credit. Some


economists disagreed, pointing out that in­
terest cost is only a small part of total
Coordination with open market operations.

Open market operations were discovered as
a valuable tool of Federal Reserve policy in
the early 1920’s. It was soon recognized
that when properly coordinated the two in­
struments used in combination were more
effective than either used singly. For re­
straint, open market operations could be
used to force member banks to the discount
window, thus making an increase in the dis­
count rate more effective. And a policy of
ease would be more effective if a reduction
in the discount rate were combined with
open market purchases to supply reserves
and reduce member bank indebtedness to
the Reserve Banks.
Turner, as a result of his studies in the
mid-1930’s, concluded that Federal Reserve
policy would be more effective if more em­
phasis were placed on the discount rate and
less on open market operations. Open mar­
ket operations could be used to offset the
reserve effect of market factors and to
maintain a more stable and continuous vol­
ume of borrowing from the Reserve Bank.
The latter would provide the basis for more
effective use of the discount rate. Adjusting
the discount rate relative to market rates on
alternative reserve adjustment media would

43 See Beckhart, o p . c it., pp. 467-71; and Caroline
Whitney, E x p e r im e n ts in C r e d it C o n t r o l: T h e F e d e r a l R e s e r v e S y s te m , pp. 211-17.


enable the System effectively to encourage
or discourage expansion.4
Coordination of the discount rate with
open market operations was discussed occa­
sionally in the 1950’s. There was some dif­
ference of opinion as to whether a policy
shift should be initiated by open market op­
erations or by a change in the discount rate.
Some favored probing with open market
operations, pending clearer evidence as to
whether a definite move toward restraint or
ease would be desirable. Open market oper­
ations have less psychological impact than a
change in the discount rate and are flexible
as to both timing and amount. Such opera­
tions could be reversed, if desirable, with­
out the risk of serious psychological reper­
cussions that might accompany a rollback
in the discount rate.
Others favored discount rate action to ini­
tiate a change in policy. Leading with open
market operations to implement a restric­
tive policy would likely result in the dis­
count rate being below market rates much
of the time. There would be an inducement
for banks to borrow from the Reserve
Banks instead of adjusting reserve positions
in the market, and to borrow from the Re­
serve Banks in order to invest the proceeds
at a profit. Monetary restraint would be
rendered less effective. With the discount
rate leading market rates upward, the re­
strictive effects of open market policy
would be reinforced instead of alleviated.4
44 See Turner, o p . c it., pp. 145-60.
45 For example, see Minutes of the Federal Open
Market Committee, Aug. 23, 1955.



Beckhart, Benjamin Haggott. The Discount Policy of the Federal
Reserve System. New York: Henry Holt & Co., 1924.
Burgess, W. Randolph, (ed). Interpretations of Federal Reserve
Policy in the Speeches and Writings of Benjamin Strong. New
York: Harper & Bros., 1930.
---------- . The Reserve Banks and the M oney M arket , rev. ed. New
York: Harper & Bros., 1936.
Currie, Lauchlin. The Supply and Control of M oney in the United
States. Cambridge: Harvard University Press, 1935.
Hardy, Charles O. Credit Policies of the Federal Reserve System.
Washington, D.C.: The Brookings Institution, 1932.
Harris, Seymour E. Twenty Years of Federal Reserve Policy, vols.
1 and 2. Cambridge: Harvard University Press, 1933.
McKinney, George W., Jr. The Federal Reserve Discount Win­
dow. New Brunswick: Rutgers University Press, 1960.
Reed, Harold L. Federal Reserve Policy, 1921-1930. New York:
McGraw-Hill Book Co., 1930.
Riefler, Winfield W. M oney Rates and M oney M arkets in the
United States. New York: Harper & Bros., 1930.
Turner, Robert C. Member-Bank Borrowing. Columbus, Ohio:
The Ohio State University, 1938.
Whitney, Caroline. Experiments in Credit Control: The Federal
Reserve System. New York: Columbia University Press, 1934.
Other References

Cassel, Gustav. “The Connection between the Discount Rate and
the Price Level,” Scandinaviska Kreditakliebolaget Quarterly
Report (Oct. 1927).
Currie, Lauchlin. “Member-Bank Indebtedness and Net Demand
Deposits in The Federal Reserve System,” Quarterly Journal
of Economics (Aug. 1928).
“The Discount and Discount Rate Mechanism,” special studies
prepared by Board of Governors and Reserve Bank personnel
(May 1953).
“The Discount and Discount Rate Mechanism,” statements of
associate economists of the Federal Open Market Committee
before the Conference of Presidents of the Federal Reserve
Banks (June 21, 1954).
Federal Reserve Board, Annual Reports.


Goldenweiser, E. A. “Significance of the Lending Function of
the Federal Reserve Banks,” Journal of the American Statis­
tical Association , vol. 31 (Mar. 1936), pp. 95-102.
______ “Instruments of Federal Reserve Policy,” Banking
Studies. Washington, D.C.: Board of Governors, 1941.
Hackley, Howard H. “A History of the Lending Functions of the
Federal Reserve Banks” (Apr. 1961), mimeographed.
Leffingwell, R. C. “The Discount Policy of the Federal Reserve
Banks: Discussion,” American Economic Review (Mar. 1921).
Minutes (or Proceedings) of Federal Reserve Conferences (ref­
erences to conferences are by numbers shown below):
(1) Conferences with the Federal Reserve Board of [the]
Governors and Chairmen and Federal Reserve Agents of
the Federal Reserve Banks, 1914-35
(2) Conferences of Governors of the Federal Reserve Banks
with the Federal Reserve Board
(3) Conferences of Governors of the Federal Reserve Banks,
(4) Conferences of [Chairmen and] Federal Reserve Agents
of the Federal Reserve Banks, 1914-35.
Smith, Warren L. “The Discount Rate as a Credit-Control Weap­
on,” Journal of Political Econom y , vol. 66 (1958).
Sprague, O. M. W. “The Discount Policy of the Federal Reserve
Banks,” American Economic Review (Mar. 1921).
______ “A New Device for Reserve Bank Control of Brokers’
Loan Inflation,” The Annalist (Oct. 19, 1928).
Steiner, W. H. “Paper Eligible for Rediscount at Federal Reserve
Banks: Theories Underlying Federal Reserve Board Rulings,”
Journal of Political Economy (June 1926).
System Committee on the Discount and Discount Rate Mecha­
nism, “Report on the Discount Mechanism” (Mar. 12, 1954).
U. S. Congress, Joint Commission of Agricultural Inquiry, Hear­
ings, “Agricultural Inquiry,” 1931.
U. S. Senate, Subcommittee of the Committee on Banking and
Currency, Hearings, S. 71, “Operations of the National and
Federal Reserve Banking Systems,” 1931.
Wallace, Robert F. “The Use of the Progressive Discount Rate
by the Federal Reserve System,” The Journal of Political Econ­
om y , vol. 64 (1956), pp. 59-68.
Youngman, Anna. “The Efficacy of Changes in the Discount
Rates of the Federal Reserve Banks,” The American Eco­
nomic Review (Sept. 1921).



George Garvy
Federal Reserve Bank of New York

Part 1

The Discount Mechanism as a Tool of Monetary Control___________________ 167

Part 2

The Discount Mechanism in Individual Countries________________________ 199

The objective of this study was to acquaint the Steer­
ing Committee with discount policies and techniques
used by the central banks of leading industrial coun­
tries, in particular since World War II. Interest
focused on the role of discounting as a tool of
monetary policy in relation to other tools for each of
11 countries, as discussed in some detail in Part 2 of
this paper. No attempt was made to appraise the
efficiency of discount policy in each country. Such
an endeavor would have required review and evalua­
tion of a wide range of factors and conditions, which
far exceed the resources and time available.
Given the considerable differences in the frame­
work in which the discount mechanism operates in
the United States and in each of the countries cov­
ered, the first part of the monograph attempts to
bring out the main differences in institutional and
policy environments that must be kept in mind when
analyzing the potential of the discount mechanism in
the United States against the background of foreign
experience. In view of the general objective of the
study, the review is not limited to policies and tech­
niques that were being used at the time of the study,
because in some cases discarded or radically modified
arrangements represent interesting variants, and the
reasons for dropping or for changing the original
techniques cast some light on the problems en­

The author has benefited from comments and sug­
gestions by Ralph A. Young and Robert F. Gemmill,
members of the Secretariat, who had special responsi­
bilities for this project. Robert C. Holland made
substantial contributions to the analysis embodied in
several chanters of Part 2. The initial drafts of the
country studies that constitute Part 2 were written by
Ruth Logue of the Board’s staff (France, Netherlands,
and Switzerland) and by Dorothy B. Christelow (Bel­
gium and Sweden), Rachel Floersheim (Austria and
Federal Republic of Germany), Leon Korobow
(United Kingdom), Isaac Menashe (Canada and
Italy), and Joachim O. Ronall (Japan), of the Federal
Reserve Bank of New York. Mr. Stephen V. O.
Clarke of the New York Bank also participated in
preparing Part 2. I am also indebted to officials of
the central banks of the individual countries whose
discount mechanisms are described in Part 2 for
their invaluable assistance.
The present study is a revised version of the report
submitted to the Steering Committee in early 1968.
For the most part the various country chapters in
Part 2 do not include data or comments concerning
the period after mid-1970. A Spanish translation of
Part 1 of this study was published in 1969 by the
C entro


E studios

M on etarios

Latinoam ericanos,

Mexico City, under the title “El Mechanismo de
Discuento Como Instrumento de Politica Monetaria.”


Part 1

Provision of Central Bank Credit at the Initiative of the Banks______________________ 170
Widening of the Range of Objectives and Tools of Monetary Policy_________________ 176
Main Contrasts with the United States_______________________________________ 179
Rate Policy____________________________________________________________ 185
Quantitative Controls____________________________________________________ 188
Selective Controls Through the Discount Window________________________________192
Indirect Access to the Discount Window______________________________________ 193
Uniformity of Administration_______________________________________________ 195
Concluding Remarks_____________________________________________________ 195


Part 1

Generalizations concerning the role played
since World War II by the discount mecha­
nism in the monetary policy of each of 11
leading industrial countries surveyed in this
study 1 are difficult to make. In each coun­
try discount policy has been shaped by the
specific characteristics of the country’s
economy and financial structure, the evolu­
tion of its economic philosophy, and its ac­
tual postwar experience. Generalizations
must be distilled largely by rationalizing the
reasons for observed differences in policies
and their evolution over time.
The specific role played by the discount
mechanism has depended in each instance
on the policy objectives of the central bank,
and in particular on the way in which the
bank has supported government economic
policies other than the traditional endeavors
to defend the internal and external value of
the national currency and to insulate it
from disruptive influences from abroad.
Concern with the widening and proper
functioning of capital markets, including
assistance in the financing of the public sec­
tor, has grown in importance since World
1 Austria, Belgium, Canada, France, Federal
Republic of G erm any (W est G erm any), Italy, Japan,
N etherlands, Sweden, Switzerland, and U nited King­
dom; “foreign central banks” or “other banks” al­
ways refer to such banks in these 11 countries. P ar­
enthetical references in P art 1 are not intended to be
exhaustive, but merely to refer the reader to one or
two specific examples that can be found in the coun­
try chapters in P art 2.

War II, along with an older concern about
the need to stimulate exports.
The way in which discounting is used in
each country at a given time generally de­
pends less on theoretical considerations and
preferences than it does on policy objectives
and on institutional realities, possibilities,
and constraints. In particular, discounting
depends on (1) the extent to which foreign
exchange surpluses or deficits are subject
to short-term variations; (2) the availabil­
ity of alternative control mechanisms (such
as cash reserve requirements, liquidity ra­
tios, and open market operations); (3) the
ability of banks to make short-run adjust­
ments through their investment portfolios;
and (4) the existence of facilities to redis­
tribute excess reserves through an interbank
money market.
The choice of instruments to implement
policy goals normally depends on the
trade-offs in terms of positive and negative
side effects and, most importantly, on the
degree of precision that may be expected
from relying on any one of the instruments,
singly or in combination, to achieve the de­
sired effect.2 Moreover, in each of the coun­
2 In some countries the authority for monetary
control is quite diffused. Different agencies may have
the authority to set the discount rate, liquid assets
ratios, or credit and reserve ceilings and to determine
eligibility requirem ents (or give final approval to
such actions). Their actions are not always perfectly
coordinated, even when elaborate coordinating agen­
cies or arrangem ents exist.


tries surveyed, the current role of the dis­
count mechanism reflects not only the
policies of the central bank with regard to
the means it chooses (or has at its dis­
posal) to influence the cash position of
banks but also the willingness of banks to
fully use the discount facilities available.

Against the background of the experi­
ence of the leading industrial countries,
the discount mechanism in the United
States, no less than our entire monetary and
banking system, appears to be unique
rather than a variant among many similar

Discounting is the oldest instrument of cen­
tral bank policy, and for a long period it
was practically the only such instrument.
Discounts and advances together are still
the most important avenue for changing the
reserve base at the initiative of commercial
banks. The flexibility inherent in discount­
ing has preserved the usefulness of the de­
vice even where the range of tools available
to the central bank has been expanded con­
siderably. Our review of foreign experience
encompasses both discounts and advances,
even though in none of the countries sur­
veyed are the two methods of obtaining re­
serves strictly equivalent in terms of cost, as
they are in the United States.
Basically, central bank policy becomes
effective by affecting first the liquidity of
commercial banks; through it, the liquidity
of the entire economy; and finally, the level
of real activity and the country’s interna­
tional payments position. Changes in bank
liquidity are normally reflected in market
rates of interest—which as a rule are
closely related to the volume of borrowing
from the central bank—and in the volume
of money and credit available to the econ­
Central bank policy may aim primarily
to influence either market rates or the vol­
ume of money and credit. The choice be­
tween these two basic approaches to mone­
tary control depends in each country on
specific conditions, including institutional

arrangements and linkage processes, as well
as on prevailing monetary views. Foreign
experience provides illustrations for the two
basic approaches and for a number of var­
An example of the first approach is
found in countries where the authorities
aim at maintaining a level of short-term
rates consistent with domestic and external
objectives. The discount rate is used as an
anchor for the entire structure of interest
rates. Banks then determine how much
they want to borrow at the discount
rate.3 The alternative approach is to place
primary reliance on regulation of the vol­
ume of reserves rather than on their price.
Access to reserves may be governed by
quantitative controls as well as by restric­
tive eligibility requirements. Such controls
are tantamount to nonprice rationing, and
they may be designed to achieve multiple
objectives. Nevertheless, countries that rely
on quantitative controls to influence the
cash position of banks may still assign to
the discount rate an important role in regu­
lating international capital movements, or
they may use changes in the rate to support
quantitative and related control techniques;
3 A variant is to consider the discount rate as the
upper limit of the proper range of short-term rates,
and to make it effective by open m arket or foreign
exchange operations when m arket rates tend to fall
away from it. A nother variant is the tying of the dis­
count rate to a m arket rate that becomes the focus
of central bank control.


but in such instances administrative disci­
pline, rather than price, is the main tool of
monetary management.
In the absence of significant alternatives,
most of the countries surveyed regard dis­
counts and advances as a normal means for
adjusting bank liquidity positions. In fact,
in some countries discounting is considered
a usual source of a considerable part of the
banking system’s cash reserves rather than
merely as a safety valve, available for the
most part to provide credit for only very
short periods, pending adjustment of banks’
assets and liabilities. Other central banks,
however, still insist that funds should be
sought at the discount window only to meet
seasonal and other specific temporary and
reversible needs.
If the central bank has alternative means
for injecting and absorbing reserves, it may
use these tools in various combinations to
achieve the desired effects and it may also
vary reserve requirements. It normally pur­
sues its rate or reserve-base aims by absorb­
ing or supplying bank cash. It is possible
for the central bank (1) to control (and
vary) the conditions under which banks
may obtain additional reserves at the dis­
count window (through rate, qualitative, or
quantitative controls, or through some com­
bination of these three means) but to re­
frain from modifying the resulting volume
of borrowing; or (2) to adjust the quantity
of reserves obtained at the initiative of the
banks to its own targets by undertaking
offsetting (or supporting, as the case may
be) operations through other channels. In
this case, the extent to which commercial
banks adjust their cash positions through
the discount window depends on the vol­
ume of reserves that the central bank
makes available to the market by other
means. One of the significant aspects of the
closer integration of monetary management
with over-all public economic policy since


World War II has been an effort in several
countries to shift the initiative for injecting
(and withdrawing) reserves from commer­
cial banks to the central bank.
Operations at the discount window can
influence the supply of bank credit and
money (by affecting the reserve base or
through the rate effect, or both) only if the
banking system needs to borrow. A central
bank may use various means to force banks
to seek additional cash from it in order to
make the rates on discounts and advances
effective. Specific techniques include opera­
tions in exchange markets, open market
sales of securities (United Kingdom), in­
creases in reserve requirements (Austria),
and reductions in discount quotas to force
banks to seek accommodations at the
higher rate on advances (West Germany).
To achieve sufficiently tight control over
bank cash, the central bank must be able to
estimate with a good deal of precision the
timing and amount of open market or for­
eign exchange operations required to
achieve the desired rate effects. By provid­
ing less than the full amount of reserves re­
quired to support seasonal, cyclical, or sec­
ular expansion of bank credit (for instance,
by abstaining from purchasing securities in
the open market), the central bank will
force the banking system to the discount
window. (The classical case of this is in the
United Kingdom where, however, the bor­
rowing is undertaken indirectly, through
discount houses). The volume of discounts,
interpreted in relation to changes in the
central bank’s securities portfolio and to
changes in relevant cash and liquidity ra­
tios, will be a direct indication of the state
of monetary stringency.
In some countries, “refinancing” of bank
credit at the central bank is common. A
considerable part of the credit in use in the
private economy is, in the final instance,
provided through the discount window.


Moreover, the cash positions of banks are
usually so tight in these countries that
banks must go to the central bank for addi­
tional refinancing during periods of sea­
sonal or cyclical pressures. In countries
where cash reserve requirements exist,
quasi-permanent borrowing by individual
banks is tantamount to an offset to such
requirements.4 In countries where reserve
requirements do not exist, but where banks
maintain (or are expected to observe) con­
ventional liquidity ratios, resort to discount­
ing in effect reduces the borrowing bank’s
net liquidity position. Thus, in all coun­
tries the frequency of borrowing by in­
dividual banks and the aggregate amount of
discounts and advances outstanding are ele­
ments that must be considered in interpret­
ing (and influencing) the central bank’s
policy posture.
In countries where rediscounting is in­
significant (either in relation to bank cash,
or as a means of making seasonal adjust­
ments in it), the reason is usually traceable
either to excessive liquidity caused by for­
eign exchange inflows or postwar monetary
overhangs (as in Switzerland; and for part
of the past decade, in Sweden and Austria)
or to other circumstances that have reduced
the importance of discount policy.
Indeed, the ability of a central bank to
use rediscounting as the main tool of mone­
tary control relates directly to the size and
types of commercial banks’ assets. These
portfolios must not be such as to provide
automatic or semiautomatic access to cen­
tral bank credit. Over long periods many
central banks were confronted with the
problem of controlling excess liquidity in
their banking systems and of neutralizing
the effects of foreign exchange surpluses. In
the immediate postwar years, banks every­
where generally had an overhang of war4 Borrowing in excess of applicable reserve require­
ments has severely affected the usefulness of this
monetary tool in several Latin A m erican countries.

generated liquidity. In subsequent years and
in varying degree, the individual countries
covered by this study also experienced bal­
ance of payments surpluses—in large part
the counterpart of U.S. deficits—and at
times were exposed to speculative inflows
of foreign capital.
In such circumstances the need for the
commercial banking systems of most of the
countries covered, and in particular those
of continental Europe, to obtain liquidity at
the discount window was much reduced. In­
deed, in many countries the balance of pay­
ments surpluses during extended periods
were much too large to be neutralized by
any means of monetary policy, and in sev­
eral the central problem of monetary policy
since World War II has been to limit the
monetization of the inflow of foreign ex­
Thus, since World War II in most of the
countries covered by the present study,
discounts and advances have provided only
a small—and in many cases, an insignifi­
cant—part of the funds needed to offset
seasonal and cyclical fluctuations in the
cash base and to meet growth requirements.
Although excess liquidity and the opportu­
nities for obtaining funds abroad reduced
sharply the need to borrow from the central
bank, a complete atrophy of the discount
function (similar to the U.S. experience in
the period after the depression of the
1930’s and well into the post-World-War-Il
period) did not develop. The reasons for
this were the wider seasonal swings in for­
eign exchange surpluses and in circulating
currency, a less-developed interbank money
market, and a lesser use of open market
operations.5 The accompanying table indi­
cates that, in contrast to the United States,
changes in holdings of foreign assets since
5 D evelopment of a national m arket for reserves
reduces the need for borrowing from the central
bank, as does concentration of banking and the
growth of branch-banking systems.



the return to convertibility in most of the
countries covered have been a very impor­
tant, or even predominant, factor in
changes in total asset holdings of central
banks; in some countries this was true even
in the earlier postwar period.
(In billions of national currency units)
bank of—


Austria ....................
Belgium ..................
Canada ....................
France ......................
West Germany ........
Italy ..........................
Japan ........................
Netherlands ............
Sweden ....................
Switzerland ............
United Kingdom ..
United States ........












N ote.—N et foreign assets = foreign assets — foreign
Net domestic assets = (claims on government — government deposits) + claims on other official entities -f- claims
on private sector + claims on deposit money banks — other
items, net.
S o u r c e .—IMF, International Financial Statistics.


Central banks of the countries surveyed
(and of many of those elsewhere) have re­
tained traditional forms and practices of
providing credit to the banking system—
that is, they have given preferential treat­
ment to credit extended by discounting
promissory notes. This prominence of redis­
counting abroad reflects in part the survival
of the trade bill as an instrument for short­
term credit accommodation. The continu­
ing, although perhaps diminishing, use of
such bills in turn is traceable in some coun­
tries to the very significant role played by
foreign trade in relation to gross national
Access to the discount window is tradi­
tionally based on eligibility requirements
with regard to purpose, maturity, and the
credit standing of drawee and endorser.
While the stress is on the self-liquidating
character of the paper discounted, there is
no tendency on the part of the central
banks surveyed to question the ultimate use

made of the funds supplied or to consider
that lending for productive purposes is
more appropriate than for other uses.
Terms and conditions, including eligibility
requirements and maturity, are usually
specified in a broad way by legislation and
are administered by the monetary authori­
ties, which set policy objectives and pro­
mulgate various operating rules that may
include differentiated rates. In most coun­
tries the applicable discount rate depends
on the nature of the paper offered (in some
cases this applies to advances as well).
The ability to rediscount a particular
credit is usually an important factor in de­
termining bank attitudes toward loan appli­
cations. In particular, the status of the trade
bill at the discount window has been an im­
portant factor in preserving the role of the
bill. In a few countries, such as Japan,
changes in eligibility requirements have
been used as a tool of monetary control.
Varying eligibility requirements in accord­
ance with policy objectives give the central
bank additional flexibility but—as in other
instances—policy requirements may not be
consistent with other considerations, such
as safety.
However, eligibility rules by themselves
are of limited significance in controlling
the aggregate volume of discounts if com­
mercial banks dispose of an adequate
volume of paper that can be substituted for
any specific items judged substandard. Simi­
larly, the prior-authorization procedure (in
France and Belgium) is by itself an insuffi­
cient means of controlling discounts if
credit demands are strong enough to pro­
duce alternative requests to replace rejected
While in all countries the discount func­
tion had its origin in the “real bills” doc­
trine, the degree to which it has weathered
the changes in credit needs and financial
structure that have occurred since the de­
pression of the 1930’s varies from country


to country. However, the administration of
the discount window everywhere is now
generally subordinated to over-all objectives
of monetary policy. Indeed, in several
countries the central bank has wide discre­
tionary powers under the law to regulate
access to discount facilities and to vary the
conditions under which it will make dis­
counts. These powers generally permit the
central bank to refuse (usually without
having to give any reason) accommodation
even when the commercial bank can submit
stipulated types of paper.
This discretionary power may lend con­
siderable effectiveness to the central bank’s
over-all ability to influence commercial
bank behavior. In effect, discounting as­
sumes the role of an enforcement mecha­
nism, because some central banks make it
clear that access to the discount window de­
pends on compliance with the over-all
objectives of monetary policy and that such
compliance is often the price to be paid for
extending the discount privilege to certain
classes of institutions other than commercial
banks. In some countries, however, access
to the window within stipulated ceilings
and quotas is considered by the commercial
banks as a right.
The review of paper offered for redis­
counting gives central banks an insight
into the credit policies followed by com­
mercial banks. This is an important feature,
because in most of the countries that have
large numbers of commercial banks the
central bank has few or no direct and cur­
rent contacts with many commercial banks,
except at the discount window. In countries
where the central bank typically provides a
large proportion of total bank reserves
through the window, the need to renew the
discounted portfolio affords the central
bank a means for continued surveillance of
commercial banks’ lending.

In many cases, compliance by commer­
cial banks with the wishes of the central
bank is also reinforced by various supervi­
sory powers of the central bank and by the
threat of requests for additional powers if
voluntary cooperation is not forthcoming.
Informal arrangements to obtain compli­
ance may involve (1 ) a “gentlemen’s agree­
ment”; (2 ) periodic conferences between
the head of the central bank and heads of
the large commercial banks; or (3 ) formal
“window guidance,” as in the case of Japan
in certain periods.
While rediscounting of bills of exchange in
many of the countries covered is still an im­
portant channel for supplying central bank
credit to the private sector of the economy,
foreign central banks have found it neces­
sary to broaden discounting techniques and
to introduce additional ways to provide
credit for reserve adjustment purposes. One
way has been through advances against col­
lateral. Such advances originally played the
role of a safety valve, but in recent years
they have become in some countries the
normal way to obtain short-term accommo­
dations at the central bank. Other recent
techniques include repurchase agreements 6
and direct purchase of acceptances. Such
credit may be extended at the initiative of
the central bank or at the initiative of bor­
rowers (as in the case of money market
dealers in Canada, within credit lines estab­
lished for them). For decades most borrow­
ing at the Federal Reserve Banks has
GThe need for repurchase agreements arises pri­
m arily when conditions applicable to regular dis­
counting are too restrictive (when paper offered must
have a specific minim um m aturity, or discounts are
m ade for the rem aining life of the instrum ents only)
or when the borrow er cannot be expected to dispose
of an adequate volum e of eligible paper (as in the
case of Canadian m oney m arket dealers).


been in the form of advances instead of dis­
counts. Central banks in most foreign coun­
tries, however, still make a distinction be­
tween discounts and advances and in some
the distinction serves to differentiate access
as a right and access as a privilege.
There is little uniformity between ad­
vances and rediscounting in the ease or rel­
ative cost of obtaining funds. Normally, the
rate structure and other terms and proce­
dures are designed to make advances
available from the central bank— when
banks have reached their discount ceilings
(West Germany) or have run out of paper
eligible for discounting— only at a penalty
rate. Advances (referred to in some Euro­
pean countries as “Lombard credit”) are
often made on collateral that is not eligible
for rediscounting, such as long-dated gov­
ernment debt. The required collateral may
be limited to government securities (as in
West Germany and Belgium) or to a
broader list of specified securities.
In line with traditional “real bills”
theory, advances are usually made only for
very short periods. Sometimes it is more ad­
vantageous to borrow for a shorter time at
the (typically higher) rate on advances
when such loans can be paid off without re­
striction (West Germany) than it is to re­
discount. And even if the rates for dis­
counts and advances are identical, other
terms may favor one of the two. This is
often true, for example, in the United King­
dom, where the fact that advances can be
obtained for shorter periods than discounts
makes advances a less expensive source of
funds (to the discount houses, in the given
case), provided, in accordance with its pol­
icy (rate) objectives, the Bank of England
is willing to make advances at the given
time. On the other hand, the opposite is
true in Canada, where the minimum dura­
tion of advances is 7 days.


Although some countries have gone to
considerable lengths to maintain the con­
ceptual and operational distinctions be­
tween discounts and advances,7 most coun­
tries do rely more on one than on the other.
In most of the countries surveyed advances
are regarded as a less normal and less desir­
able means of providing reserves, and such
accommodations are extended at a higher
rate (as in West Germany and Austria, for
instance) and/or for a limited time only.
Advances at the discount rate may be made
up to a ceiling amount set for each bank
(which may be confidential); advances of
additional amounts may be made at a pen­
alty rate (as in Canada, where this rate is
subject to case-by-case negotiation). The
rate on advances (or its equivalent, which
represents the highest rate at which banks
actually borrow from the central bank)
tends to set an effective ceiling on money
market rates.
In other countries (as in Italy and the
Netherlands), advances rather than dis­
counts have become the common technique
for extension of central bank credit. This is
true in particular where the central bank
encourages the use of advances by making
them available on essentially the same
terms as discounts. Greater reliance on ad­
vances reflects, by and large, changes in the
structure and techniques of bank lending as
well as a shifting away from the “real bills”
doctrine. On the whole, advances may be
regarded as the method likely to grow in
relative importance over the years.
All central banks recognize that their
role as lender of last resort is a crucial one,
and discounting continues to be widely used
to implement this role. Even in countries
that use discount ceilings or where alterna­
tive means for injecting liquidity on a mas­
7 In W est Germ any, discounted bills, but not ad­
vances, qualify as cover against note issue.


sive scale (for instance, through open mar­
ket operations) are available, central banks
may not refuse to lend at some price if the

would-be borrower meets the formal re
quirements with regard to collateral or eli­

In all of the countries surveyed the scope of
official economic policies has been broad­
ened since World War II to include
objectives similar to those proclaimed by
the U.S. Employment Act of 1946; and in
several countries the use of the discount
mechanism has been adapted in various
ways to the new policy objectives. Indeed,
for this and other reasons— some of which
are discussed below— in most of the coun­
tries surveyed the discount mechanism has
undergone considerable change over the
last quarter of a century, and no country
currently relies on it as the sole tool of
monetary policy. Adaptation of the tradi­
tional discount mechanism (including the
shift from rediscounts to advances) to new
needs and to new conditions has been ac­
companied by the development of new tools
of monetary management. Many of these
tools were pioneered by the Federal Re­
serve System.
In considering the evolution of the dis­
count mechanism since World War II, one
must keep in mind that each of the coun­
tries covered by this study— with the excep­
tion of Canada, Sweden, and Switzerland
— has gone through a long and difficult
period of economic adjustment and re­
construction in which various types of di­
rect controls were used, some of which
were continued into the 1960’s. Because of
the urgency of the postwar reconstruction,
financial aspects were often pushed into the
background; monetary policy was expected
to contribute by facilitating and implement­

ing attainment of targets that were set in
terms of capacity, output, and/or techno­
logical progress. Such implementation often
involved subsidy-level interest rates, “direc­
tion” of credit, and use of rediscounts
as a means of providing funds for specific
activities in preference to budget financing
or as a substitute for private capital forma­
Excessive credit demands and lack of
sufficient internal funds to support high
rates of capital formation have character­
ized the economies of the countries studied
during much of the period since World War
II. In general, monetary policies of these
countries (with the exception of the United
Kingdom and Canada) in this period have
endeavored to limit and regulate access to
the discount window by specific rules, in­
cluding quantitative provisions (allowing in
some cases for procedures that amounted to
little less than direct extension of credit for
purposes having national priority); this has
been true in particular of countries in
which banks were not reluctant to remain in
debt to the central bank. In several coun­
tries this condition led to the establishment
of discount ceiling quotas for individual
banks. In some countries the authorities
have gone even further by establishing di­
rect ceilings for bank credit expansion; in
others they have endeavored to keep
growth of bank credit in line with official
objectives through informal directives.
Indeed, the conditions and challenges
that emerged after World War II caused


several of the central banks surveyed to
seek broader powers and to develop new
tools of monetary management rather than
to try to meet the new conditions by relying
on the adaptability of the discount mecha­
nism. In most countries the discount mech­
anism has been increasingly supplemented
by other tools of monetary management; in
particular, constraints on the use of changes
in rates have led to the development of al­
ternative policy tools and techniques and to
the introduction of new ones.
The need to supplement the discount
window by other control mechanisms can
be traced to several factors, including (1 )
changes in the structure of commercial
bank portfolios, with a declining proportion
of discountable paper; (2 ) various con­
straints that tend to limit the central bank’s
latitude for using the discount rate as a ra­
tioning device; and (3 ) the tendency of
commercial banks to make excessive use of
the discount window in view of the willing­
ness of the banks’ customers to borrow at
rates considerably higher than the discount
rate. In several countries, as indicated ear­
lier, the discount window was inadequate to
deal with the consequences of huge and
fairly persistent balance of payments sur­
pluses. The need for new tools was felt
most keenly in countries where external and
internal considerations were flashing con­
flicting signals with regard to the discount
As a result, the discount mechanism has
undergone considerable change. The most
significant aspect of this change has been
the resort to quantitative limitations, and
thus to a lessened dependence on changes
in level of the discount rate itself. After
World War II it became clear that the po­
litically acceptable range within which the
discount rate could be varied had narrowed
and that a number of developments were


inhibiting free and frequent use of changes
in the discount rate. The reasons for these
developments may be summarized as fol­
(1 ) Fear that the signal would be over­
(2 ) Fear that large fluctuations in the
rate would produce disruptive ef­
fects on the market for government
securities and, more generally, on
capital markets.
(3 ) Fear that automatic linkage be­
tween the discount rate and bank
loan and/or deposit rates would
tend to produce politically unac­
ceptable levels of interest rates.
(4 ) Fear of inducing undesirable inter­
national capital flows that would
offset intended effects of changes in
rates on the domestic economy.
Because of these restraints on a flexible
use of the discount rate, nonrate rationing
of loans and manipulation of reserves ac­
quired through balance of payments sur­
pluses became supplementary, and in some
cases alternative, tools of monetary control.
Variable cash reserve requirements, liquid­
ity ratios, and open market operations have
been introduced since World War II in a
number of countries as additional monetary
tools, but in most countries they remain of
limited significance (particularly for day-today control of reserve availability).
Most of the countries surveyed (the
United Kingdom and Canada being the
conspicuous exceptions) have not suc­
ceeded in developing markets for shortdated government debt that are broad
enough and active enough to provide a
main avenue through which to supply or
absorb bank reserves, and such Treasury
bill markets as do exist are extremely nar­
row. In such countries operations to adjust


bank liquidity (as well as Treasury debt op­
erations) often involve direct dealings be­
tween the central bank and the commercial
bank, rather than impersonal transactions
through the market. In several countries
bank liquidity can be affected by issuing to
banks special Treasury instruments (usually
a special category of Treasury bills, not
available to the general public). These
carry rates that are deemed appropriate by
the authorities, not rates that are set by
market bidding; and they are repurchased
not at market rates, but at posted rates, as
in West Germany.
Because of the unavailability or limita­
tions of new monetary tools, most of the
countries covered sought to achieve greater
monetary restraint through nonprice ration­
ing at the discount window, and some
sought to shield certain sectors (for exam­
ple, export financing, municipal borrowing,
home mortgages, and so forth) from the ef­
fects that would have resulted from price
rationing. Regulation of access to discount
credit through quantitative limitations on
borrowing (rather than by tightening eligi­
bility requirements) became a policy tool.
Hence, availability of eligible paper became
a necessary, but not sufficient, condition for
access to central bank credit, thus moving
away from the automatism of the real bills
Eligibility and collateral requirements for
discounts and advances have always tended
to influence the composition of commercial
banks’ portfolios (and, presumably to a
lesser extent, the portfolios of other finan­
cial institutions having direct or indirect ac­
cess to the discount window). In recent
years several countries (for example,
France and Japan) have added restrictive
features to the discount mechanism with a
view to restraining excessive use of central
bank credit and to channeling bank credit
into priority uses.

In some countries the discount window
has been used to influence credit flows,
usually by compartmentalizing discount
procedures and by establishing a whole hi­
erarchy of rates from preferential to pen­
alty. Central bank credit has also been used
rather widely as a supplement, or even as
an alternative, to budgetary financing in
implementing a variety of officially spon­
sored programs, including implementation
of national investment plans. In such cases,
institutional arrangements have been made
for formally meeting the requirement that
discountable paper be short term by sub­
stituting a series of short-term notes for the
original medium-term loans.8 Other exam­
ples of the use of discounting as a means of
financing governmental programs are found
in Switzerland (financing of defense stocks
of raw materials) and Italy (agricultural
price-subsidy programs).
The discount mechanism thus has grown
in complexity in part because in many
countries it is being used to meet specific
objectives for which it offers certain advan­
tages, both technical and budgetary. The
need to resort to a variety of artifices to fit
the letter of the requirements of the dis­
count window arose, in part, from the in­
flexibility of the banking laws of various
countries and the unwillingness or inability
of governments to introduce desirable
New techniques had to be introduced to
sterilize the inflow of foreign exchange and
to adjust monetization of domestic assets to
variations in balance of payments surpluses.
Central banks have endeavored (paralleling
similar efforts with regard to meeting dos It should be noted, however, that use of the dis­
count mechanism for stimulating investment, includ­
ing provision of central bank credit on a semi­
perm anent basis, has resulted from shortcomings
in capital m arket structure and processes, not from
any inherent superiority of discounting as a means of
achieving policy objectives in this field.



mestic challenges) to develop alternative
policy tools that would reduce reliance on
the discount rate to prevent or correct im­
balances in international accounts and, in
particular, to cope with wide swings in for­
eign exchange flows.
Because foreign
commercial banks
usually keep part of their liquid assets
abroad, mainly in the form of interbank
balances and money market assets (subject
to applicable foreign exchange control reg­
ulations), regulation of foreign exchange
holdings of commercial banks has become
one of the most important tools of mone­
tary policy in several countries. Since con­
vertibility of major currencies was re-estab­
lished in 1958, closer integration of
financial markets and the growing impor­
tance of banks and other financial institu­
tions that operate across national borders
— borrowing from their foreign branches
and/or in foreign money markets, including
in more recent years the Euro-dollar mar­
ket— have provided commercial banks with
additional sources of liquidity in periods of
temporary strain and thus have further re­
duced the need for these banks to seek ac­
commodation at the central bank.
A common objective of measures adopted
in individual countries has been to control
commercial bank liquidity that has resulted
from foreign exchange inflows, and more

generally to develop a foreign exchange
policy that would support other monetary
tools. Management of official exchange re­
serves can supply some of the day-to-day
flexibility that otherwise would be lacking
because of the limited scope (or absence)
of open market operations and because of a
variety of factors that reduce the flexibility
of other policy tools. Several techniques are
used to influence liquidity positions of
banks in the countries covered. Among
these are: (1 ) extension of foreign cur­
rency loans (by the central bank or by a
separate foreign exchange institution typi­
cally managed by the central bank), (2 )
spot and forward swap arrangements, (3 )
forward exchange transactions, and (4 ) ma­
nipulation of reserve requirements against
foreign deposits (West Germany, Switzer­
land). A variety of techniques have been
applied in several countries to cope specific­
ally with international capital movements;
one of these— used in Italy, Switzer­
land, and Germany— prohibits payment of
interest on foreign deposits. Furthermore,
some central banks have taken measures to
control commercial banks’ borrowing
abroad and to regulate their net positions in
foreign currencies— by placing limits on the
amounts of liabilities or foreign currency
claims that banks (and nonbank institu­
tions) may assume and by other means.

On the whole, since World War II the
countries covered have relied more heavily
upon the discount mechanism than the
United States has to achieve domestic and
external monetary policy goals by influencing the supply of credit, the cost of money,
and the market pattern of rates. Before reviewing the various technicalities of the dis-

count mechanism in each of the countries
covered by this study, it might be useful to
comment on the nature and extent of differences in the setting in which monetary policy operates in the United States and in the
countries surveyed. These differences range
from forces that cause fluctuations in the
reserve base to institutional factors in the


financial area and beyond. But quite gener­
ally, access to central bank credit in each
country is embedded in policy considera­
tions, institutional arrangements, and proce­
dures that are somewhat different from
those in the United States.
In all of the countries surveyed, foreign
trade accounts for a much larger proportion
of gross national product than it does in the
United States. For this reason international
considerations are traditionally a main
focus of monetary policy, and day-to-day
management of foreign exchange reserves
requires considerable official attention.
Since commercial banks in these countries
keep part of their liquidity abroad, mainly
in the form of interbank balances and
money market assets (which are subject to
foreign exchange control regulations), reg­
ulation of foreign exchange holdings of
commercial banks in several of the coun­
tries is one of the most important expres­
sions of monetary policy.
Bank credit accounts for a much larger
share of domestic credit flows in the coun­
tries surveyed than it does in the United
States; we would go too far afield if we at­
tempted to examine the underlying reasons
for this variation. However, some of the
reasons may be stated, although they apply
to a different degree for each given country.
Among the reasons are the relative narrow­
ness of capital markets; the fact that a large
part of capital formation bypasses these
markets; the pre-emption of a considerable
part of savings by the national government
and by quasi-governmental institutions; and
the lesser importance of financial intermedi­
aries (in some cases a direct effect of ear­
lier disastrous inflations). On the other
hand, the predominant role of commercial
banks in credit markets— especially in serv­
ing credit needs of private business— has
usually resulted in rapid transmission to the
central bank of fluctuations in credit de­

Another significant difference in many of
the countries studied is that an important
segment of the commercial banking system
is nationalized (as in France and Italy); in
such instances public and specialized quasi­
public credit institutions have access to
the discount window. While nationalized
commercial banks usually operate in much
the same way as those privately owned and
do not enjoy any preferential treatment at
the discount window, subtleties may be in­
volved that are difficult to detect.
Specialized quasi-public credit institu­
tions usually combine several activities;
these include (1 ) centralizing temporarily
redundant resources for national networks
of institutions with similar specialties; (2 )
providing rediscount facilities for these in­
stitutions; (3 ) attracting certain types of
savings; and (4 ) channeling government
funds into long-term investment. Giving
such institutions direct access to the dis­
count window broadens the original func­
tion of the discount window because central
bank credit is used to implement certain
priorities set by national economic policies,
to influence the direction of investment
flows, and to implement or support a broad
range of specific economic policies, includ­
ing the diversion of central bank resources
to nonbudgetary financing. This widening
of the discount function has no direct coun­
terpart in the United States.
A related structural difference is reflected
in the origin of the paper that reaches the
discount window.9 In several of the coun­
tries surveyed, large segments of industry
are nationalized and other important units
involve some degree of government partici­
!>Also w orth noting is that while the Federal Re­
serve System has been engaged almost since its in­
ception in developing the acceptance market, it has
chosen to monetize acceptances through open m arket
purchases rather than through discounting, whereas
in the other countries paper arising from foreign
trade is not only typically an im portant part of the
discounts but also enjoys preferential terms in some


pation or sponsorship. Municipal ownership
of public utilities is widespread, and the
communications industry as well as impor­
tant railroads, airlines, and shipping lines
are usually government-owned, directly or
indirectly. Contractors and some others that
supply government owned enterprises (such
as shipyards) enjoy official support that
may extend to special facilities at the dis­
count window. In some countries with a
significant public sector (and in particular
in France and Italy, but also in Japan
where government tutelage, rather than out­
right ownership, is involved), the use of the
discount mechanism as a means of directing
credit has become a significant and integral
part of the central bank policy.
Thus, a considerable proportion of the
assets of commercial banks (whether pri­
vately or publicly owned) consist of loans
(and other credits) to public enterprises,
even though the form of the accommoda­
tions extended (and the eligible paper that
they generate) may be so much like that
used to accommodate private borrowers
that the two are indistinguishable, on the
surface at least. In effect, these assets repre­
sent credits extended to official entities or
credits guaranteed by government institu­
tions or instrumentalities, some of which
have been set up to implement specific gov­
ernment policies.
Also in contrast to the United States,
some of the central banks of Western Eu­
rope (having evolved from commercial
banks) continue to have some private clien­
tele, which have access to central bank re­
sources through direct discounting (and in
some cases also through advances, as in
West Germany, Italy, and Switzerland). D i­
rect lending to private borrowers (even to
individuals, rather than to business borrow­
ers, as in Italy) is in most cases a car­
ryover from the time when the central
banks were privately owned. The newer
central banks (Canada) have never en­


gaged in such activities, and the older ones
are trying to close them out.
By and large, the relative volume of di­
rect lending to private borrowers through
discounts or advances is negligible. Further­
more, such lending has no policy purpose,
except in the United Kingdom where the
Bank of England acquires a certain volume
of commercial bills regularly so as “to be in
touch with the market” and to ascertain the
quality and composition of the bills being
offered in the market. Since this paper is
concerned with the use of the discount win­
dow by foreign central banks as a tool of
monetary policy, we shall not discuss tech­
niques for discounting paper of private
Foreign central banks do not administer
their discount windows on the basis of rigid
rules on the public record (and, it is hoped,
uniformly interpreted and understood by
all), comparable with the Federal Reserve
Regulation A as issued in 1955. The notion
of “appropriate borrowing” is not encoun­
tered in the operations of foreign central
Only a few of the central banks surveyed
administer the discount window on the as­
sumption that commercial banks are reluc­
tant to borrow (and to stay in debt), even
though it is well known that banks prefer to
obtain liquidity elsewhere and that they go
to the central bank only as a last resort. In
most countries surveyed, commercial banks
tend to regard access to the discount win­
10 We shall also pay only passing attention to dis­
counting of, or lending on, governm ent securities un­
dertaken either to accom modate the Treasury in peri­
ods when its expenditures exceed receipts, or to
cover budget deficits, since such activities do not fall
under the heading of credit policy (although m one­
tary policy must, of course, cope with the resulting
reserve creation). In some countries, borrowing by
the national governm ent takes the form of advances
from the central bank rather than of m arketable
paper. In most countries, legislative safeguards exist
to protect the central bank against abusive use of its
facilities to cover budgetary deficits directly or indi­


dow as a right rather than a privilege
(within applicable limitations, such as quo­
tas) even though the central bank normally
has discretionary authority. This attitude,
confirmed by banks’ experience, is traceable
in some cases to the availability in their
portfolios of specific types of paper that the
central bank must discount automatically,
but generally to the inherent function of the
central bank as “lender of last resort.”1
The United States, Canada, and Switzer­
land are the only important examples of
countries that limit direct access to the dis­
count window to commercial banks and
that deny it to other money market
participants.12 Other foreign central banks
interpret their role as lender of last resort
more broadly; as a result, a variety of finan­
cial institutions other than commercial
banks usually have direct access to central
bank credit.
Some of the central banks surveyed ex­
tend (depending on historical and institu­
tional factors) discount privileges or ad­
vances to most or all of the following
groups: public and quasi-public credit insti­
tutions; central bodies of such sectoral
credit institutions as national groupings of
savings banks, farm credit associations, and
credit unions (Italy); municipal savings
banks (Italy, Japan); credit cooperatives
(Netherlands); stockbrokers who act as
dealers in government securities (Canada,
Netherlands); and private borrowers. Such
access may be available at all times ( al­
though it may, in fact, be resorted to
rarely) or under specific conditions.

Access to the discount window is deter­
mined by law and/or administrative deci­
sions; in none of the countries surveyed can
banks elect to escape regulation by the cen­
tral bank by acquiring a “nonmember”
status and by so doing lose their direct ac­
cess to the discount window. By and large,
however, reserve (and liquidity) require­
ments abroad are administered more flexi­
bly than in the United States. The greater
flexibility that foreign commercial banks
have in meeting legal reserve requirements
and/or liquidity ratios frees both them and
the central banks from some of the prob­
lems of day-by-day reserve management
that are rooted in our system of administer­
ing member bank reserve requirements.
Because of the prevalence of nationwide
branch-banking systems and the virtual
absence of secondary financial centers,1
some of the problems of reserve manage­
ment inherent in our fragmentized com­
mercial banking system do not exist to the
same extent in the countries studied.1 While
important regional, and even local, banks
exist in most countries studied, nowhere is
there a counterpart of the reserve manage­
ment problems with which thousands of our
banks must cope.
This does not necessarily mean that
offsetting of a much larger part of the local
and regional day-to-day fluctuations in the
demand for, and supply of, banking funds
within the nationwide branch system tends
to diminish to any significant degree the
over-all seasonal variations in the demand
for cash. In fact, forces operating in the op­

1 In some countries at least (Italy being perhaps
the most conspicuous exam ple), access to the dis­
count window was, originally, considered to be a
quid pro quo for establishing the note privilege of the
central bank.
12 In the United States a bank must be a member
of the Federal Reserve System in order to have ac­
cess to the discount window.

13 With some exceptions, however; but even C an­
ada and the N etherlands each has only one addi­
tional financial center of real significance.
14 While there are some parallels (the United
Kingdom comes first to m ind) to the lim itation of
the impact of our policy actions on m em ber banks,
the problem of “nonm em bership” is not duplicated


posite direction may be equally significant.
For instance, banks’ cash positions in the
countries surveyed are more exposed to fluc­
tuations in the public’s demand for cash be­
cause the portion of the banks’ money sup­
ply that consists of currency is so much
larger than it is here in the United States.
Fluctuations in currency in circulation af­
fect bank reserves one for one, whereas fluc­
tuations in deposits affect such reserves
only fractionally.1
The main objective of day-by-day dis­
count operations is to neutralize the effects
of seasonal and cyclical factors on the
money market— in other words, to provide
normal seasonal reserves and to accommo­
date, within broad policy considerations,
cyclical swings in reserve availability— and
in some instances to provide for secular
growth. In none of the countries surveyed
does there seem to be any specific philos­
ophy or policy with regard to the way in
which the cash base of the banking system
should be enlarged to provide for secular
growth. This lack may reflect, in part, an
overhang from the real bills doctrine,
which assumed, at least implicitly, that
growth of “commerce” would generate an
enlarged flow of bills to the central bank,
which in turn would increase the reserve
base. More importantly, in most of the
countries studied, inflows of foreign ex­
change and — intermittently — government
deficits have focused attention on the means
for controlling excess liquidity rather than
on the need to provide banks with reserves
to assure adequate monetary growth. On the
whole, therefore, it is proper to conclude
that discounting in those countries is gen­
15 Currently, between one-third and one-half of the
money supply of Italy, France, and G erm any still
consists of currency, and there is little reason to be­
lieve that the composition of the m arginal demand
for cash is different from its average composition.


erally considered as a residual mechanism
through which over-all availability of re­
serves is adjusted to longer-run growth re­
Most central. banks use the discount
mechanism— almost routinely-—to minimize
day-to-day and week-to-week fluctuations in
money market rates and gyrations in bank
reserves caused by tax payments, or other
market stresses that recur regularly, such
as those around the month-end. The extent
to which discounting is relied upon to regu­
late bank reserve positions on a day-by-day
basis depends on institutional factors and on
the availability of alternative mechanisms
in a given country. Specific situations are
discussed in several of the country reports
in Part 2; although by and large central
banks can and do rely to a considerable
extent on control at the discount window,
it is also appropriate to add that they
have no preference for discounting if other
methods of adjusting reserves, such as in­
tervention in foreign exchange markets
or use of open market operations, are avail­
Indeed, in most of the countries sur­
veyed, day-by-day adjustments in reserves
are made mainly by manipulating foreign
assets and through the domestic interbank
money markets (similar to our market for
Federal funds). This is true despite the fact
that nowhere is the interbank money mar­
ket so developed and so actively used as it
is in the United States and that there are no
close counterparts of our correspondent
banking system, which involves interbank
borrowing on the basis of credit lines.
Banks obtain only limited amounts of funds
in the regular money market, and in most
countries, except the United Kingdom and
Canada, nonbank participation in that mar­
ket is- either nonexistent (by tradition or
formal arrangements) or of marginal im­


portance (as in the Netherlands). Open
market operations are conducted in most
countries by the central bank only with
commercial banks and/or with a limited
number of other private financial institu­
tions, including dealers in government se­
curities and government and quasi-public
institutions active in the capital market.
The development and routine use of
open market operations have been thwarted
in many countries by the narrowness of the
market for government securities. The ac­
tivity in a market for government debt de­
pends to a large extent on the size, struc­
ture, distribution, and origin of that debt;
considerable differences in these factors
exist among the countries surveyed. In none
of these countries is the (central) govern­
ment debt so widely held and actively
traded as in the United States. And most of
these countries (exceptions: United King­
dom and Canada) have not succeeded in
developing a market for short-dated govern­
ment debt that is sufficiently broad and ac­
tive to provide the main avenue for supply­
ing and/or absorbing bank reserves.
In countries where it is not feasible to
use open market operations for adjusting
reserves and where the means of regulating
the impact of flows of foreign exchange are
insufficient, central bank intervention for
balancing out end-of-period positions and
for fine tuning of the money market (where
this is an objective) has been attempted
through other means, including, typically,
outright transactions and repurchase agree­
ments with the call-money market. In some
cases such adjustments take the form of
special arrangements at the discount win­
dow at the initiative of the central bank (as
in France); such arrangements perform a
function similar to repurchase agreements
in the United States.

Even in those countries in which open
market operations have become part of the
range of policy instruments used by the
central bank, such operations are not al­
ways continuous and are not necessarily un­
dertaken “at the market”; indeed, transac­
tions may be consummated at rates posted
by the central bank (as in West Germany)
or negotiated in each case (as in Japan).
In such circumstances both sales and pur­
chases usually take the form of special trans­
actions. In some instances it becomes neces­
sary to transform book credits to the govern­
ment into marketable securities before any
sales can be undertaken in the open market.
The traditional reliance on discounting,
together with the fact that commercial
banks as a whole are continuously “in the
Bank” for considerable amounts, has
tended to inhibit the extensive use of open
market operations even where suitable se­
curities and appropriate market arrange­
ments are available. For example, when
banks acquire excess cash, they tend to pay
off or reduce their borrowing (or sell funds
in the interbank market, and by this means
obviate the need for banks with deficiencies
to borrow at the central bank); hence, the
central bank does not need to sell securities
in the open market to mop up the excess
funds. On the other hand, if the central
bank permits commercial banks to borrow
almost continuously, the commercial banks
have little inducement to hold eligible se­
curities. Thus, in many countries, the pivotal
assets used for reserve adjustment are not
the lowest-yielding government securities
(such as Treasury bills), the yield on which
is usually lower than the discount rate, but
the lowest-yielding paper that is auto­
matically rediscountable (such as mediumterm paper in France).



Many of the changes that have been intro­
duced in the traditional discount mecha­
nism since World War II stem from
modifications introduced during the depres­
sion of the 1930’s. We shall discuss succes­
sively rate policy, quantitative controls, and
the use of the discount window as a tool of
selective control.
The discount rate is first of all the cost at
which cash may be obtained from the cen­
tral bank. Discounts have not only a rate
dimension but also a time dimension. A
technique widely used abroad is to require
discounts to be for a certain minimum pe­
riod, whereas in the United States empha­
sis is placed on maximum terms. Banks
normally endeavor to borrow at the low­
est cost, depending on the availability of
required collateral and on applicable terms
(such as minimum duration of a given ac­
commodation) .
Responsibility for setting the discount
rate and related rates (such as the rate on
advances) usually rests with the board of
directors of the central bank, although in
some cases this responsibility is lodged with
a separate monetary authority (such as the
Monetary Policy Board in Japan). Prior
consultation of the central bank with the
Treasury is usual in view of the generally
close relationship between the two insti­
tutions or, less frequently, as a result of
specific legal requirements (as in the
United Kingdom).
The minimum amount by which rates are
typically changed differs from country to
country and reflects tradition and trade uses
as well as policy objectives. In general, the
minimum change is normally V2 percentage
point, but some banks use steps of !4 per­
centage point, and there is some tendency
to make increases by the larger amount and
decreases by the smaller amount. (In Japan,

rates are changed by 0.365 of a percentage
point, or multiples thereof, this figure being
the equivalent of a rate of one-thousandth
of 1 per cent per day.) Decisive action is
usually symbolized by moves of a full per­
centage point in either direction, and in re­
cent years there have been even larger
changes (United Kingdom) to cope with
serious external disequilibria. By and large,
moves undertaken for external reasons in­
volve changes by relatively larger amounts
than those for purely domestic reasons, in
particular if the central bank tends to fol­
low rather than lead market developments.
Borrowing from the central bank usually
involves a hierarchy of instruments carrying
successively higher rates (and/or related
terms that tend to raise the real cost of bor­
rowing), so availability of specific catego­
ries of collateral determines the marginal
cost of borrowing. This is true even when
quantitative limitations are applied at the
window. As long as adequate collateral of a
given category is available within the bank­
ing system, the rate that it carries (such
as the Lombard rate in West Germany)
tends to become the effective ceiling on fluc­
tuations in money market rates. The cost of
marginal borrowing from the central bank
(whether determined by eligibility require­
ments or quantitative restrictions) tends to
determine market rates, unless conditions
are sufficiently easy to drive market rates
below the lowest applicable central bank
lending rate.
When commercial banks are free to
make the fullest possible use of credit facili­
ties offered, the restrictiveness of any given
discount rate depends on a number of fac­
tors including the terms of borrowing and
the relation of the discount rate to market
rates (or, more generally, to the cost of
funds from alternative sources). Because


of the signal role of the discount rate and/or
the relative inflexibility of that rate, and be­
cause certain rates on bank loans and de­
posits are tied to it, in actual practice dis­
counts and advances in some countries are
made at rates below or above the official
rate, as policy requires.
All countries covered by the present
study have a multiple-rate structure for cen­
tral bank credit. Public reference is typically
made to “the” discount rate, which is the
particular rate considered to be the key to
the whole structure of official rates. A mul­
tiple-rate structure is applied either by re­
lating rate to the characteristics of the paper
discounted or accepted as collateral, or by
establishing a progressive- or stepped-rate
structure designed to make it more expensive
to borrow larger amounts or to borrow for
longer periods. In the first case the discount
rate may be differentiated according to the
type and/or maturity of collateral, or by
different institutional classes of borrowers.
When a whole family of rates is used
instead of a single discount rate, subsidiary
rates may be linked to the main rate in a
variety of ways, including fixed or variable
differentials; alternatively, subsidiary official
rates may be linked to a significant market
rate (for instance, the Treasury bill rate) as
well as to the main discount rate. Such
multiple-base linkage offers greater flexibili­
ty for adjusting the cost of borrowing to
market conditions without requiring fre­
quent changes in the discount rate itself
(as in the case of the double-base system
for lending to money market dealers in
Canada). More generally, under a multiplerate structure with variable differentials,
changes in the structure of effective rates
can be made more frequently than in the
basic discount rate.1
™ F o r instance, from Dec. 3, 1959, to Apr. 8,
1965, there were a num ber of changes in one or
more of the specific rates for discounts or advances

Progressive-rate structures are used es­
sentially to reduce administrative problems
at the window. In some cases progressive
rates are applied without introducing dis­
count quotas, and in some countries it is in­
deed believed that such rates are an alter­
native to quantitative regulations. Foreign
experience includes a great variety of exam­
ples of (1) progressive-rate structures as a
function of size of borrowing (related to
capital, reserves, assets, or some other mag­
nitude) and duration of borrowing (Swe­
den, France); (2 ) posted or negotiated
rates for borrowing in excess of basic quo­
tas (Japan, France); and (3 ) preferential
rates for specific types of instruments or
categories of loans (France).
When the central bank endeavors to keep
its discount rate above important market
rates at all times, or to make the effective
cost of borrowing higher than for compara­
ble borrowing in the market, such rate is
usually referred to as a “penalty rate.” 1
When a central bank has a progressive-rate
structure, all rates above the basic rate are
usually considered penalty rates. If deemed
necessary, the central bank may operate in
the call-money or government securities
market with the specific purpose of keeping
market rates below a certain penalty-rate
Penalty rates are also used (1 ) to sup­
port other tools of monetary control, such
as observance of liquidity ratios (Sweden);
(2 ) to penalize re-lending of borrowed re­
serves by banks; and (3 ) as a means of
regulating borrowing above quotas or as a
measure of restraint if there are no quotas.
Continuous or too-frequent borrowing may
of the Bank of France (the total num ber of changes
was 17), whereas the basic discount rate was
changed only eight times.
17 In the context of this study, the term “penalty
rate” refers to a level in relation to m arket rates,
and “progressive rates” to the structure of rates.


be reduced by applying penalty rates after
a set period or for repetitive recourse to the
window within a determined period; in the
last case, penalty rates may apply to an in­
dividual bank (as in Canada), or they may
apply to all commercial banks, when such
banks, collectively, have been in debt for
more than a specificed number of days (5
days in Sweden). In some cases the penalty
rate is graduated in such a way as to become
almost prohibitive if borrowing reaches a
certain margin above the normal quota (the
“superhell” rate in France) or so high as
not to be used because funds can be ob­
tained more cheaply by other means.
A willingness to borrow at a cost higher
than the basic discount rate has been inter­
preted in several countries (France and
Japan, for the second tranche of progres­
sive rates) as prima-facie evidence of ex­
treme tightness in credit. The central banks
of these countries have made it a policy
rule in such cases to relieve the pressure by
injecting reserves through open market op­
erations or by other means in order to
avoid high marginal rates (such as the “superhell” rate in France and the second-tier
penalty rate in Japan) and to avoid push­
ing money market rates to excessively high
levels. Foreign experience also suggests that
a progressive structure of the discount rate
tends to produce discontinuities in the rate
curve around the steps and that the steps
may pose problems for monetary policy.
The principle that central bank credit
should always be available— though at pen­
alty rates— is thus preserved, but the ulti­
mate penalty rate is used mainly to encour­
age banks to adjust their reserve positions
through borrowing in the open market or by
selling securities. It may be noted, however,
that a policy of maintaining the penaltyrate status of the discount rate when an
increase in the discount rate appears inap­


propriate (Canada) may lead to periods of
excessive ease if reserves are supplied
through open market operations in order to
prevent a rise in market rates.
In many countries deposit and/or lend­
ing rates (or important segments of the rate
structures) of commercial banks are auto­
matically tied to the discount rate. Such
linkages have come into existence in a vari­
ety of ways: (1 ) as a result of the depres­
sion of the 1930’s, (2 ) under war emergen­
cies, (3 ) as part of control measures
instituted by totalitarian governments, or
(4) as .a result of actions by bankers’ asso­
ciations, with or without official review
and/or sanction. When lending rates are
rigidly linked to the basic discount rate, the
cost of discounting at higher (including
penalty) rates cannot be passed on readily
to customers; the resulting pressure on profit
margins constitutes an additional restraint
for meeting customers’ loan demands.
Tying of commercial bank rates to the
discount rate may have a certain degree of
flexibility. Margins relating commercial
bank rates to the discount rate may be var­
ied from time to time; also, commercial
bank rates may follow changes in official
rates not automatically but rather with a
delay of a varying length. In some countries
at least, and depending on credit condi­
tions, undercutting of stipulated minimum
rates or concealed additional charges are
not unknown.
Rigid tying of deposit and lending rates
to the discount rate is inimical to flexible
use of the discount rate for monetary policy
purposes. As already mentioned, some
countries have tried to resolve the problem
by lending to banks at rates that were ac­
tually higher or lower than the official dis­
count rates. In recent years there has been
a tendency to loosen or remove such tradi­
tional or institutionalized linkages.


Most of the countries surveyed have not
been able to place exclusive reliance on the
discount rate for controlling aggregate bank
reserves, that is, to rely on rationing through
rate alone and on keeping an “open win­
dow” at that rate. Those that traditionally
relied on regulation through rate (for ex­
ample, the United Kingdom) have found it
necessary in recent years to make consider­
able use of moral suasion, aiming at quanti­
tative limitation (but avoiding overt, rigid
control) of commercial bank lending, and
to apply such limitation to a steadily widen­
ing circle of credit institutions. Even those
central banks that have continued to place
exclusive or primary reliance on the rate
have found it necessary in recent years to
differentiate the cost of accommodation at
the discount window; a recent example of
the need for greater flexibility in rate ad­
ministration to differentiate between the cost
of discounts relevant for the international
flow of funds and for regulating the domes­
tic money market without changing the rate
was provided in the United Kingdom.
Some of the countries surveyed have at­
tempted to limit the growth of bank credit
to specific maximum amounts; in so doing
they have used a variety of quantitative re­
strictions. Quantitative controls may apply
to reserves (usually, to the aggregate vol­
ume of discounts) or directly to some or all
bank assets. They may be geared, as in
France, to credit targets specified in na­
tional economic plans. Various techniques
to limit bank credit expansion directly have
been used at different times in various
countries. Direct control of total redis­
counts, reserves, and/or loan volume is
usually supported and reinforced by various
forms of moral suasion; Japan is a conspic­
uous example.

Controls may involve fixed limits for
loans or total assets or maximum permissi­
ble rates of increase during specified time
periods. Alternatively, the ratio of loans to
deposits, or to some other total among a
bank’s assets or liabilities, is made subject
to regulation. Still another method of con­
trolling demand at the discount window is
by freezing a certain volume of eligible as­
sets in bank portfolios through separate
liquidity ratios.1 From time to time the
central bank may vary the list of liquid
assets that qualify for inclusion; further­
more, it may stipulate minimum percent­
ages of specific assets (such as Treasury
bills) to be held within the over-all liquid­
ity ratio. The (variable) liquidity ratio
( coefficient de tresorerie) in France, no
longer in force, was an outstanding example
of this technique.
Some central banks use discount quotas
(credit lines) as a means of influencing di­
rectly the total volume of bank credit.
These quotas are the fulcrum against which
rate policy becomes effective. Discount quo­
tas are typically used in countries where al­
ternative monetary policy tools (such as
open market operations) to control the re­
serve base are not available or cannot be
used meaningfully and/or where variable
cash reserve requirements are not available
to control the credit multiplier. In several
countries discount quotas have proved inad­
equate to achieve this goal, and they have
had to be supplemented later by ceilings on
total loan volume or by other quantitative
Still other countries have concluded that
only a direct control over bank credit
would achieve their policy goals, but they
18 In other countries, such as West G erm any and
Switzerland, liquidity ratios are imposed for other
than m onetary policy reasons.


have retained discount quotas as part of the
control mechanism. Indeed, a central bank
that directly controls the total volume of
bank credit may downgrade the role of dis­
count quotas— or may dispense with them
altogether— and supply reserves readily
(while at the same time taking into consid­
eration the volume of reserves acquired
from, or absorbed by, other sources) as
long as credit expansion remains below tar­
get limits.
Quotas to regulate the volume of dis­
counts are set— and modified— on the basis
of broad policy considerations. Such quotas
may be set for total borrowing from the
central bank, or for discounts (as in West
Germany after 1952); and additional credit
lines may be established for advances.1 Ad­
ditional quantitative limitations may apply
to the permissible amounts of specific types
of assets within the total discount quotas.
In fact, discount quotas may be equivalent
to credit lines with no questions asked, or
they may be conditional on the borrower’s
conforming with the wishes of the central
bank or on the observance of specific,
stated ground rules.20
Quantitative regulation of access to the
discount window always raises questions of
equity and flexibility. Setting of discount
quotas for institutions (and administration
of these quotas) must steer between exces­
sive generosity, which might interfere with
the conduct of monetary policy, and exces­
sive restrictiveness; in the latter case, the
problem of above-quota accommodations
becomes chronic. Quotas may be geared to
bank capital, liabilities, past changes in se19 In several countries in which dealers in govern­
ment securities are an im portant elem ent in the
mechanism through which m onetary policy is imple­
mented, separate lines o f credit may be established
for them. A related reason for such credit lines is
the endeavor to develop a national capital market.
20 Access to central bank credit still depends
on availability of proper collateral in an individual
institution’s portfolio.


lected balance sheet items, or a number of
other variables.2 Quotas need to be adjusted
upward over time to keep in step with the
growth of the economy and its expanded
credit needs because the variables on which
quotas are based, such as capital funds, do
not necessarily grow at the same rate as do
the needs that the quotas are designed to
meet. Adjustments may be automatic or may
be subject to discretionary determination.
Techniques used for setting and changing
discount quotas for individual institutions 2
range from complex formulas (as in West
Germany) to informally determined acrossthe-board percentages (as in the case of ad­
vances in Italy). Various approaches have
been developed to revise ceilings in the light
of growth requirements and, in some coun­
tries, changing policy objectives.
Quotas may be left unchanged for long
periods (as in Canada) or recalculated fre­
quently on the basis of formulas (monthly
in West Germany, quarterly in Japan), or
they may be administered informally, in the
guise of approximate guidelines (as in
Italy). Attempts to reduce the area of ad­
ministrative judgment and/or to provide for
gradual increases in quotas by linking them
to such balance sheet items as short-term
liabilities (and medium-term liabilities, if
the borrowing financial institution is a sav­
ings bank) foundered on the hard fact that
any addition to reserves may lead to sec­
ondary credit expansion, which in turn
would provide the justification for a further
rise in the quota. Indeed, any automatic
linking of quotas to bank assets or liabili­
ties (or other growth variables) carries
with it the danger of an automatic inflation
of quotas. Obviously, when quotas are
21 The smaller banks may be given special consid­
eration in setting or administering discount or loan
22 In at least one country (F rance) revisions of
ceilings were negotiated with the banks involved.


based on capital accounts, some degree of
manipulation of the base by individual
banks is possible because the banks can in­
crease their capital accounts.
Some degree of flexibility is generally
provided in one of the following ways: (1 )
by permitting banks to exceed over-all dis­
count quotas at a penalty rate or under spe­
cial conditions, (2 ) by exempting from
the quota certain categories of paper (such
as medium-term paper covering approved
financing of equipment or of exports), (3 )
by establishing additional quotas for. spe­
cific categories of credit instruments, (4 )
by granting or negotiating temporary sup­
plementary quotas for purposes and
amounts specified in advance (such as to
meet money market pressures at the end of
the month), or (5 ) by negotiating such
quotas on a case-by-case basis to accommo­
date specific situations (West Germany).
Some flexibility is essential where the central
bank does not possess adequate alternative
tools for meeting exceptional or unexpected
Such “overline credit” may take the form
of (temporary) supplementary quotas at
regular rates granted for specific reasons
and for limited periods (West Germany).
Normally, however, borrowing above the
quota is available only at a penalty rate and
is subject to quantitative restrictions or
“window guidance.” The cost of above­
quota accommodation may be stepped in
such a way as to become, in effect, prohibi­
tive beyond the first “tranche” above the
basic quota (France). Alternatively, bor­
rowing above. ceilings may involve merely
the obligation to adjust borrowing down­
ward in subsequent periods.
Under a system of discount quotas,
tighter monetary policy usually has a perva­
sive effect, inasmuch as banks that are close
to exhausting their leeway under quotas tend
to sell discounted bills to banks in a more

comfortable position. As a result, total bor­
rowings tend to rise toward the aggregate
quota ceiling; market rates also tend to rise,
and the upward pressure on rates is rein­
forced as some banks begin to borrow at
penalty rates. In effect, while offering addi­
tional accommodation at a penalty rate and
under restrictive conditions, as a privilege
rather than as a right, the central bank
counts on the rate to inhibit credit expan­
sion beyond the limits set by quotas.
The effectiveness of discount quotas de­
pends on a skillful combining of quantity
and rate controls. But it also depends on
the availability and cost of alternative
sources of reserves and on the volume of
liquid assets the banks have at their dis­
posal, as well as on whether or not the bal­
ance of payments is generating a significant
surplus. From the point o f view of mone­
tary policy,23 the main advantage of a
formal quota is that it reduces problems of
day-to-day administration of the discount
window by stating unequivocally how much
each bank may borrow within the frame­
work of established discount policy. In fact,
a discount quota indicates the amount that
an individual bank feels it can borrow as a
right, as long as it adheres to clearly stipu­
lated ground rules. To a large extent, ad­
ministrative problems are shifted from the
control of total borrowing to the control of
“overline” borrowing.
The use of discount quotas as a tool of
monetary control raises at least two ques­
tions: (1 ) what is the role of unused quo­
tas (the “unused margin”) and (2 ) how
can changes in quotas be used to implement
One of the widely recognized limita­
tions of quotas is the stated or implied right
-3 As distinct from the use of rediscount quotas to
protect the central bank from possible losses as a re­
sult of excessive lending to individual banks (as in
West G erm any before 1951).


on the part of banks to make full and con­
tinuous use of the quotas; such use, except
for the cost involved, amounts in effect to
an equivalent reduction in reserve require­
ments or in prescribed liquidity ratios.
Usually, there are considerable differences
in the actual use that various categories of
banks make of the credit lines available to
them. On the other hand, the effectiveness
of discount quotas depends, in part, on the
policy of banks to exhaust the quotas and
to require additional accommodations when
loan demands build up and/or on the un­
willingness of the central bank to permit
continuous use of the full quotas. In some
countries banks normally use only part
(but typically a substantial part) of their
credit lines but shift to fuller use when
official credit policy becomes
restrictive.24 The typical attitude of banks
toward utilization of quotas thus becomes
an element in setting their over-all level. In
formulating its day-to-day operating objec­
tives, a central bank must take into account
the willingness of banks to reduce further
the leeway available under credit lines. On
the other hand, under a system of discount
quotas, the margin between current borrow­
ings and the quota ceiling tends to become
an important consideration in determining a
commercial bank’s lending policy.2
The attitude of central banks toward in­
terbank trading in excess reserves is not
uniform. Not all foreign central banks
frown upon or penalize re-lending at a
profit. In most European countries bor­
rowing to re-lend is considered consistent
with the normal use of lines of credit; in
others (such as Sweden) it is not. In coun­

24 This is even true when, as in Italy, banks are
expected to repay their advances completely from
time to time and not to return to the window im m e­
25 Italian and West G erm an banks even include the
unused m argin in computing their liquidity positions.


tries in which re-lending (through an inter­
bank money market) is recognized as part
of the adjustment process, borrowing in
order to re-lend in the interbank market
and/or for buying bills from banks that
have exhausted their quotas is common.
Even when a penalty rate is involved,
banks with unused margins may still have a
strong inducement to discount for the pur­
pose of lending to the market (F rance).
Discretionary changes in credit lines
are used:
a. To meet special situations (such as
the reduction in these lines in West Ger­
many in 1964 to offset foreign borrowing).
b. As a sanction against nonobserv­
ance of the rules of the game or for noncompliance with the expressed wishes of the
central bank. (For instance, in West Ger­
many; in 1965, the Governor of the Bank
of France in his capacity as Vice-Chairman
of the National Credit Council, in a pub­
lished letter to the Banking Association,
threatened to reduce quotas of banks that
expanded credit too rapidly.)
c. As a countercyclical measure. The
central bank can achieve greater ease or
tightness merely by changing aggregate
quota ceilings and in this way bring about a
commensurate change (other things being
equal) in the amount of the “unused mar­
gin” (Japan).
d. For ordinary business reasons, such
as failure to meet bank examination stand­
ards, deterioration of bank management, or
adverse developments in the financial posi­
tion of the borrower (West Germany).
Thus, the role of discount quotas as a
tool of credit control depends on prevailing
bank attitudes toward them; these attitudes
in turn depend in large part on whether,
under what conditions, and at what cost a
given category of credit institution can ex­
pect to obtain central bank credit beyond
the unused portion of the quota. Uncer-


tainty about bank attitudes toward this unused margin is, indeed, one of the basic difAcuities of operating with discount quotas.

West German experience also suggests that
these attitudes may not be consistent over

In countries in which discounting is used as
a means of selective credit control to influ­
ence the distribution of bank credit
(France, West Germany, and Japan being
the most important examples), certain
types of loans may be exempt from over-all
quota ceilings or may benefit from specific
additional quotas.2
Typically, certain types of investment
and export credits are favored, and prefer­
ential discount rates may apply to such
paper (as in France). Conversely, lowpriority activities may be discouraged by
quantitative, cost, or eligibility restraints at
the window. In some countries discount
rates are structured in such a way as to en­
courage specific categories of lending, or of
lending on specific terms. The structure of
rates at the window becomes an indirect
means of influencing portfolio composition.
Distributive considerations (selective con­
trols) may also be made effective within
over-all discount (or credit) quotas if pref­
erence is given to certain categories of
paper, either through automatic access to
the discount window (frequently after prior
approval of credit by the central bank) or
through preferential rates, or through a
combination of such techniques. In fact,
such policies amount to direct central bank
financing of favored economic activities,
provided the funds supplied are in effect
used for the purpose intended; evidence
on this point is contradictory.
26 As an alternative to using the discount mecha­
nism directly as a means of qualitative credit regula­
tion, it may be used indirectly to enforce compliance
with selective credit policies applied through other
techniques (West Germany, Italy).

Sometimes a privileged status is given to
credits that private lenders would not have
undertaken without what really amounts to
a take-out commitment by the central bank
(France); private credit is thus substituted,
at least temporarily, for central bank credit
or Treasury resources. Endowing certain
credits with privileges at the discount win­
dow has the double aspect of selective
credit controls (credit direction) and crea­
tion of additional bank liquidity. The fa­
vored assets become, in effect, instruments
of secondary liquidity that give their holder
automatic access to central bank credit at
his option, since they can be converted into
reserves without prior notice.
Extension of preferential treatment to
specific types of credit (or instruments)
usually involves obtaining a preliminary au­
thorization— usually in the form of a certi­
fication by affixing a “stamp” or “visa”
from the central bank or the proper pri­
mary discount institution (see below) —
which is tantamount to a commitment to
discount the particular loan on presenta­
tion, at the holder’s option.2 “Stamped
bills” (Japan) or “visaed bills” (France),
kept in the portfolio of the original lender
(commercial banks), are in effect instru­
ments of secondary liquidity since they may
27 More generally, in some countries commercial
banks may obtain, in the form of a “visa” or
“stamp,” the central bank’s advance certification that
a particular credit is eligible for discount. Some cen­
tral banks review in advance all bank loans, or all
credits above a certain amount, to determine their el­
igibility at the window (Belgium). Such review
usually amounts, in effect, to screening and tends to
have some selective control aspects.



be converted into cash without question at
any time. After banks have obtained an of­
ficial seal of approval, they may be more
willing to hold such paper in their portfo­
lios than they otherwise would.
Indeed, some countries have used the ad­
vance approval technique (in particular,
when coupled with the availability of pref­
erential rates) to induce commercial banks
to enter new fields of lending (mediumterm loans) or to expand their assets in
specific areas in line with over-all govern­
ment economic policy. In effect, an uncon­
ditional agreement to discount through the
technique of formal advance agreements
permits the central bank to add at its own
discretion (and under certain conditions, in
a discriminatory manner) to the liquidity of
the banking system. In some countries, dis­
counting of certain instruments outside of
quotas has impaired the control by central

banks of over-all credit expansion. As a re­
sult, certain central banks have found it
necessary to put an outside (global) limit
on the volume of such preferred paper that
they would discount (West G erm any).2
Pursuance of multiple-policy goals by
countries using quantitative credit tools
sometimes results in complex schemes
under which the over-all effectiveness of
ceilings is undermined by various excep­
tions. More generally, the use of the dis­
count mechanism as a tool of selective
credit control tends to render more difficult
the implementation of over-all monetary
policy, especially when the discount win­
dow is used to stimulate particular activi­

28 For description of a special technique to restrict
rediscounting of exempt paper, see the chapter on

Access to the discount window need not be
direct. It may involve the use of a discount
market or of primary discount institutions.
The oldest and classical example is the in­
terposition of the discount market. Through
discount houses in the United Kingdom it is
possible for banks to even out some of their
reserve surpluses and deficits at rates that
may be below the official discount rate, if
warranted by money market conditions.
And if banks that have deficits obtain cen­
tral bank credit through discount houses,
they may be able to conceal their identity,
at least temporarily (C an ad a).
In other countries— in some cases as a
result of the financial crisis of the 1930’s—
special primary discount institutions have
been created, and these in turn rediscount
with the central bank. But in particular in
periods of stress, traditional eligibility re­

quirements have often proved too rigid to
permit injection of needed liquidity. To cope
with this type of problem some countries
have created separate official institutions,
the specific purpose of which is to redis­
count paper not eligible at the central
bank’s discount window. In order to carry
portfolios of such instruments, these institu­
tions usually also borrow in the short-term
money market— sometimes on call— and
from the central bank, and they are given
access to the latter’s rediscounting facilities.
These institutions (1) provide credit for
carrying out certain government economic
policies without directly involving the cen­
tral bank; (2) extend credit on terms that
are more flexible with regard to maturity,
collateral, and quality than available from
the central bank; (3) give additional flexi­
bility to the conduct of credit policy, in


particular when expansion is desired; and
(4) contribute to broadening credit and
capital markets by substituting their own
credit for that of their borrowers, by bor­
rowing at short term in order to discount
medium-term debt, and in other ways.
Some countries have created specialized
credit institutions to close a credit gap and
in particular to stimulate medium-term
financing. These institutions, which nor­
mally are government sponsored, also act as
primary discount institutions by discounting
credits that originate in specific activities
considered worthy of official support (typi­
cally export trade, but also public construc­
tion, equipment financing, and others).
They have access to rediscounting at the
central bank to the extent that alternative
sources of funds to finance their activities
are insufficient. Such sources typically in­
clude: (1) their own funds; (2) borrowing
in the money market; or (3) special re­
sources, such as Treasury deposits or long­
term funds raised in capital markets
(Belgium). Primary discount institutions
have extensive direct dealings with commer­
cial banks and usually cooperate closely
with their respective central banks.
In fact, primary discounting institutions
are a conduit for central bank credit on the
basis of collateral of a maturity or quality
not acceptable for regular central bank op­
erations. Typically, short-term instruments
(eligible at the discount window) are is­
sued against a portfolio of debt instruments
of longer maturity; this procedure is known
as “liquefying” or “mobilizing” long-term
assets. An alternative technique is for these
institutions to hold medium-term paper
until it moves close enough to maturity to
become eligible at the discount window.

The official rediscounting institution may
provide the additional endorsement (usually
the third “name” ) required to make the
instrument rediscountable at the central
bank. It also normally examines the loan
application and issues an advance discount
commitment without which the original
lender would not make the loan or would
accommodate the borrower only at a higher
rate (France).
By changing the conditions under which
it makes such rediscounts, or by varying the
ceiling for such rediscounts, the central
bank has a potentially powerful means of
controlling the activities of these public in­
vestment and primary rediscounting institu­
tions. Frequently, however, there is little
room for use of discretionary policy be­
cause the central bank is expected to imple­
ment government policies carried out by
the specialized institutions.
In some respects the specialized central
credit institutions resemble similar govern­
ment credit institutions in the United States,
which also use borrowed or Treasury funds
to finance certain sectoral activities (such
as housing). In contrast, foreign specialized
credit institutions typically rely in the main
on the rediscount technique for obtaining
official financial assistance.
Credit activities of primary discount in­
stitutions require adequate and continuous
coordination with over-all objectives of
credit policy. These institutions are usually
subject to direct and close supervision by
the Ministry of Finance, and there is nor­
mally little room for policy conflicts. To
meet such conflicts, if they do occur, sev­
eral countries have created special coordi­
nating bodies, such as the National Credit
Council in France.



Uniform administration of the discount fa­
cility does not pose significant problems
abroad because the central bank operations
are directed from one single center. This is
true even in Germany where the “Landeszentralbanken” are the closest counterpart
of Federal Reserve Banks that can be found
abroad. Discounts are usually available at
all branches of the central bank, whether the
branches are few (as in the United King­
dom) or relatively numerous (as in Italy or
France). Uniform discount administration
is assured by issuing rules and regulations
to regional and local offices. When neces­
sary, quotas are assigned to each office to
assure that the aggregate amount of dis­
counts does not exceed over-all ceilings
determined by the head office. Daily report­
ing of discounts and advances made (and
maturing) permits the head office to exert
tight and current control and to make quick
changes in individual branch-office quotas
when necessary.
Because of the prevalence of branch
banking, a large proportion of the paper
that originates locally is discounted at the

head office of the central bank. The cash
position of a branch system is normally
managed centrally by the head office. When
need to rediscount arises, the head office,
in its dealing with the central bank’s main
office, offers paper that originates at branch
offices as well as at the head office. This is
not necessarily true in countries where the
headquarters of some of the leading na­
tional branch-banking systems are not lo­
cated in the capital (as in Japan) or where
important regional branch systems exist (as
in France, Italy, and West G erm any).
Uninhibited access to the discount win­
dow and transactions undertaken by the
central bank to bridge short-term swings in
reserve availability permit banks in most
countries to reduce the demand for excess
reserves to near zero.2
29 Also, in some countries, the reserve ratio needs
to be observed only on specified control days, such
as the end of the month. The absence of the need
for meeting cash reserve requirements within rela­
tively short periods reduces the pressure for develop­
ing detailed and up-to-date data of the kind on
which the Federal Reserve System bases its elaborate
and continuously revised projections of reserve needs
and availability.

Although still an important tool of mone­
tary policy, discounting has lost the central
position it held so long; the change began
after the banking crises of the 1930’s and
has become clearer since World War II. In
almost all of the countries surveyed, central
bank policy has come to rely on additional
tools of monetary control, while the discount
mechanism itself has undergone in many
countries considerable changes, with great
emphasis placed on quantitative limitations
rather than on eligibility requirements.
Several developments contributed, in

varying degree, to reducing the original sig­
nificance of the discount tool. World War
II created conditions of excess liquidity and
caused significant changes in the institu­
tional environment. These in turn required
the introduction of new monetary tools (in
some cases, following their development in
the United States) and led— in some coun­
tries at least—-to closer integration of mon­
etary management with over-all economic
controls and planning. It is, indeed, not im­
proper to speak of a “politization” of the
discount rate inasmuch as practical limits


for discount rate variation, and in some
cases conflicting domestic and balance of
payments considerations, have tended to re­
duce the scope of control through manipu­
lating the rate.
In some countries where progress toward
developing flexible and effective open mar­
ket operations has been slow, one can
discern a tendency to regard changes in re­
serve requirements as an alternative. By
and large, however, there has been some dis­
enchantment with the potency of variable
reserve requirements as a tool of monetary
control, and as a result there has been a
tendency to introduce or expand direct con­
trols. In the larger continental countries in
particular, but also in Japan and in several
other countries, direct quantitative regula­
tion of bank liquidity and/or bank credit
has become an integral and important part
of monetary controls.
Inability of central banks to use open
market operations as a main tool of mone­
tary policy, as well as difficulties encoun­
tered in developing adequate new tools of
monetary policy (such as variable reserve
requirements, or even fixed reserve require­
ments), have tended to keep the discount
function as one of the important tools of
monetary policy, as well as a tool that is
useful in the management of liquidity of ex­
ternal origin. The only routine means by
which central banks can help commercial
banks meet short-term fluctuations in their
reserve positions is by rediscounting the
paper held by these banks or by making ad­
vances to them. But with its rationing func­
tion much reduced, the discount rate has
become in several countries mainly a peg
for manipulating the structure of a variety
of commercial bank and other rates.
Even when the average amount of re­
serves provided to the banking system as a
whole through the discount window over

the year is relatively small, the marginal role
of these reserves may be important. Simi­
larly, changes in the discount rate may have
considerable significance even though they
affect directly the cost of only a small frac­
tion of the reserves in use. One reason is
that deposit and lending rates of commer­
cial banks are geared to the discount rate;
another is that changes in the rate may
be of crucial significance in achieving desir­
able flows in international accounts.
In some countries (Netherlands, Bel­
gium) the rate still has an important do­
mestic signal function through its announce­
ment effect, but that function has been
lost in others, mainly because changes
have always been very infrequent (Italy) or
because the rate has been tied to a market
rate (as in Canada, 1956-62). Except in
Canada and Switzerland— where discounts
and advances are of quite marginal signifi­
cance, although for different reasons— dis­
counting continues everywhere to be an im­
portant tool of central bank policy, and in
some countries it has become an important
avenue for achieving economic objectives of
government policy outside the credit field.
In these countries the use of the discount
window was broadened— not primarily be­
cause it was judged to be a more powerful
means for controlling money and credit,
but because it provided a convenient way
for achieving certain government policy
objectives. To some extent it appeared to
be a natural way of utilizing the money-cre­
ating power of the central bank to meet
some of the new challenges of the postWorld-War-II era and to provide another
indirect way for government guidance of
the economy— by now an unquestioned
principle in all of the leading industrial
countries surveyed.
Many countries expect to achieve greater
policy flexibility by developing open market


operations and a more sophisticated man­
agement of fluctuations in foreign exchange
reserves, rather than by rejuvenating the
discount mechanism. But understandably,
central bank attitudes vary toward the pres­
ent role of discounting in relation to other
tools of monetary control and potential use
in the future.
In view of the numerous modifications
that the discount mechanism has already


undergone in most of the countries sur­
veyed, it seems safe to assume that further
evolution is likely, as conditions change
and new challenges arise. Only history will
show in what countries, and in what ways,
changes in the setting and objectives of
monetary policy and the gradual emergence
of other tools of monetary management will
change the relative role of discounting as a
tool of monetary policy.


Part 2



Austria ___


Banking system
Reserve requirements
Discounts and advances
Other instruments of monetary policy
B e lg iu m ___________________________________________________________________________ 207

Institutional framework
Discounts and advances
Other instruments of monetary policy
C a n a d a ____________________________________________________________________________ 214

Institutional framework
Discounts and advances
F r a n c e ____________________________________________________________________________ 219

Institutional structure
Instruments of monetary policy
Discounts and advances
Federal Republic of G e rm an y _______________________________________________________ 233

Banking system
Discounts and advances
Other instruments of monetary policy

Institutional framework
Discounts and advances
Other instruments of monetary policy


Contents Cont.
J a p a n _____________________________________________________________________________ 246

Institutional framework
Discounts and advances
Commercial bank interest rates
Other instruments of monetary policy
Quantitative role of central bank credit policy
N e th e r la n d s _______________________________________________________________________ 253

Structure of the banking system
Mechanism through which monetary policy operates
Discounts and advances
S w e d e n ___________________________________________________________________________ 259

Institutional framework
Discounts and advances
Other instruments of monetary policy
S w itz e r la n d _______________________________________________________________________ 263

Banking structure
Instruments of monetary policy
Discounts and advances
United K in g d o m ___________________________________________________________________ 268

General background
Institutional framework
Discounts and advances
Other instruments of monetary policy
Relationship of other interest rates to the discount rate

Part 2

The chapters in this part describe the essen­
tial aspects of the discount mechanism in
the 11 countries covered by this study. No
attempt has been made to keep the struc­
ture and coverage of the individual chapters
uniform. The general aim has been to in­
clude only those details that seem essential
to bring out the framework in which the
discount mechanism is operating in each of
the countries covered, to relate the mecha­
nism to other tools of monetary control,
and to describe specific processes and tech­
niques. The emphasis is on post-World-WarII developments; it did not seem necessary

to trace the historical evolution of the dis­
count mechanism in each of the 11 coun­
tries. In some cases, however, it seemed
useful to describe policies or techniques
now supplanted.
It has not proved possible to present a
comparative analysis of the role of dis­
counting in quantitative terms without at
the same time adding considerably to the
explanatory material. Therefore we con­
cluded that little would be gained— con­
sidering the over-all objective of the study
— by including statistical data that were
limited and not entirely comparable.


From the time Austria recovered sover­
eignty— through the 1955 State Treaty—
until the National Bank Law was amended
in 1969, the country was obliged to con­
duct its monetary policy with narrowly cir­
cumscribed central bank powers. After re­
covering sovereignty, Austria had little
choice but to integrate as closely as possible
with the international economy and to live
with the ebb and flow of international capi­
tal. Nevertheless, it still had to face the
problem of domestic monetary control.
Owing to the small size of the country’s
cash base in relation to international flows
of funds, the most important problem of

monetary control was to minimize any dis­
ruptive effects of changes in the cash base
arising from changes in central bank inter­
national reserves. The increase in Austria’s
international assets in the 5 years ending
December 1965 was equivalent to twothirds of the cash base of the banking sys­
tem at the end of 1960, which totaled only
$900 million. Maintenance of monetary
control under such conditions requires pow­
erful tools, but the monetary authorities
were not well equipped even with the tradi­
tional policy tools.
Prior to the 1969 amendment monetary
policy had been implemented primarily
through official ceilings on the volume of


bank credit. The discount mechanism had
played only a subordinate role. Moreover,
in rudimentary money and capital markets,
the central bank’s open market powers were
virtually useless as a means of offsetting the
effects on the cash base of the large growth
of the central bank’s holdings of interna­
tional assets. Likewise, its authority to vary
reserve requirements was too narrow in
scope— certainly too narrow to absorb into
reserve balances the funds that the commer­
cial banks had acquired as the result of sur­
pluses in Austria’s balance of payments.
Realizing their predicament, the authori­
ties rarely used the discount rate for domes­
tic monetary control purposes. However,
borrowing at the central bank was con­
trolled to some extent— with access to cen­
tral bank credit (whether in the form of
discounts or advances) being regarded as a
privilege. For control purposes, the authori­
ties resorted fairly often to changes in cash
reserve requirements— more often than to
changes in central bank rates.
Monetary powers in Austria are shared
to some extent with the Ministry of Fi­
nance. Inasmuch as they had little influence
on the cash base of the banking system, the
authorities implemented their monetary pol­
icy primarily through direct controls over
bank credit. These controls included the
so-called voluntary credit ceiling agree­
ments between the Ministry of Finance
(rather than the National Bank) and the
credit institutions, and also prescribed ob­
servance of compulsory liquid asset ratios.
The ceiling applied to all types of credit in­
cluding credit to the Government and credit
to the private sector; exceptions were made
only for special categories such as export
credit. The ceiling was set in terms of per­
centages of the bank’s total liabilities and
of its net worth. No penalty was imposed
for violation of the ceiling, but the latter
was not exceeded by all the banks taken to­

gether. When total bank credit approached
the ceiling in 1966, the authorities raised
the ceiling.
Under the 1969 amendment to the Na­
tional Bank Law, the Austrian National
Bank was given far wider powers to pursue
an effective monetary policy. In particular,
the National Bank’s power in the field of
reserve requirements and open market pol­
icy was increased considerably. The Bank
now has the authority to sterilize large in­
creases in foreign deposits. Although not
enough time has elapsed to make a firm
judgment on the over-all effects of the
changes in the National Bank Law, it ap­
pears that the National Bank has tended to
take a more active posture in monetary pol­
icy, particularly since signs of inflationary
pressures began appearing in the economy
in late 1969. While the 1969 amendment
of the central bank law does not contain
any provisions relating specifically to the
discount mechanism, the over-all strength­
ening of the National Bank’s powers may
increase the importance of the discount
mechanism in the future.
In its current state of evolution, Austrian
monetary policy seems to be in transition
from a stage where the volume of credit
was controlled chiefly by direct means to
one where the conventional tools of mone­
tary policy are becoming more important.
During most of the 1960’s Austria was
troubled by a slow rate of growth and had
few problems with inflation. The primary
task of monetary policy in this period was
to deal with the effect of fluctuations in in­
ternational reserves on the money supply.
In times of capital inflows the use of con­
ventional monetary policy instruments leads
to higher interest rates, which encourage in­
creased inflows of capital and thus further
aggravate the problem. Hence, prior to
1965, when there was a surplus in the bal­
ance of payments, the Austrian authorities


had to rely on direct controls to achieve
their monetary aims. In 1965 and 1966
when the country began to experience bal­
ance of payments deficits, this policy be­
came less effective. In the backspin of the
German recession, Austria’s rate of growth
slowed considerably during 1967, and the
authorities were forced to give primary con­
sideration to domestic rather than balance
of payments objectives in their monetary
policy. Liquidity ratios and credit ceilings
remained unchanged, but monetary policy
was eased by lowering reserve requirements
and the discount rate. And in 1965 the Na­
tional Bank began to engage in open m ar­
ket operations.
Banking system

Half of the stock of the Austrian National
Bank is owned by the Government; the
other half is held partly by bodies repre­
senting the interests of businesses and their
employees and partly by credit institutions
and insurance companies. The majority of
the board of directors is appointed by the
Government (the remaining members being
elected by the shareholders other than the
Government), and the President of Austria
appoints the president of the Bank. The
board of directors appoints the Bank’s gen­
eral manager, his deputy, and four manag­
ers to conduct the day-to-day affairs of the
Bank and to implement its monetary policy
decisions. A commissioner appointed by the
Ministry of Finance attends the board’s
meetings to assure that the policy actions
taken are in conformity with the law. In re­
cent years, the formulation and implemen­
tation of monetary policy have involved close
cooperation between the central bank and
the Ministry of Finance, which is vested
with important monetary control powers.
The banking system with which the au­
thorities deal is one that is highly concen­
trated. Two large commercial banks each


operate a nationwide system of branches;
several other commercial banks serve var­
ious regions of the country. In addition,
there are several types of specialized credit
Reserve requirem ents

Prior to the 1969 amendment to the Na­
tional Bank Law, the maximum rate for
cash reserve requirements that the National
Bank could set for any category of credit
institution was 15 per cent.1 The 1969
amendment left this ceiling unchanged for
time and savings deposits, but raised it to
25 per cent for demand deposits. This re­
serve ratio can also be applied to borrowed
funds and to foreign liabilities and liabili­
ties in foreign exchange to Austrian resi­
dents, to the extent that they exceed foreign
assets and credits in foreign exchange to
Austrian residents. In addition, the N a­
tional Bank may impose reserve require­
ments of up to 50 per cent on increases in
the excess of foreign liabilities over foreign
assets of the credit institutions. This latter
provision represents the most powerful tool
yet available to the authorities to control
inflows of foreign capital, which have often
proved disruptive to the conduct of mone­
tary policy in the past.
In the 1969 amendment the interest rate
payable on shortfalls in meeting reserve re­
quirements was raised from 3 percentage
points to 5 percentage points above the dis­
count rate. Deposits held for reserve pur­
poses are counted as part of the liquid as­
sets held under credit-control agreements
with the Ministry of Finance.
Savings banks or urban and rural credit
cooperative (Reiffeisen) societies are nor­
mally affiliated with their own central credit
institutions. They may hold their required
1 This term covers commercial banks, savings
banks, mortgage banks, urban and rural credit coop­
erative societies, and the Postal Savings Bank.


deposits with such institutions, which in
turn are required to hold equivalent depos­
its with the Austrian National Bank. Simi­
larly, commercial banks and other credit in­
stitutions, such as mortgage banks, may
deposit their reserve balances with the
Postal Savings Bank, which in turn is re­
quired to make an equivalent deposit with
the National Bank.
The National Bank tends to adjust mini­
mum reserve requirements to the interna­
tional flow of funds. As of September 1970,
reserve requirements for institutions with
total deposits of 40 million schillings or
more were 9Vi per cent on demand deposits,
IV i per cent on time and savings deposits
up to 12 months, and 6 V2 per cent on time
and savings deposits of more than 12
months. For institutions with less than 40
million schillings in deposits, reserve re­
quirements for demand deposits were 5Vi
per cent, while time and savings deposit re­
quirements were 5 per cent.
D iscounts and advances

Legally, all credit institutions have access
to facilities at the Austrian National Bank.
Until the 1969 amendment to the National
Bank Law prohibited the practice, some
private firms and individuals could discount
paper with and obtain advances from the
Bank. The ability of credit institutions to
discount and borrow depends mainly on the
availability of paper eligible for rediscount­
ing or as collateral against advances.
Paper eligible for discount includes
schilling-denominated bills and promissory
notes issued by private or publicly owned
enterprises, provided such paper has the
signatures of two parties known to be sol­
vent and is payable (in Austria) within 3
months. The Federal Government may ob­
tain advances by using Treasury certificates
as collateral. The ceiling for such advances
was raised by the 1969 amendment to the

National Bank Law from an absolute limit
of 1 billion schillings to 5 per cent of Fed­
eral Government revenue, or almost 5 bil­
lion schillings on the basis of projected rev­
enue for 1970. Bills arising from export
transactions under the export promotion
program were for awhile rediscountable at
a preferential (lower) rate, but no longer
are. In addition, the National Bank may
discount securities or coupons of securities
eligible as collateral for central bank ad­
vances, provided they are payable within 3
Decisions as to whether bills offered are
rediscountable are made by an outside
Committee of Scrutiny appointed by the
National Bank’s board of directors. How­
ever, the advice of the committee is not
binding on the board of directors.
The National Bank may also make loans
against collateral for a period of not more
than 3 months. Assets accepted as collat­
eral are gold coin or bullion, bonds listed
on the Vienna stock exchange, bills of ex­
change or promissory notes payable in na­
tional or specified foreign currency with a
maturity of no more than 3 months, foreign
exchange, and warehouse receipts issued by
officially authorized warehouses.
There are no explicit limits on redis­
counting or granting of loans at the stated
rates for discounts and advances. Neverthe­
less, the National Bank maintains informal
ceilings on the amount of central bank
credit extended to each credit institution.
When it believes that an institution’s dis­
counting is bordering on the excessive, it
requires that further borrowing by that in­
stitution be in the form of advances (at a
higher cost). The National Bank will raise
the ceiling if in its judgment such an adjust­
ment is justified. The basis for this informal
control is the provision in the law that the
National Bank may refuse rediscounting
and advances against collateral without


statement of reason. The only quantitative
restraints and ceilings apply to Government
borrowing and to export promotion bills
(currently 3 billion schillings), which are
not subject to the credit ceilings applicable
to commercial banks.
During the 15-year period since the Na­
tional Bank was organized in its present
form, the discount rate has been changed
nine times within the range of 3% to 5 per
cent, two of the nine changes having taken
place in 1969 and 1970 (through July).
These changes serve as a widely recognized
signal of the National Bank’s view of the
direction in which monetary and credit con­
ditions should move, in part because of
their possible effects on the structure of do­
mestic interest rates. Changes in the central
bank discount rate are usually accompanied
by changes in the rates on advances, which
are higher than the discount rate and are
sometimes instrumental in affecting the
lending rates of credit institutions.
There is no rigid link between the dis­
count rate and the lending rates of credit
institutions, which move in response to
other forces as well. Changes in the dis­
count rate have at times preceded, and at
other times followed, the general trend in
interest rates. In 1963 a reduction of the
discount rate to 4 lA per cent produced no
effect on interest rates, and the monetary
authorities negotiated agreements with the
credit institutions to lower their loan rates
by Vi to 1 percentage point. The discount
rate has recently been more important in
determining the structure of interest rates,
but only when used in conjunction with
other instruments, such as the issuance of
short-term cash certificates to commercial
banks and their subsequent redemption.
Other instrum ents of m onetary policy

In its direction of monetary policy, the Na­
tional Bank also makes use of credit ceil­


ings, liquidity ratios, open market opera­
tions, and moral suasion.
Credit ceilings. Under the Credit Control
Agreement (originally made in 1951 and
fundamentally revised in 1957) the author­
ities have negotiated voluntary credit ceil­
ings with credit institutions that apply to the
total volume of loans and advances that
credit institutions may make. These ceilings
are stated as fixed proportions of a credit in­
stitution’s net worth and liabilities. They
apply to the total of schilling loans on cur­
rent account, acceptances, advances to pub­
lic authorities, advances against mortgages,
and loans to credit institutions to which
ceilings or voluntary agreements do not
apply. Discounted and rediscounted bills
are included in this total, but export pro­
motion bills, European Recovery Program
bills,2 and certain other types of financing
are excluded.
Net worth is defined to include not only
paid-in capital and reserves but also pen­
sion reserves (which usually expand more
rapidly than capital and regular reserves).
Liabilities consist of schilling deposits of
Austrian and nonresident depositors and
promissory notes. To avoid double count­
ing, deposits belonging to Austrian credit
institutions that are subject to voluntary or
imposed ceilings are not considered liabili­
ties for the purpose of extension of credit.
Schilling deposits of foreign credit institu­
tions that may be included in liabilities for
this purpose are limited to the level of such
deposits on December 31, 1963. Thus, ac­
quisition of additional schilling deposits of
foreign credit institutions cannot increase
the credit ceilings.
Since July 1966 the ceiling for commer­
cial banks has been equal to 70 per cent of
2 ERP bills arise from loans made for industrial
and other development purposes by the National
Bank out of a revolving fund consisting of the schill­
ing counterpart of Marshall Plan aid to Austria.


banks is currently 30 per cent. Different
ratios with regard to primary and secondary
assets apply to other categories of credit
institutions. Any deficiency in primary
liquid assets incurs a penalty charge equal
to the discount rate, but the penalty for a
deficiency in secondary liquidity is only 1
per cent.
Open market operations. In view of almost
continuous surpluses in the Austrian bal­
ance of payments, the National Bank did
not use the authority to undertake open
market operations for the purpose of regu­
lating the money market until 1965, except
for two special transactions in 1962. In
1965 a law provided for the conversion of
the central bank’s claims on the Govern­
ment— up to a total of 3 billion schillings
— into 2 per cent Treasury certificates
(with maturities from 3 months to 2 years)
for use in open market operations. A favor­
able balance of payments situation and the
lack of money market facilities so far have
restricted the scope of open market opera­
tions, but since October 1966 the Austrian
National Bank has occasionally appeared as
a buyer in the open market. Fixed-interestbearing securities that fall due within 1
year from the purchase date are eligible for
such purchases.
The 1969 amendment to the central
bank law contained several new provisions
designed to enable the National Bank to
conduct open market operations more
effectively. Chief among these was a provi­
sion allowing the National Bank to issue
short-term debt certificates and to deter­
mine their amounts, maturities, and interest
rates. In January 1970, when the discount
rate was raised to 5 per cent, the National
Bank used its authority for the first time by
3 Net worth is defined to include paid-in capital issuing 1.5 billion schillings ($57 million)
and reserves (also pension reserves) less the value of
of cash certificates. At the end of May
certain assets, such as real estate and buildings
1970, when the National Bank believed
owned and permanent investment in other enter­
that the possibility of a severe liquidity

liabilities plus 75 per cent of net worth.3
The net worth ratio has been unchanged
since April 1957, but the liability ratio was
reduced on three occasions between 1962
and 1964 and raised in July 1966. Thus
this tool was frequently used in response to
changes in monetary conditions. Individual
banks and other credit institutions have ex­
ceeded their credit ceilings from time to
time, but credit expansion of all credit insti­
tutions has remained below the aggregate
ceiling, and only recently has the margin
available for expansion been reduced sub­
Liquidity ratios. Liquidity ratios, originally
established for the protection of depositors,
have been employed on occasion in recent
years for monetary policy purposes. These
ratios, also established under the Voluntary
Credit Control Agreement, prescribe the
form in which credit institutions must hold
a certain proportion of their assets; this
proportion is set in terms of the liabilities
of the credit institution. Such liabilities are
defined as all-schilling deposits of Austrian
and foreign depositors (including credit in­
stitutions), promissory notes, and accept­
Currently, “primary” liquid assets are de­
fined as vault cash and deposits with the
National Bank and the Postal Savings
Bank, and for banks the ratio of such assets
to liabilities is presently 10 per cent. “Sec­
ondary” liquid assets are defined as securi­
ties acceptable by the National Bank as col­
lateral for advances and bills eligible for
rediscount, net foreign assets, and collection
items sent to other credit institutions as well
as demand balances held with them; the li­
quidity ratio on “secondary” assets for


squeeze existed, it redeemed two-thirds of
these certificates. With its broadened pow­
ers and its increasingly activist stance, the
National Bank will most probably pursue
open market operations more vigorously in
the future.
Moral suasion. Moral suasion has been
used by the authorities from time to time.
Examples are (1 ) the agreement with most
categories of credit institutions to reduce
the cost of credit to the nonbank public,


and (2) the agreement with selected banks
in 1964 not to repatriate foreign assets. A
more recent example was a letter issued in
August 1966 to the credit institutions from
the Ministry of Finance stating that, accord­
ing to the Credit Control Agreement, credit
was to be granted only for economically
justified purposes, and that consumer credit
at that time was not economically justified
unless all credit demands for investment
purposes had been satisfied.


In Belgium monetary policy is administered
by the National Bank, under the direction
of the Minister of Finance. Open market
operations are executed by the Securities
Stabilization Fund (SSF), which is admin­
istered jointly by the Minister of Finance
and the National Bank. When other means
of financing its operations prove insufficient,
the SSF may obtain advances from the Na­
tional Bank.
At the end of World War II the liquidity
of Belgian commercial banks was very
high, because these banks had accumulated
a very large portfolio of short-term Treas­
ury certificates. In order to control credit
expansion in the early postwar period, the
authorities required the banks to maintain
high liquidity ratios by holding Treasury
certificates— thus preventing massive liqui­
dation of such securities to meet loan de­
However, for a number of years after the
war, credit demands of business and indus­
try were never long lasting, and they could
be regulated quite easily through changes in
official interest rates. On the other hand,
the requirement that banks maintain high
liquidity ratios had the indirect effect of

supplying funds to the Treasury when infla­
tionary pressures resulted in an increase in
bank deposits, and the opposite effect in the
case of deflationary trends; hence such ra­
tios defeated their purpose. For that reason,
toward the end of the 1950’s and in the
early 1960’s the ratios were successively
modified and ultimately abolished.
In recent years credit demands of busi­
ness and industry have been extremely large
during certain periods, and it has not been
possible to control these demands exclu­
sively by manipulation of the National
Bank’s rates. Moreover, the monetary au­
thorities could not expect to influence in a
significant way the volume of bank lending
to the private sector by regulating bank li­
quidity, for the banks have, in effect, many
possibilities for obtaining funds for such
lending. Included among these possibilities
are (1 ) sale of holdings of short-term Gov­
ernment securities and (2) rediscounting of
loans (trade bills). In April 1969, how­
ever, ceilings were established for redis­
counts and certified paper.
Indeed, the rediscounting of a large
proportion of trade bills is an important
characteristic of the Belgian credit system.
Domestic trade bills that meet the eligibility


conditions of the National Bank may be re­
discounted with that institution, but since
April 1969 only within the limit set by the
ceiling on rediscounts and certified paper.
Foreign trade acceptances if previously cer­
tified by the National Bank (see p. 210)
may be discounted at the Rediscount and
Guarantee Institute (Institut de Reescompte
et de Garantie (IR G )), which operates as
a primary discounting institution; or, when
these acceptances have a remaining term of
less than 120 days, they may be discounted
at the National Bank. Moreover, banks may
buy and sell in the market any bills regard­
less of whether the bills are rediscountable
at the National Bank or at the IRG, which
acts as a broker for the greater part of the
bills that it does not acquire for its own
account; these include uncertified bankers’
acceptances, uncertified trade bills, and
medium-term investment credits. Finally,
the banks may obtain from the National
Bank advances against Government securi­
ties for very short periods.
During periods of very active demand for
credit by business and industry, the N a­
tional Bank has established guidelines for
maximum expansion of bank loans and has
asked the banks not to exceed the amounts
allowable under the guidelines. For a time
these recommendations were supported by
a cash reserve requirement of 1 per cent.
As in previous periods when the National
Bank had set credit expansion guidelines
for the banks, the appropriate supervisory
authorities applied similar regulations to
other financial intermediaries. The Belgian
two-layer discount mechanism (IRG and
National Bank), in which two sets of dis­
count rates are used at each level, gives the
monetary authorities great flexibility in con­
trolling the volume, composition, and cost
of central bank credit, while providing a
safety valve by making it possible to obtain
secured advances for very short periods.

However, Belgium is a clear example of
how inadequate the discount mechanism of
a small country may be to control domestic
liquidity in the face of strong international
influences. Furthermore, until the introduc­
tion of rediscount ceilings in April 1969,
when the authorities acquired new control
tools, they used existing tools sparingly; for
instance, the highest reserve ratio imposed
on deposits was 1 per cent. While discount
and other domestic operations have usually
tended to dampen the effects of interna­
tional factors on bank liquidity, the contri­
bution of reserves of foreign origin to bank
liquidity (in some important instances re­
lated to Government borrowing) generally
far exceeds the volume injected by discount
Institutional fram ework

The private banking system consists of
about 80 commercial banks. The three
largest— Societe Generate de Banque,
Banque de Bruxelles, and Kredietbank—
are countrywide branch systems that to­
gether account for more than 75 per cent
of all commercial bank deposits. There are
several medium-sized banks (such as
Banque Lambert) and a few small banks
that are of importance in specialized fields
— such as the diamond trade, public works,
industrial finance, and consumer credit— as
well as some private savings banks and
some other categories of private credit insti­
Public credit institutions, the combined
assets of which are about equal to those of
the commercial banks, have an important
impact on the money market and on bank­
ing practices. These institutions include:
(1) the Government-operated postal giro
system, which has substantial deposit liabili­
ties that are invested exclusively in Treas­
ury securities; (2) a nationwide public sav­
ings bank (General Savings and Pensions
Fund), which channels savings of individu­


als into Government bonds, construction,
and medium- and long-term loans to indus­
try; (3) the Belgian Municipal Credit Insti­
tution, which makes loans to local govern­
ments from savings deposits and the
deposits of municipal funds it receives but
obtains more than half its funds by issuing
bonds; and (4) the National Industrial
Credit Company (N IC C ), which raises
funds by soliciting time deposits and issuing
Government-guaranteed bonds and in turn
uses these funds to make medium- and
long-term loans to industry.
Since these public credit institutions keep
accounts with the National Bank, their op­
erations affect directly the credit base of the
commercial banks. The nature of this im­
pact is complex, however, because these
public institutions make sizable purchases
of bills and acceptances, originated by the
banks, and place any free balances they may
have in the day-to-day market. Competition
from public credit institutions has caused
commercial banks to enter new fields; for
example, the success of the postal giro sys­
tem has stimulated the banks to broaden
their branch-banking facilities, and the
thriving term-loan business of NICC has
led them to expand their medium-term loans
to industry.
The National Bank of Belgium 4 was
founded in 1850 as a joint stock company.
The Bank’s activities have been modified by
various laws and royal decrees since 1938.
The most important laws affecting the Bank
were those of 1948 that permitted the Gov­
ernment to acquire half of the capital stock
of the central bank and introduced impor­
tant changes in the Bank’s organizational
The National Bank possesses most of the
usual central bank powers. However, its
4 Since 1935 the National Bank has also offered
some central banking services to Luxembourg (which
joined in economic union with Belgium in 1921), but
not all of these have been used.


discounting power is limited to paper with
maturities of 4 months or less, and its open
market activities are circumscribed by legal
limitations on the volume of Government
debt it may hold.5
The Belgium-Luxembourg Foreign Ex­
change Institute, established in 1944, has
the ultimate responsibility for the adminis­
tration of exchange control in the BelgiumLuxembourg Economic Union. The Insti­
tute is under the supervision of the Minister
of Finance, who exercises such supervision
through a commissioner. It is administered
by a board, the chairman of which is the
Governor of the National Bank of Belgium.
Its day-to-day management is entrusted to
the National Bank, and its exchange control
functions for most payments and transfers
are delegated to authorized banks.
Several special official institutions partici­
pate in the operation of three of the main
instruments of monetary policy; that is, re­
discounting and lending on collateral, open
market operations, and the setting of var­
ious minimum liquidity and reserve ratios.
The central bank determines discount
policy, while the IRG operates as a primary
discounting facility for certain credit instru­
ments. The IRG was established in 1935
in an attempt to prevent repetition of the
difficulties of the early 1930’s. At that time
the banks were unable to meet demands for
cash by rediscounting with the central bank
because much of the paper they held was
ineligible— for maturity or other reasons.
Capital of the IRG was supplied by the
commercial banks, but it operates as a para­
5 The limit, set in an agreement between the Bank
and the Government, was originally 44,333 million
Belgian francs (B.F.) (including B.F. 34 billion rep­
resenting consolidated war debts), plus an amount
equal to the Bank’s capital, reserves, depreciation,
and pension funds, but was raised by 6.2 billion in
September 1968. It will be reviewed after 3 years.
There are also provisions for a supplemental credit
line in certain contingencies, such as large withdraw­
als from the postal giro system.


ber of other Government credit institutions,
largely by rediscounting commercial bills
and bankers’ acceptances. Trade bills must
bear signatures of three persons or entities
known to be solvent (including that of one
Belgian bank) and must meet the National
Bank’s standards for quality and maturity.
Rediscounts— except those for the IRG—
are made for a minimum of 10 days, and
discounted bills are kept until maturity.
The Bank consolidated in July 1969 its
seven discount rates into two; it also has
three different rates on advances.
In order for bills and acceptances arising
from foreign trade to be eligible for redis­
counting when they come within 120 days
of maturity (the maximum term legally per­
mitted for central bank discounting), they
must have been “certified” by the National
Bank. The Bank’s review is designed pri­
marily to assure: (1) that an identifiable
commercial transaction is covered by the
paper, and (2) that the term of the paper
is consistent with the period of time needed
to complete the underlying transaction,
which may range up to several years. Until
June 1970 such certification was “uncondi­
tional.” Since June 1970, however, the “un­
conditional” certification ( “visa” ) has been
replaced, in the case of short-term bills and
acceptances covering exports to other coun­
tries of the European Economic Commu­
nity, by a “conditional” certification (“certi­
fication” ). The main difference between a
conditional and an unconditional certifica­
tion is that a bill, when granted the latter,
was charged at once to the bank’s ceiling
(for rediscounts and certified paper) and
was certain thereafter to be accepted for re­
discount by the National Bank, whereas,
Discounts and advances
with a conditional certification, a bill will
The National Bank extends credit to com­
be accepted for rediscount by the National
mercial banks, to the IRG, and to a num­
Bank only if the bank’s ceiling shows at the
6 While there is no statutory requirement that any time the necessary unused margin.
of these members shall be representatives of the Na­
Until recently separate discount quotas
tional Bank, in 1969 three of the board members in
fact were.
for certified bills and for other bills were

governmental organization, under a board
of eight members appointed by the Govern­
The Securities Stabilization Fund was
established in 1945 to regulate the market
for long- and medium-term Government
securities by conducting open market opera­
tions in such securities. In 1959 the SSF’s
power to engage in open market operations
was extended to short-term Government
paper. Whereas in the first few years the
SSF financed itself primarily by borrowing
in the money market, since 1957 it has
been issuing its own securities to commercial
banks and, more recently, to other financial
Operations of commercial banks are su­
pervised by the Banking Commission estab­
lished in 1935. It has authority to impose
liquidity and reserve ratios, after obtaining
governmental approval; the National Bank
has authority to make recommendations for
those ratios, which are set in the light of
policy considerations. However, not until
1946 did the Banking Commission use its
authority to set a liquidity ratio; the one set
then was designed mainly to freeze bank
claims on the Government resulting from
World War II. That ratio was eliminated in
1962. Subsequently the Commission has
imposed cash reserve ratios from time to
time. The Commission also has the author­
ity to impose capital ratios and has done so
since 1946.
Public credit institutions are supervised
by the Ministry of Finance and private
savings banks by the Central Office for
Small Savings, of which the Governor of
the National Bank is the president.


set for individual banks on the basis of
their capital and reserves;7 prior to April
1969 these quota ceilings were reached
only in exceptional circumstances and the
National Bank had almost never refused to
discount bills that satisfied the qualitative
eligibility requirements. However, in April
1969 the informal quota system was re­
placed by a more formal system of ceilings
on rediscounts and certified paper that set
a limit on each bank’s ability to borrow
from the central bank, either directly or via
the market. The new policy instrument also
enables the Bank to influence directly the
size of bill holdings that are eligible for re­
As a matter of policy, the National Bank
does not do any direct discount business
with firms domiciled in Brussels, but it does
engage indirectly in such business through
most of its agencies. These agencies have
local discounting committees consisting of
wealthy individuals who scrutinize and en­
dorse (for a fee) the paper offered, and the
Bank relies on the recommendations of
these committees.
Advances provide liquidity at a higher
cost than discounts and for very short peri­
ods only. Between 1966 and 1969 advances
to banks against collateral of Government
securities (including Treasury certificates
and certificates of indebtedness of the SSF)
accounted for less than 2.5 per cent of total
central bank credit. These loans may be re­
paid after 1 day, and the central bank does
not allow these credits to be utilized for
more than a few days.
The IRG operates as a rediscounting
agency for certified bills and acceptances. It
purchases (or rediscounts) bankers’ accept­
ances and trade bills certified by the central


bank if they are within 2 years of maturity;
for bills that mature within the 120-day
limit, it offers terms that are even more fa­
vorable than those of the central bank. The
IRG also provides the third name necessary
to make the paper discountable at the cen­
tral bank. The IRG acts both as broker and
as principal. It sells to commercial banks
and public credit institutions some of the
paper offered to it.8
Before 1962, 75 to 90 per cent of the
bills and acceptances certified by the N a­
tional Bank were offered to the IRG. Since
1962, when the high liquidity ratios that
had required banks to hold large amounts
of Government securities were eliminated,
banks have found it possible to retain some
eligible paper for longer periods in their
own portfolios— sometimes discounting the
paper as it approached maturity. Neverthe­
less, in recent years between 50 and 65 per
cent of the paper certified by the National
Bank was still acquired by the IRG. Of the
bills and acceptances acquired by the IRG,
both certified and not certified, and not
subsequently sold in the market, the pro­
portion rediscounted with the National
Bank has fluctuated between about 45 and
80 per cent in recent years.
The IRG also makes a secondary market
(as an intermediary) for commercial paper
— primarily that which has not been certi­
fied by the National Bank— with maturities
ranging from a few days to 5 years. Some
of the paper traded in this market meets the

8 The IRG also extends credit lines to banks for
general use and to finance manufacturing operations,
customers’ receivables, and public works. While origi­
nally only one of its main activities, IRG ’s redis­
count business has grown in the postwar period to
become its principal function. The ceiling for these
credits, which are not discountable at the National
Bank, as established by the directors of the IRG,
was increased from 20 billion to 27.5 billion B.F. in
7 The quotas were computed as multiples of capital January 1970. In recent years a relatively small por­
tion of the credits granted have been taken up. The
funds for the two main categories of discountable
paper: domestic commercial bills and foreign trade
IRG charges a commission of V\ percentage point
for these credits and remits half of this fee for any
bills and acceptances. The quota for certified bills for
unused credits.
each bank was communicated to that bank.


requirements of the National Bank and
therefore would be eligible for rediscount
with the central bank. Although the IRG
does buy commercial paper, it has a ceiling
on the total amount of noncertified paper
and promissory notes of banks that it will
The IRG finances its operations by bor­
rowing in the day-to-day market, by redis­
counting with the central bank, and by sell­
ing bills either outright or under repurchase
agreement.9 It alone among the day-to-day
market participants is a borrower only. The
SSF is sometimes a substantial lender and
sometimes a substantial borrower. Other
participants are usually small net lenders.
(Other Government and quasi-governmental
financial institutions, commercial banks,
and private savings banks are not allowed
to be net borrowers on balance in any
quarter (see pp. 213 and 214) and, taken
together, are heavy net lenders.)
The cost of credit available from the
IRG tends to follow market rates. When
the IRG has to increase its borrowing from
the central bank, its discount rates tend to
approach the official discount rates. IRG
intermediation adds considerable flexibility
to the availability and cost of central bank
credit to the banking system, directly or
The discount rates set by the National
Bank and the IRG (which generally adjusts
its rates to conform with rates of the central
9 Financial commitments of the IRG are limited
by the amount of the Government guarantee on IRG
obligations, which stood in January 1970 at 27.5 bil­
lion B.F.; this guarantee covers not only borrowing
in the day-to-day market but also contingent liabili­
ties created by credit lines extended to banks
(whether or not taken up by them ), liabilities under
repurchase agreements, and, most important, the con­
tingent liabilities inherent in its endorsement of com­
mercial bills and bankers’ acceptances rediscounted
with the central bank.
10 For example, between July 6, 1964, and June 3,
1966, the official discount rate was not changed, but
the schedule of IRG rates was altered 14 times.

bank, albeit sometimes with a lag) occupy
key positions in the short-term interest rate
structure. Since commercial banks tend to
rediscount a portion of their portfolios of
bills and acceptances, rediscount rates in
the secondary market move with the rates
set by the central bank and the IRG. In
fact, banks often quote interest rates in
terms of the National Bank discount rate.
Rates on bank deposits are set by agree­
ment between the National Bank and the
Belgian Bankers Association.
The extent to which the specialized agen­
cies can expand rediscounts and open mar­
ket purchases without involving central
bank credit, directly or indirectly, is of
course limited. By providing highly liquid
assets to banks and other credit institutions
and by trading in short- and medium-term
commercial obligations (in the case of the
IRG) or Government obligations (in the
case of the SSF), the IRG and the SSF
have undoubtedly contributed to the devel­
opment of the money market and of the
market for commercial paper and Govern­
ment securities in Belgium.
Nevertheless, the ability of the IRG and
the SSF to finance their operations outside
the central bank— in the day-to-day mar­
ket, for example— is immediately depend­
ent on bank credit and ultimately on cen­
tral bank credit. In Belgium, where almost
50 per cent of the money supply consists of
currency issued by the central bank, the
banks have little leeway for credit expan­
sion without the support of the central
bank. In fact, in recent years operations of
the IRG and the SSF have been supported
indirectly by the central bank in one way or
Other instrum ents of m onetary policy

Until recently the monetary tools used, in
addition to the discount mechanism, were
open market operations and foreign ex­


change operations and controls. Very little
resort has been made to reserve require­
ment ratios, but liquidity ratios, not used
since 1962, were reintroduced for a 1-year
period in June 1969. Moreover, since 1969
the National Bank has again employed
credit ceilings. The reason is that in cir­
cumstances that call for a rapid change in
credit conditions— such as was necessary
in that period— exclusive reliance on the
discount mechanism is unlikely to produce
the desired results with sufficient speed, be­
cause the effectiveness of discount policy
depends, to a large extent, on the banks’
need to borrow and/or on the elasticity of
loan demands. In this same period direct
controls were introduced over the money
The SSF influences the liquidity of the
monetary system by increasing or decreas­
ing its borrowing from the National Bank
and by making deposits with, or withdraw­
ing them from, that Bank. While operations
of the SSF are often quite substantial, a
large portion of these operations usually do
nothing more than release existing bank
liquidity; they do not inject central bank
credit into, or withdraw it from, the bank­
ing system.
Reserve requirement ratios were imposed
early in 1962, as one of the moves to in­
crease the central bank’s control powers.
The Banking Commission has the authority
to set reserve requirements of up to 20 per
cent of sight (demand) and short-term de­
posits and up to 7 per cent of other liabil­
ities and savings deposits, if requested to do
so by the central bank. But in fact, this con­
trol tool has been used in Belgium very
sparingly; a 1 per cent rate was in effect
from mid-1964 to mid-1965 only.
The Belgian National Bank has also
been experimenting with foreign exchange
operations as a means of influencing do­
mestic liquidity. In 1966 for instance it sold


on the “free” foreign exchange market part
of the proceeds of the Government’s foreign
borrowing in an effort to reduce the effects
of such borrowing on domestic liquidity by
encouraging capital outflows. Most capital
outflows and certain other payments must
be effected via the “free” as opposed to the
“official” market. The free foreign exchange
market, which is fed by the proceeds of
capital inflows, limits capital outflows; any
official additions to the supply of “free” for­
eign exchange would normally encourage
capital outflows, but the incentive may
prove ineffective in periods when tight
money markets at home favor borrowing
abroad. The Belgium-Luxembourg Foreign
Exchange Institute also occasionally im­
poses controls on the foreign exchange op­
erations and the net foreign positions of
Credit ceilings have been imposed on a
“voluntary” basis since 1964 by the N a­
tional Bank on commercial banks and by
the Finance Ministry on Government credit
institutions and insurance companies. Ceil­
ings for lending by savings banks are set by
the agency supervising this sector. At var­
ious times in recent years, the central bank
has applied direct restrictions on bank
credit expansion by setting credit ceilings
for individual banks. Related ceilings for
Government credit institutions, insurance
companies, and private savings banks have
been set concurrently by other authorities.
Direct controls have been employed re­
cently in the day-to-day (interbank) mar­
ket as well. Since this market appeared to
11 Most recently, in April 1969, the Belgium-Lux­
embourg Foreign Exchange Institute established a
ceiling for each Belgian and Luxembourg bank for
working balances in foreign exchange drawn from
the controlled market as well as for the amount of
Belgian franc advances in convertible accounts to for­
eigners; later in the year the ceiling was reduced and
applied separately to the two types of foreign ex­
change assets.


be used for more than the very short-term
liquidity adjustments it is designed to pro­
vide, directives were issued to banks, public
credit institutions, and private savings
banks requiring that the loans of each insti­
tution to the market must at least equal,
during the quarter, its borrowing from the
market; however, the new ruling does not
apply to the SSF or to the IRG.
Still another tool, which was introduced
by the Banking Commission in June 1969

but which lapsed a year later, was the
“reinvestment” ratio. This ratio was defined
as the relationship between easily negotia­
ble assets and short-term liabilities of
banks. It differed from the “cover ratios”
abandoned in 1962 because it included
commercial paper. It was designed to in­
crease gradually to 60 per cent over a 12month period the percentage of short-term
Belgian franc liabilities covered by easily
negotiable assets.


In Canada monetary policy is a major ex­
pression of official economic policy, which
has an influence on aggregate demand and
on flows of capital into and out of the
country. Economic developments and credit
conditions in the United States are of con­
siderable importance for Canada, and the
maintenance of certain relationships be­
tween Canadian interest rates and those in
the United States is frequently an objective
of, as well as a limiting factor on, monetary
policy. Nevertheless, interest rate spreads
between the two countries do vary con­
siderably at both the short and the long end
of the maturity spectrum. There is also con­
siderable scope for differences in monetary
conditions to occur as a result of variations
in the mix of monetary, fiscal, and debt
management policies.
The Bank of Canada employs open mar­
ket operations, two types of reserve require­
ments, the discount mechanism, and man­
agement of the Government’s cash balances
as its principal tools for carrying out
monetary policy. For a number of reasons,
as will be discussed below, the banking sys­
tem normally makes use of the discount
window only as a last resort. The principle
underlying discount policy in Canada is

well stated in the following excerpt from a
report submitted by the Governor of the
Bank of Canada to the Royal Commission
on Banking and Finance: 1
The present arrangem ents under w hich such ad­
vances m ay be obtained are designed to lim it the
B ank’s role as lender of last resort to exceptional
circum stances and to encourage the chartered
banks to use, whenever practicable, alternative
m ethods of adjusting their cash reserves in the
m arkets such as calling day-to-day loans or selling

There are several reasons why the dis­
count window has never been an important
and continuous source of funds for the Ca­
nadian banking system and has customarily
been used only for short periods in particu­
lar circumstances. The chief one is that the
banks can adjust their cash positions by
calling loans made to money market deal­
ers; by selling short-term securities in a
well-functioning money market; and to
some extent, by converting short-term for­
eign assets into Canadian dollars. Other
reasons are (1) the concentration of bank­
ing reserves in nine branch-banking systems
in which cash gains and losses of individual
branches tend to be offset; (2) the method
12 Bank of Canada, Evidence of the Governor of
the Bank of Canada before the Royal Commission
on Banking and Finance, May 31, 1962, p. 148.



nucleus of the system, and they operate
over 6,000 branches an d /o r offices through­
out the country. In addition, the financial
system includes a variety of other institu­
tions that carry on certain types of banking
business: savings banks; mortgage loan and
trust companies; and credit unions and
consumer credit companies. Some of these
institutions operate nationally, while some
serve whole provinces and others more
limited areas.
Until July 1967 the law required the
chartered banks to hold vault cash and/or
deposits with the central bank that would
equal 8 per cent of their total Canadiandollar deposit liabilities.1 Under a volun­
tary agreement with the Bank of Canada,
these banks also held a secondary reserve
— consisting of day-to-day loans and Treas­
ury bills— equal to 7 per cent of their total
Canadian-dollar deposit liabilities. The two
reserves brought the liquidity ratio to 15
per cent. In addition, the chartered banks
normally held a liquidity cushion consisting
of additional Treasury bills, day-to-day
loans, other loans to investment dealers and
brokers callable on demand, and a large
Institutional framework
portfolio of Canadian Government bonds
concentrated in the shorter maturity area.
The Bank of Canada, established in 1934
Under the new Bank Act, which became
and the youngest central bank among those
law on May 1, 1967, and provided for im­
covered by the present study, is vested with
plementation beginning July 1967, reserve
customary central banking powers. It is
requirements (still to be held in the form of
fully owned by the Canadian Government,
vault cash or central bank deposits) were
and its board of directors is appointed by
raised gradually between July 1967 and
the Government.
February 1968 to 12 per cent for demand
The commercial banking system is highly
deposits and lowered to 4 per cent for time
centralized. Nine chartered banks form the
deposits, and the Bank of Canada’s power
13 Shifting of Government balances by the Bank of to vary them was removed. However, the
Canada—with the approval of the Finance Minister
Bank of Canada was given the power to re­
—provides a technique for smoothing fluctuations in
of computing reserve requirements and a
relatively long averaging period (one-half
month), which gives the banks considerable
flexibility in adjusting their reserve posi­
tions; and (3) a reluctance to borrow at
the end of a month, in order to avoid show­
ing such borrowings in the published
month-end statement of assets and liabili­
The Bank of Canada usually influences
the liquidity of the banking system by open
market operations in Government securities
of all maturities and by shifting the Gov­
ernment’s cash balances between its own
books and those of the chartered banks.1 It
can also change the statutory secondary re­
serve ratios, which establish the banks’ min­
imum holdings of the total of cash in excess
of the cash reserve requirement, Treasury
bills, and day-to-day loans. In addition, the
central bank may influence the behavior of
the banks by moral suasion. One recent ex­
ample was its request, in 1969, that banks
make no further upward adjustments in in­
terest rates paid for large fixed-term depos­

bank liquidity resulting from payments into and out
of the Government’s account at the central bank
and, in addition, serves as an important instrument
for short-term adjustments in bank reserves. The
share of Government deposits placed with each bank
is determined by a formula worked out by the banks

14 Actually, the Bank of Canada had the power to
raise cash reserve requirements to 12 per cent, but it
never used that authority. While a penalty of 10 per
cent per annum is levied on any deficiency in re­
quired cash reserves, the banks are careful to avoid


quire the banks to maintain their statutory
cash reserve requirements over a semi­
monthly instead of a monthly period. Also,
the Bank of Canada was empowered to
impose a variable secondary-liquidity ratio
ranging between 6 and 12 per cent of total
Canadian-dollar deposit liabilities, to be
held at the commercial bank’s discretion in
any mix of (1) cash reserves in excess of
the minimum requirements, (2) Treasury
bills, and (3) day-to-day loans; this ratio is
currently set at 9 per cent.1
Canada has no market equivalent to the
Federal funds market in the United States.
The chartered banks normally adjust their
cash positions by calling day-to-day loans
or by disposing of Government securities.
These banks also have some scope for ob­
taining temporary liquidity from foreign
sources by drawing down their foreign as­
sets (consisting mostly of call loans, short­
term securities, and deposits with foreign
banks) or by increasing their short-term
foreign currency liabilities and converting
the proceeds into Canadian dollars. Re­
cently there has been increased use of com­
mercial paper and bankers’ acceptances as
sources of liquidity.
Discounts and advances

Central bank credit is available to the
chartered banks and one federally chartered
savings bank through rediscounts and col­
lateral advances, and to money market
dealers 1 under repurchase agreements. The
Bank of Canada has authority to make
short-term advances to the Canadian Gov­
ernment, but in practice such advances
have been extremely rare.
15 As with the old Act, deposit liabilities in curren­
cies other than Canadian dollars are not subject to
explicit reserve requirements. The new Bank Act (ar­
ticle 72) states that the banks must maintain “ade­
quate and appropriate assets against liabilities pay­
able in foreign currencies.”
16 There are about 15 money market dealers that
have entered into arrangements giving them the right
to obtain central bank accommodation at their initia­

Availability of central bank credit. Although
rediscounting of commercial paper is an
important feature of Canadian banking op­
erations, commercial banks in fact obtain
central bank accommodation entirely
through advances because they hold a large
portfolio of Government securities that they
can use as collateral.
The Bank of Canada has authority to
make advances to banks on such terms and
conditions as it deems appropriate. It may
accept a wide variety of paper as collat­
eral,1 but in practice all of its advances
have been secured by Government paper.
The Bank of Canada does not put a ceil­
ing on commercial bank borrowing from
the central bank. However, it may reduce
the attractiveness of such borrowing by pro­
gressively increasing the discount rates on
consecutive advances in any one half-month
reserve period. The first advance to a chart­
ered bank in any reserve period (up to a
certain confidential amount for each bank)
is made at the official discount rate, which
is a penalty rate in that it has always been
above the rates on day-to-day loans and
short-term Treasury bills. A second ad­
vance in the same reserve period, or a re­
newal of an advance, or an advance in ex­
cess of the amount specified by the Bank of
Canada may bear interest at a negotiated
rate above the discount rate. Advances are
made and renewed for either two or three
business days, at the option of the borrow­
ing bank.1
17 Acceptable collateral, as defined in the Bank of
Canada Act, consists of Federal and provincial gov­
ernment securities; U.K. securities within 6 months
of maturity; U.S. Government securities; most bills
of exchange and promissory notes endorsed by a
chartered bank; Canadian municipal securities; secur­
ities issued by a local school authority (corporation
or parish trustee); mortgages; gold or silver coin or
bullion, or documents of title relating thereto.
18 In addition, on the last day of any averaging pe­
riod a bank may at its option take an advance for 1
day provided it had on the previous day a cumula­
tive cash ratio at least equal to its required cash
ratio for the period.



Central bank credit to money market dealers.

Money market dealers may obtain central
bank accommodation by selling Govern­
ment securities with a maturity of 3 years
or less to the Bank of Canada under an
agreement to repurchase the securities
within a maximum period of 15 days. The
price at which these securities are resold is
such that the dealers incur a cost equal to
the so-called money market rate (see next
paragraph) or the discount rate, whichever
is lower. In contrast to the chartered banks,
money market dealers are not required to
pay interest for any minimum period of
time, and the agreements are usually out­
standing for only a few days. The dealers
are given lines of credit on the basis of the
volume of their business and inventories
and of alternative sources of financing. The
credit lines of dealers were designed in such
a way as to assure liquidity of the day-today loans through which the commercial
banks finance the dealers.
Level of the discount rate. For the first 20
years of the Bank of Canada’s operations,
the discount rate was of little significance; it
was changed only three times. However,
after a short-term money market developed
in 1954 and the use of advances rose sub­
stantially under tightening credit conditions,
the Bank of Canada raised the rate quite
often in order to keep it above market
rates. Then in 1956 the Bank of Canada
shifted to an automatic technique for set­
ting the discount rate, which came to be
known as the “tied rate.” From then
through mid-1962 the Bank of Canada’s
discount rate was fixed weekly at a margin
of lA of a percentage point above the latest
weekly tender rate for 91-day Treasury
bills. This method of setting the discount
rate is unique in the history of central
The tying of the discount rate in Can­
ada reflected a central bank philosophy that
the discount rate should not be used to lead

or influence market rates or as a means of
indicating the views of the central bank
with regard to changes in economic condi­
tions or to a new posture in monetary
policy.1 The main reason for tying the
discount rate to the weekly bill tender rate
in 1956 was to assure its penalty character;
the resulting gradual changes in the cost of
central bank credit were thought to be pref­
erable to frequent changes by discretionary
amounts. Use of the tying technique makes
it possible for the central bank to raise the
cost of credit unobtrusively in situations
when it might be difficult to obtain support
for a discretionary rate increase. Indeed,
the tying technique was introduced follow­
ing a period in which six successive in­
creases occurred within 14 months.
However, use of the rigid linkage tech­
nique amounts to giving up direct control
over the discount rate and substituting there­
for indirect control of the market (Treas­
ury bill) rate to which the discount rate is
19 The Bank of Canada wanted no policy signifi­
cance attached to these adjustments in its discount
rate and hoped to minimize any disruptions to the
economy that changes or expectations of changes
might cause. According to a press release issued at
the time of the institution of tied rates:
. . . the bank rate is not changed arbitrarily or with
a view to bringing about other interest rate changes.
On the contrary, it has been desired since the develop­
ment of the money market . . . that the bank rate
should be kept in line with other interest rates and
should move when they do, but not usually otherwise.
The present technical change in the method of setting
the bank rate from week to week is intended to
clarify this relationship and remove what has evi­
dently been a source of some public misunderstanding.

Four years later this opinion still prevailed. The
Governor of the Bank of Canada wrote in the
Bank’s Annual Report for 1960:
It will be apparent that there is no past history in
Canada of having changes in the bank rate made with
a view to influencing other interest rates, or as a
means of indicating the views of the central bank with
regard to changes in economic conditions or monetary
policy. The Bank’s view has been that moving the
bank rate would not be the best method of giving
such indication, which if they were to be given at all,
would be the subject of public statements.

By pegging the discount rate in this manner, the
Bank of Canada appeared to avoid using the rate for
policy purposes. This impression was convenient at a
time when monetary constraint was being aggres­
sively used for the first time, and when the Bank had
come under strong criticism for causing the substan­
tial rise in Canadian interest rates.


tied. Because the Bank of Canada could
substantially influence the bill rate ( and thus
the entire structure of short-term rates) by
affecting the bank’s cash reserves and by
varying the amount of Treasury bills it pur­
chases at the weekly auction, it in effect
kept a good deal of indirect control over
the bill rate, which automatically deter­
mined the discount rate. During the period
in which the discount rate was tied, the
Bank of Canada had a substantial portfolio
of Treasury bills, and actually it did not
follow a neutral policy with regard to the
rate (as it would have by merely rolling
over its bill portfolio).
While indirect management of the dis­
count rate proved effective in normal per­
iods, it became clear that an immediate, sub­
stantial increase in the cost of money could
not be achieved through this device; such a
need had developed in June 1962, when
the authorities had had to take steps to
counteract a threat to the exchange value of
the Canadian dollar. Hence indirect man­
agement was abandoned at that time as
part of a program to deal with a foreign ex­
change crisis.
The Bank of Canada has concluded
since then that a discount rate that is set
by the Bank provides an important element
of stability in the structure of money mar­
ket rates that had been missing during the
era of the tied discount rate. When changes
in the rate are being contemplated, discus­
sions between the Bank of Canada and the
Government may bring consideration of
monetary policy into sharper focus. On
some occasions, changes in the discount rate
merely confirm basic policy changes that
have been affecting market interest rates for
a considerable period.
Since the return to a fixed discount rate
in June 1962, central bank credit has been
available at two different rates. The Bank
extends advances to the chartered banks at
the official Bank rate, and it enters into re­

purchase agreements with money market
dealers at the money market rate (which
is still set weekly by the central bank at lA
of a percentage point above the 91-day
Treasury bill rate) or at the official Bank
rate, whichever is lower. Since the 91-day
Treasury bill rate has always been kept
below the official Bank rate, money market
dealers have had to pay what in fact was a
penalty rate.
The rationale behind the use of a dou­
ble-base discount rate is that such a rate
gives the central bank more operating flexi­
bility. There may be times, for example,
when the central bank would like to have
short-term rates move down without having
to take an overt action that might be con­
strued as signaling a shift in the basic direc­
tion of monetary policy. In these circum­
stances the use of a separate money market
discount rate assures money market dealers
that they will obtain central bank credit at
rates close to current (and declining)
money market rates rather than at the un­
changed (and higher) discount rate, which
would tend to counter the downward pres­
sures on short-term rates. Obviously, if in
times of rising interest rates the spread be­
tween the official discount rate and the
Treasury bill rate becomes less than V\ of 1
percentage point, the dealers will opt to get
cheaper accommodation at the official rate,
and therefore the double-base discount rate
would in effect become a single rate.
The official discount rate was set at 6 per
cent in 1962, following a serious crisis in
foreign exchange markets, as part of a com­
prehensive stabilization program designed
to restore equilibrium in Canada’s balance
of payments. Subsequent changes in the
Bank of Canada’s discount rate have been
made quite frequently, for both internal
and external reasons, including the interest
sensitivity of private capital flows between
the United States and Canada.
There is no direct link by law or custom,



rates was lifted to 7 'A per cent for the
balance of the year and was eliminated al­
together after January 1, 1968.
Quantitative role of central bank credit. Be­
tween 1958 and 1970, the yearly averages
of commercial bank borrowing from the
central bank outstanding on weekly report­
ing dates ranged from 0.001 per cent to
0.260 per cent of the chartered banks’ re­
quired reserves. During the same period
similar yearly averages of Government se­
curities held by the central bank under re­
purchase agreements with money market
dealers ranged from $2.4 million to $15.3
million (C anadian); as a proportion of
chartered banks’ required reserves, such
holdings ranged from 0.24 to 1.38 per cent.
During the same period the ratio of com­
mercial bank borrowing at the central bank
to their loans to the private sector averaged
less than 0.03 per cent. For very short peri­
ods central bank credit has of course been
much more important in cash reserve and
20 To some extent the banks had avoided this limi­ money market adjustments than these an­
tation by using various service charges.
nual average figures suggest.

and therefore no fixed spread, between the
central bank’s discount rate and the loan
and deposit rates of commercial banks.
However, until May 1, 1967, commercial
bank rates were limited under the Bank Act
to a rate of interest or discount no higher
than 6 per cent per annum on domestic
loans.2 Thus, rates of more than 6 per cent
in the money and capital markets tended to
cause pressures on the chartered banks,
which on such occasions were faced with
difficult problems of nonprice rationing.
Testifying at the hearings of the Royal
Commission on Banking and Finance in
1962-63, Governor Rasminsky pointed out
the disadvantage of interest rate rigidities in
financial markets and indicated his opposi­
tion to a direct statutory linkage between
the central bank discount rate and commer­
cial bank lending or deposit rates. Under
the new Bank Act, effective May 1, 1967,
the ceiling on commercial bank lending

In tro d u c tio n

France, like most other continental Euro­
pean countries in which international trans­
actions play a major role in domestic
monetary and credit conditions, has found
that regulation of the cash base of the
banking system is complicated by the effect
of external influences on bank liquidity.
Prior to accepting convertibility, the banks’
cash base had been enlarged mainly by dis­
counting at the Bank of France, or by some
very large loans by the Bank to the Gov­
During most of the time since 1958, the
expansion of the cash base of the banking
system in France has been brought about

largely by increases in official holdings of
international assets. In the 7-year period
1961— during which there was a reversal
in France’s external payments position,
official holdings of international assets tre­
bled and accounted for nearly four-fifths of
the expansion in the cash base. During
1968 and most of 1969, official holdings
declined and thus had a restrictive rather
than an expansionary effect on the cash
base. Because it is difficult to reduce or
offset bank liquidity brought about by sur­
pluses on international transactions, French
monetary authorities tend to rely heavily on
direct controls over bank credit expansion
to deal with inflationary pressures.


In periods when curtailment of inflows of
foreign funds became a major policy objec­
tive, the central bank tended to keep the
banking system supplied with enough cash
to maintain money rates in Paris at low lev­
els relative to those in major centers
abroad. For this purpose, policy instruments
developed to control discounting were used
and refined in various ways; however, open
market operations of the kind employed in
the United States have never been used to
supply funds to the banks in France. Such
success as has been achieved in restraining
inflows of foreign funds is attributable to
employment of other monetary policy in­
struments to minimize money market strin­
gencies that might attract funds from
abroad, rather than to regulation of the for­
eign exchange position of banks or to pro­
hibition of payment of interest on foreignowned franc balances.
instruments were not well adapted to the
relatively new situation of large payments
surpluses, and for other reasons, French
monetary authorities have made several im­
portant changes in policy instruments and
banking regulations in the last several
years: (1) Cash reserve requirements were
introduced to supplement and eventually re­
place required liquidity ratios. (2) The
number of channels through which the cen­
tral bank may funnel credit has been some­
what reduced, and the related structure of
rates has been simplified. (3) Efforts have
been made to reduce the importance of
discounting commercial bills as a means of
obtaining credit at the Bank of France. (4)
Efforts have also been made to develop an
active market for short-term Government
securities so that the Bank of France can
engage in open market operations, which for
years have been inhibited by long-standing
taboos against central bank lending to the
Government as well as by the underdevel­

oped state of the money and capital mar­
kets. And (5) progress has been made to
simplify the discount rate structure of the
Bank of France. All of these changes affect
in some way the regulation of discounting
at the Bank of France, which is basic to the
French system of monetary controls.
Discounting at the Bank by the bank­
ing system, which includes public and semi­
public financial institutions, is restricted by
a system of ceilings and liquidity ratios and
by a prior authorization procedure. Since
discounting within ceilings is considered a
right rather than a privilege, however, com­
mercial banks always have available what
is, in effect, a line of credit at the central
bank. However, there have been numerous
changes since the early 1950’s in regula­
tions designed specifically to achieve quan­
titative limitations on expansion of bank
In order to keep discounting within
bounds, all discounts above ceilings, un­
less they fall into an exempt category (see
p. 231), are made at a rate that at times is
much higher than the ordinary discount
rate. Since 1968 the differential has been
2V2 percentage points.21 In recent years the
Bank of France has supplied liquidity to
banks with the objective of keeping market
rates below this ultimate penalty rate and
— as indicated earlier— within a range that
is compatible with the objectives of reduc­
ing inflows of speculative short-term foreign
For a long time flexible liquidity ratios,
under which bank exemptions from dis­
count ceilings were limited first to Treasury
bills and later to a considerably wider vari­
21 From 1951 through 1967 banks could discount
up to 10 per cent above their ceiling at an
intermediate penalty rate called the “hell” rate. The
highest levels at which the two penalty rates, “hell”
(enfer) and “superhell” (super-enfer) , were set were
8 and 12 per cent, respectively, in 1958 when the
discount rate was 5 per cent. In December 1967 the
two rates were combined into a single penalty rate.


ety of paper, were used as an important
tool to control access to the discount win­
dow and to facilitate adjustment of the
banks’ cash positions. Until recently, they
were manipulated in conjunction with spe­
cial techniques at the discount window that
had been developed to avoid end-of-month
stringencies. One such ratio is still in force,
but it is scheduled to be gradually reduced
and ultimately abolished.
The discount mechanism has been used
also as a means of selective credit control
— in particular to support medium-term
financing of expenditures for housing and
industrial equipment and of exports. Quali­
tative credit controls in France make use of
moral suasion and of a procedure of prior
authorization by the Bank of France to
make certain credits automatically eligible
for discount.
Institutional stru ctu re
Monetary authorities. Responsibility for
formulating monetary policy is shared by
the Bank of France and the National Credit
Council (N C C ), which was established by
the 1945 law that nationalized the Bank of
France and the four largest commercial
banks. The President of the Republic ap­
points the Governor (and two deputy gov­
ernors) of the Bank of France. The presi­
dent of the NCC, which has 44 members, is
the Minister of Finance. However, the
Governor of the Bank of France is the de
facto head of the Council and is generally
the presiding officer at its meetings. In ad­
dition to these two officers the NCC con­
sists of representatives of several Govern­
ment departments, of public and semipublic
financial institutions, and of various eco­
nomic and social interests; it has its own
small secretariat drawn from the staff of the
Bank of France.
Technically, the Bank of France has pri­
mary responsibility only for decisions that


affect its own operations— mainly decisions
related to rates and terms for discounts
and advances. In these matters the NCC
may only advise the Bank. On the other
hand, matters that require action by the
banks— as for example, maintenance of li­
quidity ratios— are technically the responsi­
bility of the Council, which is concerned
with banking procedures. In practice, the
Council acts through the Bank of France as
In addition to being responsible for mon­
etary and banking control measures, the
NCC provides a medium for coordination
of views on the objectives and techniques of
monetary policy. In this process the Bank
of France provides leadership, but ultimate
responsibility rests with the Government.
The influence of the Bank of France de­
pends to a large extent on the personality
of its Governor.
A similar working relationship exists be­
tween the Bank of France and the Banking
Control Commission, which was set up by
the nationalization law primarily to admin­
ister liquidity ratios of the banks. The
members of the Banking Control Commis­
sion are the Governor of the Bank of
France, who is its ex officio president, two
representatives of the Government, one rep­
resentative of the commercial banks, and
one representative of bank employees.
Structure of the banking system. The princi­
pal types of credit institutions that are clas­
sified as banks in France can be grouped
into three categories: (1) banques de
depdts (deposit banks); (2) banques
d'affaires (investment banks); and (3)
other financial institutions. Some of the lat­
ter are organizations of a limited scope and
of a specialized nature, and as such they
are supervised by a ministry responsible for
their particular area of activity. The most
important institutions in this category are
the banques populaires (cooperative credit


societies catering to the banking needs of
small manufacturers, traders, and artisans)
and the caisses de credit agricole (agricul­
tural credit cooperatives). The cooperative
banking societies and the agricultural credit
cooperatives have their own central dis­
count institutions (the Caisse Centrale des
Banques Populaires and the Caisse Nationale de Credit Agricole, respectively). The
Caisse Centrale de Credit Cooperatif is the
central institution of nonagricultural co­
operative credit institutions.
Several other public intermediate financ­
ing institutions that do not accept deposits
play a very important role in the French
banking and credit system and have dis­
count privileges at the Bank of France.2
They include the Credit National, which
provides long- and medium-term financing
to public and private enterprises from funds
acquired primarily by the issuance of bonds
and which also endorses medium-term
equipment paper, thus satisfying a require­
ment for making this paper discountable at
the Bank of France; the Caisse Nationale
des Marches de I’Etat, which guarantees
credit granted for the purchase of equip­
ment by public and private enterprises; the
Credit Fonder de France, with its subsidi­
ary, the Comptoir des Entrepreneurs, both
of which grant mortgage credit from funds
derived primarily by the issuance of bonds;
and the Caisse Centrale de Credit Hotelier,
Industriel et Commercial. Another institu­
tion that does not accept deposits is the
Banque Frangaise du Commerce Exterieur,
which finances foreign trade on its own ac­
count and also assists other banks in such
All deposit, investment, and long- and
22 Additional financial establishments that may
make loans but that do not accept deposits from the
public include the following main categories: societes
fnancieres (financial societies, which do mainly an
investment management business), stock brokerage
houses, and instalment credit firms.

medium-term credit banks are under the ju­
risdiction of the Banking Control Commis­
sion and are known as the “registered
banks.” Their assets comprise nearly 80 per
cent of the assets of the banking system as
a whole.2
The distinction established in 1945 be­
tween deposit banks, which could not ac­
cept deposits with a maturity of more than
2 years, and investment banks, which could
not accept deposits with a maturity as short
as 2 years, was virtually eliminated on Jan­
uary 1, 1966. (However, the two types of
banks remain subject to different regula­
tions with regard to investments in shares.)
The deposit banks perform all, and the in­
vestment banks some, of the functions that
would be classified in the United States as
commercial banking. French investment
banks also engage in the same types of ac­
tivities as do investment banks in the
United States. The seven discount houses
are classified as deposit banks. The four
largest deposit banks, as already noted,
were nationalized in 1945, and two of them
were merged in 1967. The three national­
ized banks, which together account for
about one-half of total assets of all banks,
are managed very much in the same way as
privately owned banks, and they compete
among themselves for all types of business.
The nonnationalized deposit banks include
establishments located in Paris (including a
few with branches outside the city) and re­
gional and purely local banks, as well as
foreign banks. Practically all the investment
banks are located in Paris.
23 At the end of 1969 the Banking Control Com­
mission was supervising 237 French banks in Metro­
politan France, with resources of 272 billion francs
($49 billion), of which 191 were deposit banks, 18
were investment banks, and 28 were long- and medium-term credit banks. In addition, the Banking Con­
trol Commission had under its jurisdiction 9 French
banks operating overseas, 51 foreign banks in
France, and 9 banks in Monaco.


Savings institutions (caisses d’epargne)
have no direct access to central bank credit.
However, nearly all of the funds collected
by the savings institutions, which include
“autonomous” savings banks, many of
which are sponsored by municipalities, and
the nationwide Postal Savings System are
deposited with the Caisse des Depots et
Consignations, which reinvests them in ap­
proved securities; hence, in the normal
course of their business, savings banks have
no need to discount their assets. The
Caisse also manages the liquid funds of the
social security system and the reserves of
pension funds. It has access to central
bank credit.
Among these institutions, only the
Comptoir des Entrepreneurs (which sup­
plies credit to contractors of major public
works projects) is a substantial discounter
with the Bank of France of paper that it
originates; the others merely rediscount
paper that has been previously discounted
with them by banks or their member insti­
tutions. Thus, in effect, there is a two-tier
discounting system— with specialized dis­
count institutions dealing with a large num­
ber of primary credit institutions, mostly of
local or regional significance, and discount­
ing credits with the Bank of France, as
needed. In some cases, however, they dis­
count their own short-term notes drawn
against a portfolio of discounted mediumterm paper.
Indeed, an outstanding characteristic of
the French banking system is its heavy reli­
ance for liquidity upon discounting, either
at the Bank of France or at the public fi­
nancial institutions. This circumstance had
its origins in the traditional willingness of
the Bank of France to discount freely and
in the high proportion of currency in the
French money supply, which makes the
banks quite sensitive to liquidity drains. All
registered banks, as already noted, may in


principle open an account for discounting
purposes at the Bank of France, and in
practice many banks have additional ac­
counts for their main branches. The
Banque Franqaise du Commerce Exterieur
may also discount directly with the Bank of
France. A cooperative credit society may
have an account for discounting purposes at
the Bank of France, but individual agricul­
tural credit cooperatives may not.2
Types of liquid assets held. The types of
short-term assets acquired by French banks
to meet their needs for liquidity depend to
some extent upon the kinds of business that
the banks are permitted to conduct, upon
the standards of eligibility for discounting
or for obtaining advances from the Bank of
France, and upon the kinds of paper the
Bank may purchase on the open market.
Prior to the end of 1967, when they were
abolished, two separate liquidity ratios were
imposed by the NCC to control the liquid­
ity of banks. The first prescribed minimum
holdings of Treasury bills (planchers); the
other, minimum holdings of a broader
range of liquidity instruments (coefficient
de tresorerie). These ratios constituted an
additional and important tool of credit con­
trol (see below).
About 80 per cent of all commercial
bank credit in France is extended in the
form of discounted trade bills. Largely as a
result of the heavy reliance by banks upon
the Bank of France as a source of loanable
funds, and the conditions imposed by the
Bank for such accommodation, a major
part of commercial banks’ business consists
of discounting short-term bills. These banks
extend credit to the private sector largely in
the form of discounts of commercial bills,
acceptances, warrants, and cross endorse­
24 For many years the Bank has not accepted new
private customers, and for about 15 years it has dis­
couraged credit demands from its remaining private
customers—mainly nonbank, nonfinancial enterprises.


During most of the postwar period a princi­
pal objective of monetary policy in France

has been to direct bank credit into ap­
proved uses and to control its expansion. In
mid-1964, keeping money market rates
below the level that would attract inflows of
funds from abroad became another major
objective. With the development of a current-account deficit in 1966 the emphasis
shifted to keeping capital from flowing out,
and subsequently interest rate policy has
been guided by balance of payments con­
At first French monetary authorities
sought to control expansion of bank credit
by restricting its monetization through ceil­
ings on central bank credit and by use of
liquidity ratios designed to neutralize war­
generated liquidity. But in 1958 ceilings
were introduced and used intermittently to
control directly the expansion of bank
credit to the private sector.2
Discount ceilings. The first step toward
generalized credit control was the introduc­
tion in September 1948 of ceilings on dis­
counting at the Bank of France at the basic
discount rate. Originally the ceilings were
placed on each bank’s account for discount­
ing purposes at the Bank of France, but as
it turned out they were effectively restrictive
for small banks only.
Discount ceilings for individual banks
were initially set at approximately the level
of discounts outstanding on September
30, 1948. But since then the global ceilings
have risen because of adjustments in the
ceilings of individual banks, and on a few
occasions the ceilings have been raised
across-the-board for reasons of over-all
policy.2 Several years ago each bank’s dis­
count ceiling was fixed on the basis of a
complex formula that took into considera­
tion mainly a number of quantitative fac­

25 Until Jan. 31, 1967, they were required to main­
tain a balanced position in foreign exchange on spot
and forward combined. Their claims in a given for­
eign currency, vis-a-vis both residents and n o n ­
residents, were required to be equal to their liabilities
in the same currency.

26 Such ceilings were in effect for about a year,
and then again from February 1963 to June 1965.
After being formally abolished in February 1967,
bank credit ceilings were reintroduced for the period
October 1968 to October 1970.
27 Most notably, the discount ceilings were raised

ments of promissory notes, all of which are
described in French banking statistics as
“discount of bills.” At the end of 1968
“private paper” (autres effets) constituted
almost half of the total assets of regis­
tered banks. At the large deposit banks this
ratio was somewhat higher, and for invest­
ment banks it was slightly more than 40
per cent.
A considerable part of private paper con­
sists, however, of loans to Governmentowned enterprises, such as railroads, air­
craft factories, and so forth. At the end of
1968, short-term Government securities
made up less than 1 per cent of the total
assets of registered banks; cash and deposits
with the Bank of France and the Treasury,
3 per cent. Most of the nonliquid assets of
the deposit banks were advances and over­
drafts. Customers are expected to use over­
drafts only to meet marginal requirements
because such credits cannot be the basis for
obtaining central bank credit.
Other than resorting to the central bank
directly, individual French banks can in­
crease their domestic short-term (under 1
year) borrowing only through the Paris
money market. The main suppliers of funds
to the money market are the commercial
banks, stockbrokers, the various semipublic
institutions that manage large amounts of
funds, and the Bank of France (see
above). The banks at times do discount at
the Bank of France within discount ceilings
for the purpose of supplying the funds so
acquired to the money market. French
banks may also borrow abroad.2
In stru m en ts of m onetary policy


tors such as deposits, assets, and capital ac­
counts; these formulas are changed very
infrequently and do not reflect the relative
growth of each bank. At first banks were
required to bring their discounts within
the ceilings only at the end of the month,
but since 1951 they have been required to
keep within the ceilings at all times.
Several kinds of paper are exempt from
discount ceilings: in particular (1) bills
representing medium-term credit to finance
housing, industrial equipment, and exports
(approved through the prior authorization
procedure; see below), (2) grain storage
bills, and (3) short-term foreign trade bills.
Most types of paper representing mediumterm credit must be discounted first with
one of the intermediate financing agencies
before becoming eligible for rediscounting
at the Bank of France. The exemption from
discount ceilings of certain categories of
credit serves to promote the flow of credit
into such activities deemed to deserve pref­
erential treatment. The Bank of France re­
quires as a condition for discounting that
its prior authorization be obtained for bills
representing purely financial transactions
and for certain types of medium-term
When the system of making mediumterm credit discountable at the Bank of
France was introduced in the early postwar
years, it was expected that the intermediate
financing agencies, which are collectors of
savings, would hold the bulk of this credit
to maturity. Claims upon the resources of
these agencies were so great in the 1950’s,
however, that the agencies were constrained
to pass on to the Bank of France the bulk
by nearly 25 per cent in the inflationary period of
1955-57 and then lowered by about 35 per cent in
the second half of 1957 to offset the monetary effects
of new advances granted by the Bank of France to
the Treasury at that time. From 1957 to the end of
1959 the discount ceilings were stable at a level of
about 4.3 billion francs. By the end of 1969, they
had risen to 9.6 billion francs.


of the medium-term credit instruments dis­
counted by them.
Liquidity ratios. Prior to 1967, banks were
not required to keep any particular cash re­
serves, but they were subject to two related
liquidity ratios. These ratios had essentially
the same initial purpose: to force banks to
hold assets that could otherwise be mone­
tized to provide the basis for an excessive
expansion of credit— in the first case by
discounting such assets or by letting the
short-term Government securities run off,
and in the second, by discounting at the
Bank of France outside of ceilings.2
For nearly two decades the so-called
Treasury bill “floor” (plancher), instituted
in 1948, was used to immobilize banks’
large holdings of Treasury bills, inherited in
the main from World War II and from
early postwar deficits. Banks were required
to hold Treasury paper in an amount not
less than 95 per cent of their holdings of
such paper as of September 30, 1948, and
to place 20 per cent of the subsequent in­
crease in their deposit liabilities in such se­
curities. The liquidity ratio was fixed at a
uniform 25 per cent of deposit liabilities in
1956 and was reduced to 20 per cent in
1961. Since this Treasury paper was of a
type reserved solely for financial institutions
28 For purposes of safeguarding the solvency of
banks, a different agency, the Banking Control Com­
mission, prescribes a ratio of liquid assets to short­
term liabilities (rapport de liquidite). It defines liquid
assets for this purpose as cash; deposits with the
Bank of France and the Treasury; deposits with
banks and correspondents (including call loans);
Treasury bills and similar securities drawn on or
guaranteed by certain Government agencies; bills and
acceptances discountable at the central bank; coupons
collectible and in suspense accounts; claims on for­
eign exchange dealers and stockbrokers; subscrip­
tions to securities; securities that are eligible to guar­
antee advances from the Bank of France; and other
securities that are traded on the public securities
markets. The last item may comprise at most only 5
per cent of short-term liabilities. This scheme was in­
tended to apply to all classes of banks, but a specific
ratio (60 per cent) has been prescribed only for the
deposit banks. It is expected that the investment
banks will be made subject to the liquidity ratio


and yielded considerably less than other
Treasury bills, which were designed for sale
to the general public, the plancher pro­
duced a rather important and cheap source
of funds for the French Treasury. An im­
provement in Government finances made it
possible to reduce gradually (between 1961
and 1966) the Treasury-bill-floor require­
ment, which French monetary authorities
had long regarded as providing the Treas­
ury with an inflationary source of financing.
The floor was abolished effective September
1, 1967.
In 1961 an additional liquidity ratio, the
coefficient de tresorerie, was introduced.2
It required the banks to hold a percentage
of their deposit liabilities in certain liquid
assets— including cash, Treasury paper held
to meet the floor ratio, and those kinds
of paper that could be discounted at the
Bank of France outside of the banks’ ceil­
ings. The coefficient had an upper limit of
36 per cent, and its lower limit was the
floor ratio for Treasury bills, but in fact the
coefficient was varied only between 30 and
36 per cent. Thus, as the banks were al­
lowed to reduce their holdings of Treasury
bills, they were required to hold larger
amounts of medium-term or other paper ex­
empt from discount ceilings.
The institution of the coefficient consti­
tuted a technique for immobilizing desig­
nated types of credit at the banks. In effect,
this provision compelled banks to allocate a
certain percentage of their resources to
loans or investments designated as eligible
for inclusion in the coefficient. Only paper
held above the level required to satisfy the
coefficient could be discounted at the Bank
of France; making it discountable outside
the ceiling was another way of giving such
credits preferential status.

In addition to exemption from discount
ceilings, export credits have benefited from
a preferential discount rate of 3 per cent
since 1957. At the end of 1960, just before
the inauguration of the coefficient, banks
held nearly 5 billion francs of this paper
discountable at the Bank of France outside
of the ceilings; hence they were in a position
to almost double the volume of their dis­
counts without having to pay the “hell”
rate. The coefficient forced the banks to
hold about 90 per cent of this otherwise
discountable paper in their portfolios, al­
though the Bank of France, in exempting
this paper from the ceilings, had given an
implicit commitment to discount it.
The coefficient was a powerful tool for
controlling access to the discount window;
indeed, when in use it was regarded as the
principal instrument for controlling the li­
quidity of banks. While the main purpose
was to prevent excessive use of Bank of
France credit, the ratio was frequently low­
ered by a few points in order to allow the
banks greater access to the central bank in
periods of tightness due to temporary fac­
tors, such as end-of-month cash drains.
Such temporary reductions served to keep
money market rates from rising above a
level that would attract inflows of funds
from abroad. While this liquidity ratio was
originally intended to be both a creditrationing device (with preferential treatment
for Government securities) and a quantita­
tive credit-control device (since it limited
the discounting of medium-term paper), in
1965 and 1966 it was used primarily for
short-run quantitative control purposes. (In
1966 alone it was altered eight times.)
Although formally abolished in January
1967, the coefficient de tresorerie was re­
placed at that time by a similar liquidity
ratio known variously as the coefficient de
29 Although the coefficient de tresorerie could have
retenue or the portefeuille minimum and in­
been fixed separately for each class of bank, the
itially set at 14 per cent. Since the abolition
same ratio was applied to all classes.


of the coefficient de tresorerie left banks
with considerable holdings of medium-term
credits discountable at the Bank of France
outside their discount ceilings, the new
ratio, which requires the banks to hold a
portfolio of such medium-term credits equal
to a certain percentage of their liquid liabil­
ities, was designed to prevent banks from
making immediate use of this excess liquid­
ity. It is the intention of the Government to
reduce, and ultimately abolish, the portefeuille minimum as increasing reliance is
placed on discount ceilings and cash re­
serve requirements to control bank liquid­
ity. However, in 1969 and 1970 the Gov­
ernment twice increased the minimum in
response to financial developments, and it
appears that final abolition is not contem­
plated for the foreseeable future.
Cash reserve requirements. Liquidity ratios
were designed primarily to control pressures
at the discount window, and they have
been fairly successful in doing that. As the
major means for such control, however,
they were replaced in 1967 by legal reserve
requirements, which became fully effective
in October of that year, and the provisions
of portefeuille minimum were designed as a
transitional arrangement. Under the new
system the Bank of France may require
banks to maintain at the central bank cash
balances of as much as 10 (later raised to
15) per cent of their deposit liabilities.
In introducing the system of legal re­
serves, the Finance Minister gave three rea­
sons for the change: (1) alignment of
French monetary control techniques with
those in other major countries; (2) removal
of major constraints on the kinds of assets
that banks may hold; and (3) desirability
of developing a free market in Government
securities, a necessary precondition to mak­
ing Paris a major European capital market.
In 1970 the central bank began to use this
tool more vigorously. It raised requirements


twice— by 1 percentage point each time—
against both demand and time deposits (to
7.5 and 2.5 per cent, respectively, as of
July) in an effort to offset balance of pay­
ments surpluses.
In February 1971, institution of an addi­
tional reserve requirement against credits
granted was announced, but no immediate
use was made of this new power. This re­
serve requirement may be imposed on finan­
cial institutions that do not accept deposits
as well as on banks.
Open market operations. Prior to January
1967 the Bank of France used two kinds of
supplementary accommodations to cushion
short-run fluctuations in bank liquidity.
While both were referred to as “open mar­
ket operations,” neither involved a market
process that would allocate funds or set the
rate. In both cases, credit was channeled
through discount houses, for very short pe­
riods, at a cost set by the central bank.
Each bank used one specific discount house
for its operations in the money market, in­
cluding interbank sales of funds and “open
market” operations with the Bank of France.
One technique was used to meet the
day-to-day needs for funds of about 50
leading banfer, which had been given an
open market “limit” (or quota) at the
Bank of France in addition to the dis­
counting quotas (or ceilings). Each such
bank could obtain automatically additional
Bank of France credit at the basic discount
rate up to a limit that in practice was set at
about 10 per cent of the bank’s discount
ceiling. Such drawings took the form of
sales to the Bank under repurchase agree­
ment of paper already in the Bank’s cus­
tody. These en pension sales, which were
negotiated through the discount houses on
behalf of individual banks, actually consti­
tuted an additional line of central bank
The other kind of “open market opera­


tion” was used solely to meet end-of-month
strains in the money market when cash
withdrawals for the payment of wages, sala­
ries, and rents tended to reduce the liquid­
ity of the banks. The technique was similar
to that described above, but only 10 to 12
of the most important banks were involved;
the rate for such exceptional accommoda­
tion, which on occasion reached a substan­
tial volume, was usually set by the Bank
above the basic discount rate. Using esti­
mates of sources and uses of funds, supple­
mented by personal contact with the
discount houses and the banks involved
(which absorb 85 per cent of the funds
made available), officials at the Bank of
France made projections of the volume of
funds needed at the end of the month and
asked banks to deposit the necessary collat­
Unlike the Bank’s rates for regular oper­
ations, which are fixed in advance and re­
main unchanged for long periods, the rates
charged for end-of-month repurchase oper­
ations were fixed by the Governor on a
day-to-day basis. Although both kinds of
operations were always used to ease money
market pressures and were ostensibly at the
initiative of the banks, in the second kind
of operation the Bank of France took the
initiative in estimating the amount of funds
needed to keep market rates within the de­
sired range.
The central bank’s right of intervention
was limited to short-term Government and
private bills admissible to discount. How­
ever, in December 1966 a decree extended
its operations to bonds and medium-term
bills issued by credit institutions with a
special legal status; subsequently, the list of
eligible bills was further expanded.
Starting in January 1967 a number of
other modifications were made in the Bank
of France’s open market operations. The
Bank’s objectives have gradually changed

from mainly facilitating the placement of
Treasury bonds and thereby providing more
flexibility to bank liquidity, to regulating
bank liquidity on a day-to-day basis with
more precision than is possible with other
monetary instruments.
In the fall of 1968, the Bank of France
rationed the banks’ access to its open mar­
ket window so as to moderate credit expan­
sion. This led to the establishment of a
parallel interbank market for short-term
loans, a sort of Federal funds market, and
at that time the day-to-day rates in that
market were considerably higher than the
Bank of France’s rate. The interbank mar­
ket is still active, but the rates are identical
to those posted by the Bank of France.
As a result of its more active interven­
tion the Bank of France has begun to exer­
cise considerable influence on money market
rates. The Bank most frequently acts as a
lender, but on occasion it also absorbs ex­
cess liquidity. Since the suspension in 1967
of the banks’ right to negotiate certain bills
at the discount rate, the central bank has
intervened exclusively at the prevailing mar­
ket rate. Until June 1968 it used a single
rate in all open market operations; since
then, separate rates have been set for private
paper and Treasury paper, with the rate
for the former usually Vs of 1 percentage
point higher than that for the latter.
During the first few months of 1971, the
intervention rate was set below the basic
discount rate, and as a result, banks began
to borrow from the money market before
reaching their ceiling at the discount win­
dow. This has led the Bank of France to
enlarge the list of paper eligible for the
money market.
Quantitative restrictions. Direct restrictions
on certain kinds of credit were abolished
in February 1971. Until then such restric­
tions had also been an important instrument
of monetary policy in France. Credits to the



nationalized industries were restricted to the
level of 1958 by the Caisse Nationale des
Marches de VEtat, whose endorsement is
required to make such credits negotiable.
Residential construction credits were re­
stricted by a 1964 agreement— signed by
the Minister of Finance, the Governor of the
Bank of France, and the Governor of the
Credit Fonder— according to which special
construction loans outstanding were to be
progressively reduced and new authoriza­
tions for such loans were to be held within
an annual ceiling.3 Direct restriction ap­
plied not only to certain categories of loans
but also to the volume of credit extended
by the entire banking system to any individ­
ual borrower (see p. 232, footnote 35).
Moral suasion. Direct Government owner­
ship of large segments of industry as well as
of commercial banking and of the various
specialized institutions in the field of medi­
um-term credit offers various opportunities
for implementation of official policies. To
relate credit policy to over-all goals of Gov­
ernment economic policy, the Commissioner
General of the National Economic Plan is­
sues credit guidelines on behalf of the
NCC. For example, a directive issued on
September 12, 1963, asked that credit not
be extended for speculative purposes, in­
cluding land speculation, and that priority
be given to export industries, to those in­
dustries being exposed to new foreign com­
petition by reduced tariffs, and to those
projects designed to increase efficiency. Such
directives have no force of law, and it is
difficult to determine how effective moral
suasion and the prior authorization proce­
30 The original intention to reduce such loans from
10 billion francs at the end of 1964 to 8.4 billion
francs at the end of 1968 was later (August 1967)
largely nullified by raising the ceiling to 9.5 billion
francs; this ceiling was extended through December

dure have been in directing credit into ap­
proved channels.
Discounts and advances
Access to central bank credit. Bank of
France credit for the purpose of financing
or refinancing the private sector may be ex­
tended in various forms. The techniques
used include (1) discounts of Treasury
securities and specified types of private
short-term paper held by banks, other finan­
cial establishments, and public and semi­
public financing institutions as well as by
businesses; (2) purchases of short-term (up
to 2 years) private and Treasury paper,
with or without the seller’s agreeing to re­
purchase; and (3) advances to the public
as well as to banks against collateral in the
form of certain long-term securities of Gov­
ernment agencies or certain Governmentsponsored borrowers. From 1935 until
the end of 1967, banks could obtain ad­
vances for up to 30 days, against certain
short-term public securities as collateral. As
already described, discounting by the bank­
ing system, including the public finan­
cial institutions, is subject to a system of
ceilings and liquidity ratios and, in some
cases, to a procedure requiring prior au­
The Bank of France may not discount
paper directly for the Treasury, and it is
forbidden to operate in the market “for the
benefit of the Treasury.” Central bank
credit to the Government must take the
form of book-entry, nonnegotiable loans,
which require ratification by the legislature
in the form of a convention, or treaty, be­
tween the Bank and the Government. But
outstanding Government bonds may be
used as collateral for advances, and Treas­
ury bills may be purchased outright by the
Bank of France.
Many of the legal provisions governing
the extension of credit by the Bank of


France reflect the view, common at the be­
ginning of the 19th century, that the bank
of issue should also engage in regular com­
mercial banking. Thus it is still technically
possible for a member of the general public
to discount commercial bills or securities at
the Bank or to obtain an advance from the
Bank, provided the paper presented for
discount or as collateral meets eligibility re­
quirements; however, as a practical matter,
the Bank no longer accommodates private
Except for a few private customers of
long standing, the Bank of France grants
credit only to banks, to certain public and
semipublic financial institutions, and to a
few registered financial establishments,3 of
which only the instalment credit establish­
ments generate any appreciable amount of
discountable paper. Furthermore, the Bank
may refuse any request to discount or
make advances— even when eligibility re­
quirements are met— except when grain
storage bills guaranteed by the National
Cereals Office (Office National Interprofes­
sional des Cereales) are presented for dis­
count or when Treasury bills are presented
by the nonbank public, even though banks
consider access to the discount window,
within the ceiling, to be a right rather than
a privilege.
In addition to direct discounting for pri­
vate business accounts (this volume is
small) and discounting for banks and other
financial institutions, the Bank of France
makes secured advances, but these are at a
rate higher than the discount rate. Until De­
cember 21, 1967, when the facility was
withdrawn, the Bank also made advances to
the banks for 30 days at a rate that was often
below the discount rate; however, these ad­
vances were subject to very low ceilings.
31 For a list of the specialized credit agencies, see
the 19th Annual Report of the National Credit Coun­
cil for 1964, p. 190.

Eligibility requirements. To be eligible for
discount at the Bank of France, commer­
cial bills of exchange and other commer­
cial paper must have a remaining maturity
of 3 months or less and bear three good
signatures (the third signature may be re­
placed by a pledge of securities or goods);
the Bank also may require additional
guarantees.3-' Bills corresponding to a loan
of money or a line of credit without any
immediate connection with the transfer of
goods or services ( “finance” bills) require
prior authorization of the Bank in addition
to the same guarantees as commercial bills.
Medium-term credits for specified pur­
poses (housing, industrial equipment, and
exports) become eligible by a process in
which the originating bank obtains the re­
quired third signature from the appropriate
intermediate financing agency. This proce­
dure involves depositing the original docu­
ments with the intermediate financing
agency and permitting the originating bank
to draw short-term notes using the medi­
um-term paper as collateral. These notes
are then sold to the Bank of France under
repurchase agreement. Effective January 1,
1966, the Bank of France extended to 7
years from 5 years the maximum original
maturity of certain kinds of medium-term
credit for equipment and construction that
it would admit indirectly for discount,
provided the remaining maturity was only 3
years. Repurchase agreements, on the other
hand, are made on paper with periods to
maturity ranging from 15 days to 2 years,
and under present Bank policies they may
be for as short a period as 2 days. Paper
32 A decree issued in December 1966 authorizes
banks to make short-term nonguaranteed loans based
on the general credit standing of the borrower rather
than on individual commercial transactions. Subse­
quently, legislation has been passed empowering the
Bank of France to discount such two-name instru­
ments. (Previously, discounting was limited to paper
bearing three names—those of the debtor, the credi­
tor, and the banker.)


that is not eligible for discounting because
of maturity may be sold under a repurchase
(en pension) arrangement and repossessed
later by the borrowing bank and then dis­
counted when it comes within the 90-day
maturity range.
Cost of Bank of France credit. The cost of
the marginal amount of central bank credit
in use is reflected in the money market rate
for day-to-day money secured by private
bills and, since the abolition of the plancher
and the coefficient, Treasury bills. The hier­
archy of rates at the Bank of France deter­
mines the order in which the banks present
different kinds of paper to the Bank (or to
the intermediate financing agencies) to ob­
tain cash.
The level of money market rates depends
upon the degree of utilization of central
bank credit facilities. At times when many
banks have unused margins for discounting
within the ceilings, the rate for day-to-day
money secured by private bills tends to fluc­
tuate close to the basic discount rate, since
banks with surplus funds may employ them
to reduce their discounts at the Bank of
France or to lend in the money market. As
rates become firmer, banks with unused
margins within the ceilings will discount
paper at the Bank of France to obtain funds
to lend in the market. When all, or nearly
all, banks are up to their discount ceilings
at the Bank, rates for day-to-day money will
tend to move up to the rate for discounting
medium-term paper at the intermediate
financing agencies; if market conditions
tighten still further, day-to-day money rates
will move toward the penalty rate.
During 1969 the Bank of France began
to reduce the number of different rates it
charges on discounts and advances. At the
end of 1969 short-term export paper, which
is accepted without limit outside the dis­
count ceilings, and which used to benefit
from a preferential 3 per cent rate, began to


be discounted at the basic rate. Mediumterm export paper, however, still benefited
from a much lower rate; namely, 4 per cent
(except that for exports to the countries in
the European Economic Community the
basic rate applied). Ordinary commercial
paper (within applicable ceilings), grain
storage bills guaranteed by the Office Na­
tional Interprofessional des Cereales and
equipment credits to nationalized industry
guaranteed by the Caisse Nationale des
Marches de VEtat were discounted at the
basic rate. The preferential rate of 3 V2 per
cent for special advances, which was in­
tended to aid small and medium-sized enter­
prises, was abolished in October 1970.
Since the beginning of 1967, the Bank of
France has intervened in the money market
on the “buy” side to keep market rates
from declining to levels that authorities
consider inappropriate. In times of boom
conditions, with high and rising interest
rates, the Bank has raised the whole struc­
ture of its rates (except for export paper
prior to the end of 1969) and has corre­
spondingly lowered these rates when infla­
tionary pressures have eased. On 26 occa­
sions in the 14 years ending 1969 the Bank
of France changed one or more of its rates
for discounts or advances, but it changed
the basic discount rate only 12 times during
this period. Five of the seven increases were
by 1 percentage point each, while four of
the five reductions were for Vi of 1 per­
centage point each. On several occasions
the size of the change and the timing were
influenced by balance of payments consid­
erations, which varied with the require­
ments of the domestic situation.
Bank of France credit practices. As a rule,
routine discounting3 takes place at the
33 Local or regional banks normally discount with
their Paris correspondents; thus a good deal of the
paper originating throughout France is submitted for
discount or repurchase operations in Paris,


Bank of France until 11 a.m. After that
hour the Bank of France intervenes in the
open market, either by selling or by buying
eligible paper under en pension (repur­
chase) agreements, in order to achieve its
rate objectives.
Early in the day banks inform the dis­
count house, through which they ordinarily
operate in the money market, whether
they will have excess funds or whether they
will need to borrow. First, each discount
house conducts an internal operation that is
comparable to intermediation in Federal
funds in the United States. Then banks that
are still short of funds will arrange through
the discount houses to sell paper en pension
to the Bank of France. If the market is
firm, banks with margins under their dis­
count ceilings will also borrow from the
Bank in order to lend to other banks.
A t the end of 1966, the French banking
system had on its books approximately 156
billion francs ($36 billion) of short-term
and discountable medium-term loans out­
standing to businesses and individuals;
about 84 per cent ($25 billion) of this
total was backed by bills. The heavy re­
liance upon bill financing is due to the
fact that Bank of France credit is available
most cheaply and most readily on the secu­
rity of short-term bills. Since the abolition
of the plancher and the coefficient (see
p. 226), credit operations of the Bank of
France have been based upon private paper
as well as Treasury bills. The examining
and processing of private collateral to de­
termine whether it meets eligibility require­
ments, and for other reasons, require the
employment of a large staff.
The bulk of the paper discounted within
ceilings is related to normal sales transac­
tions and is always acceptable, as long as it
fulfills the applicable maturity and signa­
ture conditions. Rejection of paper that
fails to meet these conditions can have no
effect upon monetary conditions because

the right of each bank to discount up to
its full quota is not questioned and because
the supply of eligible paper is more than
ample to make up for paper rejected for
any reason.
The Bank of France requires that, in
order to be eligible at the discount window,
all finance bills (provided they fulfill the
general requirement with regard to a 3month maximum maturity and provided
they have at least three signatures) be sub­
ject to the prior authorization procedure
from which only short-term trade bills are
Prior to June 30, 1970, any extension of
credit by a bank that would increase the in­
debtedness of any single borrower above 10
million francs required a prior authorization
of the Bank of France. This last requirement
made a considerable volume of ordinary
commercial paper subject to the priorauthorization procedure, which was quite
cumbersome.3 It has been replaced by a
procedure involving ex post control of all
loans of 25 million francs or more to the
same borrower.
For each credit sought under this proce­
dure, the borrower must submit to its bank
a file (dossier) that must include (1) bal­
ance sheets of the firm for the last 3 years;
(2) an estimate of the value of trade cred­
its, inventories, and investments; (3) a
statement of all bank accommodations al­
ready obtained;3 and (4) plans for use
and repayment of the credit applied for, to­
gether with evidence showing that no alter­
native means are available for raising the
34 The Bank of France and its branches examine
about 43,000 credit dossiers a year, and the entire
procedure usually requires considerable time for each
35 The Central Risks Office (Service Central des
Risques), which is attached to the General Discount
Department of the Bank of France, collects and col­
lates data on the total volume of credit furnished to
any given borrower on the basis of monthly reports
by banks and other financial institutions. The infor­
mation is available to the Discount Committee for
its decisions to grant central bank authorization. The


required funds. This dossier is studied by
the Discount Department of the Bank of
France (or one of its branches if the credit
is small and presents no complications) not
only to ascertain the quality of the loan but
also to determine whether it conforms to
current guidelines on the allocation of
credit in accordance with the National Eco­
nomic Plan.
Linkage of lending and deposit rates to cen­
tral bank rates. Since 1966 neither the lend­

ing nor the deposit rates of the commercial
banks have been formally linked to the
lending rates of the Bank of France. The
over-all amount of credit outstanding to any bor­
rower is also communicated each month to those
banks and financial institutions that have reported a
credit in the name of that borrower, although infor­
mation as to the source of the borrower’s other cred­
it is not divulged. The Central Risks Office also tab­
ulates the data according to the purpose of each
credit in order to provide information on the extent
to which the qualitative credit guidelines of the Na­
tional Economic Plan have been followed.


system of minimum lending rates for these
banks was abandoned at the beginning of
1966 after several years in which the
connection with the Bank of France dis­
count rate was progressively loosened. Ex­
cept for deposits of more than 500,000
francs (which have been freed from ceil­
ings), the NCC does set maximum interest
rates payable by banks and financial institu­
tions on sight and time deposits and certifi­
cates of deposit (bons de caisse), but these
rates have no fixed relationship to move­
ments in the Bank’s discount rate. In gen­
eral, however, changes in maximum rates
payable on deposits have followed with
some lag changes in money market condi­
tions. Similarly, the heavy reliance of the
banks on Bank of France credit (at the end
of 1969 the Bank financed about 25 per
cent of all short- and medium-term credit to
the economy) makes it inevitable that bank
lending rates should reflect the cost of bor­
rowing from the Bank of France.


In the Federal Republic of Germany (West
Germany) the authorities have sought the
means to maintain monetary control with­
out resorting to direct restriction of interna­
tional capital movements. To this end, they
have modified the traditional monetary pol­
icy instruments and have introduced other
tools. The principal monetary policy tools
used by the German Federal Bank are vari­
able reserve requirements and discount pol­
icy. Use of open market operations has not
been feasible because the money market is
narrow and because short-term securities
(mobilization paper) can be easily con­
verted into cash at the German Federal
Bank. The central bank does influence the
market for short-term paper by adjusting its

posted selling and repurchase rates, but it
does not undertake open market operations
on its own initiative, except for a modest
amount of transactions in long-term securi­
ties initiated in 1967.
In periods of monetary restraint since
World War II, the Federal Bank has found
it necessary to discourage net borrowing
abroad. At such times variable reserve re­
quirements have been employed; require­
ments against net liabilities of German
banks to nonresidents have been set at sub­
stantially higher levels than those against
gross domestic deposits.3 The discount
36 In addition, there is a 25 per cent withholding
tax on interest earned by foreign holders of West
German securities. In early 1970 a repeal of the tax
was proposed in response to excessive net outflows of
long-term capital, but no decision had been reached
by the end of that year.


mechanism has been employed in a similar
fashion. The maximum amount that each
bank is permitted to discount at the central
bank may be reduced, at the authorities’
discretion, by an amount equal to the in­
crease in a bank’s foreign borrowing above
a specified level. And at various times the
authorities have employed swaps between
the central bank and commercial banks to
encourage the latter to hold balances
abroad rather than to sell foreign exchange
to the Federal Bank.
Reserve requirements may be varied only
within a specified range. Moreover, when
reserve requirements have been raised in
an effort to curb credit expansion, the re­
strictive effects have sometimes been offset
to a considerable extent by sales of open
market paper to the Federal Bank— at
the initiative of commercial banks— as well
as by discounting. This has been true de­
spite the fact that central bank purchases of
open market paper are subject to an over­
all ceiling, and that ceilings on the volume
of discounts apply to each credit institution.
Central bank credit is available through
three avenues— by discounting eligible
paper within the rediscount quota, by ob­
taining collateralized advances (Lombard
credit) at a higher rate, and by selling Gov­
ernment securities at rates posted by the
Federal Bank (referred to as open market
operations). The granting of advances de­
pends not only on the availability of accept­
able collateral but also on the would-be
borrower’s financial condition, the purpose
of the borrowing, and the general credit
policy of the Federal Bank. During most of
the postwar period the rate on the advances
was 1 percentage point above the Bank’s
discount rate, but more recently it has been
2 and even 3 percentage points higher.
Both discounting within ceilings and ad­
vances are regarded as a privilege, not a
right, and both are permitted to remain
outstanding for very short periods only.

The Bank’s experience, especially in the
last decade, indicates that by use of the pol­
icy tools available the best that can be
achieved is only a gradual, indirect, and de­
layed effect on the lending activity of credit
institutions. Consequently, since the early
1950’s, the Bank has placed considerable
reliance on discount ceilings to control
bank lending to the nonbank sector, and
it has also used at times reductions of such
quotas as a means of achieving credit re­
The central bank has been among the
strongest advocates of legislation under
which expenditures and revenues of the
Federal, state (L and), and local govern­
ments would be brought into a framework
of coherent fiscal policy; considerable prog­
ress in this direction was achieved by the
passage of the Stabilization Law of 1967.
On the whole, however, the German experi­
ence since the shift to convertibility in the
late 1950’s reveals the limitations on use of
monetary policy during periods of substan­
tial trade surplus and unrestricted interna­
tional capital flows.
Banking system

The Government owns the German Federal
Bank (Deutsche Bundesbank) and appoints
its Council. The Bank is an autonomous in­
stitution, and it can pursue a policy
independent of the Federal Government.
Nevertheless, it maintains a close relation­
ship with the cabinet and, more specifically,
with the Ministers of Finance and Eco­
nomic Affairs.
The German Federal Bank succeeded in
1958 the Bank Deutscher Laender, which
operated along very similar lines but had a
more decentralized structure. It has a head
office (in Frankfurt) and several regional
central banks (Landeszentralbanken) lo­
cated throughout the individual states that
constitute the Federal Republic.3
37 These regional banks serve as offices of the Fed­
eral Bank in each Land and carry out the policy


The Federal Bank is the fiscal agent of
the Federal Government, while the central
banks of the individual states hold the ac­
counts of state governments, with minor ex­
ceptions. The Federal Bank is also in
charge of all foreign exchange transactions
and other transactions with foreign coun­
tries and organizations.
The banking system is very complex and
extensive, with almost 40,000 banking
offices at the end of 1969, operated by al­
most 10,000 separate institutions, including
8,000 credit cooperatives. Three main sec­
tors may be distinguished in this structure:
(1) commercial banks, including private
banks; the latter outnumber other commer­
cial banks but account for only about onetenth of commercial bank lending to non­
banks; (2) a three-tier savings bank system,
with regional “giro” institutions acting as in­
termediaries between local institutions (but
also having a considerable volume of lend­
ing to nonbanks) and the Girozentrale,
which is their central institution; and (3) co­
operative banks.
One significant characteristic of the
banking system is the importance of savings
banks, which outnumber commercial banks
and extend a considerably larger volume of
credit to nonbanks than do commercial
banks, and of specialized institutions, such
as mortgage banks, whose volume of lend­
ing to nonbanks is about equal to that of
commercial banks. Indeed, commercial
banks account for only between one-fourth
and one-fifth of the total volume of bank
lending to nonbanks. The importance of
savings banks reflects the wide range of as­
sets that they can acquire, enabling them to
compete effectively with commercial banks.
decisions reached by the Central Bank Council. Each
Land central bank acts as the fiscal agent for its
Land and carries out on its own responsibility central
banking operations, such as establishing rediscount
quotas and providing central bank credit at the stated
rates for rediscounts and advances with all credit in­
stitutions within its geographical area.


While the six big commercial banks play an
important role in the economic life of the
country, local and regional commercial
banks are quite significant.
Of the total balances held with the Fed­
eral Bank, commercial banks accounted for
only about one-third— an amount consider­
ably smaller than reserve balances held by
the savings bank system. Industrial and ag­
ricultural credit cooperatives, as well as
banks with special functions (such as the
Reconstruction Loan Corporation), are also
important as sources of credit and in meet­
ing other banking needs. All these institu­
tions, and some less important categories of
financial institutions not specifically men­
tioned above, are subject to reserve
requirements and are considered to be
banking institutions for the purpose of reg­
Discounts and advances

Central bank credit is available to all im­
portant categories of credit institutions, but
commercial banks use it more extensively
than other eligible institutions. In more re­
cent years, savings and cooperative banks
have made considerable use of central bank
The normal avenue for obtaining central
bank credit is to discount eligible paper.
Lombard credit is more expensive and is
more in the nature of “bridging credit” to
be granted only for very short-term balanc­
ing-out purposes, usually to cover monthend needs arising from day-to-day cash
In order to be eligible for rediscounting,
commercial bills normally have to be en­
dorsed by three parties “known to be sol­
vent,” and the bills must mature within 3
months of the central bank’s purchase date.
Discountable paper also includes bankers’
prime acceptances that serve to finance for­
eign trade, promissory notes of import and
storage agencies, exporters’ bills endorsed


by a bank and by the Export Credit Com­
pany, and bills used to finance certain cate­
gories of instalment sales for business pur­
poses, as well as for the purchase of
consumer durable goods, provided they ma­
ture within 3 months.3
Assets that may serve as collateral for
Lombard loans include bills of exchange el­
igible for rediscount; Treasury bills; bonds
of the Federal Government, state govern­
ments, or the Federal Special Funds that
appear in the Debt Register; and equaliza­
tion claims (bank claims on the Federal
Government arising from the currency re­
form of 1948). Normally, securities are
used as collateral.

is located. These quotas are determined flex­
ibly with consideration being given to the
individual institution’s record of compliance
with the rules and regulations of the central
bank and of the Federal Banking Supervi­
sory office.3 However, rediscount quotas
that can be granted by the regional central
banks (which currently number 11) are set
directly by the directorate of the Federal
Bank. Each credit institution may be granted
by the Central Bank Council, usually for a
6 months’ period, supplementary quotas for
amounts up to 25 per cent of its regular
quota to cover exceptional needs.
Since discount quotas increase automati­
cally with the growth of bank equity funds,
they have been reduced from time to time
Limitation on availability of central bank
to avoid excessive credit expansion. The
credit. West German credit institutions tend
most recent across-the-board reduction in
to accommodate their customers with loans
quotas was made effective in July 1969.
as long as they are able to supplement their
Furthermore, since September 1964 the
resources by using central bank credit—
German Federal Bank has, at times, been
even if in the process they become increas­
using reductions in quotas to discourage
ingly sensitive to restrictive monetary pol­
credit institutions from borrowing abroad.
icy. However, the access to the discount
Most recently— effective June 1970— the
window is restricted by a quota system.
discount quota of each credit institution be­
This system was introduced to protect the
came subject to reductions by the amount
central bank’s exposure, but since about
of its foreign borrowing in excess of the
1951 it has been increasingly used as an
amount outstanding at the end of March
instrument of monetary control. The Cen­
1970. In effect, quotas of a considerable
tral Bank Council has established “stand­
number of banks are subject to reduction at
ard” quotas that are based on the credit
one time or another, with some reductions
institutions’ equity capital and has dif­
clearly amounting to sanctions.
ferentiated these quotas according to types
Since credit institutions may not discount
of institutions.
in excess of their quotas under any circum­
Within the framework of the “standard”
stances, there is a tendency among some in­
quota guidelines, the rediscount quota of
stitutions to maintain a substantial leeway.
each credit institution is individually deter­
This is true principally of the larger institu­
mined by the Land central bank in whose
tions, although under extremely tight credit
area the head office of the credit institution
conditions— such as in 1965 and 1966 and
38 Banks may also obtain funds by selling to the
again in 1970— they too tend to borrow
Privatdiskont, A.G. prime bankers’ acceptances or in­
very heavily. Smaller institutions, on the
struments arising from the extension of medium- and
long-term export credit; and the Privatdiskont, A.G.
other hand, typically use their full quotas.
in turn rediscounts the acceptances with the central
bank. Holdings of such assets constitute secondary
liquidity because they may be immediately converted
into cash.

39 The latter prepares, in cooperation with the Fed­
eral Bank, draft banking legislation and establishes
rules for bank operations.


Credit institutions of the Federal Repub­
lic have relied heavily on the credit facili­
ties of the central bank. In order to provide
a continuously expanding amount of credit
to the private sector, these institutions have
increased their rediscounting and other
borrowing at the Bank whenever the bal­
ance of payments or the central bank’s for­
eign exchange operations have restricted
bank liquidity. This has occurred several
times: for instance, in 1960 when the cen­
tral bank offset the accumulation of its for­
eign assets, in 1964 and 1965 when re­
strictive monetary policy was reinforced by
a decline in official holdings of foreign as­
sets, as well as in 1970 when the central
bank was striving to maintain the liquidity
squeeze that had developed in the wake of
the capital outflow following the revalua­
tion of the German mark in October 1969.
The increasing importance of discounting
in periods of reserve shortages is reflected
in several ways: (1 ) the volume of central
bank credit; (2) the relation of such credit
to credit institutions’ total reserves (which
sometimes rises to one-fifth or possibly even
to one-third); and (3 ) the rising propor­
tions of such credit to loans granted to the
private sector and to the foreign assets port­
folio of the central bank.
Rate policy. The German Federal Bank
charges a uniform rate for all rediscounts,
whereas on advances its rate has been set as
much as 3 percentage points above the dis­
count rate. The two rates are not neces­
sarily changed simultaneously. The rate on
advances normally constitutes a ceiling on
fluctuations in money market rates.
If credit conditions require it, the central
bank changes the discount rate frequently.
During 1959 and 1960, for instance, it
raised the rate three times in a span of 9
months from 3 to 5 per cent. This was
done to restrict the impact of a large for­
eign trade surplus on domestic liquidity.


However, such a boost in domestic interest
rates encouraged a massive inflow of capi­
tal, which in turn forced the authorities to
reverse their monetary policy. As a conse­
quence, between November 1960 and May
1961 the discount rate was reduced in three
successive steps back to 3 per cent.
Balance of payments considerations
prevented the Federal Bank from making
any further changes in the discount rate
until January 1965. By that time rising in­
terest rates abroad had reduced the danger
of inducing a further large inflow of foreign
capital and after that rate changes were
made more often. For example, during 4
months in 1967, the discount rate was low­
ered four times, each time by Vi percentage
point. More recently, between April 1969
and March 1970, the central bank raised
the discount rate in four steps from 3 to
IV 2 per cent in response to both external
and domestic factors.
The repercussions of frequent changes in
the discount rate on the capital market
have complicated implementation of mone­
tary policy. The effects of such changes are
transmitted to the capital market through
commercial banks, most of which are active
in the securities markets as underwriters,
brokers and dealers, and buyers for their
own account— using their securities portfo­
lios as buffers whenever changes in mone­
tary policy occur. In order to offset the
effects on the capital market of policies that
are aimed essentially at the money market,
the central bank has found it necessary from
time to time to support the prices of bonds
issued by Government agencies. Until A u­
gust 1967 the central bank undertook sup­
port operations for the account of the var­
ious agencies whose securities were
involved rather than for its own account.
While such purchases did not add to the vol­
ume of central bank credit outstanding, but
merely shifted balances at the central bank


from the Government agencies to the bank­
ing system, such operations tended to ease
commercial bank reserve positions and thus
to offset restrictive monetary policy. Since
August 1967, however, the central bank
has engaged in open market operations in
long-term securities for its own account.
Relationships between central bank rates and
market rates. Practically all market rates are

linked, or were until recently, to the Ger­
man Federal Bank’s discount rate. Also,
until April 1967 rates on loans and depos­
its of credit institutions were formally
linked to the discount rate. The Federal
Banking Supervisory Office set the ceiling
rates on loans made by credit institutions,
and these ceilings varied directly with the
discount rate. Rates on business loans were
AVz percentage points above the discount
rate, and those on bills discountable at the
central bank were 3 percentage points
above the discount rate. The linkage of de­
posit rates to the discount rate was less di­
rect, however, and changes in rates on de­
posits usually lagged behind changes in the
discount rate. On April 1, 1967, the legal
ceiling rates on both loans and deposits
were removed.
Other in strum ents of m onetary policy
Minimum reserve ratios. The Federal Bank

is authorized to set minimum reserve re­
quirements against all sight (dem and),
time, and savings deposits. These ratios are
variable, and they apply to all credit institu­
tions that accept such deposits.
Reserve requirements can be satisfied
only by holding nonearning balances with
the central bank. These balances may be
counted toward the liquid assets that must
be maintained under other laws.4 The upper
40 Credit institutions must also observe certain
guidelines concerning their liquidity and solvency.
These are expressed as ratios of prescribed assets to

limits for imiximum reserve ratios against
sight, time, and savings deposits are 30, 20,
and 10 per cent, respectively. Actual reserve
ratios may vary not only with the type of
deposit but also with the type of depositor
and the location and size of the credit insti­
tution, so the number of specific ratios ap­
plicable at any given point in time is quite
large. Any reserve deficiency is subject to
a fine of 3 percentage points above the rate
on central bank advances.4
Reserve ratios are changed quite often.
The changes that have been made in re­
serve ratios since November 1959 have
been across-the-board, and the same per­
centage change (not the same number of
percentage points) has been applied each
time in order to maintain the same structure
of reserve ratios. At various times additional
minimum reserve requirements have been
imposed on marginal increases in bank lia­
bilities above the level prevailing at a given
date or during a given period.4 Changes
in reserve ratios against nonresident de­
posits, separate from those in reserve ratios
against other deposits ( and allowing, at
times, for bank borrowing abroad to be
counted as an offset against such liabilites),
have been used to regulate the liquidity of
prescribed net worth and liabilities. These ratios are
administered by the Federal Banking Supervisory
Office and are not used as an instrument of mone­
tary policy.
41 Reserve requirements are computed on the basis
of the monthly average of deposit liabilities on four
statement days (the 23rd and the last business day of
the preceding calendar month, and the 7th and 15th
of the current calendar month). The reserve period,
which is the current calendar month, permits individ:
ual credit institutions to average out sharp oscilla­
tions. This is especially important in Germany where
there is no equivalent of the “tax and loan account”
at the Federal Reserve Banks.
42 For example, between December 1968 and No­
vember 1969, additions to external liabilities were
subjected to 100 per cent reserve requirements.


the banking system in periods of large
capital inflows. Another technique, intro­
duced in 1970, was to subject to reserve
requirements bank guarantees on certain
types of direct business borrowing abroad.
Open market operations. For several rea­
sons, the principal of which are mentioned
in the introductory section, open market
operations of the German Federal Bank are
a passive element among the monetary pol­
icy tools. The level of bank reserves is af­
fected only when the banks choose to buy
securities from, or sell them to, the central
bank. The Federal Bank does not initiate
market sales or purchases, but rather re­
stricts itself to making changes from time to
time in the rates at which it will buy or sell
Federal Treasury bills and bonds as well as
short- and medium-term securities (of up
to 2-year maturity) of certain Government
agencies. The decision of how much to buy
or sell at the posted rates— these are changed


somewhat more often than the discount
rate— is left to the credit institution.
Credit institutions as a whole have come
to regard their holdings of open market
paper as secondary liquidity. Most such
paper was created by issuing securities to
replace— “mobilize”— book claims of the
Federal Bank against the Federal Govern­
ment arising from the postwar currency re­
form. The amount of “mobilization paper”
is limited to 8 billion German marks, which,
once fully issued, was large enough to per­
mit credit institutions to counteract, at least
temporarily, the central bank’s policy aim­
ing at a specific level of free reserves. To
put the central bank in a position to mop up
additional bank liquidity once its holdings
of mobilization paper were exhausted, the
Federal Bank was authorized in 1967 to
sell up to 8 billion marks of “liquidity
paper” issued to it by the Treasury in the
form of bills and bonds.


Discount policy plays an important role as
a monetary policy tool of the Bank of
Italy, even though there are no formal
statements or regulations setting forth the
Bank’s objectives in this area. The Bank
administers discount policy flexibly, and its
day-to-day course depends to a large extent
on how Treasury operations and balance of
payments developments affect the monetary
base. Moreover, until mid-1969, the em­
phasis appears to have been on changes in
credit availability affected through rationing
rather than on the discount rate, which had
remained unchanged since 1958. Since Au­
gust 1969, however, the discount rate has
been raised in two steps from 3 Vi to 5 Vi

per cent as part of a policy to bring the do­
mestic rate structure closer into line with
interest rates abroad. Accommodation is
mostly in the form of advances rather than
The Bank has broad discretionary pow­
ers in implementing its discount policy with
respect to both form of accommodation and
type of asset accepted. These powers give
the Bank considerable leverage in directly
controlling the expansion of credit. The
monetary authorities also maintain control
over the volume of liquidity available to
Italian banks from their foreign balances by
regulating the banks’ net foreign exchange
positions vis-a-vis nonresidents and by mak­
ing available, at their discretion, cost-free


forward exchange cover facilities. Before
May 1969, when the amount being offered
to the banks began to be limited to their
actual required reserve needs, the Bank of
Italy had substantial control over a third
source of bank liquidity-—the amount of
Treasury bills held in excess of the banks’
compulsory reserve requirements.
The central bank’s commitment to sup­
port the Government’s budget constitutes a
major loophole in its control over liquidity.
However, since World War II, successive
governments have not abused their power
to obtain credits from the central bank.
There has been no serious slippage in mone­
tary control as a result of Treasury opera­
tions, especially since the Bank of Italy is
in a position to offset any disequilibrating
influences emanating from that source.
Reserve requirements, introduced origi­
nally in 1926 as liquidity ratios to protect
depositors, have been used as a tool of
monetary policy since World War II. The
use of this tool has proved cumbersome,
however, because the reserve ratios are de­
termined by a very complex formula (see
pp. 244 and 245). Moreover, the effective­
ness of this tool is limited by the fact that
the reserve requirements can be satisfied
in a way that provides the banks with a
return, which until mid-1969 was fairly
close to market rates.
Institutional fram ework

Over-all monetary policy in Italy is formu­
lated by the Interministerial Committee for
Credit and Savings. This Committee, which
consists of the Minister of the Treasury (its
chairman), seven other ministers, and the
Governor of the Bank of Italy as a nonvot­
ing member, meets seven or eight times a
year. Its policy decisions are embodied in
decrees signed by the Minister of the Treas­
ury and in regulations issued by the Bank of
Italy. For example, the discount rate is es­

tablished by a decree of the Minister of the
Treasury acting upon recommendation of
the Governor of the Bank. Execution of
monetary policy is entrusted to the Bank of
Italy, which has a network of regional
The outstanding stock of the Bank of
Italy is owned by various types of financial
institutions, all of which are publicly owned
in whole or in part. Even though the Gov­
ernment itself holds none of the central
bank’s capital stock and does not participate
in the activities of any of its governing
bodies, the Treasury in effect has control
over the Bank of Italy. However, the stature
and prestige of the Bank’s governors have
given the Bank considerable autonomy and
great weight in policy decisions in the whole
area of Government financial policy.
In the international field the Bank of Ita­
ly’s functions are complemented by the Ex­
change Office ( Ufficio Italiano dei Cambi),
which— though nominally an independent
public body— is in effect an affiliate of the
central bank. The Exchange Office carries
out its domestic operations through the
Bank of Italy’s branches, which act as its
agents. The Exchange Office obtains the
lire it needs to acquire foreign exchange
through an unlimited line of credit from the
Bank of Italy.
The Italian banking system has grown
over the years into a heterogeneous con­
glomerate of institutions (some of them
nearly 500 years old and pioneers of bank­
ing) that are not easily fitted into precise
classifications according to type of activity.
All of these institutions engage to a greater
or lesser extent in short-, medium-, or
long-term lending. By the Banking Law of
1936, the Italian credit system was divided
into two sectors. One consists of banking
institutions that take most of their deposits
as “short-term savings” (defined as demand
deposits and savings and time deposits) and



that are forbidden to accept deposits with
more than 18 months’ maturity. The other
consists of institutions that accept mediumterm savings— with maturities of 18 to 60
months— but that, with one exception, raise
most of their funds by issuing bonds in the
capital market. The former are called
“credit institutions” (aziende di credito) and
the latter “special credit institutions” (istituti
speciali di credito). Both groups are subject
to supervision by the Bank of Italy.
The credit institutions number about
1,200 (with over 10,000 branches); about
350 larger institutions account for about
98 per cent of total deposits. The leading
banking institutions include: (1 ) “public
law banks” ; directors of these banks are ap­
pointed by the Government (because they
have no share capital, or because the capi­
tal is owned by the Government); and (2)
“banks of national interest” ; banks in this
group have widespread networks of
branches and most of their capital is pub­
licly owned.
The scope of business of some of the sav­
ings banks is virtually indistinguishable
from that of the commercial banks. Certain
categories of credit institutions— Coopera­
tive People’s Banks, savings banks, and jointstock banks and private banks— belong to
“group institutes” that hold part of their liq­
uid reserves and provide a variety of serv­
ices— such as issuing bank drafts (assegni
circolari) ,4 providing clearing facilities and
technical assistance, and representing the
members in dealings with the Treasury and
other branches of the Government.4
The special credit institutions number
43 Assegno circolare is an instrument very widely
used by the public in Italy, where the practice of
payment by check for general purposes is rather lim­
44 On Dec. 31, 1969, total liabilities and net worth
of the group institutes amounted to 2,132 billion lire
($3.4 billion equivalent); most of this total presuma­
bly represented claims of the member institutions.

about 80, of which 21 are engaged in mort­
gage credit, 12 in agricultural credit, and
the rest in industrial credit and miscella­
neous activities.
Discounts and advances

Central bank credit is available to all the
credit institutions and group institutes (all
of which are generally referred to herein as
banks), and in principle also to private in­
dustry and individuals.4 In contrast to the
central government, local governments do
not have direct access to central bank
credit. No type of paper, other than Storage
Agency Bills (see footnote 46), is auto­
matically eligible for rediscounting or as
collateral for a loan. The Bank of Italy de­
termines how much credit it wishes to ex­
tend in the light of prevailing monetary pol­
icy and then scrutinizes every credit
appliction individually.
Accommodation to credit institutions and
group institutes. Central bank accommoda­

tion of credit institutions and group insti­
tutes takes three forms: advances on collat­
eral, rediscounts of commercial paper and
Treasury bills, and “deferred payments” at
the clearing house.4 Commercial banks are
45 In principle, special credit institutions, except
those extending credit to agriculture, have no direct
access to central bank credit. However, under unu­
sual circumstances they may obtain advances on col­
lateral on the same terms as nonbank borrowers; the
volume of such advances has been insignificant—less
than 0.5 per cent of the Bank of Italy’s total ad­
vances in recent years.
46 A fourth type of central bank accommodation
consists of the rediscounting of bills issued through
the crop year 1963-64 to finance the Government’s
farm price-support program (particularly the price of
wheat). These Storage Agency Bills are first dis­
counted with the credit institutions at rates ranging
from 5 V2 to 6 V2 per cent per annum; all such bills
are automatically eligible for rediscount at the Bank
of Italy and for the most part are passed on to the
latter. Such rediscounts rose from 383 billion lire at
the end of 1958 to 905 billion lire at the end of De­
cember 1969. In this instance, the Bank of Italy acts
as agent for the Government, and discount policy is
presumably adjusted to take account of the auto­
matic rediscounting of Storage Agency Bills. Conse­
quently, the discussion in the text is confined to “or­
dinary” rediscounting.


the main users of central bank credit. Ital­
ian banks as a group borrow continuously
from the central bank, which is usually pre­
pared to meet seasonal and local needs.
Permanent financing of required reserves,
however, is avoided.
Accommodation by the Bank of Italy is
mainly in the form of advances on collat­
eral. These advances are made on the basis
of lines of credit that the central bank
opens in favor of the individual banks
against securities deposited with it when the
line of credit is established. The paper
eligible as collateral consists of Govern­
ment and Government-guaranteed securities,
mortgage bonds, and bonds of “equivalent
rating.” 4 The line remains open for 4
months and is renewable. The banks are
not expected to draw the credit at once and
to remain fully indebted for the duration of
the credit period; rather, it is expected that
drawings and repayments will be continu­
ous. In 1967 the Bank of Italy introduced
advances on collateral with a fixed maturity
of 8, 15, or 22 days. Such advances, when
granted, must be drawn in full, but in every
other respect they resemble the line-ofcredit advances.
The second type of accommodation con­
sists of rediscounting of commercial paper
and Treasury bills. In practice, the bulk of
the paper discounted consists of commercial
bills, since the banks prefer to keep Treas­
ury bills for other operations. Commercial
bills presented for rediscounting must have
a maximum remaining maturity of not more
than 4 months, and they must bear the
signature of at least two persons or firms
known to be solvent. In normal times redis­
counting is a marginal item in the total of

the banks’ borrowing from the central
bank. In case of tightness, banks will first
use their credit lines for advances, and only
when these lines are running short will
banks resort to rediscounting.4 In normal
times, total central bank credit tends to be
very small in proportion to the banks’ lira
loans to the private sector (less than 1 per
cent) and relatively small in proportion to
the banks’ required reserves (3 to 6 per
Collateralized advances as well as redis­
counting are available as a privilege, sub­
ject to the discretion of the Bank of Italy.
The Bank has established individual ceil­
ings for lines of credit for each bank as
well as for local branches of institutions
with national networks of branches. As a
rule of thumb, these ceilings are set at 5
per cent of the individual bank’s total de­
posits, but they are occasionally reviewed
and revised. Branch managers of the Bank
of Italy, who are intimately acquainted with
the needs of the local banks, have some dis­
cretion in increasing these ceilings, but they
refer decisions concerning any substantial
upward revisions to the main office. An in­
dividual bank does not know what its ceil­
ing is, and the Bank of Italy does not dis­
cuss th e 5 p e r c e n t fig u re p u b lic ly .
Although there are no ceilings for redis­
counting and fixed-maturity advances, it is
worth noting that aggregate advances and
rediscounts have seldom reached 5 per cent
of the total deposits of all banks. At the end
of 1969, however, the ratio was 6.8 per
cent, and the central bank provided about
one-fourth of bank reserves.
Large banks generally prefer to obtain
central bank credit through collateralized

47 This category comprises bonds issued by impor­
tant official financial institutions, such as Istituto per
la Ricostruzione Industriale and Ente Nazionale Idrocarburi; special credit institutions, such as Istituto
Mobiliare Italiano; and the nationalized enterprises,
such as Ente Nazionale Elettricita.

48 Excluding rediscounts of Storage Agency Bills,
ordinary rediscounting is relatively insignificant com­
pared with advances on collateral; however, in times
of liquidity pressures (for instance, during most of
1963 and in early 1964), the relative share of redis­
counting has tended to increase.


advances rather than through rediscount­
ing, for the most part because the former
method is more flexible and less costly but
also because the banks do not want their
customers to know that they use central
bank credit. The official rates for redis­
counts and advances have been identical
since 1950, but in the case of advances on
current account, interest is charged only on
outstanding balances and banks may repay
the loan at any time, whereas rediscounts
and fixed-maturity advances, even though
repaid early, are considered as outstanding
for the full period to maturity. Large banks
resort to rediscounting at the central bank
chiefly to meet unusually heavy withdrawals
of funds and sharp increases in drawings
under confirmed credit lines. The smaller
banks resort to rediscounting more often.
Finally, a minor avenue of central bank
credit open to banks has been a system of
“deferred payments” (prorogati pagamenti)
for meeting adverse clearing balances at the
local clearinghouses operated by the Bank
of Italy. Such accommodation is granted—
normally for a single day but in exceptional
instances for as many as 4 days— to clear­
inghouse members against collateral of the
kind accepted by the Bank of Italy for reg­
ular advances.4 Since the introduction of
fixed-maturity advances, however, recourse
to “deferred payments” as an additional
source of funds has been officially discour­
aged, and since July 1967 an end-of-month
balance outstanding has been a very rare


per cent of the original ordinary budget ap­
propriations and of any supplementary ex­
penditures approved by Parliament, was re­
duced to 14 per cent in 1964. Moreover,
the Bank of Italy is authorized to subscribe
without limit to securities issued or guaran­
teed by the Italian Government. It also re­
discounts special paper issued in connection
with the Government’s agricultural pricesupport programs (see p. 241, footnote 46).
Discounts by the Bank of Italy for
private individuals were forbidden by law
in 1936. However, the law does not prevent
the central bank from making advances to
private customers on the following types of
collateral: Treasury bills; bonds issued or
guaranteed by the Government; bonds of
mortgage credit institutions; Italian and for­
eign legal tender gold coins; gold bonds;
foreign government securities payable in
gold; and raw and processed silk. In 1958
advances to individuals represented 14 per
cent of the total advances of the Bank; such
advances have declined since then and in
the last 3 years were a little over 1 per cent
of the total. There are indications that the
Bank of Italy intends to eliminate the re­
maining private accounts as quickly as fea­
sible, but it wants to retain the legal author­
ity to make direct loans for emergency
Relationship of bank deposit and lending
rates to the discount rate. The volume of

commercial bank borrowing at the central
bank is influenced by availability of funds
rather than by cost. In principle, there are
Accommodation to the central government
no obstacles to large or frequent changes
and private individuals. Since 1948 the Bank
in the discount rate, but for several rea­
of Italy has been required by law to grant
sons— chiefly the lack of an organized and
the Treasury unsecured short-term over­
interest-sensitive money market— the central
draft facilities. The initial limit, set at 15
bank has relied until recently almost exclu­
49 In normal years these deferred-payment loans sively on tight controls of the volume of its
(year-end basis) have not amounted to more than
credit. However, during the last year, partly
0.5 per cent of the banks’ required reserves. During
under pressure of external factors, the
the 1963-64 “squeeze” they amounted to nearly 2
Bank’s emphasis on the cost of credit has
per cent.


greatly increased. After having remained
unchanged at 3 Vi per cent since June
1958, between August 1969 and March
1970 the discount rate was raised in two
steps to 5Y2 per cent. In March 1969, a
new rule concerning the interest rate on
fixed-term advances was introduced: banks
that borrow at the Bank of Italy more than
once in a 6-month period have to pay a
penalty rate, which may exceed the official
rate on advances by IV 2 percentage points.
Moreover, since July 1, 1969, the Bank of
Italy has been charging a penalty rate of
1V2 percentage points to banks whose aver­
age rediscounting in the preceding half year
exceeded 5 per cent of their reserve re­
The structure of interest rates in Italy
used to be regulated under a voluntary “In­
terbank Agreement” that set minimum rates
on loans and maximum rates on deposits.5
However, the Agreement, which had pre­
viously been renewed every year since its
inception in 1954, was allowed to lapse at
the end of 1969 under pressure of very
tight conditions in the domestic money
market and sharp competition for deposits.
After the lapse of the Agreement, banks
began almost universally to pay interest
well above the “cartel” rates.5 Moreover,
50 The Agreement linked the banks’ minimum
lending rates to the official discount rate, but with
variations according to the type of lending. (In July
1969 this link was abandoned.) Thus, the banks’ dis­
count rate for commercial paper was usually set IV2
percentage points above the official discount rate; the
“cartel” minimum rate for overdrafts was ZVi per­
centage points above the Bank of Italy’s discount
rate (and Lombard rate), plus a quarterly commis­
sion of Vs of a percentage point on the highest bal­
ance outstanding. The enforcement of the Agreement
was entrusted to a special committee—chaired
by the president of the Italian Bankers Association
and including representatives of the major banking
groups—that was able to impose penalties of up to a
hundred times the amount paid to a depositor (or
charged to a borrower) above (or below) the maxi­
mum (or minimum) agreed rate.
51 The maximum rates payable under the Agree­
ment were V2 per cent for current accounts (2 per
cent where the average balance exceeded 5 million

the lending rates actually charged by indi­
vidual banks had exceeded the minimum
“cartel” rates long before the lapse of the
Agreement. Through most of the period
since the 1964-65 recession, actual lending
rates have, according to some reports, ex­
ceeded the cartel rates by as much as 3 to
4 percentage points. On the other hand,
when Euro-dollar rates were still relatively
low, the Italian banks— to meet competi­
tion of foreign banks— kept rates on for­
eign currency loans to their prime custom­
ers below the cartel rates on lira loans.
Although in late 1970— with the Euro­
dollar market losing much of its attractive­
ness and the liquidity of the domestic money
market easing rapidly— the major banks
were able to negotiate a new agreement cov­
ering interest payable on deposits, no new
agreement concerning the lending rates was
reached before the end of the year.
Other instrum ents of m onetary policy

In recent years the most important of the
other instruments of monetary policy have
been controls over maximum expansion of
bank credit and manipulation of commer­
cial banks’ net foreign assets positions. The
monetary authorities also set and vary re­
serve requirements and engage in open mar­
ket operations; and they may impose ad
hoc direct and selective controls, such as
those over securities issued by both the
banking and the nonbanking sectors.
Relatively little use is made of the re­
serve requirement tool in policy manage­
ment; changes in the rates are infrequent.5
lire), IV 4 per cent for normal savings deposits, and
33 per cent for tied savings deposits. Yet, holders
of sizable current accounts were able to obtain in­
terest rates of 6 per cent or more.
52 Reserve requirements for credit institutions have
been changed only once (in 1962) after having been
modified in 1947.. However, from time to time the
Bank of Italy has used this instrument as a counter­
cyclical weapon by changing the types of financial
assets that can be used to satisfy reserve require­



and moral suasion. The latter is particularly
effective because of the wide discretionary
powers that the Bank of Italy has in reject­
ing or accepting applications for redis­
counts or advances and perhaps because of
the state ownership or control of many lead­
ing banks.
The Bank of Italy must give prior au­
thorization to a commercial or savings bank
before such a bank can provide credit ac­
commodation or renew a loan to any one
customer if such accommodation would
raise the customer’s total liability to the
bank above the so-called “legal limit on
credit” (limite legale di fido), defined as
one-fifth of the paid-up capital and reserves
of the lending bank. Introduced in 1926 to
safeguard depositors, the scope of this rule
has been extended considerably in the post­
war period as inflation has greatly reduced
the capital/deposit ratio of banks.5
The exercise of this power has been use­
ful, at least at certain times, as a tool of
monetary policy. It enables the Bank of
Italy to exert a selective and restrictive in­
fluence on the quantity and quality of bank
credit, and it enables commercial banks to
resist local political pressures to provide
Direct controls over private credit flows.
funds to support local government spend­
Direct controls over the banks’ loan expan­
ing. For example, of all lira-denominated
sion are implemented by both legal authority
loans outstanding to the private sector at
5 Under the present system, two types of Treasury the end of 1962 and 1963, about 25 per
bills are offered. One type, which remains eligible for
cent had been approved by the Bank of
the fulfillment of reserve requirements but is appar­
Italy, and more than 70 per cent of these
ently offered only in limited amounts, carries a fixed
interest rate of 3.75 per cent. If total bids exceed the
had been granted by the big banks. This
total amount offered, allotments to banks are made
control has been used to prevent speculative
on a pro rata basis. The second type of bill (not eli­
gible to fulfill reserve requirements and not qualify­
inventory building during boom periods
ing for central bank support) is offered for invest­
and to limit the use of short-term credits
ment purposes at a “market” rate of interest, strictly
to meet the Treasury’s temporary need for cash. Any
for long-term financing of fixed invest­
amount tendered and not purchased by commercial
banks may or may not be taken up by the Bank of
Italy, at its discretion. Once the amount of the new
The “legal limit on credit” varies greatly
type of Treasury bill in the portfolios of both the
in amount of course from one institution to
commercial banks and the central bank reaches a

Different reserve requirements are applied
to individual categories of credit institutions
and types of liabilities, and the reserve coef­
ficients are to some extent progressive. In
general, the credit institutions must satisfy
their reserve requirements by holding interest-bearing deposits with the Bank of Italy
against the first 10 per cent of their total
deposit liabilities in excess of net capital re­
sources, and they may satisfy the balance,
at the option of the Bank, by holding addi­
tional cash balances, Treasury bills, or cer­
tain types of long-term securities.
Thus far, open market operations are
still only a potential instrument of monetary
management, inasmuch as an important in­
stitutional reform in November 1962,
aimed at establishing an organized money
market, has been slow in producing signifi­
cant results. Recently, however, the Bank
of Italy has been dealing with banks in
long-term securities on a fairly large scale.
Moreover, the new Treasury bill issue sys­
tem introduced in early 1969 has made it
possible for the central bank ultimately to
include short-term Government securities in
its open market operations.5

sufficient volume, the latter should be able to engage
in open market operations for monetary policy pur­
poses and thus to contribute importantly to the de­
velopment of a broadly based money market.

54 Whereas the capital/deposit ratio was about 12
per cent in 1938, it dropped to less than 2 per cent
in 1947 and was still not much more than 3 per cent
in September 1969.


another and rises as a bank’s capital re­
sources increase. Therefore, while effective
for small and medium-sized banks, this in­
strument has only limited usefulness with
regard to the few giant banks. Limitation of
lending by the large banks is achieved
mainly through moral suasion. As a result
of the close relationship of the central bank
to these institutions— in most of which the
Government owns a controlling interest,
either directly or through holding companies
— the Bank of Italy has obtained the coop­
eration of these institutions in applying more
stringent “qualitative” criteria and in other
ways slowing down loan expansion.
Finally, direct control over flows of
credit in the economy is enhanced by the
authority of the Bank of Italy to approve
(concurrently with the Ministry of the
Treasury and subject to approval by the Interministerial Committee), or to withhold
approval of, all issues of bonds and stocks
made through the intermediary of institu­

tions subject to the Bank of Italy’s supervi­
sion or to be listed on a stock exchange.5
This requirement extends also to bonds is­
sued (other than mortgage bonds) by
credit institutions. Authorizations may be
delayed or speeded up, depending on the
current objectives of monetary policy.
Manipulation of commercial banks’ net exter­
nal position. Manipulation of the commercial

banks’ net foreign exchange position has
been used vigorously since August 1960
and, during times of large balance of pay­
ments surpluses, had been one of the most
significant tools of monetary management.
The authorities can affect this position by
instructing banks to adjust their net foreign
exchange holdings vis-a-vis nonresidents to
specified levels and thus bring about desired
changes in the banks’ domestic liquidity
through inflows or outflows of funds.
55 The power to authorize special credit institutions
(see p. 241) to float bond issues is vested with the
Governor of the Bank of Italy.

In tro d u c tio n

The Japanese monetary authorities (the
Bank of Japan and the Ministry of Fi­
nance) are well equipped to control exter­
nal sources of liquidity and to maintain
monetary control through their power to
regulate the cost and availability of central
bank credit. This is so in large part because
the Japanese banking system, being chroni­
cally in need of liquidity, is heavily depend­
ent on the central bank. Moreover, broad
powers to control foreign exchange enable
the authorities to exercise a significant in­
fluence over changes in the central bank’s
holdings of international assets and thus
over changes in the cash base that result
from movements in Japan’s balance of pay­

ments. In borrowing abroad, the Japanese
are “guided” by the central bank.
Discount policy plays a central role in
Japanese monetary policy, although the
Bank of Japan also employs to some extent
open market operations and variable re­
serve requirements to achieve its aims. Since
November 1962, when the Bank of Japan
introduced discount ceilings after some
lapse and began to buy and sell securities,
open market operations have provided a
rising proportion of the banking system’s
credit needs. Under the conditions that
have existed since World War II, however,
there has been only a very limited scope for
use of reserve requirements. Deposits with
the Bank of Japan to meet legal reserve re-



quirements— the present maximum being
W 2 per cent of deposit liabilities— are of
minor importance.
Access to the discount window is consid­
ered a privilege. A scale of rates is estab­
lished that varies with the type of paper of­
fered. Ceilings are set on the amounts that
will be lent to individual banks at the basic
discount rate, and penalty rates are applica­
ble to borrowing in excess of the ceiling.
The structure of discount rates, the types of
paper acceptable, and the ceilings on bor­
rowing are all subject to change— and in­
deed are frequently changed— in accord­
ance with the authorities’ monetary policy
objectives. And these objectives in turn are
closely geared to over-all economic policy.
The authorities’ control is strengthened
by the close links that exist between the
structure of discount rates and the structure
of market rates. Although rates on commer­
cial bank loans are permitted to fluctuate,
they may not exceed the maximum level set
by the Bank of Japan. Moreover, there is
an indirect tie between the bank prime rate,
which is set by the Banking Association (a
trade organization), and the discount rate.
The bank prime rate, which is the mini­
mum rate charged by commercial banks on
commercial paper eligible for discount at
the Bank of Japan, is at present set at a
level no higher than the basic discount rate.
In addition to controls over market rates,
the authorities control the rate that banks
may offer in the market for short-term de­
Other policy instruments include socalled “window guidance,” under which the
authorities have, from time to time, used
moral suasion— which has developed into a
system of close supervision of each bank’s
day-to-day activities— to influence the com­
mercial banks’ lending policies, and selec­
tive credit controls, such as those over the
financing of securities and imports. No spe­

cific monetary controls are applied at pres­
ent to consumer and housing credit.
Until fairly recently, the traditional in­
struments of monetary policy appear to
have been considered adequate to deal with
both domestic and external disequilibria.
Since 1964, however, the authorities have
placed increased reliance on fiscal measures
for implementing over-all economic policy.
Institutional framework

The Bank of Japan is operated as part of
the Government’s economic administration
in close liaison with the Ministry of Fi­
nance. Some 55 per cent of its capital is
owned by the Ministry of Finance; the re­
mainder by local authorities, financial insti­
tutions, and other private corporations and
individuals. The Bank is managed by the
Governor, the Vice Governor, and the
board of directors; the directors are usually
selected from the Bank’s senior staff. Over­
all policy is determined by a Policy Board
consisting of (1 ) the Governor, (2 ) four
outside members (required to be experi­
enced, respectively, in banking, industry,
commerce, and agriculture) appointed by
the Cabinet and approved by both houses
of Parliament, and (3 ) two direct repre­
sentatives of the Government. The Policy
Board is not concerned with the Bank’s
management on a current basis.
The banking system is dominated by 15
so-called “city banks,” which operate
branches throughout the country and ac­
count for almost 60 per cent of the assets
of the banking system. In addition, there
are some 60 local commercial banks and a
variety of other credit institutions, including
trust banks, long-term credit and other spe­
cialized banks, mutual savings and loan
banks, credit associations, and agricultural
credit cooperatives.
The outstanding features of Japan’s finan­
cial structure are the extremely low ratio of


commercial banks’ liquid assets to total as­
sets and the heavy indebtedness of the
banks to the Bank of Japan. This “over­
loaned” situation is the result of the infla­
tionary aftermath of World War II, which
led to high debt/equity ratios for Japanese
industry generally; virtually all industry
debt consists of short-term bank loans.
While correction of this weakness in the
banking system and in business has been a
policy objective, the authorities have been
reluctant to permit long-term interest rates
to rise to a level that would promote devel­
opment of an adequate supply of long-term
capital and thus reduce the dependence on
short-term bank loans; hence a large pro­
portion of private investment continues to
be financed through commercial bank
credit, and the banks in turn replenish their
cash reserves through credits from the cen­
tral bank.
Liquid assets of the banking system as a
whole consist of cash, deposits with the
Bank of Japan and with other financial in­
stitutions, call loans, and credit extended to
financial institutions. Treasury operations
greatly affect the banking system’s liquidity.
The Japanese Government holds on deposit
in the Bank of Japan all of its funds, in­
cluding the proceeds of tax collections and
of all Government borrowings. When the
Government receives taxes or when it bor­
rows, the liquidity of the commercial banks
is adversely affected. There are similar
effects when the public, which likes to hold
currency, increases its demand for currency.
Commercial banks maintain such liquid
asset ratios as they deem suitable; there are
no required ratios. In recent years liquid as­
sets, including deposits with the Bank of
Japan to meet legal reserve requirements,
have ranged between 3.0 and 3.8 per cent
of the banking system’s total assets, with
the bulk accounted for by vault cash.3 Al­
56 During the 1960-69 period, liquid assets of the
city banks averaged 2.1 per cent of their total assets,

though there are no formal liquidity ratios,
window guidance includes guidelines on
The reintroduction of ceilings on com­
mercial bank rediscounts and advances in
November 1962 stimulated the city banks
to search aggressively for sources of investable funds, and they turned mostly to the
call-loan market. During the next 2 years,
when Japanese monetary policy was restric­
tive, the proportion of the city banks’ re­
sources obtained in that market expanded
On the average, during the period
1960-69, 53 per cent of the funds bor­
rowed by the city banks came from the
Bank of Japan, 32 per cent from the callloan market, and 13 per cent from other fi­
nancial institutions. The call-loan market is
supplied almost entirely by local banks,
trust banks, and mutual savings and loan
banks. In the same period city banks sup­
plied less than 2 per cent of the funds
placed in the call-loan market, but they
borrowed more than 70 per cent of the
funds available in that market.
Discounts and advances

Discounts and advances are the main
source of central bank credit in Japan. In
accordance with Japanese monetary policy,
the authorities make such changes as may
be necessary in the discount rate structure,
the types of instruments eligible for dis­
counting and as collateral for advances,
and the ceilings on borrowing from the cen­
tral bank at the regular rates. As a matter
of practice, the Bank of Japan has restricted
discount facilities to commercial banks,
while local banks’ holdings averaged 6.6 per cent.
The city banks hold only small amounts of claims
on the Government that are readily convertible into
cash. At the end of December 1969, the equivalent
of $1,040 million, or less than 2 per cent of total as­
sets, was held in this form. However, since mid-1965
banks’ holdings of long-term Government paper have



even though the law does not limit exten­
sion of such facilities to any specific cate­
gory of borrower. There has been a tend­
ency lately to expand the range of financial
institutions that are welcome to use central
bank credit. Private corporations and indi­
viduals have not in practice used the Bank
of Japan’s facilities. Individual banks bor­
row from the central bank on a continuous
basis. City banks are the main borrowers,
in terms of both volume and duration of
borrowing; local banks borrow less and for
shorter periods.
Commercial bills,5 including notes
drawn by specified marketing organizations,
and export trade bills are eligible for dis­
count at the applicable rate. The following
types of paper may be used as collateral
for advances: Government bonds and
bills, Government-guaranteed bonds, bank
debentures, specified municipal and corpo­
rate bonds, rediscountable commercial bills,
export trade bills, and other general bills
considered suitable by the Bank of Japan.
Rate structure. The rate structure is fairly
complex. The Bank of Japan presently
maintains five “basic money rates,” depend­
ing on the type of paper discounted or
pledged as collateral.5 Discounted commer­
cial bills are charged the Bank of Japan’s
“basic discount rate,” which is subject to
frequent change, usually in conjunction
with the whole range of rates. The rates ap­
plicable to export paper are lower than the
basic rate, whereas the rates on advances
secured by specified Government securities
are higher. In September 1969 the Bank of
Japan discontinued the preferential treat­
ment of commercial bills, and on the occa­
sion of the official discount rate change
57 Two-name paper either drawn or accepted by a
purchaser of goods for resale in settlement of the
purchase and payable by the buyer.
58 Prior to September 1967, when import trade
bills and overdrafts ceased to be eligible for dis­
counting, the structure consisted of seven basic
money rates.

during that month the rate for commercial
bills was equalized with that for loans se­
cured by Government securities and desig­
nated paper, as shown in the accompanying
Per cent per annum

Commercial bills...........................
Government securities and spe­
cially designated securities. . . .
Export trade bills:
Usance bills in yen...................
Advance bills............................. |
Advances, secured by —
Export trade bills......................
Export advance bills.................
Other bills and securities..........

















6. 57


5 . 50

Export financing is an important part of
bank lending in Japan. About half of all
export financing is through commercial
bills, which are rediscountable provided the
remaining maturity does not exceed 3
months and there is a supporting letter of
credit. Although much foreign trade is
financed abroad, goods for export are
financed domestically until they are actually
shipped, and discounts of and advances
on these bills have been substantial.5 Al­
though the rate structure makes the dis­
counting of export bills the preferred means
of obtaining central bank credit, the banks
borrow from the central bank mainly
through advances, presumably because
there is a shortage of export bills. In May
1970 the Bank of Japan introduced a dif­
ferential of Va of a percentage point be­
tween the rates on “export usance bills in
yen” (postshipment bills) and “export ad­
vance bills” (preshipment bills), which pre­
viously had always been discounted at the
same rate.
Penalty rates. The Bank of Japan has
used a system of ceilings on discounts and

5 Until September 1967 commercial banks could
also obtain overdrafts at the Bank of Japan, but this
facility was used little because the last rate was 1.09
percentage points above the basic rediscount rate.


advances and of “penalty” rates on borrow­
ing above the ceilings more or less continu­
ously since 1912. Since World War II, the
system has involved three levels of rates:
basic rates on discounts and advances, and
two sets of higher rates on borrowing in ex­
cess of specified percentages of a (fre­
quently revised) ceiling for each bank. Be­
cause of the heavy reliance by commercial
banks on central bank credit, particularly
during the early postwar reconstruction pe­
riod, the maximum penalty rates, rather
than the relatively low basic rates, deter­
mine the actual cost of borrowing.
The discount rate structure has been sub­
ject to several major changes in recent
years. In March 1957 the complex penalty
rate system was replaced by a single set of
penalty rates. This arrangement was contin­
ued under the “New Monetary Adjustment
Measures,” which were introduced in No­
vember 1962. At that time the Bank of
Japan began more active operations in
Government securities in order to facilitate
the adjustment of commercial banks’ re­
serve positions (see p. 251).
Such open market operations, together
with adjustments (so far, with one excep­
tion, downward) in the commercial banks’
ceilings on discounts and advances, have
for all practical purposes eliminated com­
mercial bank borrowing from the Bank of
Japan in excess of individual discount ceil­
ings. Since the end of 1962, therefore, a
rising proportion of central bank credit to
the banking system has been provided
through increases in the Bank of Japan’s
holdings of securities. Although discounts
and advances have continued to expand in
absolute terms, they have declined some­
what in relative importance.
Ceilings on discounts and advances. When
ceilings for central bank credit (discounts
and advances combined) were reintroduced
in 1962, the total ceiling was set at the

level of total borrowing at that time from
the Bank of Japan by the 10 city banks
subject to ceilings, and each bank’s ceiling
was fixed at the amount of its actual bor­
rowing. After 1964, however, the ceilings
of individual banks were determined as a
percentage of the total ceiling— the percent­
age for a particular city bank being calcu­
lated on the basis of the relation of the
bank’s borrowing in the call-money market
to the total of its capital and deposits.
Finally, since August 1967 a more com­
plex formula has been in effect, and at pressent the ceiling for each bank is revised every
3 months. Under this system a fixed factor
is applied to capital funds (including surplus
and undivided profits), and from the result­
ing figure the amount of borrowing in the
call-money market and from the Bank of
Japan is subtracted. A certain percentage of
this residual is assigned to the bank as its
ceiling. The new method of calculating the
ceiling gives an advantage to banks with
large and increasing capital funds.
In determining credit ceilings, the Bank
of Japan excludes export financing credits.
It also excludes certain credits granted to
the city banks that made loans in 1964 and
1965 to two companies for the purpose of
stabilizing the stock market (see p. 252).
The proceeds of such loans by the Bank of
Japan were available to the borrowing
banks to reduce their regular borrowing.
Thereafter, the ceilings of these banks and
the total over-all ceiling were cut by ap­
proximately the amount of such special loans.
Central bank discounts and advances
are not formally limited in duration, nor
are the rates charged by the central
bank changed with the term or the fre­
quency of such borrowing. However, in
practice, individual loan agreements often
specify a maximum and a minimum time to
maturity. These maturities, which are deter­
mined by the central bank, vary from 2


days to 3 months, depending on the author­
ities’ assessment of the projected cash needs
of the individual bank.
Commercial bank interest rates

The Bank of Japan, in conjunction with the
Ministry of Finance, has the authority
(under the Temporary Rates Adjustment
Law of 1947) to set maximum rates on
loans and deposits for all banks.
Rates on loans are determined, within
the Bank of Japan’s maximum rates (which
have not been changed since 1957), by in­
terbank agreement through the Banking
Association. Effective rates are currently
lower than maximum rates; for instance, in
December 1969 the rate for discountable
prime bills— lowest in the rate range— was
the same as the central bank’s basic dis­
count rate (6.25 per cent), while the maxi­
mum rate was 9.50 per cent. Changes in
the “prime” or “standard” rate on loans fol­
low changes in the discount rate almost au­
The rates payable by commercial banks
on deposits are not linked to the discount
rate. They tend to change infrequently; in
fact, only two changes have been made in
the last 10 years. At present the prevailing
rates on deposits are at the ceiling set by
the authorities.
Other instrum ents of m onetary policy

An important change in implementing mon­
etary policy in the postwar period has
been the expansion of open market opera­
tions by the Bank of Japan. Although open
market operations had been conducted for
some time on a small scale for strictly lim­
ited purposes, it was not until 1958 that the
Bank of Japan began to sell bills from its
portfolio to banks in order to absorb sur­
plus funds. Since 1960 open market pur­
chases of Government-guaranteed bonds


have been undertaken to offset the tighten­
ing effects of seasonal inflows of funds to
the Treasury.
In November 1962 the Bank of Japan
became more active in buying and selling
securities, but these operations were still of
limited significance for several years be­
cause of the shortage of Government
securities.6 However, large amounts of 70
year Government bonds have been issued
since 1966, mainly to banks, and purchases
of such bonds by the Bank of Japan in
1968 and 1969 equaled nearly two-thirds
and one-fourth, respectively, of the increase
in note circulation in those years.
Although authority to impose flexible re­
serve requirements was granted to the Bank
of Japan in 1957, it was not used until
1959. The central bank has authority to
impose separate ratios on time deposits and
on all other deposits— for the latter cate­
gory up to a maximum of 10 per cent.
Since their introduction in 1959, reserve re­
quirements have been changed seven times,
mostly to reinforce the effects of changes in
the discount rate. In September 1969 (after
the most recent change) the required ratios
ranged between Va and 1V-i percentage
points, the effective ratio for a particular
commercial bank reflecting the amount of
deposit liabilities in each category. There is
a uniform penalty at a rate 3% percentage
points above the basic discount rate on all
reserve deficiencies.
Moral suasion in the form of window
guidance is used by the Bank of Japan as
60 In December 1965 the Bank of Japan, in addi­
tion, introduced a repurchase system for foreign ex­
change bills (denominated in U.S. dollars) against
which previously the central bank had extended
loans. Credit supplied to each bank under repurchase
agreement is subject to a separate ceiling determined
by the central bank. Reportedly this arrangement has
so far not been used by the Bank of Japan, which
considers it as a safety valve to give commercial
banks access to foreign exchange, mainly dollars, to
meet their external commitments.


a form of credit control, particularly in pe­
riods of monetary restraint. Window guid­
ance may be applied to individual banks or
through general directives to all commercial
banks. The central bank advises the com­
mercial banks regarding lending policies
that the banks should follow and also regard­
ing other uses of funds. The banks use this
advice as a guide in dealing with their cus­
Until May 1963 the formal system of
window guidance in use was based on a
monthly review of commercial banks’ lend­
ing, on which detailed reports were sub­
mitted to the central bank, and on projec­
tions of sources and uses of funds. Monetary
policy was easy throughout the remainder of
1963, but was tightened in January 1964.
Thereafter, window guidance was based on
a 3-month— and after 1965 on a 6-month
— review of commercial banks’ lending and
on guidelines that limited all banks to ex­
plicit and uniform rates of credit expansion.
In June 1965 the formal system of win­
dow guidance was discontinued, because at
that point the Bank of Japan believed that
the commercial banks’ cautious attitude
under conditions of domestic sluggishness
would be adequate to curtail lending. But
in September 1967 the Bank reinstated the
system it had abandoned in 1965.
Then in October 1968 the Bank of Japan
changed the nature of its window guidance.
Almost uniform controls on the rates of in­
crease of loans of all city banks were re­
placed by a procedure that determines indi­
vidual banks’ lending quotas on the basis of
their liquidity positions as well as total loan
The authorities regard window guidance
as a temporary and supplementary mone­
tary tool to be applied especially when mon­
etary restraint is indicated. The Bank of
Japan believes that in ordinary circum­

stances the lending activities of commercial
banks ought to be left to the banks’ own
judgment and discretion, and that the
banks’ knowledge of, and desire to cooper­
ate with, over-all Government economic
policies provides adequate guidance.
The banking system’s high degree of reli­
ance on central bank credit suggests that
the importance of window guidance as a
means of policy implementation should not
be underestimated. Such guidance does not
involve the use of formal penalties; it is car­
ried out on the basis of the traditionally
close relationship between the central bank
and individual commercial banks, and the
success of the system depends on the latter’s
cooperation and desire to avoid expression
of official criticism, which in Japan is a
major factor shaping business behavior.
Under the Securities Transactions Law,
the Ministry of Finance has the power to
impose margin requirements on securities
transactions, and the Bank of Japan is au­
thorized to control the conditions of lending
by financial institutions to securities compa­
nies. The Ministry has acted under this au­
thority, but the Bank of Japan has not.
Other credit control instruments, such as
pre-deposits for imports (suspended since
May 1970), are administered by the Minis­
try of International Trade and Industry
with the agreement of the Ministry of Fi­
Toward the end of 1964 the persistent
weakness in the stock market prompted the
Bank of Japan, together with other finan­
cial institutions, to undertake extensive sup­
port operations. This support took the form
of central bank credit— on an unspecified
emergency basis and reportedly amounting
to about $1 billion equivalent— to quasigovernmental stock-buying and stock-holding agencies. The portfolios of these agen­
cies have now been liquidated.



Quantitative role of central bank
credit policy

The private sector’s heavy reliance on cen­
tral bank credit is a main feature of Japan’s
financial structure. In individual years since
1958 central bank loans and discounts have
accounted for between 4.1 and 11.7 per

cent of all bank loans to the private sector.
However, open market operations have be­
come gradually more important since N o­
vember 1962; indeed, in the 4 years ended
September 1966, the Bank of Japan’s hold­
ings of securities increased substantially
more than its discounts and advances.


In its conduct of monetary policy the Neth­
erlands has relied heavily in recent years on
direct control of credit and on management
of liquidity of external origin. The discount
mechanism, as well as all other indirect in­
struments of monetary policy, has played a
secondary role because until recently most
of the banks had ample liquidity. The main
focus of monetary policy in the Netherlands
has been on the availability of credit rather
than on interest rates.
In its efforts to achieve internal monetary
stability, the Netherlands Bank has been
hindered by the conflicting requirements of
external policy. It is this conflict between
domestic and external policy objectives that
has caused the Bank to subordinate indirect
means of monetary control in favor of di­
rect controls over bank credit expansion.
Variation of the cash reserve ratio was dis­
continued because, in the words of the
Bank, if the ratio were raised “the resulting
sterilization of liquidity would have led to
sales of foreign exchange to it (the Bank)
without effectively reducing the liquidity of
the banks.” 6 On the same grounds, open
market operations have not been used restrictively to any significant degree.

The discount mechanism performs essen­
tially as a safety value. It serves to accom­
modate the banks in meeting seasonal
swings in their cash needs caused by
changes in circulation of bank notes, in the
balance of payments, or in Government fi­
nancial operations. Changes in the discount
rate serve in the main to signal changes in
the economic situation. In general, the
Bank’s discount rate is a ceiling for the
rates on short-term Treasury bills and call
S tructure of the banking system

The accompanying tabulation shows the
number and total assets, as of the end of
1969, of the registered credit institutions
supervised directly or indirectly by the
Netherlands Bank.
Type of institution
Commercial banks
Central institutions of the
agricultural credit banks 1
Unaffiliated agricultural credit
Security credit institutions
General savings banks

Total assets
(millions of
Number guilders)






1 With 1,251 member credit banks and 1,272 member savings banks.
S o u r c e .— Netherlands Bank, R e p o r t fo r the ye a r 1969.

Although the Netherlands has many
commercial banks, a very large proportion
61 Netherlands Bank, Report for the year 1964,
of commercial banking business is done by
p. 104.


a relatively few banks, and the concentra­
tion of banking has been considerably in­
creased by mergers that have taken place
since 1964. Branch banking is highly devel­
oped. In the spring of 1968 the three larg­
est commercial banks in the Netherlands
controlled about three-fourths of the assets
of all commercial banks.
The money market in the Netherlands is
probably less important, in terms of total
volume relative to the size of the country,
than the money markets of the United
States and the United Kingdom. Commer­
cial banks, the bill brokers (discount
houses), and the two central institutions for
agricultural banks participate on both sides
of the market. The central government and
the local authorities appear mainly as bor­
rowers, and the two giro transfer services,
institutional investors, savings banks, and
large business firms appear mainly as lend­
ers in the market. In the past the Nether­
lands Bank has intervened occasionally on
one side of the money market or the other,
but since the spring of 1964 it has not en­
gaged in any open market operations.
Commercial banks may obtain funds
from the money market, which is concen­
trated in Amsterdam, either by borrowing
on call loans or by selling Treasury bills; in
terms of quantity, borrowing is the more
usual means. Since 1958, when the guilder
was made fully convertible and the banks
began to invest abroad on a large scale be­
cause of the interest incentive, repatriation
of funds has been an important means by
which the banks adjust their cash positions.
M echanism through which m onetary policy
o p erates

The Netherlands Bank is charged (by an
Act of 1948) with responsibility for regu­
lating the value of the guilder in such a
way as to promote the welfare of the coun­
try and (by an Act amended in 1956) for
supervising the credit system.

Instruments of monetary policy. The instru­
ments of monetary policy available to the
Bank are: (1) control over the volume of
central bank credit, both in the form of
borrowing by the credit institutions and in
the form of open market operations; (2)
operations in the foreign exchange market;
(3) control over borrowing from or lending
to foreigners; (4) variation of cash reserve
requirements; and (5) direct limitation of
the volume of credit extended by banks and
other credit institutions.
The Netherlands Bank uses discount pol­
icy mainly to signal a change in, or rein­
forcement of, its monetary policy and at
times to influence the lending rates of com­
mercial banks. Although there is no formal
linkage between central bank and commer­
cial bank rates, changes in the former tend
to be reflected in the latter.
In its use of discount policy and in its
open market and foreign exchange opera­
tions, the Bank is empowered to act with­
out consulting either the Government or the
credit institutions. Two other principal in­
struments of monetary policy—variation of
cash reserve requirements and credit guide­
lines—may be employed only by securing
the voluntary cooperation of the credit in­
stitutions. Although the Act for the Super­
vision of the Credit System (as amended in
1956) empowers the Bank to issue general
directives to the credit institutions on cash
reserve requirements and on lending poli­
cies for the purpose of regulating the value
of the guilder, the Bank may issue such
directives only after failing to secure volun­
tary cooperation. And in such case the
Bank’s directives must be approved by the
Finance Minister and ratified by the legisla­
ture within 3 months, after which they may
have a maximum validity of 2 years. How­
ever, the Bank has never found it necessary
to exercise this authority.
Although the Netherlands Bank is au­
thorized to undertake open market opera­


tions and to impose cash reserve require­
ments, it currently makes no use of these
policy instruments. And whereas formerly
the Bank eased temporary pressures in
the money market by purchasing Treasury
bills from bill brokers under repurchase
agreement, its present policy is to employ
operations in the foreign exchange market
for that purpose.
The Bank is also empowered to issue
general directives of unlimited duration to
the banks and to other credit institutions
for the purpose of ensuring their liquidity
and solvency. These directives sometimes
have an effect on the credit situation as, for
example, in 1964. At that time the Nether­
lands Bank issued a directive increasing re­
serve requirements for savings banks. Ac­
cording to this directive, savings banks were
required to hold in the form of primary
liquid assets—that is, cash and sight depos­
its in other banks— 10 per cent of all de­
posits that have a high rate of turnover.
An agreement between the credit institu­
tions and the Netherlands Bank concerning
maintenance of minimum cash reserves is
still formally in effect although it is not in
use. The agreement, concluded in 1954,
provides that the commercial banks and the
central institutions of the agricultural credit
banks may be required to maintain reserves
at the Netherlands Bank that may range as
high as 15 per cent of their deposit liabili­
ties, with the first 15 million guilders of de­
posits being exempt.
This required cash ratio has been zero
since September 1963. At that time the
Netherlands Bank established direct and
specific limits on credit expansion and re­
quired the deposit of interest-free compen­
sating balances at the Bank for noncompli­
ance with these guidelines. The required
cash reserve ratio was reduced to zero be­
cause, given the tightening effect of the in­
crease in bank note circulation, mainte­
nance of the ratio would have led to


repatriation of funds from abroad rather
than to an effective reduction in the domes­
tic liquidity of the banks.
The higher levels of interest rates abroad
have been the main factor inducing com­
mercial banks to keep a substantial propor­
tion of their liquid assets in foreign invest­
ments. During the early 1960’s the
Netherlands Bank discouraged the banks
from repatriating funds to meet temporary
tightness in the money market. In 1965,
however, the Bank ceased to buy Treasury
bills from the bill brokers under repurchase
agreement and instead offered to sell dollars
forward—often without charging a prem­
ium—while simultaneously making spot
purchases. As explained in the 1965 annual
report of the Netherlands Bank, “The
banks were thus enabled to acquire guilders
by temporarily repatriating funds from
abroad instead of by temporarily parting
with Treasury paper.”
Under the Foreign Exchange Control
Decree of 1945, the Netherlands Bank may
also order the commercial banks to restrict
their foreign borrowings. In 1964, for in­
stance, it directed each bank authorized to
deal in foreign exchange markets not to
permit its foreign liabilities to exceed its
foreign assets by more than 5 million guild­
ers ($1.4 million). Under the same decree
foreign capital issues and loans to nonresi­
dents also require a license from the Neth­
erlands Bank. The Bank thus regulates for­
eign issues in accordance with the
requirements of domestic monetary policy
—at times withholding approval for a long
time or refusing it altogether.
The Netherlands Bank also uses adminis­
tration of foreign exchange controls and its
authority to operate in the foreign exchange
markets to influence domestic monetary
conditions. From time to time the Bank in­
tervenes in the forward exchange market to
encourage commercial banks to increase or
decrease their holdings of foreign exchange


in order to influence the domestic liquidity
of the banking system and conditions in the
money market. The Netherlands Bank has
also relied on direct control of commercial
banks’ net foreign asset positions. For ex­
ample, when attractive rates in the Euro­
dollar market in 1969 induced commercial
banks to increase substantially their net for­
eign asset positions and the banks financed
this build-up largely through reliance on the
discount window, the Netherlands Bank re­
quested that commercial banks halt the
growth of their net foreign assets and cut
such assets back by 10 per cent during the
second half of the year.
Control over credit expansion. Direct con­
trol over the rate of credit expansion was
the principal instrument of monetary policy
between 1960 and 1970. Agreement with
the organizations representing the banks
and agricultural credit institutions on a gen­
eral formula for restricting credit expansion
was reached by the Netherlands Bank in
1960. This formula was to be applied when
necessary and the permitted rates of expan­
sion altered as required.
The Netherlands Bank relied strongly on
voluntary credit ceiling agreements in the
1960’s: it allowed the agreements to lapse
only briefly, once in 1963 and again in
1967 and 1968. Central bank consultations
every 4 months with the bankers’ organiza­
tions helped to make the system a flexible
one. The permissible expansion of lending
was expressed in terms of a formula re­
stricting the growth of short-term credit to
a certain percentage of the average credit
outstanding in a previous base period. Vari­
ations in the permissible rates of credit ex­
pansion were made to allow for seasonal
variation in lending.
Credit ceilings in the early 1960’s ap­
plied only to short-term lending to the pri­
vate sector, defined as loans with a maturity
of less than 2 years. Due to frequent and

excessive reliance of local government au­
thorities on short-term bank credit, how­
ever, the monetary authorities in 1967 ex­
tended the credit guidelines to cover bank
loans to local authorities as well.
Moreover, the Netherlands Bank acted to
close the loophole for long-term lending on
May 1, 1965. At that time, after consulting
with the representative organizations, it re­
quested that the banks not allow the in­
crease in their long-term assets to exceed the
increase in their long-term liabilities. The
restriction on long-term lending was allowed
to lapse in 1967 in line with a more expan­
sionary monetary policy, but was invoked
again in late 1968 (and was maintained
throughout 1969) as the monetary author­
ities effected another policy reversal. In
March 1969 the Netherlands Bank, recog­
nizing a trend toward an increased turnover
in savings deposits, extended the applica­
tion of restrictions on long-term credit to
include savings banks.
Each bank that exceeded its total credit
ceiling was requested to hold at the Nether­
lands Bank for 1 month an interest-free de­
posit in the amount by which the ceiling
was exceeded. The criterion for compliance
with credit guidelines was determined on
the basis of the bank’s level of loans out­
standing at the end of the month; if the
average of the last three end-of-the-month
positions was in excess of the credit
guidelines, a penalty deposit was required.
Each bank is penalized only if the aggregate
of all types of bank lending has exceeded the
credit ceiling. The enforcement of penalties
was also modified on occasion to support
policy goals. For example, in June 1966
the Bank required that under certain cir­
cumstances penalty deposits be maintained
at the prescribed level at all times instead of
allowing the banks to take the average of
their positions over the period.


D iscounts and advances

The Netherlands Bank establishes its rate of
discount, the rates on certain other types of
loans and advances, and the maturity of the
paper it will accept. The types of borrowers
to be accommodated and the types of col­
lateral acceptable, however, are stipulated
by law.
Eligible borrowers. All “registered” credit
institutions, including savings banks as well
as bill brokers, have access to central bank
credit. However, the Bank accommodates
savings banks only on the condition that
they refrain from making new investments
while they are indebted to the Bank. The
Bank also has a small number of private
customers, who occasionally take a secured
advance from the Bank at a rate of 1 per­
centage point above the rate charged credit
institutions for similar advances.
Local authorities have access to the dis­
count window, but their access is subject to
formal quantitative restrictions.6 These re­
strictions appear to be directed more at re­
straining short-term borrowing by local
authorities than at reducing the amount of
such paper actually discounted or used as
collateral for advances from the Bank.6
The Netherlands Bank regards access to
its credit as a privilege, not a right, and
credit institutions are expected not to use
its facilities on a continuous basis. The
Bank has no formal guidelines governing
the amount of credit that the banks and bill
brokers may take up; rather it relies upon
moral suasion to keep use of its credit
62 Only those local authorities whose floating debt
does not exceed 25 per cent of their current revenues
are allowed access to the Bank’s credit facilities.
63 The N ational G overnm ent has in general no di­
rect access to the discount window. However, the
N etherlands Bank m ay, on its own initiative, buy
Treasury bills directly from the N ational G overn­
ment, as it did for instance in the sum m er of 1968,
to avoid seasonal pressures in the money market. The
Bank is also authorized by statute to grant the N a­
tional G overnm ent an interest-free line of credit up
to 150 million guilders ($41 m illion).


within bounds. Banks and other credit insti­
tutions have traditionally resorted to central
bank credit only to a small extent.
Credit is made available through dis­
counting of eligible paper as well as in the
form of advances at a higher rate. The
Bank may refuse credit to prospective bor­
rowers, and at times it has made access to
its resources dependent upon the conduct of
the borrowers. As a general rule, banks try
to manage their cash positions in such a
way that they have no need to borrow from
the Netherlands Bank. However, the tradi­
tion against such borrowing tends to break
down when the banks are subject to very
strong liquidity pressures. Except for the
local authorities, there are no formal quotas
or ceilings, nor is there an official maxi­
mum duration for advances. However, the
Netherlands Bank does exert moral suasion
on banks making excessive use of its credit
Eligible paper and collateral. The Nether­
lands Bank may discount (1) bills of ex­
change and promissory notes having two
signatures and having a maturity in accord­
ance with the customs of trade; (2) bills
and notes of the Netherlands Treasury; and
(3) debenture bonds redeemable within 6
months. By contrast, the range of assets
that the Bank may accept as collateral for
advances is quite broad, since it includes all
discountable assets, plus other securities,
merchandise, warehouse receipts, and coin
and bullion.
The Bank has set a limit of 105 days on
the maturity of short-term securities (Treas­
ury paper, commercial bills, and bank ac­
ceptances) that it will accept for discount.
Subsequent to an agreement in 1967, how­
ever, it has allowed export credits with ma­
turities of 5 years or more to be considered
discountable and eligible as collateral for
loans. The purpose of this exception was to
lower the interest rate for these bills.


Rates. In addition to the discount rate—
its rate for discounting bills of exchange—
the Bank specifies rates for three other
kinds of transactions: discounts of promis­
sory notes; loans and advances to private
customers; and loans and advances to oth­
ers. The principal effective rate is the rate
on advances to others, the category that in­
cludes banks and bill brokers. This rate is
regularly the same as the rate for discount
of promissory notes, and both rates are gen­
erally 50 basis points higher than the dis­
count rate. The rate for advances to private
customers is regularly 1 percentage point
higher than the rate for advances to banks
and bill brokers.
Actual practices with respect to central bank
credit. Borrowing from the Netherlands

Bank by banks, bill brokers, and local au­
thorities often takes the form of secured
overdrafts (advances on current account).
These advances are obtained mainly against
the security of Treasury bills and notes that
the banks have in safekeeping at the Nether­
lands Bank. Such overdrafts accounted for
62 per cent of the 273 million guilders of
loans outstanding on the average to the
Bank’s nongovernmental customers in 1967;
the remainder represented discounts of
Treasury paper and bank acceptances.
Although commercial bills are legally eli­
gible, in practice the Bank rarely discounts
such bills or accepts them as collateral for
advances as long as the borrower has
short-term Treasury paper in its portfolio.
The preference of banks for advances, de­
spite the fact that the rate is 50 basis points
higher than the Bank’s discount rate, stems
largely from the fact that an advance can
be for as short a period as 1 day. The
banks normally need recourse to the central
bank only for short periods, and discounts
at the Bank must be for a minimum of 10

Banks having debit balances resulting
from check clearings obtain almost auto­
matic advances from the Bank to cover
such balances; normally the banks repay
within the same day, and there is no
charge. Banks obtain funds for repaying
advances from the Bank by borrowing in,
or recalling funds from, the call-money
market; by selling Treasury bills; or by con­
verting foreign exchange.
Netherlands Bank credit in the form of
open market transactions has been used in­
frequently in recent years. One reason for
the negligible recourse to the Netherlands
Bank through the mid-1960’s was that
whenever tightness in the money market
threatened to induce banks to repatriate
funds held abroad, the Netherlands Bank
would temporarily lower the required cash
ratio. Another deterrent was the fact that
banks could average their balances at the
Netherlands Bank over a reserve period in
order to conform to the required cash ratio;
in other words, they could draw down their
large balances at the Netherlands Bank to
meet temporary liquidity drains provided
their balances met the required average
over the reserve period as a whole. In 1963
the required reserve ratio was reduced in
three steps to zero, and as of July 1970 it
was still zero.
After the cash ratio became inoperative,
banks were required to keep deposits at the
Netherlands Bank only if they exceeded the
prescribed limits on credit expansion. On
the other hand, as a result of the decline in
the banks’ foreign assets and of the increase
in bank note circulation, the average
amount of borrowing from the Netherlands
Bank has increased in the past few years;
hence the ratio of bank borrowing to cash
balances has risen sharply.
Because the major factors influencing the
money market—such as the foreign bal­
ance, Treasury receipts and expenditures,


and seasonal cash drains—tend to affect the
liquidity of banks and bill brokers in the
same direction and at the same time, the
volume of central bank credit often fluc­
tuates sharply from week to week, and even
from day to day.
Linkage of commercial bank rates to central
bank rates. In setting the rates they charge

on loans, banks are not restricted by either
regulations or formal conventions. Neither
are the banks required to inform anyone
except their customers of these rates. Ac­
cording to unofficial reports, lending rates
appear to run from 2 to 2Vi percentage
points higher than the discount rate of the
Netherlands Bank. It is also reported that
the banks usually do not lend at rates of
less than 5 per cent; therefore, changes in
the Netherlands Bank’s discount rate below


the 3 per cent level have little effect upon
commercial bank lending rates. However,
the discount rate of the Netherlands Bank
has not been below this level since No­
vember 1959.
Similarly, no formal regulations govern
rates paid on deposits. As a consequence of
sharp competition in this field among the
banks, especially in recent years, rates on
deposits are relatively high.
Changes in the rates of the Netherlands
Bank are often made in concert with
changes in other monetary policy measures.
The fact that commercial bank lending
rates tend to follow changes in the Bank’s
discount rate reflects not a direct causal
link between these rates, but rather the
economic climate in which monetary policy
is made.


Monetary policy in Sweden is the responsi­
bility of the Bank of Sweden (R iksbank ),
but in implementing that policy the Bank is
assisted considerably by the operation of
the National Debt Office, which is responsi­
ble for management of the Government
debt. Both are official agencies responsible
to Parliament.
The Swedish discount mechanism, sup­
ported by a variety of other policy tools, is
an effective instrument for influencing the
cash base of the banking system. Further­
more, the Bank of Sweden has broad pow­
ers to restrict borrowing abroad by Swedish
residents—although not commercial bor­
rowing associated with the conduct of
The central bank influences the over-all
volume of bank credit in several ways: (1)
by modifying the terms of its advances to

commercial banks, (2) by open market op­
erations and debt management policy (im­
plemented in part through the borrowing
and lending operations of the National
Debt Office), (3) by required liquidity ra­
tios (which are designed as much to secure
a supply of bank credit to the Government
and the housing sector as to control over-all
bank credit), (4) by penalty rates for con­
tinued or excessive rediscounts, and (5) by
bond-issue control. Cash ratios for, and
ceilings on advances to, commercial banks
and required portfolio ratios for other finan­
cial institutions have also been applied from
time to time.
The discount mechanism in Sweden is
used primarily to meet the extreme bi­
monthly squeeze on bank liquidity caused
by the pattern of Government tax receipts
and expenditures. Changes in the central
bank’s holdings of Government securities—


which reflect mainly transactions with the
National Debt Office—are used to cushion
swings in the bank’s holdings of foreign
currencies and in deposits of the Invest­
ment Reserve System. (See footnotes 64 and
65.) The results of the net change in all of
the Bank’s assets and liabilities (including
advances and Government current-account
deposits) affecting bank liquidity and of the
operations of the other two accounts have
been to expand the banking system’s re­
serves each year. In general, the amount of
funds supplied by all such Bank transactions
has varied roughly with the posture of
monetary policy.
On the whole, it appears that in recent
years commercial bank credit has responded
to monetary policy with considerable sensi­
tivity, which suggests that the Swedish mon­
etary authorities possess adequate tools to
control the liquidity of commercial banks in
the face of fairly wide fluctuations in Swe­
den’s external positions.
Institutional framework

The Bank of Sweden is expected to imple­
ment the Government’s economic policy as
enunciated in the budget message and ac­
cepted by Parliament. It administers foreign
exchange control and performs a number of
banking and other functions for the Gov­
ernment. As the Government’s banker, it
makes funds available to the National Debt
Office6 and receives deposits from that
office and from the central government—
but not from business enterprises of the
central government (which deal with a
Government-owned commercial bank) or
from local governments. It acts also as de­
positary for the Investment Reserve Sys­
tem.6 In recent years fluctuations in the
64 The N ational D ebt Office administers the public
debt and is responsible for managing the funding and
borrowing operations of the central government.
65 The Investment Reserve System, administered by
the L abor M arket Board, was established in the

deposits of this system have accounted for
the bulk of the movement in the funds of
all depositors at the Bank of Sweden.
The Bank of Sweden works closely with
the National Debt Office with a view to in­
tegrating debt management and general
monetary policy. On the other hand, it
maintains no direct working relationship
with the administering board of the Invest­
ment Reserve System, and its role with re­
spect to management of the funds of that
system is passive.
The banking system in Sweden is highly
concentrated. It consists of five large banks*1
—four with branches throughout the coun­
try and one that is active only in the Stock­
holm and Goteborg areas—and nine re­
gional banks. In addition, two specialized
central institutions serve as lenders of last
resort, one for savings banks and the other
for agricultural credit associations.
The banks adjust their liquidity first by
buying and selling Government securities
and foreign exchange and, if further adjust­
ments are necessary on any day, by borrow­
ing in the day-to-day market. The banks,
the National Debt Office, and some other
financial and nonfinancial institutions par­
ticipate in that market. Borrowing against
collateral at the central bank is used only
as a last resort.
Discounts and advances

Central bank credit to the commercial
banks is in the form of advances against
collateral. This collateral may be Treasury
bills, Government bonds, or other bonds
quoted on the stock exchange, but the pre­
dominant part is in the form of Treasury
bills and Government bonds.6 The basic
1930’s and expanded in 1955 as a means by which
to foster, through the establishm ent of tax-favored
reserves, countercyclical capital spending.
66 One of the large banks is Government-owned.
67 The central bank also grants discounts to non­
financial business concerns, but the am ount of such
direct lending is not significant.


rate that the central bank charges on ad­
vances is a key determinant of the interest
rate structure in Sweden. Until 1970, rates
on loans and deposits of commercial banks
customarily were geared to the discount rate.
Advances by the central bank to com­
mercial banks are normally made at the
discount rate, or at a rate that is 1 percent­
age point above the discount rate if the
banking system, collectively, has been in
debt for more than 5 days. An even higher
penalty rate is imposed on banks that bor­
row excessively in relation to their capital
accounts or that do not meet the liquidity
ratio. The penalty rate is particularly effec­
tive in controlling the amounts that banks
borrow to cover the large swings in liquid­
ity that are associated with bimonthly
swings in Government receipts and expend­
itures. (See below.)
Advances are normally made by the cen­
tral bank only to meet temporary needs of
the banking system. Such borrowing by the
commercial banks is for a minimum period
of 3 days. The borrowing bank pays the
basic rate on funds borrowed for that
period and for the next 2 days; for addi­
tional days the bank pays an additional 1
percentage point.6
In periods of tight monetary policy, how­
ever, the effective rates on advances are
higher than the discount rate. Penalty rates
were applied intermittently between 1961
and 1964. Such rates are usually levied
against commercial banks whose borrow­
ings from the central bank are high relative
to their capital and/or against banks not
observing recommended liquidity ratios (see
below). At first, a rate double the dis­
count rate was charged on borrowings that
exceeded 50 per cent of a bank’s share cap­
ital and reserves. Subsequently, during peri68 A n additional condition is th at in order to be
able to borrow at the basic rate, a bank m ust have
been free from debt to the central bank fo r at least
3 days.


ods of tightness the conditions were made
still more rigorous; under these circum­
stances a bank that failed to follow the li­
quidity recommendations of the central bank
paid a penalty rate on all borrowing in ex­
cess of 25 per cent of its own funds.
However, after 1964 the penalty rate was
set uniformly at 3 percentage points above
the discount rate. To make the penalty-rate
system fully effective, borrowing for the
purpose of re-lending to other banks is pro­
Funds may also be supplied to the bank­
ing system by the National Debt Office.
This office, which as noted above has au­
thority to borrow at the central bank, has
been empowered since 1964 to lend in the
day-to-day market. Such lending, under­
taken after consultations with the central
bank, has helped to even out the swings in
reserves associated with the bimonthly tax
collections. The National Debt Office also
borrows extensively in the short-term mar­
ket every other month between the 10th—
when the central government makes large
expenditures to the local governments,
which deposit the funds with the banks—
and the 20th—when the central govern­
ment recei¥es-tax payments.* The effect of
these borrowings is to smooth out money
market conditions because the banks have a
surplus of funds during that period.
After the 20th of the month, tax collec­
tions cause a squeeze on the banks; this
squeeze tightens until the end of the month
and then gradually weakens. It is during
this bimonthly squeeze that the banks are
usually forced to seek advances from the
Bank of Sweden, thus providing the central
bank with its best opportunity to restrain
commercial bank lending through the use
of the penalty rate.
During the period 1959-69 average net
borrowings (indebtedness minus sight de­
posits) of commercial banks from the Bank


of Sweden generally increased as monetary
policy tightened (except in 1964, when
there was a large external surplus) and de­
creased as policy eased. Nevertheless, for
the period as a whole there was a strong
upward trend in average gross borrowing
by the banks.
Other in strum ents of m onetary policy

Lending by the Bank of Sweden to com­
mercial banks is integrated with other mon­
etary policy tools, especially minimum li­
quidity ratios, open market operations, and
control of bond issues. The central bank
also operates in the foreign exchange mar­
ket to maintain the external stability of the
krona. To facilitate achieving the goals of
domestic monetary policy, the Bank admin­
isters foreign exchange controls in such a
way as to insulate the Swedish credit mar­
ket to some degree from international influ­
Controls over the distribution of credit- The
Bank of Sweden exercises considerable con­
trol over the distribution of long- and
short-term credits—by setting liquidity ra­
tios for commercial banks and by mak­
ing recommendations to other financial in­
stitutions (such as insurance companies and
savings banks) concerning the composition
of their assets and the pattern of their lend­
ing (especially to the central government
and the housing sectors). Moreover, the
central bank exercises general control over
issuance of bonds. The control of capital
issues does not involve the choice of individ­
ual companies or qualitative examination
of the issues offered. It assumes rather a
form of rationing among the major cate­
gories of borrowers for which commercial
banks act as underwriters. The participation
of commercial banks in any issue—includ­
ing timing, amount, interest, and repayment
conditions—must be approved by the cen­
tral bank.
Liquidity and cash ratios. Liquidity ratios

have been designed to assure priority for
Government borrowing and for the financ­
ing of residential construction. They have
not been used as a flexible tool of monetary
policy, but they do influence the cost of
central bank credit because banks that do
not observe the ratios are charged penalty
rates on their borrowing from the central
bank. Also, liquidity ratios reinforce the
pressure on banks to curb any lending that
is financed by open market sales of long­
term securities. Although the central bank
was given powers in 1962 to impose com­
pulsory liquidity ratios on commercial
banks and other credit institutions, it pre­
ferred to continue the voluntary approach
until March 1969. At that time, the pre­
vious “recommendations” observed volun­
tarily by the banks became mandatory.
The liquidity ratio to be maintained var­
ies with the size of the bank; the number of
size groups has been reduced gradually
over the years from five in 1952 (with ra­
tios ranging from 15 to 33 per cent) to two
(with ratios of 24 and 30 per cent, respec­
The liquidity ratio for each bank—ex­
pressed as a percentage—relates total liquid
assets to total liabilities. The numerator in­
cludes not only vault cash and the bank’s
net position with the central bank, with
other Swedish banks, and with the National
Debt Office, but also net foreign exchange
holdings, Government securities, mortgage
bonds, and certain other commercial bank
assets. The denominator consists primarily
of deposits, including bank drafts and ac­
Specification for the ratio remained vir­
tually unchanged from 1952 until 1968. In
1968 the central bank stipulated (mainly as
an incentive to the banks to keep funds in
Sweden) that only one-half of the banks’
net foreign assets were to be regarded as
liquid in calculating the ratio. In 1969, the
liquidity requirements were stiffened further


by the provision that bonds should be val­
ued at current rather than at face value.
Furthermore, the maximum amount of net
foreign exchange assets that might be in­
cluded in the liquid assets total was limited
to IV2 per cent of a bank’s liabilities.
In certain circumstances the liquidity
ratio offers a partial substitute for reserve
requirements; that is, under certain condi­
tions the central bank may charge the pen­
alty rate on advances if the borrower fails
to observe the required liquidity ratio. On
the other hand, use of the liquidity ratio as
a tool is limited because the ratio is also de­
signed to influence the distribution of cred­
its in favor of securities of the Government
and specified mortgage institutions.
In order to sterilize increases in bank
liquidity, the central bank moved for the
first time in December 1967 to implement
the cash-ratio law of 1962. During the first
6 weeks of 1968 the five biggest banks were
required to hold at least 2 per cent—and
other banks to hold at least 1 per cent—of
their liabilities, defined in the same way as
those included in the denominator of the
liquidity ratio, with the Bank of Sweden.
The cash-ratio provisions were activated
again effective August 1, 1969, with the
ratios fixed at 1 per cent. A bank failing to
fulfill the cash reserve requirements is sub­


ject to a penalty on any deficiency in its
required reserves.
Operations in Government securities. Opera­
tions in Government securities are con­
ducted by the Bank of Sweden and, more
importantly, by the National Debt Office in
consultation with the central bank. Sales
of Treasury bills and of Government bonds
are conducted primarily by the National
Debt Office. Such transactions are an im­
portant instrument used to reinforce the
impact of changes in the official discount
rate. Nevertheless, the effectiveness of such
operations as a restrictive device is limited
because the market for short-term Govern­
ment securities outside the banking sector is
insignificant, and because in periods of very
large demands for credit the banks would
probably not be interested in buying secu­
rities unless yields were high.
Increases in the discount rate are often
also accompanied by a refinancing of Treas­
ury debt into longer-term Government
bonds by the National Debt Office in order
to put the banks’ cash and liquidity posi­
tions under pressure. Changes in interest
rates offered by the National Debt Office on
new long-term Government security issues
complement and reinforce the effect of
changes in the discount rate on market rates
of interest.


In Switzerland, perhaps more than in any
other country surveyed, the inflow of inter­
national capital has vitiated monetary con­
trol through traditional instruments gener­
ally, particularly through the discount
mechanism, and has led the authorities to
rely mainly on direct controls over bank
credit. The stability of the currency, com­
bined with the country’s international neu­

trality, has made Switzerland a major re­
fuge for flight capital. Consequently, the
Swiss banking system has become highly
liquid. As a matter of fact, the banks’ hold­
ings of cash and liquid assets far exceed the
minimum required ratios, which in any
event are not employed for monetary policy
The Swiss National Bank has limited
powers to conduct open market operations.


Such operations have been confined thus
far largely to the placement of Treasury
bills (rescriptions ) with the banks. Practi­
cally no use has been made of mediumand long-term paper for purposes of open
market policy, because the Bank’s portfolio
of marketable securities is tiny relative to
the cash balances and other liquid assets of
the banking system. In part because the
banks are so liquid, but also for domestic
political reasons, and above all to discour­
age further capital inflows, the Swiss Na­
tional Bank has held its discount rate
among the lowest in the world and has thus
fostered an interest rate structure that is
low relative to those of other money cen­
Hence, the major Swiss banks hold a
substantial proportion of their assets abroad
and adjust their cash positions mainly
through exchange operations. Access to
central bank discounts and advances is re­
garded as a privilege, and the authorities
encourage the large banks, at least, to rely
on their own resources rather than to resort
to central bank credit. In practice, banks
rely on such borrowing only to a minor ex­
tent for adjusting their cash positions. Of
late, however, they have repeatedly had re­
course to central bank credit for quarterend reporting purposes. This is related to
the fact that, in view of the favorable inter­
est rates prevailing on the Euro-dollar
market, the banks have generally abstained
from increasing their domestic liquidity in
step with the rise in their liabilities, but
nevertheless have been anxious to restore
temporarily the traditional relationship be­
tween liabilities and cash resources in pre­
paring their quarter-end balance sheets and
have borrowed for this purpose.
Monetary policy in Switzerland has been
strongly reinforced by Federal Government
budget surpluses that were partly sterilized.
Although fiscal activities have been largely

expansionary in recent years, the Federal
budget accounts have continued in general
to show surpluses.
The Swiss monetary authorities—having
found that reliance on voluntary agree­
ments with the banks (see p. 265) was
not fully satisfactory—have been concerned
about the insufficiency of the available in­
struments of monetary policy and have
been pressing since at least 1964 for a sub­
stantial enlargement of the National Bank’s
powers. The procedure for the adoption of
new monetary legislation is cumbersome:
legislation must be submitted to the vot­
ers for ratification if a referendum is re­
quested. After much delay, new legislation
was proposed in September 1968 that
sought the following: (1) imposition of
minimum reserve requirements on the in­
crease in deposits; (2) quantitative restric­
tions on credit expansion; (3) widening of
the scope of open market operations; and
(4) authorization to engage in foreign ex­
change operations. However, the proposed
bill was shelved by Parliament in May
1969. This decision was made in anticipa­
tion of a basic agreement, concluded on
September 1, 1969, between the National
Bank and the banks on the imposition of
minimum reserve requirements and restric­
tions on credit expansion (see p. 265).
Banking stru ctu re

The Swiss banking system is still considera­
bly less centralized than those of other Eu­
ropean countries surveyed, even though
there has been some trend toward concen­
tration in recent years. At the end of 1969,
about one-half of the total assets of the
banking system were held by the five big­
gest banks, with the other half being dis­
tributed among approximately 400 can­
tonal, local, mortgage, and savings banks,
and loan associations, as well as about 90
banks engaged in international business.


The “big five” and certain “other” banks
hold the bulk of the banking system’s for­
eign assets. At the end of 1969 the total of
these foreign assets was officially estimated
at about $10 billion equivalent, an amount
more than twice as large as the entire cash
base (bank balances at the central bank
plus currency in circulation) at the time.
The power to regulate Swiss monetary
affairs is diffused, reflecting the country’s
constitutional arrangements. Although the
Swiss National Bank has certain of the
powers normally vested in the central bank,
the Federal Government retains important
regulatory powers.
The central bank is owned to the extent
of 40 per cent by private stockholders; the
rest is owned by the cantons, the cantonal
banks, and other public law corporations.
The influence of the stockholders is very
limited because all senior officers of the
Bank are appointed by the Federal Council.
The National Bank advises the Federal au­
thorities on monetary policy.
in strum ents of m onetary policy

Since many of the tools of monetary policy
that are used to influence credit conditions
indirectly are not available to the Swiss Na­
tional Bank, chief reliance has been placed
on direct controls on credit expansion and
foreign capital flows.
The Swiss National Bank has the power
to grant or deny access to its credit facili­
ties, to set its rates, to buy and to sell for­
eign exchange spot and short-term securi­
ties, and to veto credits of 1 year or more
to foreign borrowers in amounts of more
than 10 million Swiss francs ($2.3 mil­
lion). Except for the last one mentioned,
these powers of the National Bank have
been rendered ineffectual by a persistently
high degree of money market liquidity,
which results largely from Switzerland’s po­
sition as a haven and as an intermediary for


foreign funds. The liquidity of the market
has prevented the National Bank from
building up an open market portfolio and
also has made it unnecessary for the banks
to make much use of the discount window.
Consequently, monetary policy in the post­
war period has been put into effect primar­
ily by means of voluntary “gentlemen’s
agreements” between the banks and the Na­
tional Bank.
In 1955 and 1956, for instance, gentle­
men’s agreements provided that the banks
would hold minimum balances at the Na­
tional Bank. Other gentlemen’s agreements
have aimed at checking the inflow of for­
eign funds by prohibiting payment of inter­
est on foreign deposits and by providing
that several months’ notice be given for
withdrawal. In the spring of 1962 the Na­
tional Bank concluded an agreement with
the banks restricting the growth of bank
credit. This agreement was renewed on a
voluntary basis in 1963, but it became
mandatory for a period of 3 years under
emergency legislation approved by the Fed­
eral Assembly in 1964 and ratified by a ref­
erendum in 1965. In 1965 the banks also
agreed not to assist the investment of for­
eign capital in Swiss real estate or mort­
gages, and they agreed to sell Swiss securi­
ties to foreigners only to the extent that
Swiss securities had been sold by foreigners
to the bank concerned. Following the re­
fusal by Parliament in early 1969 to en­
large the National Bank’s regulatory powers
on a permanent basis—and by virtue of the
basic agreement of September 1, 1969—an
agreement restricting the growth of credit
was concluded in September of that year
and strengthened in February 1970.
Banks are required to maintain certain
cash and liquidity ratios. These ratios, how­
ever, are intended primarily to set uniform
standards of liquidity and to safeguard the
individual bank’s solvency. They are not


used as an instrument of monetary policy.
The ratios are prescribed by a separate
agency, the Banking Commission, which
may waive the requirements for individual
banks in appropriate circumstances.6
The Swiss domestic money market is ex­
tremely narrow. Other than borrowing from
the National Bank, the principal source of
short-term borrowing open to Swiss banks
is the interbank market for call money.
Usually, the large banks are lenders in this
market, and the cantonal banks and other
categories of banks are borrowers; the mar­
ket is small. Until several years ago the
large banks tended to adjust their cash po­
sitions mainly by liquidating short-term
foreign investments in the foreign exchange
markets. Because of seasonal patterns in
cash payments—and also a desire on the
part of both banks and other institutions to
show a good cash position on their balance
sheets at the end of June and December,
and to a lesser extent at the end of the first
and third quarters—the Swiss banks would
69 The prescribed ratios are not very meaningful
because the banks do not report the ratios on a con­
tinuous basis and, moreover, there are no penalties
for noncompliance. Since m ost banks, however, tend
to do a considerable am ount of “window dressing”
for balance sheet purposes, the actual ratios (based
on year-end balance figures) tend to be significantly
larger than the prescribed ratios, irrespective of ac­
tual liquidity conditions during the period. Thus, at
the end of 1966, when Swiss banking conditions were
characterized by a high degree of liquidity, the pre­
scribed ratio of cash assets to total deposit liabilities,
including medium -term bank bonds, averaged 2.4 per
cent for all banks, whereas the actual ratio shown by
the banks averaged 6.6 per cent. Similarly, the pre­
scribed ratio of cash assets to short-term liabilities
averaged 7.4 per cent, whereas the actual ratio was
20 per cent, and the prescribed ratio of cash and liq­
uid assets combined to short-term liabilities was 44
per cent, and the actual ratio was 73 per cent. A t
the end of 1969 the actual ratios were still around
7.5, 20, and 78 per cent, respectively, even though,
through most of the year, the banks tended to keep
their domestic liquidity at the bare m inim um while
shifting the bulk of their liquid resources into more
attractive Euro-currency assets.

repatriate several hundred million dollars
just before these reporting dates.
But this process of window dressing and
other end-of-the-year transactions had an
unsettling effect on the foreign exchange
markets that it seemed desirable to avoid.
In the past few years, therefore, the Swiss
National Bank has arranged short-term
swap transactions with the banks and in
turn has swapped the dollars it received
from these banks with the Bank for Inter­
national Settlements or foreign banks. Fur­
thermore, in circumstances where foreigners
(nonresidents) were shifting funds into
Switzerland on their own initiative, the
National Bank passed on to the banks for
investment purposes, on a swap basis, ratesecured balances of foreign exchange that it
had taken over from foreign central banks
within the framework of the swap system.
The Swiss National Bank does not con­
duct open market operations in the sense of
buying and selling securities in the market.
In its endeavor to offset certain foreign
flows, however, the National Bank has
placed Treasury bills (rescriptions ) of
the Federal Government directly with the
banks and has sterilized the proceeds—
charging interest costs to its own account.
To relieve itself of part of the cost of these
sterilization transactions, the National Bank
had purchased in 1962 franc-denominated
U.S. Treasury securities. Rescriptions can
be used as collateral for loans by the Na­
tional Bank to tide the banks over short pe­
riods of stress, especially at the end of the
month, the quarter, or the year; alterna­
tively, when the maturities are within the
range of 90 days, the National Bank may
rediscount rescriptions for the same pur­
pose. These open market operations have
had the effect of smoothing money market
rates, but they do not seem to have re­
stricted bank liquidity significantly.


Discounts and advances
Eligibility requirements. Paper eligible for
rediscount by the Swiss National Bank in­
cludes Swiss commercial bills and checks
bearing at least two independent signatures
of known solvency, Federal Treasury bills,
Swiss bonds, and Federal Debt Register
claims. All discountable paper must have a
maturity of not more than 3 months. Vir­
tually the same items are acceptable as col­
lateral for advances.
Access to central bank credit. According to
the law, the Swiss National Bank may grant
credit to any resident customer—whether
business firm, bank, or government. Ad­
vances to the Federal Government are de­
termined by fluctuations in the Treasury’s
cash position. As a carryover from earlier
times, some business firms other than banks
have accounts at the National Bank; and
within individual limits, they may discount
their bills with that Bank. The National
Bank does not open new credit lines for
business firms, except in special circum­
stances, and it is gradually reducing the list
of the firms that have access to direct dis­
About 20 agricultural cooperative orga­
nizations also have accounts at the Bank
and can discount with it the paper of their
members. Direct lending to these organiza­
tions is in line with the general Swiss policy
of aiding agriculture.
In general, the National Bank is not
obliged to grant credit to any customer.
However, in response to a request from the
Government, the Bank has undertaken to
discount automatically bills financing the
“compulsory stocks” of essential raw mate­
rials, foodstuffs, and fodder, which are held
for emergency purposes.
Official rates. In the postwar period in­
terest rates of the Swiss National Bank for
discounts and advances have been changed

26 7

six times—the first of these changes came
in 1957. In general, the changes in rates
followed trends in money market rates. Of­
ficials of the National Bank consider that
the role of the discount rate is to “sanc­
tion” changes in market rates. Only in ex­
ceptional instances has the Bank changed
the discount rate to lead the market. The
National Bank’s lending rates are always
well below commercial bank rates for loans
and advances, which constitute the bulk of
the business of the average Swiss commercial
bank.7 Advances by the Bank are subject
to call at 10 days’ notice or less. The Na­
tional Bank’s rate for advances always ex­
ceeds the discount rate by at least one-half
of a percentage point and generally by a
full point.
Use of central bank credit.. All banks have
accounts at the National Bank, but except
at month-end, only the smaller banks bor­
row in the form of discounts. The National
Bank has fostered a tradition that the large
banks should rely on their own funds and
that they should not borrow from the cen­
tral bank. However, in the face of a growing
liquidity squeeze, the amount of total cen­
tral bank credit has recently increased con­
The maximum level of National Bank
discounts, although still quite moderate in
relation to total bank credit, has increased
about threefold in recent years from around
Vi of 1 per cent to about IV2 per cent.7
70 In addition to the official discount rate, the N a­
tional Bank sets special rates fo r two kinds of com ­
pulsory stock bills— those financing storage of food
and fodder and those financing the storage of other
essential materials. The comm ercial banks discount
the compulsory stock bills at the same rates as does
the N ational Bank, which endeavors to set the rates
at the lowest level that will still induce the banks to
hold the bills. Since 1957, when compulsory stock
bills were introduced, the rates fo r discounting these
bills have sometimes been above, but most of the
time have been below, the official discount rate.
71 The am ount of bills held by the Swiss N ational


Central bank credit tends to rise at the end
of each calendar quarter because of win­
dow dressing, and the range of fluctuation
is fairly large.7 This, despite the fact that
the banks have, especially in recent years,
met their needs for cash assets for end-ofquarter purposes to a great extent through
foreign currency swaps with the National
Bank (m onthly-statem ent-date basis) increased from
252 million Swiss francs on June 30, 1965, to 1,137
million francs on June 30, 1969.
72 In 1969, for instance, end-of-m onth figures for
N ational Bank discounts and advances outstanding
averaged 665 million Swiss francs compared with a
peak of 1,392 million francs in June 1969.
73 These swaps, under which the N ational Bank
buys foreign currency assets from the banks spot and
sells such assets forward, lead to a tem porary rise in
foreign exchange holdings of the Bank.

Commercial bank lending and borrowing
rates. Minimum lending rates of commercial

banks are set by interbank agreement and
are not published. Although there is no for­
mal link between deposit rates and central
bank lending rates, in any decision to
change the discount rate the National Bank
considers the trend and levels of rates on
bank bonds and time deposits along with
call-money rates. The rates that banks pay
on time deposits, other than savings depos­
its, respond to market forces. Medium-term
bank bonds, however, are sold at a given
rate, and this rate may be changed only
after 2 weeks’ notice to the National Bank.
Rates on these bonds therefore fluctuate less
than those on time deposits, but they con­
form to the general trend of deposit rates.


In the United Kingdom monetary policy has
been implemented traditionally by control
of interest rates but, in more recent years,
also by credit ceilings. The British author­
ities (a term used in the United Kingdom
to convey the notion that the Bank of Eng­
land acts as an agency of the Government)
use the discount mechanism primarily to
control interest rates in the London money
market. Such control is regarded as neces­
sary to achieve the broad objectives of na­
tional policy and to protect the international
position of sterling. Since the British Treas­
ury, in contrast to the U.S. Treasury, does
not maintain large working balances, one
important objective of monetary policy is
to meet the day-to-day financing require­
ments of the Government.
Ordinarily, the discount mechanism is
administered with a view to preventing

sharp fluctuations in rates on U.K. Treasury
bills because wide swings in such rates
would be communicated to the bond mar­
ket and would adversely affect endeavors
to refund longer-term debt. The discount
mechanism, which links the large commer­
cial banks to the central bank through the
discount houses, also provides a means for
influencing the employment of short-term
banking funds. This aspect of the discount
mechanism too is a matter of considerable
concern to the authorities.
The authorities have powerful tools that
they can use to influence the interest rate
structure. Conventions that have grown
over the years and are now well established
link many bank lending and money market
rates to the central bank discount rate—
thus providing the authorities with a lever
for raising or lowering the entire spectrum
of short-term money rates, as well as bank
lending rates.


General background

Control of money market rates in Britain
involves strict limitation on access to the
Bank of England’s discount window. Ac­
cess is granted only to specialized interme­
diaries— 11 recognized discount houses.7 In
return for this privilege, the discount houses
submit a syndicated bid for, and undertake
to cover, the weekly tender of U.K. Treas­
ury bills, thus assuring the central govern­
ment that its short-term financing require­
ments will be met. For its part, the Bank of
England’s strategy at the weekly Treasury
bill tender is designed—by manipulation of
the amount of bills offered and by means of
open market operations—to keep the dis­
count market initially “short” of cash.
Under such circumstances the authorities
have the option of providing assistance
through open market purchases or through
more costly rediscounts or loans from the
Bank, on which the Bank may charge a
rate above the discount rate, generally re­
ferred to as “Bank rate.” (See p. 271.)
Enforced borrowing at the discount win­
dow is thus a device by which the Bank of
England can, when necessary, make clear
to the market that it would like to see that
rates are firm or rising. To such signals,
which are supplemented by frequent per­
sonal contacts of discount houses with repre­
sentatives of the Bank of England, the dis­
count houses normally respond by main­
taining or raising the interest rate at which
they will bid at the next tender. If its proce­
dures achieve the desired result, the Bank
of England can permit borrowing to disap­
pear, because the amount of borrowing is
not by itself an indicator of market condi­
tions. On the other hand, if the expected re­
sponse does not materialize, sustained or in­
74 Except for London clearing banks seeking to re­
discount export and shipbuilding paper, as discussed
on p. 273.


tensified pressure by the central bank and
further costly borrowing at the central bank
can be expected. Clearly the central bank
discount rate is a penalty rate when com­
pared with the rate on call loans that com­
mercial banks normally charge to the dis­
count houses.
Open market operations of the Bank of
England are designed to reinforce the effec­
tiveness of rate policy rather than to influ­
ence the cash position of banks and,
thereby, the volume of credit outstanding.
Through such operations the pressures on
the banks’ cash positions are passed on to
the discount houses, whose liabilities consist
largely of secured call loans from the
banks. When the banks call these loans, the
discount houses obtain relief by borrowing
at the discount window—an accommoda­
tion that the central bank may not refuse—
on terms established by the Bank. Thus,
pressures on banks’ cash positions tend to
be offset by the provision of funds through
the discount window, with the result that
the Bank’s interest rate policy is reinforced.
If used boldly, interest rate policy could
exert a significant influence on credit flows.
However, for a number of domestic and in­
ternational reasons, the range within which
the discount rate can be moved is limited.
Therefore, since the end of World War II,
the traditional modus operandi of British
monetary policy has been supplemented by
direct quantitative and qualitative controls.
These controls, which have been operated
in a very informal fashion, derive their
main strength from the authority that the
Bank of England and its Governor enjoy
and from the willingness of banks and other
financial institutions to cooperate—in part,
to avoid formalization of the controls, with
the attending rigidities and overt sanctions.
To supplement rate control, the authori­


ties have used various means to regulate the
total liquidity of banks and nonbank insti­
tutions and ultimately the amount of credit
supplied by the banking community. For
example, to backstop their interest rate pol­
icy, the authorities require that the London
clearing banks maintain specific liquid as­
sets ratios and that both the London clear­
ing and Scottish banks hold “special depos­
its” at the Bank of England. By requiring
an increase in special deposits (or con­
versely by releasing such deposits) and by
making purchases (or sales) of Treasury
bills in the open market, the Bank of Eng­
land forces the impact of a change in spe­
cial deposits to spread to other categories of
liquid assets.
Institutional fram ework

The Bank of England is the chief adviser to
the Government on all domestic and inter­
national monetary matters, but at the same
time the Government has considerable di­
rect influence on the Bank’s policies. This
central bank is more deeply involved per­
haps than most others in assuring day-today financing of Treasury operations and in
the management of the public debt.
Until the end of World War II the link­
ages that made it possible to express official
Government policy action through the
central bank were largely informal. But in
1946 legislation was passed that transferred
capital stock of the Bank of England to the
Treasury and formalized the basic relation­
ship linking the Bank with the Government.
Since then the Governor, Deputy Governor,
and the Court (equivalent to a board of
directors), which consists of 16 members,
have been appointed by the Crown. Some
of the directors are full-time officers of the
Bank (“executive directors”).
Most importantly, the 1946 legislation
gave the central government the statutory
power to obtain central bank compliance

with its policies by issuing directives to the
Governor of the Bank of England, after
due consultation with him—this despite the
fact that long before the 1946 legislation it
had been established that the Bank would
make no change in the discount rate with­
out prior approval of the Government. The
Bank of England Act of 1946 also gave the
central bank the power to issue general
directives to any banker; the Bank has
never found it necessary, however, to issue
a formal directive in order to obtain com­
pliance by the financial community.
In addition to official accounts and those
for foreign central banks, the Bank of Eng­
land maintains accounts for various types
of banking institutions, among which the
London clearing banks are the most impor­
tant. The Bank also keeps a few accounts
for employees, other individuals, and busi­
ness firms; this practice, a holdover from the
time when the Bank was engaged in com­
mercial banking business, gives the Bank
direct exposure to present-day banking
The commercial banking structure of the
United Kingdom is quite complex. It was
formed when Great Britain was the most
advanced industrial country of the world,
the center of world trade, the leading finan­
cial power, and the center of the British
Empire and when London was the most
important and active financial market in the
world. While the banking structure is still
characterized by many traditional influ­
ences, it has been quite responsive to new
challenges, and there have been numerous
innovations since World War II.
The London clearing banks form the
core of the commercial banking system. As
recently as 1968 there were 11 such banks,
but by 1970 a series of mergers had re­
duced their number to six. All of them have
extensive networks of domestic branches;
and most of them have foreign branches,


agencies, or subsidiaries, as well as domes­
tic financial affiliates. The clearing banks
also have substantial equity holdings in the
overseas banks, described below, and in
consumer finance houses. The clearing
banks, which held about 80 per cent of all
domestically owned deposits in 1969 and
1970 (but no significant amount of foreign
currency deposits), extend about two-thirds
of all domestic loans. Banks in Scotland and
in Northern Ireland serve local needs for the
most part, although they do place signifi­
cant amounts of call money in the London
money market.
In London there are also about 200
other “nonclearing” banks. Such banks are
included in the following important cate­
gories: (1) merchant banks, (2) overseas
banks (domestic banks whose main activ­
ities are in the Commonwealth and in for­
eign countries), and (3) foreign banks. All
of these banks are active in taking foreign
currency deposits (mainly dollars, but other
convertible currencies also) and re-lending
them abroad or swapping them into sterling
assets. The nonclearing banks have grown
very much more rapidly than the clearing
banks in recent years and since 1968 their
total deposits have exceeded those of the
clearing banks. This greater growth is
largely because London’s rapidly increasing
Euro-dollar business is virtually all concen­
trated in the nonclearing banks, but also
because liquidity ratio restraints and inter­
est rate conventions do not apply to either
the foreign currency or sterling operations
of those banks. In mid-1970 nonclearing
banks accounted for about 15 per cent of
the total banking sector’s sterling deposit
Discounts and advances

The discount rate establishes the pattern of
rates for bank loans and deposits of London
clearing banks and influences the entire


spectrum of the money market rates. The
rate is established by the Court of the Bank
of England with approval of the Chancellor
of the Exchequer. Changes in the discount
rate, if any, are traditionally announced on
a Thursday, shortly before noon; departure
from this tradition has occurred only in cri­
sis situations. Changes are made either to
increase the authorities’ room to maneuver
in their day-to-day management of the
money market or to give a lead to the finan­
cial community on general economic pol­
icy, or both.
Only the 11 houses that make up the Lon­
don Discount Market Association have
regular access to the Bank of England’s dis­
count window and thus are a key element in
the rediscount mechanism. As specialists
dealing in short-term money, they do busi­
ness mainly with banks but they also do
some with nonbank institutions; they have
practically no business at all with the gen­
eral public. The principal activities of these
11 houses are summarized as follows:
1. The discount houses undertake to
underwrite the weekly tender of U.K.
Treasury bills. With the concurrence of the
authorities, they submit a syndicated bid
that puts a floor under the market price at
the auction. The price quoted in this bid
must be calculated very carefully. The dis­
count houses cannot afford to go without
Treasury bills; and at the same time they
must meet the competition from the out­
side. Such competition stems particularly
from the nonclearing banks and bill brokers
outside the Discount Market Association
that bid for their own accounts and from
the banks that offer bids for insurance com­
panies, nonfinancial corporations, and over­
seas and other customers. Clearing banks
do not submit bids for Treasury bills for
their own account.
2. When the discount houses need
funds, they borrow on a secured basis any


excess cash that the clearing banks may
have; such loans provide the banks with a
highly liquid asset in the form of call
money. The discount houses obtain about
two-thirds of their liquid resources in this
manner. The remainder comes largely from
other banks operating in the London
money market; such “outside money” is
borrowed at rates that fluctuate with money
market conditions but that are slightly
higher in general than the cost of funds ob­
tained from the clearing banks. The clear­
ing banks never borrow funds from each
other but normally recall from the discount
houses each day sufficient cash to meet
their cash reserve requirements.7
3. The discount houses invest in Treas­
ury bills, prime commercial bills, negotiable
sterling certificates of deposit, other Gov­
ernment securities with maturities of up to
5 years, and local authority bonds and bills.
Treasury bills are held by the discount
houses primarily to meet anticipated pur­
chases by the clearing banks, but also be­
cause they are immediately discountable at
the Bank of England (although discount
houses normally seek central bank assist­
ance through advances against suitable col­
lateral (see below)).
The discount houses make a market for
Treasury bills, bank bills, and trade bills, as
well as for Government bonds of up to 5
years to maturity, and they use these instru­
ments as collateral when they borrow from
the clearing banks or from the rest of the
money market. In recent years the discount
houses’ holdings of commercial bills have
grown relatively faster than their other as­
sets—reversing a long-term trend.
75 Nonclearing banks similarly may recall needed
cash balances; in the last few years, however, an ac­
tive interbank m arket has developed among the non­
clearing banks. These banks, which keep accounts
with and m ake settlements through the clearing
banks, can adjust their cash positions by borrowing
or lending sterling deposits among themselves on an
unsecured basis, in addition to using the discount

When the discount houses seek central
bank credit, they may either rediscount bills
or borrow on collateral, normally at the
discount rate. In either case rediscountable
paper or acceptable loan collateral consists
of Treasury bills, Government securities
maturing within 5 years, bills issued by
local authorities that comply with the Bank
of England’s requirements, and commer­
cial bills carrying two established names;
such names usually include a British bank
and a discount house, one of which must be
the primary acceptor.
To reinforce the penal nature of borrow­
ing, Bank of England regulations require
that rediscounts have an average maturity
of at least 21 days; and until 1966, ad­
vances had normally been made for a mini­
mum of 7 days but now some are shorter,
as noted below. When bills are offered
for rediscount, the Bank of England insists
that no bill in the parcel have less than 15
days to maturity; and as noted above, it re­
quires an average life of 21 days for the ag­
gregation of the bills involved in each
transaction. Rediscounts are treated by the
discount houses in their balance sheets as
sales of assets; there is no counterpart of re­
purchase agreements as practiced in the
United States.
As a general rule, discount houses re­
quire assistance for much shorter periods
than 21 days, and they try to obtain loans
with the shortest possible maturity in order
to minimize the total interest cost. There­
fore, they prefer to borrow not by means of
rediscounts but rather by advances, usually
secured by “short” Government securities
(bonds within 5 years of maturity), because
the interest rate is uniform (usually the
Bank of England discount rate) regardless
of the maturity.
On June 30, 1966, the Bank of England
informed the discount houses that it was
prepared on occasions of its own choosing,
and for purely technical money market pur­


poses, to assist them with overnight loans
—thus reducing the actual cost of borrow­
ing. Overnight lending has sometimes taken
place when a large surplus was expected to
follow an acute shortage of money. With
the new accommodation, the Bank does not
have to buy bills one day and sell the next.
Overnight lending has also been used to
push forward a shortage from day to day
and thereby ensure the opportunity for tak­
ing penal action the following day, if de­
So far, overnight lending has been at a
rate below the Bank’s discount rate, and
usually at the highest effective market rate.
However, the authorities have reserved the
right to charge for overnight accommoda­
tion whatever rate seems appropriate in the
light of policy objectives at the particular
The authorities’ signals may be rein­
forced by charging on discounts or ad­
vances a rate above the regular discount
rate if it seems inadvisable to raise that rate.
But as of the middle of 1970, the super­
penalty rate had been used only once—in
March 1963.
Technically, there is no ceiling on the
amount that a discount house may borrow,
provided the house can present enough ac­
ceptable collateral and is willing to pay the
rate set by the central bank. Nor are there
limits on the total amount of commercial
bills that may be rediscounted, although for
business reasons the Bank of England does
observe internal limits on the amounts rep­
resenting individual acceptors and drawers.
In periods of relative stringency, the Bank
makes no attempt to hold new borrowing
by any individual house to maturities that
are shorter than the average for outstanding
discounts. In fact, during such periods—as
for example during the early part of 1965
when total borrowings were exceptionally
large—there have been increases in the
number of days on which such borrowing


occurred, and the total time that loans
were outstanding has lengthened. This use
of central bank credit reflected the pres­
sures imposed on the discount market by
the Bank of England through its day-to-day
open market operations.
The discount houses, however, seldom
borrow or rediscount in excess of their
short-term needs, for they cannot profitably
finance investments in prime short-term as­
sets on funds borrowed at a penalty rate.
Excessive acquisitions of high-yield paper
with considerable risk exposure would
surely incur the disapproval of the Bank of
England. Moreover, the clearing banks
would not accept such assets as collateral
for money market loans because such col­
lateral in turn must be eligible as security at
the Bank of England. Still, some leeway ex­
ists for “speculative” operations in short­
term Government securities. For instance, if
the discount houses anticipate that over the
near term interest rates will decline (as for
example, after a stringent official credit pol­
icy has been in force for some time and the
market has reason to expect an easing of
policy), they will increase their holdings of
these types of assets.
Another refinancing device, but one that
is not part of the mechanism whereby the
Bank of England seeks to influence mone­
tary conditions, relates to export and ship­
building paper. Since 1969, the Bank has
been prepared to refinance directly Government-guaranteed export and shipbuilding
loans held by the London clearing and
Scottish banks to the extent that such loans
are not eligible to be counted as liquid
assets 7 and are in excess of 5 per cent of
gross deposits. The purpose of this facility
is to relieve the clearing banks of the neces­
76 The Bank also stands ready, subject to certain
limits, to refinance fixed-rate loans th at do count as
liquid assets. This facility has apparently not been


sity of holding unduly large amounts of rela­
tively low-yield paper. Until October 1970
the rate chargeable on such refinancing was
5Vi per cent; at that time the rate was
raised to 7 per cent.
Other in strum ents of m onetary policy

In addition to the discount mechanism,
other instruments employed by the Bank in
its management of monetary policy are
open market operations, debt management
operations, and credit ceilings. Also there
are the customary minimum cash and
liquidity ratios which, in fact, have become
mandatory. More recently, such ratios have
been supplemented by a “special deposit”
requirement and also by a cash deposit
scheme, but as of the end of 1970, the latter
had not been implemented.
Open market and debt management opera­
tions. Open market operations in the money

market are designed to keep short-term
rates within the desired range. In the long­
term market—given the existing debt man­
agement arrangements—the authorities have
considerable influence on interest rates,
apart from the secondary effects that such
operations may have on short-term rates.
The Bank of England has control over both
the supply and the terms of sale of mediumand long-term Government securities, some
of which are almost always available to the
public from the Issue Department’s hold­
ings. Moreover, debt management opera­
tions are continuous; the Bank usually pur­
chases large maturing issues in advance of
maturity and sells long-term issues whenever
possible. The authorities’ desire to avoid
sharp swings in long-term interest rates has
been an important factor affecting the vol­
ume of open market operations during any
given period.
At times since 1969 debt management
operations have been undertaken with a
view to influencing the monetary aggregates

even though this involved some sacrifice of
short-term interest rate stability. To facili­
tate the new approach the authorities an­
nounced: (1) that they would no longer
specify the price at which they were pre­
pared to sell “tap stocks” (leaving it up to
the market to bid for them instead); and
(2) that the official buying price for Gov­
ernment securities within 3 months of ma­
turity would no longer be tied to the Treas­
ury bill rate.
In implementing debt management
policies, the authorities automatically offset
the effects of flows of foreign-currency-based
liquidity. In fact, official purchases or sales
of sterling through the Exchange Equaliza­
tion Account are reflected in smaller or
larger issues of Treasury bills, respectively,
which are integrated into the Bank of Eng­
land’s daily management of the money mar­
ket—thus returning to, or absorbing from,
the market the cash equivalent of flows of
foreign exchange.
Bank reserves and liquidity ratios. Require­
ments concerning cash reserves and liquid
assets vary from one type of British finan­
cial institution to another, depending in
large part on the type of institution and its
function in the financial system.
The London clearing banks, by long-es­
tablished tradition, maintain minimum cash
as well as liquidity ratios. These ratios were
originally adopted, and still are maintained,
to protect the banks’ customers, but they
also have become a means of implementing
monetary policy.
Indeed, the Bank of England expects
the clearing banks to maintain ratios that
have evolved as a matter of custom. As
nearly as possible on a day-to-day basis,
the clearing banks keep 8 per cent of their
total deposits in the form of cash—that
is, coin, notes, and balances with the
central bank. In addition to their required
cash reserves, the clearing banks currently


must keep an additional 20 per cent of
their total deposits in the form of specified
types of liquid assets—that is, call loans
and money available on short notice (loans
to the money market and loans to others
with maturities up to 28 days), U.K. Treas­
ury bills, commercial bills, or specified refinanceable export credits. The Bank of
England has varied the liquidity ratio only
once—in 1963—and the banks themselves
determine in what proportion to hold each
type of asset, depending on the type of busi­
ness in which they are engaged.
Cash and liquidity ratios are applicable
not only to the London clearing banks but
also to the Scottish banks and the banks in
Northern Ireland, whose balance sheets are
broadly similar to those of the clearing
banks. However, the standards of liquidity
that the Bank of England expects these
banks to maintain are somewhat more flexi­
ble and less explicit than those that apply
to the clearing banks. This distinction re­
flects in part the greater emphasis on time
deposits by the banks in those areas.
The Bank of England expects other
banking institutions to maintain liquidity
standards suitable to their particular pattern
of business. It applies no formal liquidity
ratios to the discount houses, the merchant
banks, or the overseas and foreign banks.
However, most of these institutions (espe­
cially those whose bills are bought by the
Bank) submit to central bank judgment as
to the adequacy of their capital resources,
liquidity, and general standing.
The Bank of England has supplemented
cash and liquidity ratios by intermittently
requiring the London clearing and Scottish
banks to make special deposits that ordinar­
ily bear interest at the Treasury bill rate but
are not included in liquidity ratios. (For ex­
ample, in April 1970 these ratios were
raised from 2 to 2 ^ per cent of gross de­
posits for the London clearing banks and


from 1 to P/4 per cent for the Scottish
banks.) A cash deposit scheme for non­
clearing banks was developed in 1967. The
authorities plan to apply it at times when
credit ceilings have been lifted or as a form
of penalty when ceilings or other guidance
“requests” of the Bank of England are
In recent years, it may be noted, several
developments have tended to reduce the po­
tency of liquidity controls over the banking
system. One, the clearing banks themselves
have often been able to adjust their portfo­
lios by selling Government securities to ob­
tain needed liquid assets. The central
bank’s support of Government bond prices
limited its ability to squeeze the cash posi­
tion of the banks. Another development has
been a resurgence of financing through issu­
ance of commercial bills; this has provided
the banks with a means of extending credit
while at the same time improving their
liquidity positions, because many commer­
cial bills qualify as liquid assets. This
growth in the banks’ holdings of commercial
bills has been the result of a number of fac­
tors. To some extent it reflects the growth
of consumer instalment credit extended
largely by finance houses, which rely on
commercial paper to obtain funds.
Credit ceilings. To cope with the tendency
of the clearing banks to augment their liq­
uid asset holdings through transactions with
the nonbank public, and with the tendency
for peripheral institutions to expand into
any credit gap left by curbs on the major
banks, the authorities have issued credit
ceiling requests to the clearing banks and to
a gradually increasing list of other financial
institutions. These requests have been used
to impose both quantitative restrictions and
to a certain extent qualitative guidance on
lending (including financing through com­
mercial bills) by almost all banking institu­


R elationship of other interest rates to the
discount rate

The pattern of interest rates and the rela­
tionships among the various rates are imple­
mented in part through formal agreements.
For example, the London clearing banks,
by agreement, currently pay 2 percentage
points less than “Bank rate” on their
deposit accounts,7 and they generally
charge rates from Vi to 1 percentage point
above that rate on prime loans, but no
less than 5 per cent. Nonclearing banks,
finance houses, and local authorities nor­
mally pay a rate close to Bank rate for
3-month time deposits, although in re­
cent years when the official discount rate
has not always fully reflected market strin­
gency, the rate on such deposits has some­
times exceeded Bank rate by 1 percentage
point, or even more.
The central bank rate establishes the
minimum rate that clearing banks may
charge the discount houses for call loans;
77 Accounts not directly subject to check, but calla­
ble on 7 days’ notice. The clearing banks do not offer
longer maturities.

this rate is normally l s/s points below the
discount rate. It also establishes a ceiling
for the Treasury bill rate and, by conven­
tion, a lower limit to the price that discount
houses may bid for Treasury bills at the
weekly tender and at the same time expect
that official operations in the open market
will keep the money market on an even
keel. In the recent past, for instance, the
authorities have usually been willing to
allow the rate on Treasury bills to range
from lA to 3 of a percentage point below
the discount rate. At the same time, such a
spread has given the discount houses suffi­
cient maneuvering room at the weekly
tender to garner enough bills to meet the
liquid asset needs of their main customers,
the clearing banks.7
78 A t least once in the recent past the Bank of
England has acted to move the Treasury bill rate unprecedentedly close to the current central bank dis­
count rate in order to keep short-term interest rates
internationally competitive. On one other occasion it
used the exceptional technique of lending above the
central bank discount rate to produce this result.
Earlier, the Bank of England had used similar de­
vices in its discount procedures in order to achieve
specific objectives.