The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Volume 1 REAPPRAISAL OF THE FEDERAL RESERVE DISCOUNT MECHANISM PREFACE 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, PUBLISHED IN AUGUST 1971 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 iat. 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 REAPPRAISAL OF THE FEDERAL RESERVE DISCOUNT MECHANISM CONTENTS REPORT OF A SYSTEM COMMITTEE 1 Steering Committee REPORT ON RESEARCH UNDERTAKEN IN CONNECTION WITH A SYSTEM STUDY 27 Bernard Shull TRANSMITTAL MEMORANDA 77 BORROWINGS DATA 113 RATIONALE AND OBJECTIVES OF THE 1955 REVISION OF REGULATION A 117 Bernard Shull EVOLUTION OF THE ROLE AND THE FUNCTIONING OF THE DISCOUNT MECHANISM 133 Clay J. Anderson THE DISCOUNT MECHANISM IN LEADING INDUSTRIAL COUNTRIES SINCE WORLD WAR II George Garvy 165 REPORT OF A SYSTEM COMMITTEE Governor George W. Mitchell, Chairman Governor Sherman J. Maisel Governor William W. Sherrill President Karl R. Bopp, Philadelphia President President President Chairman 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 Contents I. Summary of the Proposed Redesign of the Discount Window___________________ II. Background of the Proposed Redesign of the Discount Window_________________ 4 3 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 9 IV. Seasonal Credit Accommodation_________________________________________ 15 A. Needs for seasonal credit assistance B. Seasonal borrowing privilege V. 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 window 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 REPORT OF A SYSTEM COMMITTEE I. SUMMARY OF THE PROPOSED REDESIGN OF THE DISCOUNT WINDOW 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 tries. 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. 4 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, II. 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. BACKGROUND OF THE PROPOSED REDESIGN OF THE DISCOUNT WINDOW 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 REPORT OF A SYSTEM COMMITTEE 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 mittee. 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 5 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 6 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 market. 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 periods. 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 need. 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, TABLE 1 SOURCES OF RESERVE BANK CREDIT (Percentage of total) Period 1920-27 1928-33 1934-44 1945-50 1951-53 1954-59 1960-66 Open market Discount operations ing 37 65 96 97 95 95 95 59 33 1 1 2 2 1 Float Total 4 2 3 2 3 3 4 100 100 100 100 100 100 100 REPORT OF A SYSTEM COMMITTEE 7 RESERVE BANK CREDIT 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 8 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 markets. 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 REPORT OF A SYSTEM COMMITTEE 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 III. 9 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. SHORT-TERM ADJUSTMENT CREDIT 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, 10 are regarded as less destabilizing than the fluctuations in pressures on financial mar kets and institutions that would otherwise result. 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 Regulation. 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 window. 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. REPORT OF A SYSTEM COMMITTEE 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 11 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 objectives. 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 12 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 period. 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 13 REPORT OF A SYSTEM COMMITTEE 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 loan. In any case where a member bank, dur 14 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 ment. 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 15 REPORT OF A SYSTEM COMMITTEE 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. IV. 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. SEASONAL CREDIT ACCOMMODATION 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 16 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. 17 REPORT OF A SYSTEM COMMITTEE 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 table. 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 CALCULATION OF A SEASONAL CREDIT NEED Month in Total base year deposits 1 2 3 4 5 6 7 8 9 10 11 12 5.3 5.2 5.2 5.0 4.8 4.8 4.6 4.7 4.8 5.0 5.4 5.2 Total Net fund customer avail loans ability 2.3 2.2 2.2 2.5 2.6 2.6 2.6 2.7 2.8 2.5 2.4 2.2 3.01 3.0^ Peak 3.0j 2.5 2.2 2.2 2.0] 2. OfTrough 2.0J 2.5 3.'0/Peak Seasonal swing from peak - .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 18 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 needed. V. 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. EMERGENCY CREDIT ASSISTANCE 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 19 REPORT OF A SYSTEM COMMITTEE 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 20 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 tion.2 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 loans. 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. REPORT OF A SYSTEM COMMITTEE 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 VI. 21 cost of maintaining reserves with the System which is continuously borne by member banks. 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 market. DISCOUNT RATE POLICY 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 22 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 levels. 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 23 REPORT OF A SYSTEM COMMITTEE operations do not subvert monetary control generally. 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 VII. 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. ANCILLARY RECOMMENDATIONS OF THE STEERING COMMITTEE 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 24 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 REPORT OF A SYSTEM COMMITTEE 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 25 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 ance.” REPORT ON RESEARCH UNDERTAKEN IN CONNECTION WITH A SYSTEM STUDY Bernard Shull Board of Governors of the Federal Reserve System Contents I. II. Introduction_________________________________________________________31 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 Tables 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 loans_______________________________________________ 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, 1963_______________________________________________ 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_______________________________________ 57 57 58 59 59 60 61 63 67 67 68 Charts 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_______ 36 47 .47 66 REPORT ON RESEARCH UNDERTAKEN IN CONNECTION WITH A SYSTEM STUDY I. INTRODUCTION 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. 32 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 clusive. 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 after.4 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 mists.3 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. REPORT ON RESEARCH 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 II. 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. EVOLUTION OF THE CURRENT DISCOUNT MECHANISM 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 functioning. A. 33 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 34 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. 10A 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 vision.14 The significance of this standard for bank supervision was clarified in a series of events TABLE 1 MEMBER BANKS BORROWING CONTINUOUSLY FOR A YEAR OR MORE FROM RESERVE BANKS As of— Number 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. 11See 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.” 12 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. 13Friedman and Schwartz, op. cit., p. 269. 14A 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. 153-54. 35 REPORT ON RESEARCH 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 1CThe 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. 10 See Table 1. The figure of 593, shown in Table 1, is a subsequent revision. 17Overextended 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. 18Statement 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 existence.21 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.22 B. Development of concept of appropriate borrowing 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 19Sprague, Minutes of Joint Conference, op. cit., p. 77. 20 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. 36 1923 had reaffirmed that credit should not be used for investment or speculative pur poses, in accordance with the real-bills doc trine.24 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.” 25 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___ ” 26 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. 25I b id ., p. 34, 35. 26Ib 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. 27 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 itors.” 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,” 30 with a provision for long-term credit 28Ib id . 29I b id ., p. 5. 80 That the issue of “borrowing-to-profit” had not been resolved by the mid-1920’s is indicated by the 11DISCOUNTS and ADVANCES... PER CENT 37 REPORT ON RESEARCH 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. C. Activity at the discount window in the 1920’s 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. 31F 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.32 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 32 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 PER CENT 15 10 38 TABLE 2 D. MEMBER BANKS BORROWING AT FEDERAL RE 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.35 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.30 Member banks Year Number discounting paper i Total number 2 Proportion borrowing 1915.................................. 1916.................................. 1917.................................. 1918................................... 1919.................................. 1,920 1,788 3,127 5,493 5,993 7,615 7,606 7,653 8,213 8,822 25.2 23.5 40.9 66.9 67.9 1920................................... 1921.................................. 1922.................................. 1923.................................. 1924.................................. 6,941 7,415 6,956 6,333 6,060 9,399 9,745 9,892 9,856 9,650 73.8 76.1 70.3 64.3 62.8 1925.................................. 1926.................................. 1927.................................. 1928.................................. 1929.................................. 5,183 5,343 4,869 4,718 5,113 9,538 9,375 9,099 8,929 8,707 54.3 57.0 53.5 52.8 58.7 1930.................................. 1931................................... 1932.................................. 1933.................................. 1934................................... 4,991 5,260 5,017 4,270 1,393 8,315 7,782 6,980 5,606 6,375 60.0 67.6 71.9 76.2 21.8 1935.................................. 692 6,410 10.8 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) .34 33The 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. 34It should be noted, however, that in August of III. 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 policy. 35Anderson, op. cit. !0See Lester V. Chandler, “Selective Credit Control” (Discount Study). THE CURRENT DISCOUNT MECHANISM 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. REPORT ON RESEARCH 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 A. 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 Study). ’ “Report on Discount Mechanism, 1954,” p. 22. 39 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). 40 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 restraint.9 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.” 10 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 basis.11 9I b id .y p. 26. 10Ib id ., Appendix B, p. 1. 11 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. REPORT ON RESEARCH 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. . . 12Finally, it was suggested that correspondent banking relationships amelio rate the seasonal problem, at least for city banks. 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 B. Reliance on the tradition against borrowing 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 borrowing. 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 12I b id ., Appendix B, p. 11. 13Ib 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 tightness. 14Ib id ., pp. 10-13 [parenthetical material and italics added]. 41 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,15 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.” 14 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.17The 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.18 Nevertheless, it was not expected that dif ficult rationing decisions would have to be made very often, or in the case of very many 15 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. 18 Shull, o p . c it. 17It 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. 18 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. 42 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" C. 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,21 an additional questionnaire sent to the discount departments of five Reserve Banks.22 and a variety of other sources.23 A reasonably complete picture of discount-window administration has been obtained. 1‘*“Report on the Discount Mechanism, 1954.” pp. 36-40. * lb id . 21“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. 23These 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.24 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 light. 1. 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); 34 By “initial” is meant the first request of a bank that is not currently subject to surveillance for reason of previous borrowing. 25Shull, o p . c it. 43 REPORT ON RESEARCH 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.20 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.27 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 “counseled.” 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 TABLE 3 BORROWERS AND “COUNSELED" BORROWERS IN FIVE FEDERAL RESERVE DISTRICTS, 1965 AND 1966 1965 Item 1966 Reserve Reserve Country city | Country city banks banks banks banks Number of member banks. . . 67 2,145 67 2,101 Borrowing at least once: Number............................... Percentage borrowing......... 57 85 384 18 62 93 551 26 16 32 17 129 28 8 27 23 Borrowers counseled: Number............................... 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 44 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.28 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.29 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 28See 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. 29Since 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.30 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.31 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” 2. Administrative differences. m Ib id . 31For 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 . REPORT ON RESEARCH 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 Principles.” Reserve Bank responses to the question naire tended to fall into three categories: a lower, or below average, group with respect 45 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.32 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.33 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 :J2The 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. 33In 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 differences. 46 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.34 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.85 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.30 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.37 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.” 85It 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). *7The 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. REPORT ON RESEARCH 47 Member Bank Borrowing at Federal Reserve Ratio of number of borrowers to all member banks PER CENT ’62 ’64 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 PER CENT ;6o ALL SOURCES 40 120 FEDERAL RESERVE _______ J_ _ ’60 ’62 ’64 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) . ..” 58 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.” 311 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. . . . ” 40 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 :58George 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. 39 Ibid. 40 Ibid. 48 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.41 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.42 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 41 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.” 12I 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.43 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.44 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!i “ Ib id ., Part I. 44Ib 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.) 49 REPORT ON RESEARCH IV. RELEVANT CHARACTERISTICS OF THE FINANCIAL ENVIRONMENT 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. 2. 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. 50 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 influenced. 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 tion. 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. REPORT ON RESEARCH suggests a bank motivation that is not, in reality, independent of borrowing aimed at a better earnings position. 3. 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 serve. These findings are generally in accord with expectations. They tend to confirm that funds. *Jones, op. c it 51 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.10 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. 88-92. 10 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” 52 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.11 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.12 4. 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. 11Lynn, 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.13 It 13This note appears on opposite page. 53 REPORT ON RESEARCH 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.14 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. 1. The nature of structural disadvantage. 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.15 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.16 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.17 Since the expected yields on 16For 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). 17 Lawrence postulates that D — D (r Si r 0, Y ) and 33 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 14 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 54 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.13 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.19 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.20 It would appear, however, that differences in the quality of such markets do not necessarily constitute a unique problem for small, unit, rural banks.21 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 property. 18Lawrence, o p . c it. " Ib id . 20Staff 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). 21Improvements 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 serves.22 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). 28 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. REPORT ON RESEARCH sions at the discount window were believed to be necessary because the vast majority of banks held large amounts of Government securities.23The 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.24 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 disadvantage. 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 areas. “ The emphasis on short- or possibly intermediateterm adjustment stems from the restriction on con tinuous borrowing reviewed above. 55 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.25 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 deposit. a. 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. 25 On the reserve distribution problem, see Gold feld, o p . c it., p. 153. 56 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.”26 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 26 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.27 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.28 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 27Ibid. 23Ibid. REPORT ON RESEARCH 57 TABLE 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 Net deposits (millions of dollars) Net deposits (millions of dollars) Period Total Under 2.5 2.5 to 4.9 5.0 to 9.9 15.0 to 24.9 10.0 to 14.9 100.0 and over 25.0 to 99.9 Total Member banks Jan.-June 1966. Jan.-June 1963. 14 16 18 27 27 20 15 15 1 0) 7 8 1 1 9 9 2 July-Sept. 1962. Oct.-Dec. 1962. 10 Jan.-Mar. 1963. Apr.-June 1963. 14 15 24 3 3 10 8 2.5 to 4.9 5.0 to 9.9 10.0 to 14.9 15.0 to 24.9 25.0 to 99.9 100.0 and over Member and insured nonmember banks 1 1 July-Dee. 1965. July-Dee. 1962. Under 2.5 3 (0 1 Less than one-half of 1 per cent. 3 2 2 3 2 2 2 2 18 20 31 30 19 21 16 14 2 5 2 10 1 5 2 3 10 9 16 15 10 10 6 6 10 9 3 0) S o u r c e .—Emanuel Melichar, “Intra-Year Flows of Funds” (Dis count Study). TABLE 5 ORIGIN OF FUND FLOWS Distribution of Member Banks and Their Net Fund Flows, by Change in IPC Deposits and in Loans 1 Deposits down Period Total Loans down Loans up Deposits down Deposits up Loans down Loans up Percentage distribution of banks Total Loans down Loans up Deposits up Loans down Loans up Net fund outflow, ( —) ; 1or inflow, ( + ) (in millions of dollars) July-Dee. 1965........ July-Dee. 1962........ 100 100 11 13 8 8 46 50 35 29 +8,237 +7,108 -143 -3 8 -3 2 4 -285 +5,525 + 4,844 +3,180 +2,583 Jan.-June 1966......... Jan.-June 1963........ 100 100 35 29 46 50 8 8 11 13 -8 ,2 3 7 -7 ,1 0 8 -3 ,1 8 0 -2 ,5 8 3 -5 ,5 2 5 -4 ,8 4 4 +324 +285 +143 +38 July-Sept. 1962........ Oct.-Dec. 1962........ 100 100 23 15 13 16 42 35 22 35 +520 +6,588 -4 8 8 -1 0 6 -1 ,2 9 3 -4 4 4 +1,811 +4,370 +490 +2,769 Jan.-Mar. 1963........ Apr.-June 1963........ 100 100 47 18 27 42 15 9 10 31 -4 ,6 4 8 -2,461 -3 ,2 9 5 -561 -2 ,1 0 0 -2 ,7 4 7 +690 +742 +58 +103 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 riod29 (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.30 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, 29Ib id . 58 TABLE 6 TOTAL GROSS FUND OUTFLOW, BY RELATIVE OUTFLOW AT BANK (In billions of dollars) Fund outflow as percentage of net deposits Period Total Under 5.0 5.0 to 9.9 10.0 to 14.9 15.0 I 20.0 to ' to 19.9 24.9 25.0 and over Fund outflow as percentage of net deposits Total Member banks .9 .6 .6 .4 .2 .1 0) 0) 0) 0) 0) Jan.-June 1966. Jan.-June 1963. 9.1 7.7 2.6 3.8 3.9 3.6 .9 .2 .2 .1 1.1 July-Sept. 1962........... Oct.-Dec. 1962............ 2.1 .9 1.5 .5 .5 .1 Jan.-Mar. 1963........... Apr.-June 1963........... 5.7 4.1 2.8 2.2 2.4 .2 1.3 .1 .6 .3 0) C1) .1 .1 0) 0) 1.3 .9 .7 .5 .3 .2 11.6 9.7 4.4 3.0 2.5 1.4 7.0 5.3 .2 .1 0) 0) O) 0) 0) 0) C1) 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.31 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.32 In the tenth Federal Re 81 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. 5.0 to 9.9 10.0 to 14.9 15.0 ! 20.0 to J to 19.9 24.9 25.0 and over Member and insured nonmember banks July-Dee. 1965. July-Dee. 1962. .1 j Under | 5.0 ! 0) .1 4.8 4.2 1.4 1.4 .5 .4 .2 .3 .3 1.7 .6 .1 .2 0) .1 O 0)) 3.2 2.7 .7 .4 .2 0) 0) .1 C1) .6 .2 .4 1.8 .1 . .2 .1 (l) .3 .1 O) 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.33 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. 38Ibid. 59 REPORT ON RESEARCH TABLE 7 RATIO OF BANK HOLDINGS OF U. S. GOVERNMENT SECURITIES TO NET DEPOSITS Percentage Change, June 1961-June 1965 Qass of bank, and deposit size (millions of dollars) Member: Reserve city: 25 and under............ 25-100...................... Over 100.................. New York Boston Phila delphia Cleve land Rich mond Atlanta Chicago St. Louis Minne apolis Kansas City Dallas San Fran cisco - 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 -52.5 - 5 4 .7 -3 5 .3 Country: 25 and under.. 25-100............ Over 100........ -27.0 -36.0 -47.7 -1 7 .3 - 3 1 .6 -3 8 .7 -17.7 -16.1 -26.7 - 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.. . . 25-100................ Over 100............ -21.5 -31.7 ........ -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 —31.0 - 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 TABLE 8 MEMBER BANK BORROWING ON ELIGIBLE PAPER Face value of paper presented and analyzed (millions of dollars) Year Number borrowing All member All member except reserve city banks in banks N.Y. district 1959.................................. 13 153 143 1960................................... 1961................................... 1962................................... 1963................................... 1964................................... 21 5 7 8 20 673 5 71 134 249 673 5 71 134 120 1965................................... 1966.................................. 40 82 7,186 20,085 602 3,691 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).31 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 34 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. 60 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.33 d. 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.” 36 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 clear. 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.37 Analysis of 35 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). 39 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. 132-33. 37 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.38 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 9). TABLE 9 TYPES OF CREDIT AVAILABLE SPONDENT BANKS, 1963 FROM CORRE (In millions of dollars) Type of credit All insured commercial banks Banks with deposits less than $100 million Participation loans—amount held by correspondent: 1 Commercial and industrial....... Non-real-estate farm................. Other........................................... 2,845 218 1,990 878 150 367 Total participation credit___ 5,054 1,395 330 136 228 48 5,521 1,672 Borrowing under lines of credit 2.. Sales of assets to correspondents 3 Total............................... 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 poses.39 38 Staff study of correspondent banking was under taken by a task force headed by Ernest Baughman and Dorothy Nichols, Federal Reserve Bank of Chicago. 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 61 REPORT ON RESEARCH 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). TABLE 10 USE OF CORRESPONDENT CREDIT BY INSURED COMMERCIAL BANKS, 1963 (Pei* cent of all insured banks) Size of insured bank (total deposits, in millions of dollars) Type of credit reported Any credit arrangements with correspondents......................... Measurable credit on date of survey....................................... Participation loans on date of survey....................................... Borrowing under lines of credit. Sales of assets.............................. Number of banks—total............. Under 100, total 50-99 Under 5 62.3 63.1 86.5 40.7 69.2 35.3 41.7 5.8 1.7 68.5 7.7 3.8 35.9 6.8 1.0 12,782 260 7,000 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.40 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.41 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 40 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. 62 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 justment.42 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.43 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 cent. 43Staff 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. e. 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.44 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 41 Parker Willis, “A Study of the Market for Fed eral Funds,” o p . c i t . REPORT ON RESEARCH 63 TABLE 11 MEMBER BANK PARTICIPATION IN THE FEDERAL FUNDS MARKET, 1966 Banks with Less Than $10 Million in Deposits Banks in district District Percentage trading Total number i Number trading* Boston................................ New York.......................... Philadelphia....................... Cleveland........................... Richmond.......................... Atlanta............................... 139 185 237 285 251 280 100 44 50 63 57 56 72 24 21 22 23 20 Chicago.............................. Minneapolis....................... Kansas City....................... Dallas................................. San Francisco.................... 600 346 360 650 491 117 150 69 54 90 98 39 25 20 15 14 20 33 Total........................... 3,941 870 22 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.45 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 45 Ibid. still in flux, though there is doubt that large numbers of additional small banks will be incorporated into it in the near future.40 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.” 4T 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.48 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,50 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 MIbid. Ibid. 48Ibid. This includes the purchases of all banks in the country bank classification. 49Ibid. 50Ibid. 64 longer-term arrangements are made from time to time.51 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 adjustments. f. 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 off151Ibid. prime CD’s when issued and traded require a higher rate than CD’s of prime name banks in New York.52 “In this sense,” it was reported, “buyers discriminate against certifi cates of smaller, less well-known banks.” 53 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.54 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.55 The designations of “prime” and “offprime” reflect relative marketability. Mar ketability depends on the degree to which a bank is “known.” 56 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. 3. 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). 53Ibid. “ Ibid. 55Ibid. “ Ibid. 65 REPORT ON RESEARCH 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 higher. 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 V. 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. ACTIVITY AT THE DISCOUNT W DOW SINCE 1955 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. 66 Member Bank Borrowing at the Discount Window PER CENT 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 window. 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. 67 REPORT ON RESEARCH TABLE 12 INFLUENCE OF TREND AND OTHER FACTORS ON RATIO OF BORROWING TO REQUIRED RESERVES Regression Coefficients for 1955-65 Independent variable Class of bank Reserve city: Including “central reserve city” .. Excluding “central reserve city” .. Country............................................ Bill rate Discount rate Percent age of required to total reserves 3.1* (.9) - .0 8 0 . 12) 1.46* (.49) -.3 3 * 3.1* (.9) - .1 2 (1.13) 1.67* (.52) - .3 5 * (.01) .24 (.40) 1.36* (.50) .17* (.05) - . 22 * Ratio of offices to banks ( . 12) (.06) District classification1 Trend Coefficient of multiple determina tion R 2 Upper Middle -.9 1 * 4.30* .08 (.50) .61 30.5 (. 68) -.9 4 * 4.29* (.69) .11 ( . 10) (.52) .60 29.4 - .5 0 * (.05) .37 (.25) -.2 6 ( . 21) .53 22.5 ( . 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 table. 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 TABLE 13 RATIO OF MEMBER BANK BORROWING TO RE QUIRED RESERVES Federal Reserve Banks Compared with All Sources Federal Reserve Banks Year All sources All Reserve All Reserve member city Country member city Country banks banks banks banks banks banks 1959............ 4 .0 4.6 3.8 12.0 17.8 6.5 1960............ 1961............ 1962............ 1963............ 1964............ 2.2 .4 .5 1.2 1.3 2.4 .3 .5 1.5 1.6 2.5 .5 .5 .9 1.0 13.4 6.6 10.8 15.6 17.4 19.7 8.8 14.8 21.4 23.2 6.1 2.2 2.9 4.5 6.6 1965............ 1966............ 2.2 2.8 2.7 2.8 1.4 2.8 21.6 26.9 29.3 36.8 7.6 9.5 Percentage change, 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. 68 TABLE 14 PERCENTAGE CHANGE IN PROPORTION OF COUNTRY BANK BORROWING FROM THE FEDERAL RESERVE AND FROM ALL SOURCES, SELECTED PERIODS District Source Boston New York Phila delphia Cleve land Rich mond Atlanta Chicago St. Louis Minne apolis Kansas City Dallas San Fran cisco + 7 .6 + 78.8 -2 3 .9 + 75.0 Change from 1959 to 1966 Proportion borrowing from: Federal Reserve............. All sources..................... - 6 .5 +10.1 - 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 from: Federal Reserve............. All sources..................... - 3 0 .7 -3 2 .6 - 4 0 .7 + 10.6 - 11.8 -.2 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 +27.3 - 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 +171.8 Change from 1960 to 1965 Proportion borrowing from: Federal Reserve............. All sources..................... -36.9 + 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...................... 50.0 28.0 + 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 +11.1 -6 1 .1 - 9 .3 - 5 1 .7 + 11.8 -4 3 .5 +33.3 - 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 69 REPORT ON RESEARCH 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 Why- 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. VI. RELATED SYSTEM POLICIES AND ALTERNATIVE FORMULATIONS OF THE DISCOUNT MECHANISM 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 70 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 sharply. 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 71 REPORT ON RESEARCH 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 stated: . . . 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 shocks.3 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, 1966. 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 mechanism 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 . 72 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 mechanism10 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.11 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.12Moreover, 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. REPORT ON RESEARCH technical and conceptual considerations.13 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 study.14 VII. CONCLUDING REMARKS 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 rowing. As a result of recent developments in interbank borrowing and in other credit markets, along with relatively permissive 11 For a review of discussion on these matters at the academic seminar on discounting in 1966, see Ormsby, op. cit. 14In this connection see the recent paper by Franco Modigliani, “Some Proposals for Reform of the Dis count Mechanism” (Discount Study). 73 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 74 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. REPORT ON RESEARCH 75 APPENDIX A FEDERAL RESERVE SYSTEM MANUSCRIPTS AND DOCUMENTS CITED Documents Prepared for the Discount Study, 1965-68 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 Banks.” 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 nism.” Lawrence, Robert, “The Regional Distribu tion of Bank Loans.” Lynn, Dolores P., “Reserve Adjustments of the Eight Major New York City Banks During 1966” 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 1966. 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 studies. 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. TRANSMITTAL MEMORANDA Contents Evolution of the role and the functioning of the discount mechanism Clay J. Anderson 81 A review of recent academic literature on the discount mechanism David M. Jones 84 Summary of issues raised at the academic seminar on discounting Priscilla Ormsby 84 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 87 89 91 93 95 96 97 99 101 102 103 105 106 110 TRANSMITTAL MEMORANDA 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. 81 TRANSMITTAL MEMORANDA MARCH 1, 1967 EVOLUTION OF THE ROLE AND THE FUNCTIONING OF THE DISCOUNT MECHANISM 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 constraints 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 gress. 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. 82 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 recognized. 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 83 TRANSMITTAL MEMORANDA 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 systems. 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 ture. 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 system. 84 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 process. MARCH 27, 1967 A REVIEW OF RECENT ACADEMIC LITERATURE ON THE DISCOUNT MECHANISM David M. Jones Federal Reserve Bank of New York and SUMMARY OF ISSUES RAISED AT THE ACADEMIC SEMINAR ON DISCOUNTING 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 TRANSMITTAL MEMORANDA 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 conclusions. 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 mechanism 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 discussion. 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 85 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 86 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 spread. 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 TRANSMITTAL MEMORANDA 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- 87 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. Conclusion 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 gestions. MARCH 27, 1967 FINANCIAL INSTABILITY REVISITED: THE ECONOMICS OF DISASTER 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 economists. The paper draws much of its evidence from the experiences of 1966 and might be regarded as a lesson in economic brink manship. In the remainder of this memorandum, the 14 main points that the Secretariat be lieves to be important are briefly summa rized. 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 uncertainty. 2. Initial effects of euphoria When continuing economic prosperity gen erates euphoric attitudes, expectations as to 88 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 assets. 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 quidity. 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 authorities. l6. Limits on monetary restraint premium is also placed on a careful and owledgeable weighing by the central 89 TRANSMITTAL MEMORANDA 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 ports). 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 velop. JULY 5, 1967 THE SECONDARY MORTGAGE MARKET 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: 1. 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 underwriters. 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. 2. 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 90 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 ings. 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. 3. 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 sources. 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 nism. 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 vices. 91 TRANSMITTAL MEMORANDA 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 THE DISCOUNT MECHANISM IN LEADING INDUSTRIAL COUNTRIES SINCE WORLD WAR II 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 country. 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 92 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 securities. 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 management: 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 portfolios. 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 93 TRANSMITTAL MEMORANDA bly be supported through the discount mechanism. 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 situations. 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. 8. 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 CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE, AND PROPOSALS TO INCREASE AVAILABILITY OF BANK CREDIT 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 94 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 ments. 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 agencies. TRANSMITTAL MEMORANDA 95 JULY 5, 1967 A STUDY OF THE MARKET FOR FEDERAL FUNDS 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 reserves. The Secretariat believes that the follow ing points should be kept in mind in re designing the discount mechanism. 1. 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 priority. 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 96 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 THE SECONDARY MARKET FOR STATE AND LOCAL GOVERNMENT BONDS 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: 1. Considering the extreme nature of the pressure placed on the municipals market in TRANSMITTAL MEMORANDA 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. 2. 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 97 secondary market for municipal securities could become an increasingly important al ternative to discount accommodation. 3. 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 DISCOUNT POLICY AND BANK SUPERVISION 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 98 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 window 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. 99 TRANSMITTAL MEMORANDA AUGUST 1, 1967 THE SECONDARY MARKET FOR NEGOTIABLE CERTIFICATES OF DEPOSIT 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 tions. 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 ing. 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 levels. 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 100 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 dow. 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 window. 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. 101 TRANSMITTAL MEMORANDA AUGUST 23, 1967 OVERSEAS BRANCH BALANCES IN THE RESERVE MANAGEMENT PRACTICES OF LARGE MONEY MARKET BANKS 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 one-third. 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 ments. 3. 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 102 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. 4. 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. SEPTEMBER 6, 1967 AN EVALUATION OF SOME DETERMINANTS OF MEMBER BANK BORROWING 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 bank. 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 ences. TRANSMITTAL MEMORANDA 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 103 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 DISCOUNT POLICY AND OPEN MARKET OPERATIONS 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. 4. 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. 104 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 stances. 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 ronment. 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 TRANSMITTAL MEMORANDA shortcomings in the current system could become so troublesome under the stresses of a period of monetary restraint as to war- 105 rant a prompt introduction of some reme dial changes in discounting rules, even at the cost of transitional operating difficulties. FEBRUARY 27, 1968 THE LEGITIMACY OF CENTRAL BANKS 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 106 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 versed. 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 beneficial. MAY 13, 1968 INTRAYEAR FUND FLOWS AT COMMERCIAL BANKS 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 TRANSMITTAL MEMORANDA 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 107 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 compared 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 108 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 its. 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 ods. 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: TRANSMITTAL MEMORANDA 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 erations.” 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 levels 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 times. The amount of outflow exceeding a spec 109 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. 110 NOVEMBER 13, 1968 SOME PROPOSALS FOR A REFORM OF THE DISCOUNT WINDOW 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 ademics. 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 dow. 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. TRANSMITTAL MEMORANDA 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 111 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. BORROWINGS DATA Contents Table 1— Member Banks: Number, and Number Borrowing, 1959-68, by Class 114 Table 2— Borrowings and Required Reserves of Member Banks, 1959-68, by Class 114 Table 3— Collateral for Member Bank Borrowing at Federal Reserve Banks 115 114 BORROWINGS DATA TABLE 1 MEMBER BANKS: NUMBER, AND NUMBER BORROWING, 1959-68, BY CLASS Number (at year-end) Year 1959................................. 1960................................. 1961................................. 1962................................. 1963................................. 1964................................. 1965................................. 1966................................. 1967................................. 1968................................. All member 6,233 6,171 6,113 6,049 6,116 6,221 6,217 6,145 6,068 5,977 Reserve city Number borrowing (during year) At least once from Federal Reserve From all sources Country 293 240 225 5,940 5,931 5,888 5,829 5,901 6,013 6,023 5,953 5,883 5,795 220 215 208 194 192 185 182 All member Reserve city Country All member Reserve city Country 1,911 1,903 1,268 238 207 161 150 168 158 161 172 129 147 1,673 1,696 1,107 952 1,054 1,074 996 1,479 976 1,149 2,341 2,360 1,821 1,759 1,897 2,226 2,251 2,626 2,489 2,586 256 223 207 198 196 189 189 183 176 178 2,085 2,137 1,614 1,561 1,701 2,037 2,062 2,443 2,313 2,408 1,102 1,222 1,232 1,157 1,651 1,105 1,296 TABLE 2 BORROWINGS AND REQUIRED RESERVES OF MEMBER BANKS, 1959-68, BY CLASS Averages of daily figures, in millions of dollars Borrowing from— Year 1959.............................. 1960.............................. 1961.............................. 1962.............................. 1963............................. 1964.............................. 1965............................. 1966............................. 1967............................. 1968............................. Federal Reserve Banks Required reserves All sources All member Reserve city Country All member Reserve city Country 731.4 398.6 75.3 543.4 271.6 44.6 239.8 270.5 467.2 633.9 171.5 553.0 185.3 208.1 366.9 406.2 116.5 344.8 187.9 127.0 30.6 32.8 54.5 62.5 100.3 227.7 55.0 208.2 2,187.6 2,401.0 1,227.7 2,085.6 2,996.3 3 ,50§.0 4,604.5 6,084.3 5,561.5 7,276.5 1,851.8 2,061.8 1,091.7 1,898.9 2,701.5 3,047.4 4,027.7 5,311.4 4,961.9 6,387.9 335.8 339.3 136.0 186.7 294.8 460.6 576.8 772.9 599.6 101.0 68.2 888.6 All member Reserve city Country 18,201.2 17,969.1 18,696.9 19,357.9 19,254.2 20,130.1 21,346.5 22,580.6 23,667.3 25,934.5 12,745.1 12,367.9 12,525.0 12,853.6 12,640.7 13,136.8 13,771.2 14,450.3 15,357.4 16,686.1 5,456.2 5,601.2 6,171.9 6,504.3 6,613.4 6,993.3 7,575.3 8,130.3 8,309.9 9,248.4 BORROWINGS DATA 115 TABLE 3 COLLATERAL FOR MEMBER BANK BORROWING AT FEDERAL RESERVE BANKS A. Under Sections 13 and 13a Number of banks borrowing Collateral Number of pieces Year All member 1959.............................. 1960.............................. 1961.............................. 1962.............................. 1963.............................. 1964.............................. 1965.............................. 1966.............................. 1967.............................. 1968.............................. 13 215 7 2 08 40 87 43 61 Reserve city Country 8 1 125 9 3 5 8 21 46 27 41 4 4 3 12 19 41 16 20 Face amount (in millions of dollars) All member Reserve city Country All member Reserve city 527 1,006 123 397 277 833 18,343 23,255 6,712 10,409 355 448 5 131 223 271 11,934 15,617 5,286 10,062 172 558 118 266 54 570 6,409 7,708 1,426 347 153.0 673.0 5.4 71.3 133.7 248.6 7,186.4 19,683.2 6,180.9 10,256.5 82.3 241.3 4.2 56.9 133.4 239.3 7,064.9 19,238.1 6,152.7 10,055.6 Country 70.7 431.7 1.2 14.4 .3 9.2 121.5 445.1 28.2 200.9 TABLE 3 (Cont.) COLLATERAL FOR MEMBER BANK BORROWING AT FEDERAL RESERVE BANKS B. Under Section 10b Number of banks borrowing Year 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 Type of collateral (face amount, in millions of dollars) Total All mem ber 12 8 4 1 0 24 16 31 43 12 22 Re serve city Coun try 4 8 12 8 4 10 21 4 0 0 0 3 1 3 0 5 30 40 12 17 All mem ber 6.3 22.8 3.5 2.8 4.7 32.9 4,211.0 113.1 4.7 144.5 Re serve city 3.3 14.3 0 00 3.7 .7 73.3 0 39.1 Mortgages Coun try All mem ber Re serve city Coun try 0 0 0 00 0 .9 0 .4 0 0 0 18.6 12.0 2.200 0 0 0 .9 0 2.20 2.8 0 0 4.7 0 30.3 3.0 8.5 3.5 4,210.3 39.8 4.7 105.4 Municipal bonds .4 0 6.6 All mem ber 6.2 2.8 4.5 17.3 3.5 6.7 12.7 32.9 3.3 113.9 Other Re serve city Coun try 3.3 14.3 2.9 3.0 3.5 3.3 4.5 5.9 12.7 27.4 3.3 96.6 26.2 4,197.4 79.8 1.4 0 00 .8 0 5.5 0 17.3 2.8 All mem ber .1 0 .20 12.0 Re serve city 00 0 00 2.9 .7 67.8 0 9.8 Coun try .1 0 .20 3.3 24.4 4,196.7 12.0 1.4 2.2 RATIONALE AND OBJECTIVES OF THE 1955 REVISION OF REGULATION A Bernard Shull Board of Governors of the Federal Reserve System Contents 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__________________ 119 119 125 126 130 RATIONALE AND OBJECTIVES OF THE 1955 REVISION OF REGULATION A I. INTRODUCTION 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). II. 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 CURRENT REGULATION: OBJECTIVES AND TECHNIQUES 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 billion.3 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. 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 i, 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 RATIONALE AND OBJECTIVES 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 Banks.10 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.11 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. 121 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.” 12 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... .”13 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.14 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.” 15 The principles ad12 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. 122 vanced, the Committee stated, were . . intended to be general guides and standards and not precise administrative instructions inflexibly applicable to all cases.” 16 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.17 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.18 The General Principles of the current regulation may be viewed as the device designed to achieve the objec tives developed in the System Committee Report. 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. 123 RATIONALE AND OBJECTIVES 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 3. 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,” 20 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 operate. 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”; 21 and the question of continu ous borrowing “. . . would arise first at the time of the first renewal.” 22 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.” 23 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. 1. Restriction on “continuous” borrowing. It might seem, at first, that the restriction on “continuous” borrowing was intended to be sufficient, in and of itself, to limit the supply of credit. While it is possible to 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. 34. 22 Ibid., Appendix C, p. 7. 23 Ibid., p. 24. 124 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.25 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.”26 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.” 27 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 borrowing.28 2. “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 . . . ” 29 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.” RATIONALE AND OBJECTIVES 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- III. 125 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. ADMINISTRATION OF REGULATION A 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.30 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.31 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 borrowing. Beyond this initial accommodation, the administrative process can, for purposes of analysis, be broken down into at least three stages: (1) surveillance of the borrowing bank; (2) a decision on the 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, 1965”). 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 dow. 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 126 interest.32 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.33 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. IV. RESTRICTIVE IMPACT OF REGULATION A The principal intention of the 1955 revision of Regulation A was to limit the flow of credit through the discount window, 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 credit. 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” 127 RATIONALE AND OBJECTIVES 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 rate 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. 128 C. General Principles and the supply of credit 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.35 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.36 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.” 37 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. 129 RATIONALE AND OBJECTIVES ceived of as interacting in influencing the “appropriate—inappropriate” decision.38 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? 39 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 rationing. 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.40 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 .” 130 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 rowing. 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, V. 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 ministered. 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. SUMMARY AND CONCLUSIONS 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 RATIONALE AND OBJECTIVES 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, 131 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. EVOLUTION OF THE ROLE AND THE FUNCTIONING OF THE DISCOUNT MECHANISM Clay J. Anderson Federal Reserve Bank of Philadelphia Contents Introduction__________ __ _____________________________________________________________________ 135 Summary of Findings________________________________________________________________________ 136 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 EVOLUTION OF THE ROLE AND THE FUNCTIONING OF THE DISCOUNT MECHANISM INTRODUCTION 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. 2. 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 were: 1. Unpublished material available within the System, especially the Proceedings of 136 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 included. SUMMARY OF FINDINGS 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 poses. 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 agriculture. 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; ROLE AND FUNCTIONING OF DISCOUNT MECHANISM however, experience soon demonstrated that the kind of paper offered for discount was no indication of the uses made of the bank credit extended on the basis of the proceeds. Following World War I, emphasis shifted to “direct pressure” as a means of confining bank credit to appropriate uses. Even though Reserve Bank officials might not be able to identify the specific uses made of the proceeds of a discount, they could and should keep informed of the loan and 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 137 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 among1banks 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. 138 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 ations. 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. ROLE AND FUNCTIONING OF DISCOUNT MECHANISM Borrowing is to afford time for a more or derly adjustment of assets and/or lending policy. The discount rate The Federal Reserve Act contained little guidance for discount rate policy. Section 14 stated that rates should be established “with a view of accommodating commerce and business.” Initially, there was little crystallized thinking among System officials either as to the role of the discount rate or as to criteria that would be useful in determining the timing of rate changes. The penalty-rate concept was widely accepted in principle but considered impractical in the United States. Several factors influenced the role of the discount rate in the 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 139 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 centers. 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: 1. 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 140 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 market. 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 2. 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 EVOLUTION OF THE DISCOUNT FUNCTION: EPISODES OF CURRENT SIGNIFICANCE 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. 141 ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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 theory. 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 dow.3 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. 142 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 spread. Turner, using available statistical data, attempted to test the validity of the profit theory. His findings may be summarized as follows: 1. There was no correlation (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. ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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 143 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 policy. 144 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 port: 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 ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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 farmers.10 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: 145 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 lished.11 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 se.12 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. 146 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 uses. 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 Bank. 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.13 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. ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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.15 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 actions. 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 loans. 14 See “Review of the Month,” Federal Reserve 147 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. 148 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.18 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.19 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. 336-56. 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 ernors. 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 149 ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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 importance. 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 banks.” 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. 150 problems that had their origin in the war and early postwar periods.21 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 function. 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.22 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.24 Additional margins of collateral of this magnitude, however, were apparently infre quent. 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. ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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 151 prices of such securities or to work a hard ship on those still carrying a large part of the Liberty Bonds acquired on original subscription.25 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. 152 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 Bank. 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.” 27 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. 153 ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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 tricts. 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.29 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 cussed. 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. 154 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 directors.30 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: Tt 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.31 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, . . 32 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.” 33 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. ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 155 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 resources.” 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.34 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 1955. 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: 1. To help finance speculative activities 1. 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. 156 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.35 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 inappropriate. 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.” 36 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. ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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.” 37 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 sion. 37 Ibid. 157 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 158 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.38 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 riods: . . 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.” 39 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.” 40 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. ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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 window. 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. 159 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. 160 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. 42 32. 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 ROLE AND FUNCTIONING OF DISCOUNT MECHANISM economists disagreed, pointing out that in terest cost is only a small part of total costs.43 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. 161 enable the System effectively to encourage or discourage expansion.44 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.45 44 See Turner, o p . c it., pp. 145-60. 45 For example, see Minutes of the Federal Open Market Committee, Aug. 23, 1955. 162 BIBLIOGRAPHY Books 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. ROLE AND FUNCTIONING OF DISCOUNT MECHANISM 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, 1914-35 (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). 163 THE DISCOUNT MECHANISM IN LEADING INDUSTRIAL COUNTRIES SINCE WORLD WAR II George Garvy Federal Reserve Bank of New York Contents Part 1 The Discount Mechanism as a Tool of Monetary Control___________________ 167 Part 2 The Discount Mechanism in Individual Countries________________________ 199 Foreword 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 countered. 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 de E studios M on etarios Latinoam ericanos, Mexico City, under the title “El Mechanismo de Discuento Como Instrumento de Politica Monetaria.” Part 1 THE DISCOUNT MECHANISM AS A TOOL OF MONETARY CONTROL Contents Introduction____________________________________________________________169 Provision of Central Bank Credit at the Initiative of the Banks______________________ 170 Discounts Advances 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 THE DISCOUNT MECHANISM AS A TOOL OF MONETARY CONTROL INTRODUCTION 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. 170 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 systems. PROVISION OF CENTRAL BANK CREDIT AT THE INITIATIVE OF THE BANKS 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 omy. 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 iants. 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. LEADING INDUSTRIAL COUNTRIES 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 171 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. 172 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 change. 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. LEADING INDUSTRIAL COUNTRIES 173 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. CHANGES IN CENTRAL BANK ASSETS (In billions of national currency units) Central bank of— Period Austria .................... Belgium .................. Canada .................... France ...................... West Germany ........ Italy .......................... Japan ........................ Netherlands ............ Sweden .................... Switzerland ............ United Kingdom .. United States ........ 1958-69 1958-69 1958-69 1958-69 1958-69 1961-69 1958-69 1958-69 1958-69 1958-69 1963-69 1958-69 Net foreign assets 26.3 70.1 1.4 10.1 4.2 1,003.0 1,056.0 5.4 .9 .1 —2.2 —7.5 Net domestic assets 3.6 —1.8 1.0 37.3 22.9 5,217.0 3,038.0 —.2 5.8 1.1 3.5 43.4 N ote.—N et foreign assets = foreign assets — foreign liabilities. 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. Discounts 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 product. 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 applications. 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 174 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. Advances 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). LEADING IN D U ST R IA L C O U N T R IES 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. 175 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. 176 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 gibility. WIDENING OF THE RANGE OF OBJECTIVES AND TOOLS OF MONETARY POLICY 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 tion. 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 LEADING IN D U ST R IA L C O U N T R IES 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 rate. 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 177 inhibiting free and frequent use of changes in the discount rate. The reasons for these developments may be summarized as fol lows: (1 ) Fear that the signal would be over interpreted. (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 178 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 doctrine. 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 changes. 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. 179 LEADING IN D U ST R IA L C O U N T R IES 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. MAIN CONTRASTS WITH THE UNITED STATES 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 180 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 mands. 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 cases. LEADING IN D U ST R IA L C O U N T R IES 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 181 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 customers.10 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 banks. 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 rectly. 182 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.”11 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,13 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.14 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 11 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 abroad. LEADING IN D U ST R IA L C O U N T R IES 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.15 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. 183 erally considered as a residual mechanism through which over-all availability of re serves is adjusted to longer-run growth re quirements. 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 able. 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 184 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). LEADING INDUSTRIAL COUNTRIES 185 RATE POLICY 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 186 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.16 ™ 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.” 17 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 level. 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. LEADING IN D U ST R IA L C O U N T R IES 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 187 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. 188 QUANTITATIVE CONTROLS 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.18 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 controls. 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. LEADING IN D U ST R IA L C O U N T R IES 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.19 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. 189 lected balance sheet items, or a number of other variables.21 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 22 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 quotas. 22 In at least one country (F rance) revisions of ceilings were negotiated with the banks involved. 190 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 situations. 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 policy. 1. 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). LEADING IN D U ST R IA L C O U N T R IE S 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 more 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.25 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 diately. 25 Italian and West G erm an banks even include the unused m argin in computing their liquidity positions. 191 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). 2. 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- 192 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 time. SELECTIVE CONTROLS THROUGH THE DISCOUNT WINDOW 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.26 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.27 “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. 193 LEADING INDUSTRIAL COUNTRIES 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).28 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 ties. 28 For description of a special technique to restrict rediscounting of exempt paper, see the chapter on France. INDIRECT ACCESS TO THE DISCOUNT WINDOW 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 194 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. LEADING INDUSTRIAL COUNTRIES 195 UNIFORMITY OF ADMINISTRATION 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.29 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. CONCLUDING REMARKS 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 196 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 LEADING INDUSTRIAL COUNTRIES 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 197 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 THE DISCOUNT MECHANISM IN INDIVIDUAL COUNTRIES Contents Introduction 201 Austria ___ 201 Introduction Banking system Reserve requirements Discounts and advances Other instruments of monetary policy B e lg iu m ___________________________________________________________________________ 207 Introduction Institutional framework Discounts and advances Other instruments of monetary policy C a n a d a ____________________________________________________________________________ 214 Introduction Institutional framework Discounts and advances F r a n c e ____________________________________________________________________________ 219 Introduction Institutional structure Instruments of monetary policy Discounts and advances Federal Republic of G e rm an y _______________________________________________________ 233 Introduction Banking system Discounts and advances Other instruments of monetary policy Italy Introduction Institutional framework Discounts and advances Other instruments of monetary policy 239 Contents Cont. J a p a n _____________________________________________________________________________ 246 Introduction 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 Introduction Structure of the banking system Mechanism through which monetary policy operates Discounts and advances S w e d e n ___________________________________________________________________________ 259 Introduction Institutional framework Discounts and advances Other instruments of monetary policy S w itz e r la n d _______________________________________________________________________ 263 Introduction Banking structure Instruments of monetary policy Discounts and advances United K in g d o m ___________________________________________________________________ 268 Introduction General background Institutional framework Discounts and advances Other instruments of monetary policy Relationship of other interest rates to the discount rate Part 2 THE DISCOUNT MECHANISM IN INDIVIDUAL COUNTRIES INTRODUCTION 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. AUSTRIA Introduction 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 202 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 LEADING INDUSTRIAL COUNTRIES 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 203 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 institutions. 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. 204 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 months. 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 LEADING INDUSTRIAL COUNTRIES 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 205 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. 206 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 prises. 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 stantially. 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 ances. 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 LEADING INDUSTRIAL COUNTRIES 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, 207 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. BELGIUM Introduction 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 mands. 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 208 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 operations. 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 tutions. 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 LEADING INDUSTRIAL COUNTRIES 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 structure. 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. 209 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. 210 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 ment.0 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 institutions. 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. LEADING INDUSTRIAL COUNTRIES 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 discounting. 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 211 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. 212 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 hold. 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 indirectly.10 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 another. 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 LEADING INDUSTRIAL COUNTRIES 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 market. 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 213 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 banks.11 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. 214 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. CANADA Introduction 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: 12 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 securities. 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. LEADING INDUSTRIAL COUNTRIES 215 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.14 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 ties. 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.13 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 its. 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 themselves. 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 deficiencies. 216 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.15 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 16 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 tive. 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,17 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.18 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. 217 LEADING INDUSTRIAL COUNTRIES 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 banking. 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.19 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. 218 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, LEADING INDUSTRIAL COUNTRIES 219 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.20 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 FRANCE 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 ernment. 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—67, 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. 220 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. Because existing monetary policy 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 credit. 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 funds. 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. LEADING INDUSTRIAL COUNTRIES 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 221 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 agent. 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 222 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.22 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 financing. 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.23 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. LEADING INDUSTRIAL COUNTRIES 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 223 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.24 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. 224 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 siderations. 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.26 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.27 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.23 In stru m en ts of m onetary policy LEADING INDUSTRIAL COUNTRIES 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 paper. 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. 225 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.28 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 later. 226 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.29 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. LEADING INDUSTRIAL COUNTRIES 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 227 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 credit. The other kind of “open market opera 228 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 eral. 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 229 LEADING INDUSTRIAL COUNTRIES 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.30 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 1970. 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 thorization. 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 230 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 customers. 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,31 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.) LEADING INDUSTRIAL COUNTRIES 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 231 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 discounting33 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, 232 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 exempt. 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.34 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;35 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 dossier. 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 LEADING INDUSTRIAL COUNTRIES 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. 233 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. FEDERAL REPUBLIC OF GERMANY Introduction 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.36 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. 234 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 straint. 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.37 37 These regional banks serve as offices of the Fed eral Bank in each Land and carry out the policy LEADING INDUSTRIAL COUNTRIES 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. 235 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 ulation. 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 credit. 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 flows. 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 236 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.38 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.39 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. LEADING INDUSTRIAL COUNTRIES 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. 237 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 238 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.40 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.41 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.42 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. LEADING INDUSTRIAL COUNTRIES 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 239 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. ITALY Introduction 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 rediscounts. 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 240 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 branches. 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 241 LEADING INDUSTRIAL COUNTRIES 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) ,43 providing clearing facilities and technical assistance, and representing the members in dealings with the Treasury and other branches of the Government.44 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 ited. 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.45 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.46 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. 242 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.” 47 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.48 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 cent). 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. LEADING INDUSTRIAL COUNTRIES 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.49 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 phenomenon. 243 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 purposes. 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. 244 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 quirements. 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.50 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.51 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.52 lire), IV 4 per cent for normal savings deposits, and 33A 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 ments. LEADING INDUSTRIAL COUNTRIES 245 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.54 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 53 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 ment. 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.53 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. 246 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.55 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. JAPAN 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- 247 LEADING INDUSTRIAL COUNTRIES 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 posits. 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 248 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.30 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 liquidity. 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 significantly. 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 increased. 249 LEADING INDUSTRIAL COUNTRIES 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,57 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.58 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 table. RECENT C H A N G ES IN RATES ON D ISC O U N T S AN D ADV AN C ES Per cent per annum Type 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.......... August 1968 5.84 1 6.21 j 4.02 \ September 1969 January 1971 6.25 5.75 4.25 4.38 4.50 6. 57 6.75 / \ 5.00 5.25 5 . 50 6.00 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.50 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 59 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. 250 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 LEADING INDUSTRIAL COUNTRIES 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 tomatically. 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 251 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.60 However, large amounts of 7year 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. 252 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 tomers. 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 volumes. 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 nance. 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. 253 LEADING INDUSTRIAL COUNTRIES 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. NETHERLANDS Introduction 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.” 61 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 money. 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 banks Security credit institutions General savings banks Total assets (millions of Number guilders) 80 40,549 2 16,576 11 336 166 8,370 45 205 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. 254 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 LEADING IN D U ST R IA L C O U N T R IE S 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 255 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 256 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. LEADING IN D U S T R IA L C O U N T R IE S 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.62 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.63 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). 257 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 facilities. 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. 258 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 days. 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, LEADING IN D U ST R IA L C O U N T R IE S 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 259 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. SWEDEN Introduction 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 trade. 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— 260 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 Office64 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.65 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*16 —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.67 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. LEADING IN D U S T R IA L C O U N T R IE S 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.68 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. 261 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 hibited. 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 262 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 ences. 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 tively). 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 ceptances. 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 LEAD ING IN D U ST R IA L C O U N T R IE S 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 263 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. SWITZERLAND Introduction 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 purposes. The Swiss National Bank has limited powers to conduct open market operations. 264 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 ters. 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. LEAD ING IN D U ST R IA L C O U N T R IE S 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 265 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 266 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.69 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. LEAD ING IN D U ST R IA L C O U N T R IE S 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 counting. 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.70 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 siderably. 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.71 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 268 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.72 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.73 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. UNITED KINGDOM Introduction 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. LEAD ING IN D U S T R IA L C O U N T R IE S 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.74 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. 269 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 270 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 problems. 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, LEADING IN D U ST R IA L C O U N T R IE S 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 liabilities. Discounts and advances The discount rate establishes the pattern of rates for bank loans and deposits of London clearing banks and influences the entire 271 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 272 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.75 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 market. 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 LEAD ING IN D U S T R IA L C O U N T R IE S 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 sired. 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 time. 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 273 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 76 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 used. 274 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 LEA D ING IN D U ST R IA L C O U N T R IE S 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 275 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 breached. 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 tions. 276 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,77 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 3A 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.78 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.