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• P . O . B O X 4 4 2 • S T . L O U IS 6 6 , M O.


The Business Situation
— D em and for Credit Stre ngthe ns..................


— Expansion o f Economic Activity Continues. .


Central Reserve Cities/ Reserve Cities, an d Reserve
Requirements— A Brief S u rv e y ........................

This issue released on M ay 22

VOL. 41 • No. 5 * MAY ’59


— Demand for Credit Strengthens
I n TEREST RATES are now high in relation to experience of the past twenty-five years, and comment
on the plight of borrowers—including the United
States Treasury— widespread. At the same time the
money supply has continued to rise at a substantial
rate and the total volume of funds flowing to borrow­
ers has been at near record levels.
The increase in the cost of credit during the past
year has reflected mainly a sharp increase in demand
for funds rather than a restriction of supply. An in­
crease in borrowing characteristically occurs during
a period of optimism and economic expansion; pres­
ently, fears of future decline in the purchasing power
of the dollar may in some measure act to stimulate
demand for funds. Consumers have been heavy bor­
rowers, especially to finance record house buying;
business demand for funds to support investment in
inventories and plant has been rising; and govern­
ments have drawn unusually heavily on the economy’s
credit supply.

A brightened economic outlook in 1959 has stimu­
lated an accumulation of business inventories fol­
lowing the sustained liquidation which took place
during the 1957-58 recession. In the first quarter of
1958 business firms liquidated inventories by $2 bil­
lion on a seasonally adjusted basis. By contrast they
expanded stocks of goods by $1 billion in the first
quarter this year. Burgeoning activity has also en­
couraged some increase in business outlays for plant
and equipment. In the second quarter, this invest­
ment is expected to reach a seasonally adjusted rate
of $8 billion, up 6 per cent from the like quarter last
Steadily rising personal income together with great­
er optimism concerning the future have contributed
to an upsurge in consumer durable goods purchases
and a related expansion in consumer credit. The
latter increased $1.4 billion in the first three months
of 1959 on a seasonally adjusted basis as compared to
a decline of $0.2 billion last year.

Supply of Funds
Demand for Funds
The quickened tempo of building construction has
been accompanied by a rapid rise in mortgage debt.
In the first quarter of 1959 such debt was increased
by about $5 billion or double the pace of a year ago.
In addition to private outlays, construction by state
and local governments continued at a high level in
early 1959. New schools, roads, and other facilities
together with current operating needs sent state and
local governments to the capital markets for some
$3 billion of new funds in the first four months of
1959, just slightly below the record amount in the
corresponding period last year.
The Federal Government also has been contribut­
ing to the demand for funds. In the first four months
of 1959 the Federal marketable debt rose $5.1 billion
as against a $1.8 billion rise in the like period last
year. However, it is expected that the Federal Gov­
ernment’s cash budget will be in balance in the near
future which should reduce the Treasury’s demand
for funds.
Page 50

Funds available to accommodate the increased
credit demand of businesses, governments, and con­
sumers stem primarily from current saving, credit
creation by the banking system, and activation of cash
According to preliminary information, the rate of
personal saving in the first quarter of 1959 was about
the same as a year earlier, amounting to an annual
rate of about $21 billion as compared with $20 bil­
lion last year. An increase in corporate saving, large­
ly reflecting a sharp gain in net profits, has also in­
creased the supply of funds available for investment.
Corporate profits after taxes were $5.5 billion in the
fourth quarter of 1958 after adjustment for seasonal
influences. Although data are not yet available, in­
dications point to a still higher figure for the first
quarter of 1959. By comparison, in the first quarter
last year corporate profits after taxes were less than
$4 billion. As a result many commercial and indus­
trial firms have temporarily been able to finance ex­
pansion programs and also have funds to lend to

Credit and money creation by the banking system
has been substantial during the past year. From
February to November, 1958, daily average demand
deposits and currency (adjusted for seasonal varia­
tion) increased at a rate of 5.0 per cent per annum.
From November 1958 to February this year the
annual rate of increase was 0.9 per cent, but in March
and April the rise was at the annual rate of 5.4 per
cent. This compares with a postwar average rate of
increase in the money supply of about 2.5 per cent.
The expansion in the seasonally adjusted money sup­
ply during the first four months of 1959 was made
possible, in part, by a less than seasonal contraction
in Reserve Bank credit.

Turnover of demand deposits at the 337 reporting
centers (outside the seven big financial centers) was
at the seasonally adjusted rate of 23.9 times per year
in the first quarter of 1959. By comparison, turnover
was at a rate of 22.9 times per year in the first quarter
of last year.

Recent Course of Interest Rates
From last September through March this year the
marked rise in the demand for credit was virtually
matched by an increase in the supply of funds. In­
terest rates generally were remarkably stable during
this period, with some rates working up and some
drifting lower (see chart).

Another important source of funds in recent months
has been more intensive utilization of cash balances.

W e e k ly A ve rag e s of D a ily Figures

Season a lly A djusted
D em and deposits adjusted and currency outside banks

M onthly averages of d aily figures

Billions of

D ollars

Billions of Dollars



Latest figures plotted:


W e e k ended M a y 15.

P er C en t

R ate of Change


from Previous

P er

However, during April and early May, the demand
for funds was rising at a faster pace than the avail­
able supply. Hence, interest rates have been moving
up on most marketable issues. The following table
shows selected interest rates as of the end of last
September, the end of March, and May 18.

Sept. 30,



Three-month Treasury B ills ....................
Long-term Government Bonds...............
Corporate Bonds:
Highest g r a d e ...........................................
Medium-grade ........................................
Highest grade Municipal Bonds.............
Prime Rate on Business L o an s.............

March 31,

2 .7 0 %

2 .7 8 %

4 .1 3
4 .0 0

4 .1 5
4 .0 0

May 18,
2 .8 4 %
4 .5 0

Page 51

Function of Interest Rates
In a free market system the interest rate is the price
which balances the supply and demand for funds.
Although saving is large, it is not unlimited. The
function of interest rates is to allocate the limited
amount of funds among competing uses. It is quite
generally believed in this country that allocation in
the market place is usually preferable to rationing by
Government fiat.
A basic economic problem is limiting the plans of
those seeking to invest in capital goods under condi­
tions of high-level employment to the amount others
are willing to save. Just as a family cannot buy all
that it would like or could use, so an economic so­
ciety cannot both consume and invest in unlimited
amounts. With a given state of technology and a
limited amount of resources (workers, land, and plant
and equipment) possibilities for current production
are not unlimited. Since we cannot obtain all the
things we want, we must pick and choose. The vari­
ous uses for funds have to compete for savings. The
resultant price for funds—
the interest rate—
has to be
paid for current borrowing and for refinancing by
individuals, businesses, and governments.
Indeed, the economy as a whole is much more re­
stricted than an individual family, a single business
firm, or a governmental unit. A family can for a
while spend more than its income. A business can
invest more than it saves, or a government can run a
deficit by borrowing. But an entire economy cannot
consume and invest more than it produces. In other
words, new capital goods must be matched by saving,
either voluntary, or involuntary through inflation.
By and large, interest rates are what they are, and
become what they become, as a reflection of how use­
ful and valuable the users of funds find them. Busi­
nessmen, consumers, and the Government pay the
interest rates which they pay because they find the
use of the funds worth the cost. A higher rate now
than at some earlier period indicates a stronger de­
mand for funds relative to the supply available, which
reflects the fact that projects on which the funds are
used are deemed increasingly attractive.
The productivity of capital may have increased in
recent years for a number of reasons. For one thing
business concerns have been spending more and more
on research and development. As a result of these
Page 52

programs new plants are being constructed and new
equipment is being installed which has caused an
increase in the demand for funds.
It may also be that the demand for capital is in
some degree a reaction to steadily increasing wage
rates during the postwar period. Some firms, as a
result of higher labor costs, have sought to substitute
machines for workers as a method of controlling ex­
penses. Hence, the higher wage rates in the post­
war period may have increased the demand for funds,
tending to push up interest rates.
Another force tending to sustain the demand for
credit has been the guarantee of loans by the Govern­
ment. A Government guarantee generally reduces
the risk of default to the lender enabling the bor­
rower to obtain more favorable terms. Hence, some
borrowers who might not have obtained funds with­
out the guarantee do in fact get them, thereby con­
tributing to the pressure on interest rates.
Saving, on the other hand, may have been dis­
couraged to some extent in recent years by inflation.
Since a large portion of saving is in the form of de­
posits or other liquid debt instruments, and since in­
flation reduces the purchasing power of funds in­
vested in these instruments, it may be that some sav­
ers feel that it is better to consume more of their
income currently. Evidence as to the effect that
continued price increases have had on the propensity
to save is not conclusive. However, to the extent that
saving has been reduced, this reduction has been a
factor in pushing interest rates up. But whether the
rate of current saving is affected or not, it appears
quite likely that its form is altered by inflation, en­
couraging the purchase of property and other equities
and discouraging the purchase of fixed debt instru­
Because of the numerous forces bearing upon in­
terest rates, it is impossible to state with certainty
what interest rates will do in the future. There is some
feeling that the demand for credit will rise in the
next few months as businessmen seek additional funds
to expand inventories and finance new plant and
equipment. On the other hand, the demand for money
by the Federal Government may decline as it comes
closer to balancing its budget. In any case, changes
in interest rates will be a natural response to changes
in supply and demand forces.

Expansion of Economic Activity Continues
* •*

LOTAL PRODUCTION of goods and services in
the nation has now been increasing for about a year.
Cross national product reached a seasonally adjusted
annual rate of $467 billion in the first quarter of the
year, and signs point to a continued increase. The
first-quarter rate at current prices was more than 9
per cent higher than the rate in the first quarter of
last year, and “real” total production—
measured at
1958 prices—
was 8 per cent higher than a year ago.
Consumer income after taxes during the first quar­
ter of this year was about 5 per cent higher than in
the same quarter of last year, and 1.6 per cent above
the late 1958 level. Since consumer prices have
remained stable since last June, “real” income of
consumers has risen appreciably. Per capita real
disposable income in the first quarter of this year was
approximately 2.2 per cent higher than in the corres­
ponding quarter of 1958, although slightly below the
level reached two years ago.
Production of goods and services expanded further
during April and early May, as evidenced by the
growing volume of industrial production and the
sharp upswing in employment. Consequently, con­
sumer income and spending are likely to be substan­
tially higher in the second quarter than in the first
three months of this year.

Industrial Output in April Shows Further Gains
th e rapid rise in business activity experienced
during the first quarter of this year continued in April
and early May. The seasonally adjusted index of in­
dustrial production increased between March and
April by 2 points to 149 per cent of the 1947-1949
average. The pre-recession peak was 146. Manu­
facturing of durable goods, especially machinery,
showed sharp increases, while activity in the building
materials and automotive industries remained at high
Steel production in April continued to expand,
reaching the highest level in history. Average weekly
output increased by about 2 per cent over March,


• U » j.


' 5

and was more than double the April 1958 rate. Total
output during the first four months of this year was
71 per cent larger than during the corresponding
period last year, the bottom of the recession, reflect­
ing the continuously strong demand from such major
consumers as the automobile, construction, and
machinery industries.
Production of durable producer goods, notably of
machinery, has been growing at an increasing rate.
April output of machinery, seasonally adjusted, was
about 2.5 per cent higher than the March total, and
about 19 per cent ahead of a year ago, but was about
8 per cent below the monthly high established in
December 1956.
Output of consumer durables reached the highest
volume of the year in April. Passenger car produc­
tion rose to a seasonally adjusted annual rate of about
six million units, and production for the first four
months of this year ran about 40 per cent ahead of
the volume produced during the corresponding period
of last year. Production of television sets and furni­
ture also advanced between March and April.

Construction Activity Remains High
Estimated expenditures for new construction out­
lays in April reached a seasonally adjusted annual
rate of $53.9 billion. Although this was slightiy
below the March rate, it was still substantially above
the rate achieved in any previous April. New con­
struction expenditures during the first four months
of this year ran at an annual rate of $54.3 billion, as
compared with total 1958 spending of $49 billion, a
high for any one year.
Spending on private construction in April was
about 15 per cent greater than in April of last year,
largely because of an increase in residential building.
Total expenditures on private construction during
the first four months of this year amounted to $10.7
billion, up 11 per cent from the corresponding 1958
Page 53

Public construction outlays during the first four
months of this year totalled $4.4 billion, as compared
to $3.8 billion in the first four months of 1958. The
bulk of the increase resulted from growing expendi­
tures for highways, housing, and military construction.
The value of construction contract awards, which
provides some indication of future construction ac­
tivity, was 43 per cent greater in March than in
February, and was 23 per cent larger than in March
of last year. The increase over February was con­
siderably larger than the usual seasonal increase,
and was mainly the result of a marked rise in awards
for residential construction and power projects. The
total for the first quarter of this year was 18 per cent
larger than the corresponding 1958 total. Most pro­
nounced was the rise in contract awards for residen­
tial construction, especially for one- and two-family
houses. On the other hand, the value of contracts
awarded for school construction was 20 per cent
lower in the first three months of this year than in
the first quarter of 1958.

Sales, Inventories, and New Orders Advance
Sales of manufacturers, wholesalers, and retailers
combined reached a seasonally adjusted total of $59.1
billion in March, an increase of $1.1 billion over the
previous month, and of $7.8 billion over March 1958.
The sharpest gain in March of this year was regis­
tered in the sale of durables by manufacturers, which
rose by about 3 per cent over February. Both whole­
sale and retail sales increased about 1.7 per cent,
seasonally adjusted, during the same month, and
retail sales in April were virtually unchanged from
Inventories of manufacturers, seasonally adjusted,
had risen to $50.3 billion by the end of March. This
was an increase of $400 million over February, but
inventories were still $1.7 billion below the March
1958 level. During the first three months of this year
manufacturers’ inventories showed an increase of $1.1
billion, seasonally adjusted, as compared with a $1.5
billion decline during the first quarter of last year.
Stocks of metal producers and fabricators have been
gaining the largest share in recent months, reflecting
rising industrial activity and efforts of steel users to
hedge against a possible summer strike. Wholesale
and retail inventories at the end of March were at
virtually the same levels as at the beginning of the
year, and only wholesale inventories showed any
change— 4 per cent decline—
from the March 1958
Manufacturers’ new orders reached a seasonally
adjusted total of $30 billion in March, an increase of
Page 54

about 1 per cent over February. New orders to steel
producers declined from their high February level,
but this drop was more than offset by a further rise
in orders received by manufacturers of other durable
goods. Machinery—
both electrical and nonelectrical
and transportation equipment registered the largest
gains. Orders for machine tools, especially of the
cutting and forming type, also continued to rise

Employment and Income Continue to Rise
One of the most outstanding features of the April
economy was the sharp decline in unemployment
and the corresponding rise in employment. Unem­
ployment last month dropped by an estimated 735,000, almost double the usual seasonal decline during
this time of the year. The percentage of the civilian
labor force which remained unemployed dropped
from 5.8 in March to 5.3 in April. This constitutes
the sharpest monthly decline since the turn from
the 1957-1958 recession, and brings the percentage
unemployed to the lowest point since December 1957.
Total employment in April increased by 1,200,000,
also about double the usual seasonal increase. Non­
farm employment rose approximately 500,000, mainly
as a result of the substantial increase in construction
activity in recent months and because of stepped-up
hiring by durable goods manufacturers.
The sharp rise in employment was accompanied
by a further growth in personal income which reached
an annual rate of about $373 billion in April, almost
7 per cent higher than the rate of the corresponding
month last year. The increase reflected both a
lengthening of the factory work week and higher
wage and salary payments, especially in manufac­
turing and construction. Average weekly earnings
in manufacturing rose by 63 cents to $89.87 in April,
a new high.

Prices Are Subject To Upward Pressures


Industrial wholesale prices as a group rose at an
annual rate of 3 per cent during March and April,
under the pressure of increased business activity.
Advances were most pronounced among leather and
leather products, lumber and wood products, and
textiles. Leather prices in March were about 9 per
cent higher than a year ago, and 3 per cent higher
than in February. Increased shoe production and an
unusually small supply of hides were the main forces
behind the price rise. Metal and metal products,
fuel, and power, were among the items which ex­
perienced less marked price increases.

Selected Consumer Price Indices

1947- 49=100

Wholesale prices of farm products increased slightly
in April for the first time since May of last year, but
declined again in the first two weeks of this month.
The wholesale price index for all commodities which
rose 0.1 to 119.6 in March (1947-1949=100), gained
0.2 in April.
The consumer price index in March remained at
the February level, as a decline in food prices offset
a further increase in prices of nonfood products and
services. Declining food prices have accounted for
much of the stability in the consumer price index
since last summer, as shown in Chart 1.

Commodity Imports Increase
United States trade with other countries during the
first quarter of this year showed a further rise in
imports and a decline in exports. Sharp increases in
the purchase of foreign automobiles, steel, petroleum
products, rubber, and wool exceeded declines in
imports of newsprint, cattle and meat by almost $1
billion at an annual rate. The decline in merchandise
exports reflected mainly a further drop in sales of
machinery and equipment to foreign customers.
Despite the large first quarter balance of payments
deficit, United States gold sales during this period
were small, mainly as a result of substantial repay­
ments by Germany to the United States and by the
United Kingdom to the International Monetary Fund.
Gold sales picked up again in April and reached
substantial proportions in the final two weeks of last
month and the first week of this month.

P * r Cent

STABILITY in the consumer price index between 1953 and 1956
was in part produced by declines in the cost of food, housefurnishings,
and transportation, which offset increases in, among others, the cost of
rent and medical care. The 1956-1958 inflation was largely manifest in
a sudden and substantial upturn in prices of foodstuffs and transporta­
tion, and continuing increase in the cost of medical care and rent.
Since the middle of last year a sharp drop in total food prices and
continuing stability in prices of apparel and housefurnishings have
again offset increases in the cost of services.

Among food prices,

those of meat, poultry, and fish combined have experienced the most
significant decline. Prices of dairy products in March of this year were
about the same as in the fall of 1957, and those of cereals and bakery
products combined were moderately higher.

Latest Data Plotted:


Source: Bureau of Labor Statistics

Page 55

Central Reserve Cities, Reserve Cities, and
Reserve Requirements— A Brief Survey
commercial banks that they are the most closely
regulated business firms in the world. Banking laws
abound in precise prescriptions and carefully worded
proscriptions relating to the conditions under which
banks may be organized as well as the nature and
magnitude of their operations. This close supervision
of commercial banks reflects a public acknowledg­
ment that they are intimately involved with the na­
tion’s money supply and are thus heavily vested with
the public interest.
In part, this involvement stems from the legal ob­
ligation of a commercial bank to surrender the bulk
of its assets on demand, and in cash. Commercial
banks, however, are organized and operated on the
assumption that only a relatively small amount of
their resources need be reserved in cash for such
surrender. Originally, the determination of this
“reserve” was, and in England and many other coun­
tries still is, left to the discretion of the individual
banks. However, in the United States during the
19th century many states as well as the Federal Gov­
ernment changed it from a matter of private decision
to one of legal requirement. By the turn of the
century required reserves had become an accepted
feature of banking statutes. While these require­
ments varied in detail and application, they were die
pivot in every framework of public control and were
motivated by a common intention to assure the safety
of deposits by providing a source of funds to meet
anticipated withdrawals.
Yet if American banking history, from its begin­
nings to the bank holidays of the 1930’s, proved any­
thing, die high incidence of bank failure during this
period demonstrated that a nominal ratio of reserves
to deposits did not, of itself, adequately provide in­
dividual safety for the depositor nor collective safety
for the banking system. Nonetheless, the notion that
it did persisted well into the 20th century, surviv­
ing and, indeed, underlying the attempted solutions
to the varying and manifest inadequacies of die
American banking system set out in the National
Page 56

Banking Act of 1863 and the Federal Reserve Act of
1913. Both of these major reforms addressed them­
selves to the structure of the banking system and not
to its underlying rationale. Both involved the com­
mon theme of providing safety by requiring that re­
serves be maintained by individual banks. The latter
legislation, in particular, attempted to accomplish
this by “mobilizing” reserves, in a tightly knit sys­
tem of twelve regional quasi-public institutions.
Yet from the earliest days of the Federal Reserve
System, reserve accounts were seen to have a dimen­
sion distinct and apart from their protective function.
Thus, in discussing the transition from the higher
percentage requirements of superseded national bank­
ing legislation to the lower ones of the Federal Re­
serve Act, die Federal Reserve Board said not one
word about depositor safety. Rather, its first report
discussed decreased reserves solely in terms of the
increase in member bank lending power caused by
this release of funds and the consequent effect on the
pattern of interest rates.1
That results of this type should be produced
through reserves as a matter of policy rather than
happenstance was increasingly comprehended, and
after a decade of Federal Reserve operation, the
primary function of reserves gradually was seen as
a means of adjusting the volume of commercial bank
credit and the nation’s money supply rather than a
resource for the safety of depositors. However, the
old idea that reserves provided for deposit safety
still had widespread adherence until its total in­
adequacy was revealed by the wholesale collapse of
the banking system in the 1930’s. Its theoretical
coup de grace was contained in a 1931 report of a
Federal Reserve Committee which summed up an ex­
haustive investigation of the subject with the state­
ment “ . . . it is no longer the primary function of
legal reserve requirements to assure or preserve the
liquidity of the individual bank.”2
1 Firit Annual Report of the Federal Reserve Board (15>14), page 11.
2 Nineteenth Annual Report o f the Federal Reserve Board (1932), page 260.

The statutory requiem of the protective function of
reserves was contained in successive acts of Congress
passed in 1933 and 1935. It should be noted, how­
ever, that depositor safety did not thereby cease to
be an object of legislative concern for each of these
enactments was paralleled by other Congressional
action, first instituting and then refining deposit in­
surance as the means by which this end was to be
achieved.3 The 1933 statute concerning reserves gave
the Federal Reserve Board power—
providing Presi­
dential concurrence was forthcoming — to raise re­
quirements in any amount to offset inflationary credit
developments. This authority was restated and modi­
fied by the Banking Act of 1935, which cast statutory
reserve requirements in their present form by setting
a basic reserve subject to limited adjustment by the
Board of Governors on its own motion:
(Percentages of Deposits)
Demand Deposits

Time Deposits

Central Reserve City Banks....... . . .




Reserve City Banks................. . . .









Country Banks........................


One of the more striking incidents of this profound
conceptual change is the fact that it came about with
a minimum of textual alteration. The basic statute

still employs much of the terminology and many ot
the concepts of an earlier era. This legacy of the
past has produced inequities, which the Board of
Governors has attempted to ameliorate in 1958 and
again this year by suggesting that certain amendatory
proposals be made to the basic statute. In brief,
these suggested revisions would authorize the Board
(1) Permit individual member banks in any part
of a reserve or central reserve city to carry, where
reasonable and appropriate in view of the character
of their business, reserves at the lower requirement
level prescribed for country or for reserve city
(2) Permit member banks to include in their re­
quired reserves all or part of their vault cash hold­
ings in addition to balances with Federal Reserve
(3) Set the reserve requirements for demand de­
posits of central reserve city banks within a range
of 10 to 20 per cent instead of the present author­
ized range of 13 to 26 per cent.
The scope and goal of such proposals might be illu­
minated by a brief survey of present requirements,
their origin and development.4

Reserve Classification—
Statutory Background
The Federal Reserve Act today, as it did in 1913,
uses a dual standard for prescribing reserves. One is
the character of the deposit involved, the other is the
location of the bank. Under the first criterion, time
and savings deposits carry lower reserves than de­
posits which are payable on demand. The reserve
requirement against time and savings deposits is
uniform, applying equally to all member banks re­
gardless of size or location.
The second criterion is geographic and applies only
to demand deposits. Accordingly, banks in “central
reserve cities” (New York and Chicago) may be re­
quired to carry the highest reserves; banks in “re­
serve cities” (relatively large cities and towns) carry
a lesser percentage; banks located elsewhere (the socalled country banks) carry the lowest percentage of
all. This tripartite statutory classification of member
banks did not originate with the Federal Reserve Act
T he Federal Reserve System provides additional liquidity and safety for
member banks when it lends to and purchases assets from them.

but was, m the most literal sense, transferred from
the then existing national banking legislation.
Such legislation had from its earliest days provided
for a pyramidal system of holding reserves. National
banks outside of large cities were required to keep at
least 40 per cent of their reserves in their vaults and
permitted to keep the remainder (up to 60 per cent)
with banks in reserve cities. The latter, in turn, were
expected to maintain reserve balances at central re­
serve city banks, which were at the very top of the
pyramid and were required to keep their reserves in
The rationale for both the distinction between time
deposits and demand deposits and the geographical
differentiation of the latter was rooted in the original
T h e Board’s proposals were incorporated in current bills in both houses
of Congress (S . 1120 and H .R . 5 2 3 7 ). As reported by the Senate Banking
and Currency Committee, S . 1120 continues the vault cash proposal and the
proposal concerning the carrying o f reduced reserves, but abolishes the
central reserve city designation. H .R . 5237 was sim ilarly reported by a
Subcommittee o f the House Banking and Currency Committee, except that
three years would be allowed for abolition o f the central reserve city

Page 57

concept of reserves as a source of depositor protec­
tion. The amount of reserves necessary for this func­
tion was assumed to depend on the character and
behavior of the deposit to be protected. Hence, a
substantial differential was applied to slower moving
time deposits, and the same logic underlay the loca­
tional classification of those payable on demand.5
Deposits in country banks were deemed to be rela­
tively static, those in larger cities somewhat more
dynamic, and those in large financial centers, the ulti­
mate reserve depositaries of the nation, highly volatile.
While this device of private reserve depositaries
under the National Banking System was probably
better than no device at all, the flow of funds be­
tween the country and the cities in a sequence of
deposit and redeposit made for recurrent and periodic
attacks of financial indigestion. When loan demand
was slack, country banks built up interest-earning
reserve balances at city banks. These concentrated
pools of funds in the nation’s financial centers quickly
dried up when grass roots loan demand tautened, as
country banks abruptly drew down their reserve bal­
ances in order to satisfy the needs of their own cus­
In addition to this seasonal tug on money markets
which was reflected in alternating periods of credit
ease and tightness and high and low interest rates,
there was the recurring problem of financial panics.
All too often, at the first signs of crisis, the outlying

banks called upon their reserve city balances and the
reserve city bank, in turn, pressed their central re­
serve correspondents. This phenomenon of runs on
banks by banks resulted in forced liquidation, loss,
and frequent disaster.
The creation of the Federal Reserve System with
its regional reserve banks, which was largely prompted
by this inadequacy of the credit apparatus, weakened
the rationale for a threefold classification of banks
based largely upon the use of private reserve deposi­
taries. This was particularly true after a 1917 amend­
ment to the Federal Reserve Act required all member
bank reserves to be kept with the reserve banks (the
original Act required only one-third of the re­
serves to be so deposited). Despite the 1917 amend­
ment, however, the designation of central reserve
city, reserve city, and country banks with their dif­
ferential reserve requirements was retained. While
the necessity for such a classification was less com­
pelling after 1917 than it was before, the necessity
was only diminished, not eliminated. Member banks
continued to carry accounts with banking institutions
in the larger cities for a variety of reasons, and the
big city banks—
particularly those in the New York
and Chicago money markets—
had a large portion of
their demand deposit liability in this highly volatile
form.0 Banks in other reserve cities, while receiving
deposits from country banks, tended, in turn, to
maintain substantial balances in New York and

Central Reserve and Reserve Cities—
Administrative Designation
The original Federal Reserve Act gave the Federal
Reserve Board discretion to classify and reclassify
localities as central reserve and reserve cities, and the
continuous use of this authority has reflected the
changing pattern of American finance. In some cases
changes in classification were made upon petition of
the banks in a city, on other occasions the Board acted
upon its own initiative. During the thirty years fol­
lowing the 1917 amendment the entire matter of
classifying cities for reserve purposes was under more
or less continuous study and in 1947 the Board set
forth certain standards of classification which were
T h e reserve differentjal applicable to time deposits was not provided by
national banking legislation, but was introduced by the Federal Reserve Act.

Page 58

based primarily on the volume of interbank deposits.
Thus, the designation “central reserve city” which
had been confined to New York and Chicago for
thirty years was continued.7 Other localities were
6 Nonmember banks, whose reserve requirements are fixed solely by state
statutes, also carry out-of-town bank balances, and the latter accounts are
recognized in varying degrees as reserves by the applicable laws.
T he
resulting network o f correspondent banking is heavily dependent upon and.
in a sense, complements Federal Reserve organization to provide a financial
apparatus o f astonishing speed, capacity and sensitivity. T h e Federal Reserve
wire transfer facility interlocks the reserve account o f each member bank,
wherever located, with every other one, and the interbank balances carried
with member institutions in turn fan out to encompass every bank in the
Thus, in addition to their primary function as instruments of
monetary policy, reserve accounts are the conduits of American finance through
which are channelled clearings, collections, transfers o f funds, and fiscal
agency transactions in astronomical amounts and with speed, safety, and
7 St. Louis was the only other city to hold this status under the original
Federal Reserve A ct. In 1922 the Federal Reserve Board made it a reserve
city follow ing two requests for such reclassification by the St. Louis Clearing
House Association.

classified as reserve cities if they contained (a) a Fed­
eral Reserve bank or branch or (b) banks with inter­

did more than undercut the original logic of the three­

bank deposits totaling between one-fourth and onethird of 1 per cent of all such deposits held by all
member banks in the United States. Those cities

made vault cash, the coin and currency banks kept on

which were already classified as reserve cities but
could not meet the new criteria retained their desig­
nation if every member bank in the city requested it,

The expanding use of checks continually reduced a

fold geographical classification alluded to earlier. It
the premises to meet over-the-counter withdrawals,
an addition to, rather than a part of, required reserves.
bank’s need for till money but did not eliminate it,
and a subsequent System study revealed that the

and from time to time institutions so located have vig­
orously applied to maintain their status even though

wholly accidental factor of proximity to a Federal Re­

reclassification as “country banks” might have meant
a substantial increase in earning assets. Under these

material bearing on a member bank’s supply of vault

criteria 49 communities are currently designated re­
serve cities.

eral Reserve offices carried fairly little cash, while

Small Banks in Big Cities
However, there was one incident of classification,
originating with the national banking legislation and
subsequently adopted root and branch by the Federal
Reserve Act, which involved substantial inequities.
This concerned the so-called “neighborhood” banks
whose metropolitan addresses mask the real character
of their operations. As early as 1917, the Board noted
that these institutions were in justice entitled to re­
quirements based on their essentially parochial opera­
tions. In 1918 Congress responded by authorizing
the Board to grant banks in the “outlying” districts of
large cities a lower reserve requirement than that
applicable to other banks in the same community.8
By its very terms this provision could not apply to
small downtown banks, and the Board was unable to
accord the latter institutions the reserve adjustment
available to banks of like character located elsewhere
in their city. The Board of Governors has accordingly
suggested that its 1918 authorization to modify re­
serve requirements of “outlying” banks be extended
to a logical conclusion by enlarging its power to
modify the reserve requirements of individual banks
located in the center of reserve or central reserve
cities if the character of a bank’s business so justifies.

serve office and the latter’s stock of currency had a

Investigation showed that banks near Fed­

those located elsewhere carried relatively l a r g e r
While all member banks today hold between $2
billion and $2.5 billion of vault cash, about 60 per
cent of this total is held by country banks where it
constitutes from 3 to 4 per cent of their demand de­

For reserve city banks, vault cash comprises

from 1.5 to 2 per cent and for central reserve city
banks less than 1 per cent of their demand deposits.
“Since vault cash holdings and reserve balances at the
reserve banks are interchangeable and both have the
same effect in limiting the volume of credit a bank
may extend, it is logical and proper that both be
counted as reserves.”9 Furthermore, the distribution
of vault cash among member banks tends to reduce
the reserve requirement differential between them.
Whereas the reserve requirements of demand deposits
alone were 11 per cent for country banks, 16V per
cent for reserve city banks, and 18 per cent for cen­
tral reserve city banks, the ratio of reserve require­
ments and vault cash holdings together were 14.3
per cent for country banks, 18.1 per cent for reserve
city banks, and 18.6 per cent for central reserve city
Since this proposal, if adopted, would add $2 bil­
lion to member bank reserves it has been indicated

The Vault Cash Problem

that any such change would be accomplished gradu­

The 1917 amendment to the Federal Reserve Act
requiring that all reserves be carried in reserve banks


Thus, for example, banks within the city limits o f New Y o rk and
Chicago but outside the respective "fin an cial districts” are classified as
either reserve city or country banks depending on their exact location.

9 From the statement of Governor Balderston on S . 1120 before the Senate
Banking and Currency Committee, M arch 23, 1959.


Page 59

Reserve Requirements for Central Reserve
City Banks

The last proposal of the Board, which would revise
reserve requirements for central reserve city banks,
does not directly grow out of existing imperfections
in the law but rather is partly a consequence of
remedying them. For if vault cash is to be counted
as part of the member banks’ reserve, country banks
would derive the greatest benefit and central reserve
city banks the least. For this and other reasons, the
Board has suggested that reserve limits for such
banks might well be reduced to the levels which per­
tain to reserve city banks, that is, 10 to 20 per cent.11
However, in submitting the latter proposal the
Board suggested retention of the central reserve
city classification on the grounds that the char­

acteristics of deposits of large banks in New York
and Chicago might justify a special reserve category
for those institutions. The Board noted in statements
filed with both the Senate and House Banking and
Currency Committees that the “central reserve city”
classification enabled it to deal with any undue con­
centration of reserves in money market centers, and
pointed out that New York and Chicago continue to
stand out strikingly in many respects from other cities.
Along the latter lines, the Board cited the high con­
centration of interbank deposits lodged in the large
Chicago and New York banks, their retention of the
bulk of the more active balances of businesses and
financial institutions, and their superior position—
compared with banks in other large cities— invest
available funds actively and promptly in local money

A Perspective
The Board has emphasized that its current pro­
posals involve neither organic revision nor radical
reordering of current reserve statutes. Rather, it has
emphasized that from the administrator s point of
view, the present law gives it an adequate tool and
that the suggested revisions, essentially peripheral,
are put forward in the interest of fairness to the in­
stitutions which are regulated. Indeed, its proposals

merely attempt to give concrete expression to the
general proposition enunciated in 1931 that “legal
requirements differentiate in operation between
highly active deposits and deposits of a less active
character. Requirements for reserves should also be
equitable in the incidence, simple in administration,
and, so far as possible, not susceptible of abuse.”18
12 Ibid.

11 See Board testimony, Hearings before the Committee on Banking and
Currency, United States Senate, 86tn Congress, 1st Session, March 23-24, 1959.

13 Report of Committee on Bank Reserves, Nineteenth Annual Report of
the Federal Reserve Board (1932), page 261.

O sT 3