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WHY STATE BANKS SHOULD JOIN THE FEDERAL RESERVE SYSTEM :: :: ® https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - s https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis A DDRESS of hon. chas. o. AUSTIN COMMISSIONER OF BANKING OF TEXAS DELIVERED BEFORE THE MEETING OF FIFTH DISTRICT, TEXAS BANKERS AT DALLAS, ON THE ELEVENTH DAY OF FEBRUARY, NINETEEN EIGHTEEN In discussing the relationship of the Federal Reserve Sys tem to state banks let us first consider the conditions under which state banks may become members of the sytem and the benefits specifically offered to member banks by the statute, and the disadvantages, if any, as they appear upon the sur face, and which may accrue to state banks by reason of affilia tion with the system. So far, I am informed that only about 300 state banks in the entire United States have become members of the system. As this is considerably less than 2 per cent of the total number of state banks, according to reliable records, it, of course, fur nishes no adequate basis of an experience that would enable us to argue either the advantages or disadvantages from the standpoint of practical results, and therefore our argument must be largely academic. The original Federal Reserve Act of December 23, 1913, was apparently not intended to take the state banks into serious consideration in connection with the establishment of a stable and elastic system of national cur rency, nor to extend any privileges to them that would permit them to become members without virtually surrendering their chai ter rights. By the Act of June 21, 1917, the original terms of the Re serve Act with respect to state bank memberships were greatly modified and many inducements given to the state banks to join the system, and which in some instances permit these con cerns greater latitude and more privileges than heretofore or now permitted to and enjoyed by the national banks them selves. - https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis (ill) We are not concerned then with the original act as affect ing state banks further than so far as it is the foundation upon which the present structure has been builded and for the pur poses of this argument our consideration of the subject will be limited chiefly to the new enactments which we will pro ceed to briefly review. First, state banks may become stockholders of the Fed eral Reserve Bank in the district in which the applying bank is located and thus are given the opportunity to participate in the profits, if any, accruing from the organization which their membership assists in supporting. The amount of stock for which they may subscribe is the same as that to which national banks are required to subscribe, viz., 6 per cent of the paid-up capital stock and surplus of the subscribing in stitution, one-half of which must be paid up and the other half remain subject to call for payment in the discretion of the Federal Reserve Board. There is nothing unreasonable or objectionable in this requirement. The amount of capital required to be purchased by the member bank is very small, and while the Federal Reserve Banks are not intended to be money making institutions and therefore their dividends are limited to 6 per cent upon their capital stock, nevertheless, the amount invested by the member bank being very small, the difference in income between dividends upon the stock owned and the usual rate of interest earned by the average country bank upon its loans, will be insignificant in amount. State banks are required to comply with the reserve and capital requirements of the act and to conform to those pro visions of law imposed upon national banks which prohibit such banks from lending on or purchasing their own stock and which relate to the withdrawal or impairment of capital stock and to the payment of unearned dividends. Let us first see what the requirements are with respect to reserve. The 3rd Called Session of the 33rd Legislature of Texas passed an act permitting state banks to become mem bers of the Federal Reserve System and fixing the reserves of state banks which should do so upon the same terms as were required by the Federal Reserve Act of national banks. The Federal Reserve Act divides all member banks into three (IV) https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis classes, viz., those located in central reserve cities, those lo cated in reserve cities and those not located in a central or reserve city, and which latter class is commonly known as ■‘country banks.” We have no central reserve city in Texas at all and the number of reserve cities in Texas is small, the larger number of our banks being of the class commonly called “country banks” and therefore we shall not discuss the reserves of any other class of banks, confining ourselves solely to the so-called country banks; and right here let it be understood that many of the conditions which are true of country banks and their experiences now or hereafter as mem bers of the Federal Reserve System are not necessarily true of banks located in reserve cities, and in considering this sub ject due allowance must be made for the difference in the nature of the business of country banks and many of the larger banks located in reserve cities. Our statute required state banks becoming members of the Federal Reserve Sys tem to maintain a reserve of 12 per cent of the aggregate de mand deposits and 5 per cent of the time deposits of the bank, of which reserve 4/12 was required to be retained in the vaults of the bank, 5/12 in the Federal Reserve Bank of the district and the remaining 3/12 either in the bank’s own vaults or on deposit with the Federal Reserve Bank of the district. Now the State Act enabling banks to become members of the Fed eral Reserve System, and above referred to, authorizes state banks to conform to the Federal Reserve Law at the time the Act was passed, or as hereafter amended, and all rules and regulations promulgated relative thereto by lawful authority, and so insistent was our Legislature that the state banks might have this authority that it is repeated in the Act, being found in Subdivision 1, of Section 1 of the bill and then again in Section 2 of the bill, which specifically provides as follows: “Any bank incorporated under the laws of this state which becomes a member of the Federal Reserve Sys tem shall have authority to conform to the Federal Re serve Act as the same now exists, or as it may hereafter be amended, and such rules and regulations as the Fed eral Reserve Board may prescribe in order to entitle it to membership in a Federal Reserve Bank.” https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis (V) The Department of Insurance and Banking takes the view that this provision of the law was intended to give the state banks which should desire to become members of the Fed eral Reserve System all of the rights and advantages which the system might extend to most favored members, and not to simply prescribe their rights with respect to complying with the requirements for membership made by the Federal Reserve Act or the Federal Reserve Board. In other words, the Department construes this section of the State Law as setting aside the special requirements of State Laws respect ing reserves to be maintained by state banks becoming mem bers of the Federal Reserve System and substituting therefor in toto the reserve provisions of the Federal Reserve Act. Now the Congress of 1917 changed the reserve requirements of the original law as respecting country banks, and to read as follows: “Every bank, banking association or trust company which is or which becomes a member of any Federal Re serve Bank shall establish and maintain reserve balances with its Federal Reserve Bank as follows: It shall hold and maintain with the Federal Reserve Bank of its dis trict an actual net balance equal to not less than 7 per cent of the aggregate amount of its demand deposits and 3 per cent of its time deposits.” I call your attention especially to the language of this statute and to the fact that with the exception of a provision for 7 per cent reserve to be maintained upon demand deposits and 3 per cent reserve to be maintained upon time deposits, and all of which shall be maintained with the Federal Re serve Bank, there is absolutely no other requirement with respect to reserves. In other words, it is not required by law that any cash whatever be kept in the vault of the member bank. This in itself would seem to be a very radical departure from the time honored requirements of all of our American Banking Laws that a large amount of cash be maintained in the vaults of banking institutions, but nevertheless the law is plain and 7 per cent upon demand deposits and 3 per cent upon time deposits is all the reserve a country bank is re quired to maintain and this reserve must be on deposit with the Federal Reserve Bank. Of course, in the practical opera(VI) https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis tion of any bank it is necessary to maintain a certain amount of cash in vault, but the statute is silent as to the amount which must be held, leaving this to be determined solely by the experience and in the judgment of the management of each individual bank and the exigencies of business. This re duction of reserves from requirements heretofore made by our laws, releases a very considerable volume of cash for loaning purposes and enables banks to derive more profit from loans and at the same time the public is given the advantage of an increased circulating credit heretofore arbitrarily withdrawn by law from the channels of trade and unavailable for any useful purpose, so far as serving the credit needs of the busi ness community. State banks must have the same capital requirements as made of national banks in order to become members of the system. These requirements are: in towns of a population not exceeding 3,000 souls, $25,000 capital; in towns exceed ing 3,000 population and not more than 6,000 population, $50, 000 capital; in towns of more than 6,000 population but not exceeding 50,000 population, $100,000 capital, and in towns of more than 50,000 population, the capital shall not be less than $200,000. State bank members are not permitted to make loans upon their capital stock. But this is also a wise provision of our State Banking Laws and the requirement works no hardship upon the banks. Neither may state banks purchase their own stock except such as may be necessary to prevent loss upon debts previously contracted in good faith. This is also a wise provision of our state laws and works no hardship. State banks are subject to examination by direction of the Federal Reserve Board or the Federal Reserve Bank. However, the Federal Reserve Bank may elect to approve examinations made by state authorities and accept same in lieu of examinations made by direction of the Federal Re serve Board. This is as it should be and works no hardship whatever upon the state banks, for it is presumed that in all cases where state bank supervision is worthy of confidence the Federal Reserve Board will readily accept it and in Texas, where state bank examinations have set the standard, there https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis (VII) is every reason to believe that the Federal Reserve Board will be very glad to waive its rights of examination in favor of the state supervision, in order that state bank members may not be subjected to unnecessary expense by reason of addi tional examinations. I am happy to say that I have been in formed by my good friend Judge Ramsey that the Federal Reserve Bank of this district has approved of and agreed to accept examinations made under supervision of the State Banking Department. For one, I should strenuously object to any other attitude and would oppose state banks becoming members of the Federal Reserve System, if in order to do so the supervisory powers of the state should be interrupted or interfered with to the slightest extent, for notwithstanding the repeated and constant aggression of Federal authority upon the rights of the state, the time has not yet come when the people of Texas are willing to surrender all of their rights of supervision over their own banking corporations. State bank members are required to make reports of con dition and of the payment of dividends to the Federal Re serve Bank, not less than three of such reports to be made annually on dates fixed by the Federal Reserve Board. There is no objection to this requirement and it works no additional burden or hardship upon the state bank members. Under our state laws banks are required to make at least two annual reports of their condition to the Commissioner and may be required to make as many more as the Commissioner deems necessary. Custom has long prevailed in our Department of Insurance and Banking of calling for the same number of reports and upon the same dates as called by the Comptroller of the Currency for national banks and which has been five per annum. While it is true that with our four or more ex aminations per annum of state banks, little necessity exists for the calling of published reports, so far as supervising the transactions of the banks is concerned, yet nevertheless, it is very desirable to have these reports made coincident with the reports of national banks, in order that the United States Treasury Department may at all times be able to obtain correct figures of the banking power of the country and the condition of bank credits. When the large number of state (VIII) https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis banks of the United States, nearly three times the number of national banks, is taken into consideration and the immense volume of business handled by these institutions is realized, it is apparent that no correct approximation of the banking credit and resources of the nation can be obtained unless these institutions are taken into consideration. This is about the only useful purpose subserved by requiring so many offi cial statements of our state banks. Such statements are of little or no advantage whatever so far as superyising the banks and maintaining their solvency is concerned, neither do they afford the public any considerable degree of protec tion in any other way. Published reports of banking concerns are little read by the general public and when read are under standable only to a very small part thereof. Subject to the provisions of the Act and to the regulations of the Federal Reserve Board, state banks becoming members of the system are permitted to retain their full charter and statutory rights as state banks or trust companies, and may continue to exercise all of the powers granted by the state. There are, however, some limitations to this authority. Un der our statutes state banks are permitted to extend credit lines to one borrower in an amount equal to 25 per cent of the capital and surplus of the bank. The Federal Reserve Bank, however, is not permitted to rediscount for any state bank its notes, drafts or bills of exchange of any one borrower who is liable to the bank for borrowed money in excess of 10 per cent of the capital and surplus of such bank, making exceptions, however, in favor of bills of exchange drawn against actually existing values and commercial paper actually owned by the person negotiating the same with the state bank. The Federal Reserve Bank is required to obtain a certificate or guaranty from the state bank to the effect that the borrower is not liable thereto in excess of 10 per cent of the capital and surplus and that he will not be permitted to become liable in excess of this amount while his notes, drafts or bills of exchange are under discount with the Federal Re serve Bank. This is the same rule as affects national banks and should work no hardship upon the state banks, but on the contrary is a wise provision of the law, as tending to dis courage one of the greatest of all evil practices of banks, viz., https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis (IX) the tendency to invest too much of their funds in the enter prises of favored customers. It seems hard to convince bank ers of the danger of putting all of their eggs in one basket and it usually requires the bitter experience of a heavy loss to teach them that no matter how good a customer may ap pear to be or how valuable his business may seem to the bank, nevertheless, conservatism and caution are the foundation stones of prudent banking. ' • One provision of the Federal Reserve Act with which I am in most hearty accord and sympathy is that which makes all officers and employees of state bank members, as well as national banks, subject to severe penalties for embezzlement, abstraction or wilful misapplication of the funds of such bank, or who puts forth any obligation on behalf of the bank or make any acceptance or assign any instrument belonging to the bank or make any false entry in any book, report or state ment with intent to' injure or defraud the bank or any other person or any Bank Examiner and also makes any person as sisting any officer or employee of the bank in doing any of these things equally liable under the law, and fixes the penalty for any or all of these misdemeanors at not less than 5 nor more than 10 years imprisonment. I apprehend especially that this provision of the Federal statutes will enable the state authorities, co-operating through the Federal authorities, to secure conviction and adequate punishment for violators of the law. The greatest weakness in our State banking system is our inability to secure indictments and proper prosecution of offenders against the Banking Laws and it is almost an im possibility to obtain any convictions. I do not mind saying that I apprehended with sentiments of the greatest glee, the possibilty of being able to get some crooked bankers into the clutches of the Federal courts. State banks possess one privilege under the Federal Re serve Act not given to national banks, viz., the privilege of withdrawal. It is provided by the Act that upon giving six months’ notice in writing of intention to withdraw from the Federal Reserve System, a state bank member may do so by taking up all of its obligations, due or to become due to the Federal Reserve Bank, and provided that the total amount (X) https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis of the capital stock of all withdrawing banks shall not exceed 1/4 of the capital stock of the Federal Reserve Bank in any one year. The withdrawing bank must surrender and cancel its stock in the Federal Reserve Bank and when permitted to withdraw, all balances, and amounts due it by the Federal Reserve Bank will be returned. Thus, the way is left open for state banks which may become dissatisfied with the opera tions of the Federal Reserve Bank, or which may conclude that connection therewith is of no value, to withdraw within a reasonable time under conditions which certainly could not be more liberal and at the same time afford a reasonable amount of protection to the Federal Reserve System. It has been suggested by some state bankers that after becoming members of the system there is a possibility they might be subjected to different treatment than that afforded the national banks, that special rules affecting their business might be adopted by the Federal Reserve Board and that the management of the Federal Reserve Bank might adopt an attitude towards the state bank members different from that displayed towards the national bank members. Such a suggestion is unworthy of serious consideration. In the first place, under the Act of Congress the same consideration must be shown all member banks alike by the Federal Reserve Board and if a state bank will maintain its solvency and con duct its business in accordance with the commonly accepted rules of prudent banking, not only is it entitled under the law to the same treatment as the national banks, but will be in a position to compel the Federal Reserve System to accord it the same treatment. Furthermore, both the Federal Re serve Board and the boards of the respective Federal Reserve Banks are composed of men of the highest financial and social standing in their respective1 communities, and to assume for a moment that these men would be guilty of any unfairness or discrimination against state banks and in favor of national banks, would be an imputation of their integrity, deserving the severest condemnation at the hands of all fair-minded men. ' In considering the question of membership in the Fed eral Reserve System every state bank must do SO' from two separate and distinct points of view. First, from the stand- https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis (XI, point of profit as measured by dollars and cents; second, from the standpoint of that greater profit which may be measured only in terms of patriotism and public approval of patriotic acts. In the first consideration a bank must weigh the cost of membership against the material income. Loss of interest on balances kept with the Federal Reserve Bank, loss of in terest, perhaps, by reason of investment in the stock which under most favorable conditions can never return as high a. rate of income upon investment as that obtained by the aver age country bank from its customers, 'together with perhaps some small additional expense by reason of extra reports, must be offset against the material benefit to be derived from the ability to always obtain rediscounts of eligible paper at exceedingly low rates of interest and the public prestige and distinction which membership in the nation’s financial ma chinery will ultimately confer upon its members. As a pure question of profit and loss measured in dollars, it is doubtful if there would be much of a balance on either side of the ledger. There is one distinctive advantage, however, which member ship in the system would give a bank and that is the ability to call upon the Federal Reserve Bank at any and all times with paper eligible for rediscount and convert such into cash. The writer has a very vivid recollection of the experience of coun try banks during the great panic of 1893. He saw drafts of the best country banks, drawn against actually existing bal ances with the biggest and strongest banks in New York City, sell at a discount of $20 per thousand for currency. He saw many banks close their doors and go into the hands of re ceivers purely because of their inability to obtain currency upon the pledge of the most solvent and liquid assets and with which to meet current demands of frightened depositors. Those of you whose experiences with panics have been lim ited to the so-called panic of 1907, have no conception of what a real panic is, for the flurry of that year was as a summer zephyr to an Oklahoma cyclone when compared with the in ternational crisis of 1893, when banks throughout the United States closed so fast that supervising authorities were unable to. obtain receivers fast enough to take charge of them. ’ Un der the Federal Reserve System, even as it stands today in a more or less crude form, a recurrence of such a financial cata(XII) https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis clysm is a practical impossibility, for the power of the Fed eral Reserve Banks to rediscount the commercial paper of member banks and to issue Federal Reserve notes or currency against such security provides a means of increasing the cir culating medium of the country in response to the demands of business to such an extent that all reasonable possibility of panics has been guarded against. Banks insure loss of their buildings by fire in fire insurance companies. They insure against loss from burglary or from embezzlement or theft by employees, but heretofore they have had no opportunity of insuring against panic until the organization of the Reserve System which furnishes insurance against panic far more ef fective and far more responsible than any insurance against fire, burglary or embezzlement can possibly do. I do not pre tend to assert that the Federal Reserve System is a perfect financial machine by any means, but on the contrary believe that I can see many imperfections in the present system. I believe that with experience and a broader degree of intelli gence upon the part of our Congress with respect to financial affairs and as the result of our new experience as a leading world power in finance and in commerce, many changes will be made in the Federal Reserve System during the next few years. Just what these changes should be I shall not pre sume to say, leaving their suggestion for wiser and more ex perienced heads than mine, and realizing that it is easy enough to criticise, to find fault and to tear down, but harder to con serve and construct, and that no man should ever presume to criticise an existing condition until he is prepared to offer something better. There comes to my mind, however, the necessity for a broader viewpoint than that of mere profit and loss in con sidering membership in the Federal Reserve System. Created at a time when the entire world was at peace, when the worst calamities imagined by the most pessimistic statesmen were panics and business depression, it is altogether probable that the system as founded upon the original scheme and charter, would have run along for a generation with little change, its friends supporting it and its enemies denouncing it, had not the world’s greatest war broken out shortly after the act was https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis (XIII) passed by Congress and before the System had gotten into practical operation. Had we not possessed the Federal Re serve System on the first of September, 1914, we would have unquestionably experienced the greatest panic of American history, and while the institution was not able to offer any material assistance on the occasion of the collapse of the world’s commercial structure, nevertheless its very existence acted as a sentimental brake upon the situation and enabled us to weather the storms of financial distress and business paralysis that followed the memorable day when the Kaiser’s army invaded Belgium. ' , The relationship of the Federal Reserve System to the banks of the country is that of a great reservoir in which credit is being constantly stored up and accumulated in times of prosperity for use in times of distress. Every bank that becomes a member of the System strengthens and augments the store of credit in this reservoir by the amount of its re serve deposit and the potential strength of its entire resources. As the accumulated power of the flood waters of many inunda tions restrained within the confines of a great reservoir promise prosperity and abundance to the lands they water, where if permitted to rush unrestrained across these lands they would have destroyed the crops, the inhabitants and the very soil itself, so the accumulated power of 20,000 or more independent banks stored in the Federal Reserve System promises great strength, prosperity and abundance and finan cial and commercial power to the nation, whereas, 20,000 in dependent and separate institutions would constitute as many different sources of peril in times of trouble. Someone has said that “In Unity there is Strength” and this is absolutely true of the financial situation in this country today. America has the greatest hoard of gold ever known in the history of the world and far beyond the dreams of the wildest imagina tion. If we can store this gold in one great storehouse, if we can control the credit based upon this gold through one great channel, it matters little, so far as the ultimate result is con cerned, whether this war continues 2 years or whether it continues 20. America will come out of it the most powerful, financial and commercial nation the world has ever known. (XIV) https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The markets of the world will be at our feet, the seas of the world will be traversed by our merchant fleets, the nations of the world will be our economic subjects. Our fleets and our armies will control the peace of the world and our mer chants and our bankers its trade, and whatever value half hearted patriots may today put upon American citizenship, in those days to come it will be the greatest of all prizes to be sought by all men. This condition can only become true as the result of full and complete co-operation among all classes of American citizens, but our financial and commercial pre dominance as a nation depends directly upon the patriotic citizenship of the bankers of America. Therefore, I say that as patriots it is proper to forget the subject from the stand point of profit and loss and to consider it from the standpoint of patriotic duty. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis XV)