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M29 FEDERAL RESERVE BANK OF PHILADELPHIA TRANSMITTAL SLIP ........... ~~~.:~ ...~.! ....~?..~.?. DATE ...... · TO ...........~~EE.~E.~...~~E.~.l?.~!.~...: ... ~~.~E~E;!... .................... FROM .......... :!.~~~~.~ ...~f!.!.J:~E~.E.~!?:~.~E.................................... . Attached is a copy of the article that appeared in the February 28 edition of the American Banker. Federal Reserve Bank of Philadelphia LIBRARY http://fraser.stlouisfed.org/ Federal-~ Reserve Bank -of- -St. ~---··--- -Louis - J An Attack on Attrition by David P. Eastburn, President Federal Reserve Bank of Philadelphia The commotion that occurred in New England recently when several banks withdrew from the Federal Reserve System may be the spark that finally ignites some action to solve ·the Fed's membership problem. Much discussion is going on within the Federal Reserve System to 'develop strategies for a feasible, practical counterattack on member bank attrit~on. Paying interest on reserves held at the Fed is an idea whose time may be approaching. The problem of declining membership is hardly new. count as members over 50 percent of all commercial banks. only 40 percent. Now it has Of even greater importance, Fed member banks used to hold nearly 90 percent of all commercial bank deposits. only 76 percent. The Fed used to Now they claim Between 1965 and 1975 the banking industry grew from 13,542 institutions to 14,633. from 6,220 to 5,788. The Fed's rolls simultaneously slipped What's more, during that period,· 29 banks that with- drew from System membership had assets greater than $100 million. departure~ The or threatened departure, of these ·relatively large institutions has become acute in recent years and underscores the fact that membe:ship is costly to a wide spectrum of banks, not just to small country banks or banks located in a specific geographic r~gion. This dissatisfaction with the balance of costs and benefits of membership is nationwide, and the pressures to alter the- ground rules under which reserve requirements are set are broadly based as well. Why the Concern? If the only costs of Fed membership losses were the bruises inflicted on the egos of central bankers, there would be no serious concern. Un- -2fortunately, there are significant costs to society: (1) blunted rnone- tary control, and (2) increasing distance between banks and the ultimate source of liquidity--the Fed. Monetary Control. Money is important to the health of the economy. It helps determine the number of jobs, the pace of inflation, the tempo of production, and the volume of sales. Maintaining an appropriate flow of money is the main job of the Federal Reserve. Basically, the Fed controls the money supply by changing the level of reserves in the banking system. The money supply is a multiple of the reserve base. As more and more banks leave the System that multiple becomes less predictable. At some point, this loss of precision could seriously hamper the effectiveness of the Fed to gauge the money supply. That's a point none of us wants to reach. tp~ Stability of Banking System. Another major cost to the public of . eroding membership ·is the potential instability it introduces into the banking system. Prior to the creation of the Fed in 1913, commercial banks held.large shares of their required reserves with other commercial banks. ·These recipient banks, in turn, held reserves e3:gains.t those de. P?S~ts . with still other banks •. This system of "pyramiding" reserves.made the entire banking sys~em unstable and contributed to the experienced in the late 1800s and early. 1900s. financi~l panics The Federal Reserve System was created to provide a more stable reserve deposit system, a system under which member banks held their reserve deposi~s only at the Federal Reserve District Banks. ·As more and more banks leave the System pyramiding increases. dist~nce between the Fed and many banks lengthens. The Potential in~tability l I ' -3~unnecessarily ' , I slips back into the banking system. Hopefully, old lessons .i i will not have to be relearned the.hard lY"~Y--through experience. The Search for a Solution Somehow the burdens of membership. have to be reduced. an effective central bank must be borne more equally. The costs of The list of possi- ble solutions reads like a familiar litany to bankers--uniform reserve requirements, lower reserve requirements, counting interest-bearing assets, paying interest on reserves, and so on. tages and disadvantages. All have their. advan- But the one that looks more and.more attractive is paying interest on required reserves on deposit at the Fed. It can stop the membership drain and enhance the effectiveness of monetary management. It can achieve equity within the context of the dual banking system. It opens the door for a straightforward solution to the problems of access and pricing of Fed services. A feasible package of paying interest on reserves might include several elements. The first is that interest payments could be phased in over several years. This would permit interest payments to come from increases in Fed earnings. The Treasury would not have to take a reduction in pay- ments from the Fed~ In addition, banks would pay taxes on interest payments. The Treasury over the long haul could actually end up with more revenue from the Fed. A second element might be to link the payment of interest on reserves to strengthening ~ank capital positions. The mechanics would ·have to be worked out, but the idea is that interest payments would go into retained earnings rather than dividends. expand Banks would then be better positioned to their lending and facilitate the business expansion. A third element could include special consideration for smaller banks. All required reserve balances would be eligible for a flat rate of return. -4Reserve balances under some amount would be eligible for an extra return. This would help smaller banks justify maintaining membership. A fourth element is more controversial. Some bankers believe that paying interest on demand deposits is inevitable. could make an equity argument. If that is so, bankers Fed payments on reserves could be thought of as an offset to payment of interest on demand deposits. appeal. It has some Consumers receive additional interest income and bankers are com- pensated by receiving interest on their deposits as well. Conclusion The loss of members from the Federal Reserve System is a national problem with potentially serious consequences. is now. The time for solution Paying interest on required reserves held by members at the Fed makes a lot of sense. The benefits to the economy and financial stability are substantial and the costs are manageable.
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