View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

For release on
September 11, 1968




Statement of
George W. Mitchell,
Member, Board of Governors of the Federal Reserve System
before' the
Joint Economic Committee
on the
Report of the System Steering Committee on Reappraisal of
the Federal Reserve Discount Mechanism— Its Rationale and
Implications

September 11, 1968




Statement of George W. Mitchell,
Member, Board of Governors of the Federal Reserve System,
before the Joint Economic Committee
September 11, 1968

Mr. Chairman:
I am glad to appear before this Committee today to discuss
the recently released Federal Reserve report proposing changes in
lending facilities for member banks.

The studies and research on

which the Report is based were undertaken to be sure our lending
operations— popularly called our discount mechanism— were appropriate
to present-day banking institutions and environment.

To be more

effective in meeting changing community credit needs, commercial
banks need central bank assistance as well as supervision.

We are

pleased to discuss our findings with you.
The redesign suggested by the Report would represent the
latest in a series of evolutionary changes in Federal Reserve lending
policies and procedures.

When first established by the Federal Reserve

Act in 1913, the discount mechanism was expected to operate by member
banks presenting certain types of short-term customer notes (termed
"eligible paper") as collateral for borrowing at the Reserve Banks.
During most of the first twenty years of Federal Reserve operation,
member banks borrowed a sizable proportion of their total required
reserves on the security of such customer notes.

-

2-

After 1934, however, member banks accumulated large
amounts of Government securities and other liquid assets;
accordingly, they did very little borrowing from their Federal
Reserve Banks, and collateralized such borrowing as they did
with Government securities.

This marginal role for the discount

window was formally recognized in a change in 1955 in the Board's
Regulation A covering loans to member banks; under that revision,
bank borrowings from the Federal Reserve were to be limited to
assistance over the peaks of temporary, seasonal or emergency
needs for funds that exceeded the dimensions that the banks could
reasonably be expected to meet out of their own resources.
In the last decade or so, however, credit demands on
banks have grown and loan-to-deposit ratios are much higher,
rising from 47% to 60%.

Moreover, at many banks portfolio manage­

ment has pared liquidity positions substantially, and borrowings
from sources other than the Federal Reserve have expanded.

In

addition, a small but growing number of banks has also been <led
to withdraw from membership in the Federal Reserve System,
chiefly in order to avoid reserve requirements and thus enable
them to invest a greater portion of their resources in earning
assets.

In view of these developments, the proposed redesign

of the discount mechanism is aimed at relating Federal Reserve
lending more clearly and closely to the changing banking and
community needs.




-3Before I outline the new proposals which have been
made for our lending facilities, it might be well for me to
mention three long-standing basic principles of Federal Reserve
lending that were reaffirmed by our study.
First among these is that Federal Reserve credit is
extended primarily to accommodate bank asset and liability adjust­
ments over limited time periods and to meet essentially short-term
fluctuations in member bank needs for funds.
The second principle reaffirmed, however, is that Federal
Reserve Banks always stand ready to lend to any of their member
banks caught in special regional or local adversities— such as
droughts, drastic deposit drains, or other emergencies— for as
long as reasonably needed for the bank to work out of these
circumstances.
Thirdly, the report recognizes that the Federal Reserve
serves as "lender of last resort" to buttress the entire financial
system in the event of widespread emergency.

Within the limits of

existing law, and lending primarily through member banks as inter­
mediaries, the Federal Reserve is prepared to supply liquid funds
to other types of financial institutions when such assistance is
not available elsewhere and is necessary to avoid major economic
disruption.
Along with these continuing principles, the Report
suggests several modifications of lending operations to better
serve emerging needs.




Let me summarize the main new suggestions

-

4-

briefly, and then outline each one in somewhat greater detail.
To provide more clear-cut access to Federal Reserve
lending facilities, the report proposes that each soundly operated
member bank be given a "basic borrowing privilege," enabling it to
borrow up to a specified limit from its Reserve Bank upon request
in as much as half of its weekly reserve periods.
[n addition, it is proposed that any member bank fore­
seeing large seasonal bulges in its needs for funds would be able
to arrange for loans from its Reserve Bank to meet such needs in
excess of a specified minimum.

This arrangement, more explicit

and more liberal than currently-provided, is termed the "seasonal
borrowing privilege."
Member banks experiencing drains of funds that are not
of a seasonal or emergency nature, but that are bigger or longer
in duration than can be accommodated under the new "basic borrowing
privilege," could also arrange for additional credit pending an
expected and timely reversal of their fund outflows or an orderly
adjustment of their assets and liabilities.

Such borrowings

would be subject to essentially the same kinds of administrative
procedures now applied to similar situations.
A final innovation proposed by the report is to make
the discount'rate— the interest rate charged by Federal Reserve
Banks on their loans to member banks--more flexible than heretofore.
It is recommended in the Report that the discount rate be changed




-5considerably more frequently and by smaller amounts, keeping
it reasonably closely in line with the movements in other
money market rates.
The most commonly used of the new lending provisions
for member banks in sound condition would undoubtedly be the
basic borrowing privilege.

The size of each bank's basic

borrowing privilege would be established as a proportion of some
base drawn from the bank's balance sheet; the current proposal
suggests capital stock and surplus.

Frequency of use of the basic

borrowing privilege would also be limited.

This is necessary

because Federal Reserve credit i.s not properly a long-term or
permanent addition to the loanable funds of individual member
banks.

The aim is to make credit available over a long enough

period to cushion the bulk of short-term fluctuations or portfolio
adjustments and in most cases permit orderly adjustment to longerterm movements of funds.
The proposed frequency limitation would allow assured
and virtually automatic access to credit so long as the bank is
indebted in no more than half the reserve periods in the specified
interval.
Before the plan is finally made effective, choices will
be made in the light of comments received as to the particular
percentages which would apply to the amount and frequency limitations.
The consideration? will be that individual credit access should not
be so small or so infrequently available as to be insignificant to




-

6-

the member banks, nor should total access be so liberal as to
interfere with Federal Reserve open market operations aimed at
carrying out national credit policy objectives.
Borrowing within the basic borrowing privilege limitations
could, as noted, take place virtually upon request, unless the
Reserve Bank had notified the member bank that its over-all
condition was unsatisfactory as determined by such factors as
adequacy of capital, liquidity, soundness, management, or noncompliance with law or regulation and that such unsatisfactory
condition was not being corrected to the Reserve Bank's satisfaction.
The only other circumscription oh the actions of a qualified
borrowing bank would be the avoidance of net sales in the Federal
funds market during the reserve periods in which it was borrowing
from the Federal Reserve.

This administrative rule, already in

force, is retained in the new proposal in the interest of pre­
cluding retailing operations in Federal Reserve credit obtained
through the discount window.
It is recognized that the basic borrowing privilege would
not be large enough to encompass every member bank's needs for
funds in all instances that justify the use of discount credit.
This is particularly true in cases of the larger banks which
borrow infrequently but for rather large amounts, but it is
also true in cases of smaller banks faced with sharp temporary
drains of funds.




Arrangements are therefore recognized as

-7necessary to permit member bank borrowings outside the basic
borrowing privilege up to the limits of appropriate needs on
as convenient and understandable terms as possible.

These

arrangements, referred to in the Report as "other adjustment
credit," would be available pending an expected and timely
reversal of fund outflows or an orderly portfolio adjustment.
Such borrowings would be subject to essentially the same kinds
of administrative procedures now applied to similar situations,
with the precise timing and nature of administrative actions
determined as at present by the circumstances surrounding
individual cases.

Close contact among the Federal Reserve Board

staff and the Federal Reserve Banks' discount officials will be
maintained in the interest of dealing uniformly with similar
cases.
The third general category of credit which would be
available to member banks at the proposed discount window is
called the "seasonal borrowing privilege."

A Reserve Bank would

be prepared to establish such a seasonal borrowing privilege for
any member bank experiencing demonstrable seasonal pressures
persisting for a period of at least four consecutive weeks and
exceeding a minimum relative size.

It is expected that this

borrowing privilege would be of value principally to smaller
unit banks in agricultural or resort areas in which seasonal
swings have a substantial impact on the entire community and
where access to the national money markets or other adjustment
resources is not always readily available.




-

8-

The existence of seasonal pressures would be judged on
the basis of past years' patterns of loan and deposit fluctuations.
The establishment of a qualifying seasonal swing in net availability
of funds (defined as deposits minus loans to customers in the bank's
market area) would ordinarily be fixed by negotiation once a year*
Once the existence of a qualifying seasonal need was established,
the Reserve Banks would agree to extend discount credit up to the
qualifying amount and for the length of time the need was expected
to persist, up to 90 days.

The 90-day maximum is imposed by

statute; however, should the need extend over a longer period than
this, the Reserve Banks would regard renewals of credit as in
accordance with the initial seasonal credit negotiation.

Seasonal

credit needs would normally be expected to last for several months,
but in exceptional cases could range up to as much as nine months.
Seasonal credit obtainable at a Reserve Bank would be
limited to the amount of the borrowing bank's seasonal swing in
excess of a specified percentage of its average deposits in the
preceding year.

This "deductible" principle, requiring a bank

to meet a part of its seasonal needs out of its own resources,
is designed to encourage individual bank maintenance of some
minimum level of liquidity for purposes of flexibility.

It would

also serve effectively to limit the aggregate amount of credit
extended under the seasonal borrowing privilege to an amount
consistent with overall monetary policy, while allowing the
Federal Reserve to provide this assistance to all those member
banks with relatively large seasonal needs.




-

9-

The proposed redesign of the discount window would
provide that the Federal Reserve continue to supply liberal
help to its member banks in emergency situations.

So long as

the member bank is solvent and steps are being taken to find a
solution to its problems, credit would be available on the same
basis as it currently is, and, within the limits of the law,
special and flexible arrangements would continue to be made
where necessary.

Assisting a bank in an emergency situation

would generally require credit extension for periods longer than
would normally be allowed at the window, but this would be
expected and regarded as appropriate.
The Federal Reserve, in its role as lender of last resort
to other sectors of the economy, may find it necessary to extend
credit assistance to institutions other than member banks.

This

action would be taken only when other sources of credit have been
exhausted and failure of the troubled institutions would have a
significant impact on the economy's financial structure.

When

lending to nonmembers, the Federal Reserve would act in cooperation
with the relevant supervisory authority to insure that steps are
taken to find a solution to their problems.

The Federal Reserve

Act authorizes direct advances to nonmembers, but only if
collateralized by U.S. Government securities.

Since most nonmember

institutions of the types apt to require emergency credit assistance
do not have sizable holdings of this asset, credit would normally




- lObe extended through a conduit arrangement with a member bank.
Most types of nonbank financial institutions have borrowing
relationships with their commercial banks as a matter of course;
and ideally, this indirect lending by the Federal Reserve could
fit in with such business practice.

Such credit would be provided

at a higher rate than the basic discount rate.
The proposed discount window does not include the provision
of intermediate- or long-term credit to meet the needs of banks
servicing credit-deficit areas or sectors--that is, areas or
sectors where the opportunities for profitable investment
continuously outstrip the savings generated locally.

While this

is recognized as a problem of some significance, it was concluded
that its solution lies outside the proper scope of the discount
window.

The Steering Committee concluded that an appropriate and

effective solution to this problem was most likely to be found in
the improvement of secondary markets for bank assets and liabilities.
Detailed studies of the feasibility of actions to promote such
improvement are expected to begin in the near future.
I should emphasize that Federal Reserve open market
operations are still envisioned as the main tool of monetary policy.
The proposed changes in discount operations, however, would alter
to some degree the current relationship between these two methods
of reserve injection, with the discount mechanism assuming a
somewhat increased role.




This would come about as a result of

-li­
the accommodation of more of the day-to-day fluctuations of
reserve needs at the window, the improved distribution of reserves
brought about by injection of some reserves directly at the point
of need, and more flexible and effective use of the discount rate
as an influence on bank borrowing.

The first and second of these

benefits would entail a generally higher level of borrowing being
done bv a typically rotating group of member banks.

But this is

not conceived to mean a corresponding increase in total reserves
or a loss of control in this area, since the Federal Reserve would
retain the ability to bring about and maintain the desired level
of overall credit availability, taking into account the relatively
small increase expected in credit outstanding at the window,
through purchases and sales of securities in the open market.
To simplify my oral remarks this morning, I have avoided
citing specific numbers, technical conditions, or underlying
statistical evidence associated with the proposed changes in the
discount mechanism.

For your convenience, I have summarized

these details in the two-page appendix table attached to my
statement.

If you have any questions about such matters, I

will be glad to answer them either now or in subsequent correspondence.
Let me emphasize that all these details are provisional
at this stage, and subject to review and modification in the light
of our study of the comments and reactions received.

The proposal

at this stage represents a report of a Federal Reserve committee.




-

12-

The Board of Governors has not yet taken any substantive action
on the proposals contained in the Report nor published any change
in its Regulation A which governs borrowing.

We have already

received a good many comments on the Report from a variety of
sources, including both bankers and banking organizations and
others.

We've had assistance from the reactions and suggestions

of numerous academic scholars; several leading economists have
contributed analytical papers on one question or another related
to the discounting area, and the Board has scheduled two different
seminars with a number of professors of economics at which ideas
on this subject could be exchanged.

I can assure you that the views expressed in these hearings
also will be taken into account by the Board.
As we now see it, the shape of the proposal under considera­
tion can be encompassed within the framework of existing legislation.
It may be, however, that certain aspects of the studies and of
comments received might make it desirable for the Board to request
some amendments in the language of certain governing statutes in
order to permit the revised discount mechanism to be as effective
as possible.

As you know, the Federal Reserve has already proposed

a bill (S.966)— popularly termed the "eligible paper" bill— which
would make certain changes in the provisions of the Federal Reserve
Act relating specifically to lending to member banks.

It would

seem likely that most, if not all, of the changes suggested by our
studies could be encompassed by the language in that bill.




Of course,

-13neither the eventual changes which might be made in the mechanism
nor any resultant need for legislation can be finally settled at
this stage, but at a somewhat later date we may need to address a
communication to the Congress regarding the pending or possibly
additional amendments to the statute.
All of us involved in this reappraisal recognize that,
even after any of the suggested changes were introduced, a period
of transition would undoubtedly be required before the full
potential of the discount mechanism could be realized either by
the Federal Reserve or the member banks.

However, I believe that

there is a good possibility that this redesign can bring this
mechanism in closer touch with the prevailing economic climate
and lead to a more effectively functioning banking system that




is better equipped to serve evolving needs of the community.

APPENDIX TABLE— p. 1
Summary of Proposal for Redesign of Discount Mechanism

Basic Borrowing
Privilege
Definition

Rate
Quantity
Limitations

Frequency or
Duration Limi­
tations




Member bank access
to credit upon re­
quest, within pre­
cisely stated
limits on amounts
and frequency and
on specified con­
ditions.

Discount rate.
(20-40) % o f
first $1 million
capital stock &
surplus plus
(10-20) % of
next $9 million of
plus
(10) %
of remainder.
(6-13) of any
(13-26) conr
secutive reserve
computation
periods.

Other Adjustment
Credit
(2 )
Supplemental discount
accommodation, sub­
ject to administra­
tive procedures, to
help a member bank
meet temporary needs
that prove either
larger or longer in
duration than could
be covered by its
basic borrowing
privilege.
Discount rate.
None specified.

.None specified.

Seasonal Borrowing
Privilege

Emergency
Credit to
Member Banks

Member bank access
to credit on a
longer-term and,
to the extent pos­
sible, prearranged
basis to meet
demonstrable sea­
sonal pressures
exceeding minimum
duration and rela­
tive amount.

Credit extended
to member banks
in unusual or
exigent circumstances.

Discount rate.
Seasonal needs in
excess of
(510) % of average
deposits subject to
reserve require­
ments in preceding
calendar year.

Discount rate.

Need and arrange­
ment must be for
more than four
weeks. Maximum
nine consecutive
months.

Emergency
Credit to
Others
| Credit extended
j to institutions
j other than member
; banks in emergency
; circumstances in
j fulfilling role as
! lender of last
1 resort to the
' economy.
1
1

None specified

Significant penalty
■above discount rate.
1
: None specified
i
i
i

i

None specified.

None specified.

-

2

-

Emergency
Credit to
Member Banks

Basic Borrowin»
Privilege
Administrative
Procedures

Other
Restrictions

Method of
Provision




Other Adjustment
Credit

Seasonal Borrowing
Privilege

Hone other than
general discour­
agement of net
selling of
Federal funds by
borrowing banks.

Appraisal and, where
necessary, action
broadly similar to
procedures developed
under existing dis­
count arrangements*

Prearrangement in­
volves discussion
between discount
officer and bank
management concern­
ing amount, dura­
tion, and season­
ality of need.
Administrative
review maintained
during borrowing
to prevent abuse
or misuse.

Continuous and
thorough-going
surveillance.
Require that
bank develop
and pursue
workable pro­
gram for
alleviating
difficulties.

None specified.

None specified.

None specified.

Direct.

Direct*

Direct.

Must not have
been found to
be in unsatis­
factory condi­
tion.
Direct.

Emergency
Credit to
Others
Continuous and
thorough-going sur­
veillance (may have
to be thru conduit).
Require that insti­
tution develop and
pursue workable pro­
gram for alleviating
difficulties.

Required to use
ail other practicable
sources of credit
first.
(1) through central
agency; (2) direct;
(3) conduit thru member
bank.