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1 The Tradition against Rediscounting. "It is a generally recognized principle that reserve bank credit should not be used for profit, and tha ^ continu ous indebtedness at the reserve banks, except under unusual circumstances, is an abuse of reserve bonk facilities. where individual banks have been guilty of such abuse, In cases the Federal reserve authorities have taken up the natter -.vith officers of the offending banks and have made clear to them that their reserve position should be adjusted by liquidating a part of their loan or investment account rather than through borrowing. Abuses of t h e privileges of the Federal reserve systen, how ever, have not been general among member banks. The tradition against continuous borrowing is well established, and it is the 1. policy of the Federal reserve banks to m a i n t a i n ! i t ." In these words the Federal Reserve Board described the tradition against r ediscounti n g . The tradition against rediscounting is a new n^me for an old practice of commercial banks. of the reserve system, Long before the establishment commercial bankers, striving to accomplish their two-fold objective of liquidity and profits, developed certain principles and rules of thumb. Among these the most familiar probably is that certain ratios should be maintained between various assets on the one hand and deposit liabilities on the other. A nother old rule which many bankers follow is that their institutions should not normally be in debt to other banks on loan account. With the establishment of the Federal 2 reserve system, o&nks simply extended this practice and strive nor;;&iiy to be ’’even” witn the reserve banks, that is to have neither excess reserves at nor indebtedness t-: the reserve oanks. Most writers agree that the tradition is an extension 3. of pre-federal reserve practice. Periodically, as during, roughly, the decs-; e of the 2 0 ’s, reserve authorities ha e 4. encouraged member banks to follow the tradition. During the war of 1914-191S and a gain in the 1 9 3 0 fs, however, the pressure of the reserve authorities on the member banks was all the 5. other way, i.e., encouraging them to borrow. The effects of the tradition are clearly reflected in the money markets. Mr. Riefler has shown that whereas "market rates on acceptances have never varied greatly from the buying rates established by the r e s e r v e b a n k s .... other open-market rates...have frequently ruled at levels sufficiently far above discount rates to have permitted a wide margin of profit to member banks if reserve funds had been borrowed for the purpose of lending in these markets, while at other times they have fallen well b elow discount frates. It is obvious that these rates in the short-term open markets could not have remained so far above discount rates for such long periods, if member banks had borrowed freely fro m the reserve banks whenever tne 6. operation v/as profitable." Just because the tradition aids t o an understanding of market rates, it does not f o l l o w that the reserve banks may rely upon it as an adequate instrument to restrict the volume of reserve tank credit extended to the market. The fallacy of such a conclusion nay be illustrated • ith an analogy fron English banking. English member banks customarily do not borrow from tne Bank of England. Instead, they caLl loans extended to the bill brokers. hie); they have The Bank of England does net rely upon the custom of the English banks of not borrowing to control the voluiie of reserve resources or the volume of credit which it extends to the market, because it knows that the bill brokers follow no such custom. They borrov fro:., the Esnk when borrowing is profitable; and they are d i s c o u r s e d by the Bank through increases in the rate. The basic instruments which the Bank uses to control the volume of reserve resources and the volume of credit which it extends to the market are the rate and open-market operations, not the tradition of the banks. The tradition merely influences who shall borrow, not how much will be borrowed. Yet it is the volume -vhich is of greatest importance. If one examines the reliability of the tradition as an instrument of central banking control rather than as a concept to explain money market rates, he notes a number of important restrictions in it. In the first place it is not uniformly effective against all banks. against many banks, no one will deny. That it is effective 3one bankers, whose institutions are members of the reserve system, take pride in being able to say that theyfhave '.|ieve^ borrowed from the reserve bank and insist that they^will never>do so short of a catastrophe. But this is not true of ail bankers. Evidence RATES PROFIT AND DISCOUNTS DIS- •• COUNTS 100000000 MARKET RATE BANK RATE SYSTEM DISCOUNTS MARKET RATE MINUS --------7^ BANK RATE /V ,'A / ; /'AAI A / V, NEW YORK DISCOUNTS 1919 1920 1921 V 1922 1923 1924 1925 1926 1927 1928 4 may be cited to show that some banks violate the tradition especially when it is profitable to do so. The Federal Reserve Board reported that some member banks borrowed continuously in excess of three times their basic lines of credit for several years 7. after the war of 1914-1918. In other words, some member banks have not always availed themselves of the opportunity to reduce borrow ings instead of expanding loans. Sometimes \lfrien the latter 8 is more profitable than repayment, some banks expand. . Tersely stated, some bankers will violate the tradition whan borrow ing is sufficiently profitable. The concentration of borrowings even in a few banks, however, is a serious shortcoming of the tradition as an instrument of control over the total volume of credit. The following analysis will make this clear. If Bank A violates the tradition and borrows at the reserve bank to fcxpand, it will presumably suffer adverse clearing balances. The bank or banks to which it loses funds, however, will receive them as new deposits and new reserves in due course. These banks may now expand without reeourse to the reserve bank. 2fee expansion of these banks, in turn, will permit other hanks to expand without recourse to the reserve bank. Thus the violation of the tradition by some trnnfcs makes possible a manifold expansion of loans and deposits throughout the banking system. All the banks save those which violate the tradition and borrow » y say that they never have recourse to the reserve bank; hut their expansion i a b a s e d upon reserve bank credit waft the l e e s b e c a u se i t i s l& d lr e e t * Another nore serious practical difficulty is tLi-t it If possible for banks to fellow the letter of the tradition (if one may so speak of it) without abiding by its purpose. Cer tain types of short tine borrowing which are not included in the tradition but are of real importance in the control of 9. credit are of this character. To illustrate: If bank A, after being indebted to the Reserve bank for several days, calls loans to repay the Reserve bank anc discount; and bank B, of a few nore days, in turn, thus forces bank B to calls loans after the lapse only to force bank C into the Reserve bank, no single bank will have violated the tradition against continuous borrowing; nevertheless, the total volume of dis counting may be continuously large. The same consequences follow if the action is not deliberate. Indeed, it is just such circumstances which constitute a so-called legitimate "emergency" which warrants a bank in rediscounting at the Reserve bank. It has been said that one of the basic occasions for so-called legitimate borrowing at the Reserve bank is the necessity of member bankd to restore inpaired reserves. Exc^t in unusual circumstances a banK whicn borrows to expand its earning assets *111 not remain in good favor at the Reserve bank. Mr. Keynes says "...pressure is put on the member banks to restrain their use of rediscounting facilities with the Federal reserve banks by enticising them, asking them inconvenient questions, and creating a public opinion to the effedt that it is not quite respectable for a member bank 6 or good for its credit, to be using the resources of the 10. Reserve bank nore than its neighbors.M borrowing to restore a reserve, on the other hand, is acceptable to the officials. Yet the latter p e m i t s member banks a_s a whole to laaintain an extended condition. The tradition against rediscounting does not meet tne problem. It is also true that discounts and open-market purchases do not exhaust the avenues of access to the Reserve banks. Purchased bi„ls constitute another avenue. The funds which the Reserve bank withdraws fron the i.rrket through a sale of securities may be returned to the market by such purchases of bills at the initiative of the member banks. Again, the tradition is not even designed to operate against such transactions. The tradition would seem to be effective against bankers in proportion to their temerity and scrupulousness. V/ithout the use of other instruments (eg. rationing or threats to ration) it would appear ineffective against the boldly unscrupulous. If this be true, however, it tends to penalize those banks which follow it for the benefit of those which do not follow. The followers do not borrow and make less necessajry increases in the rate; but the advantages of the lower rate accrue to the borrowers, who do not follow the tradition. A third Serious limitation to the tradition is that it is not uniformly effective in time. As one analysis reserve policy in the 1920*s it becomes clear that open market opera tions, the tradition, and the rate are intimately related, Indeed, the theory of the tradition was developed to explain the effectiveness of open mark e t operations. At first some people assumed that a sale of securities by the reserve banks would reduce member banks* feserves by a c o r r e s p o n d i n g amount. was soon discovered, however, was a corresponding increase the Reserve banks would It that frequently the actual result in rediscounts. In effect, have to lend the funds which w e r e used to buy the securities. U nder these c i r c u m s t a n c e s , how could the policy of contraction be served? Hr. Burgess answers the question as follows: The importance of the p u rchase or sale of s e c u r i ties Mlies usua l l y in their effect upon the amount of indebtedness of m e m b e r banks to the R eserve Banks. By increasing their holdings of government securities the Reserve Banks lighten the indebtedness of the m e mber banks, and by selling securities they increase this indebtedness. The s ignificance of this operation ari^ses from the unwillingness of the m e mber banks to remain c o ntinuously in de b t at t he Reserve Banks. Their lending and investing policy is very closely r e l a ted indeed to the amount of such indebtedness. "The principle of open-market operations m $ y be summarized by saying that purchases of securities by Reserv e Banks t e n d to relieve m e m b e r banks from debt to t h e Reserve Banks, a n d lead them t o adopt a m o r e liberal lending and investing policy. M o n e y rates become easier; ban k deposits increase. S u c h purchases tend to create a b o r r o w e r fs market. Conversely, sales of securities by the R e s e r v e Banks increase neriber bank borrowing and lead the banks to ad o p t a somewhat less liberal policy. M o n e y rates g r o w firmer; bank deposits tend to decline. Sales of securi t i e s tend to create a l e n d e r ’s m a r k e t . " (11) If one compares the reserve s y s t e m ’s h o l d i n g s of govern ment securities wit h the ra t e of discount, however, he notes that all fc^preciable changes in t h e s y s t e m ’s holdings 8 In other words, when the systen wishes to tighten the narket, ^supports" the tradition by an increase in the raie. it It is also significant that "Reserve credit is uore costly to nenber banks when Reserve banks substitute rediscounts for other 12 earning assets." Diagram 2 relates for the decade 1919-1928 profitableness of discounting and volume of discounting for the systen and for the New York member banks v/here orofitableness is measured by 13. the difference between the market rate as corroiled by Riefler 14. and the Hew York Bank rate. 'General conditions in the market may be described as follows: first, there was a large supply of short term paper in the market in which investments could be made by banks; second there was a cluster of money rates around the bank rate; third, the discount window was active. At that time it amounted to around #500,000,000 plus at least $100,000,000 of reserve bank investment in bills. These facts were related not only to the tradition but also to the rate. Had the rate been higher, the volume of discounting would doubtless have been less; had it been lower, the volume of discounting would doubt less have been greater. significant. The general conclusion is clear and In general the volume of discounts vailed with the profitableness of discounting. few strategic periods. Attention nay be called to a Practically throughout both periods (1922 and 1924) when borrowing was unprofitable, the volume of dis counts fell appreciably and continuously. The period of greatest increase in discounts (1919-1920) was also the period in which y discounting w a s most profitable. None of the conditions of the 2 0 *s obtained intthe 3 0 *s. One nay summarise experience with the t r a d i t i o n as an instrument of policy. It appears most effective at the very times that the reserve banks a re reducing rates and are otherwis w interested in expanding credit; a n d it a p p e a r s to be least effective precisely when the other actions of t h e Reserve officials indicate t h e y w i s h it we r e most effective. This conclusion is warranted from t he fact th a t the volume of d i s counts, the number of banks borrowing, a n d t h e rate roughly paralled each other. Therein lies the mo s t telling criticism against the t radi tion. It is not s ufficiently effective to curb a persistent demand for credit w h e n pr o f i t a b l e investments a re available. If rediscou n t i n g is suff i c i e n t l y profitable, indulge regardless of the tradition. some banks will R e l i a n c e u p o n it permits a situation to develop in w h i c h it is n e c e s s a r y to adopt 110re vigorous m ea s u r e s to a g r e a t e r extent t h a n might sary had they been used originally. the m a t t e r as follows: have b e e n n e c e s Mr. K e y n e s has expressed "...measures of c a j o l e r y and m i l d discipline might prove inadequate against a w i d e s p r e a d move m e n t of e x p a n sion ascribable to the s o o a l l e d ’legitimate* demands of t rade - w h i c h are just as i n f l a t i o n a r y as the so - c a l l e d 15. demands of finance, and m a y be more so." In periods of depression* are not anxious for fIllegitimate* on the other hand, w h e n bank e r s examinations, all t h e inconvenient questions 10 which the Reserve bankers asked t j discourage b o r r owing at other tines will be recalled; and the m e m b e r ing than ever to borrow. At such tines, that the tradition is effective; public baiks wi j.1 b e less w i l l one n a y say, perhaps, but thr-t is p r e c isely when the interest might be served better if the t r a d i t i o n were violated. At such times the Reserve banks reduce their rates, yet such efforts to stimulate borrowing by direct appeal to profits could hardly be expected to be successful - if the tradition is effective. In short, the tradition has a reverse effectiveness. Hr. Burgess seens to r e c o g n i z e this. A t any rate, in 1927 he said that the feeling a g a i n s t b o r r o w i n g was encouraged by the officers of the r e s e r v e s y s t e m (p. 182). In 1936, he added the significant q u alifying phrase "at tines" (p. 220). These factors indicate the w i s d o m of Mr. H a r r i s ’s sugg e s tion: "Reserve policy should a llow for the inability of the member banks in the larger city, subject t o m u l t i p l e x incomings a nd outgoings, always to b a l a n c e their hooks. But when the ban'-cs ¡10 t h emselves in de b t for long p e r iods of time a n d wh e n the number of banks in debt is a b normall y large, there is something wrong fundamentally; the difficulty is n o longer t e m p o r a r y d i s e q u i l i b r i u m of the balance of payments. The N e w Y o r k B a n k is will i n g to discuss m a t t e r s ’.ith the m e m b e r b a n k s out of line; but w h e n all banks a re borrowing excessively, the si t u a tion is t o be m e t not by refusals but b y a higher rate."(l6) U n i v e r s i t y of M i s s o u r i Ka r l R. Bopp 1. Annual R e p o rt o f th e F e d e r a l R e se r v e B o a rd , 1928, p * 8. 2. A lthough s i m i l a r in in o o r t a n t w ays, in te r - b a n k l e a n s a r e to be s h a r p ly d is t i n g u is h e d fr o n in t e r - b a a .: d e p o s i t s in th e p re sen t d is c u ss io n . 3. W. IV. R i e f l e r , Money R a te s and Honey M ark ets in th e U n ited S t a t e s , New Y ork . 1 9 3 6 . P P .""S 9 - j£ ; •'/. R . B u r g e s s , The k e s e r v e Banks and th e Honey M ark et, New Y o rk , 1 9 3 6 , p . 2 1 9 . K r . Ila rr o d , how ever, in Economic J o u r n a l , V o l. 37, p . 2 8 5 , a t t r i b u t e s th e o r i g i n o f t h e t r a d i t i o n t o "a n i n i t i a l d i s t r u s t o f th e new sy ste m and th e d e s i r e o f member b an k s n o t t o becon e in d e b te d t o i t . " 4. Se e th e open in g q u o t a t io n o f t h i s s e c t i o n . Se e a l s o R. B u r g e s s , C£. C i t . , p . 220; B en jam in S tr o n g in 6 7 th C o n g r e ss, 1 s t s e s s i o n , A g r i c u l t u r e 1 I n q u ir y , H e a rin g s on S e n . Cone. R e s. 4 , /a s h in g to n , 1 9 2 1 , p a r t 1 3 , p p . 50b -5$7; J . !•:. K ey n es, A T r e a t i s e on H oney, New Y o rk , 1 9 3 0 , V ol. 2, p . 240. 5. C f. New York T im es. A u gu st 2 1 , 1 9 3 7 , A u gu st 2 2 , 1 9 3 7 ( A r t i c l e by E l l i o t t V. B e l l ) , A u gu st 2 7 , 1 9 3 7 . 6. W. W. R i e f l e r , Cp. c i t . » pi>. 2 2 -2 3 . 7. Annual R e p o rt wf th e F e d e r a l R e se r v e ¿ o a r d f o r 1 9 2 2 « p . 3* 8. W. W# R i e f l e r , 0 £ . c i t . . o . l 6 i ; S . 15. H a r r i s , C|>. c i t . , p . 1 5 ; 69th C o n g r e ss , 1 s t s e s s i o n , S t a b i l i z a t i o n . H e a r in g s on H# R . 7 8 9 5 . W ash ington, 1 9 2 7 , p p . 6 6 $ , 'ir>2-$73. 9. 69th C o n g r e ss , 1 s t s e s s i o n , Op. c i t . , p . 1 5 0 , te stim o n y o f P r o f e s s o r S p ra g u e * 10. J . M. K ey n es, A T r e a t i s e on Ilon ey, New Y o rk , 1 9 3 0 , V o l 2 , 2 4 0 . 11. 0j>• c i t . , p p . 238- 239 . 12. S . E . H a r r i s , Twenty Y e a r s o f F e d e r a l & 66erve P o l i c y , C am bridge, 1 9 3 3 , p . 65T 13. W. W. R i e f l e r , Money R a t e s and Money M ark e ts in th e U n ite d S t a t e s . New Y o rk , 1 9 3 $ , PP* 2 3 2 -2 3 6 . 14* T h is method kn ow in gly ig n o r e s th e f a c t t h a t even a s i n g l e bank may b e a b l e t o expand i t s l o a n s by a g r e a t e r amount th an i t s b o rro w in g s f r o n th e r e s e r v e b an k . S e e C. A. P h i l l i p s , Bank C redi t , New Y o rk , 1 9 2 4 , p p . 3 2 -1 2 0 ; J . E . R o g e r s , S p e c u la t io n and t h e Money M a rk e t. C o lu m b ia, Ho. 1927 15. 1 . J . M. K e y n e s, 0 j). c i t . , 16. S . E. H a r r i s , 0j>. c i t . . pp. 18-19. V o l. 2 , p . 2 4 3 .
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