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Address by
Lawrence K. Roos
Federal Reserve Bank of St. Louis

Before the
Hot Springs, Arkansas
May 16, 1977

Coming to Hot Springs is always a pleasure.

This is one of

A m e r i c a ' s m o s t beautiful resort cities and, certainly, one of the most
beautiful parts of the Eighth Federal Reserve District.
For m e , personally, being here today is a special pleasure
because this occasion offers an opportunity to m e e t and talk with so many
of our good friends in the banking industry.
As a representative of the Federal R e s e r v e System, I wanted to
be particularly careful to choose a subject that would be of interest to each
of you, whether your bank happens to be a m e m b e r of the Fed or whether it
is a


After giving the matter some thought, it occurred to

m e that one current topic that should be of i n t e r e s t to all bankers i s the
subject of Fed membership, s o m e t i m e s referred to as the Federal R e s e r v e
membership problem.
F r o m the perspective of you who are associated with member
banks, the importance of finding an early solution to the membership problem is obvious.

Membership is an i s s u e that affects member banks 1

earnings and, after all, for most of you the "bottom line 11 is of more than
passing importance.

I'm sure that more than a few of you Fed m e m b e r s

-and your boards of directors are currently struggling with the question of
whether your bank f s best interests are best served by continuing your
membership in the Federal Reserve System.

- 2 -

Indeed, this is not a decision to be taken lightly.

For most

m e m b e r banks, to leave the System would mean departing from a relationship of long standing, a tradition that, perhaps, dates from the bank's

More important, leaving the S y s t e m would mean giving up a c c e s s

to the discount window, losing the benefits of seasonal borrowings and
giving up many other s e r v i c e s provided by the Federal Reserve which are
of value to you.
For non-member banks, the membership question should be of
importance also because the ultimate resolution of the problem, whatever
it may be, is certain to have a major impact on the future of our overall
financial s y s t e m , and the prosperity of all banks is dependent upon the
perpetuation of a strong national economy.
Members and non-members alike share an interest in the continued ability of the Federal Reserve System to conduct monetary policy
in an independent manner geared to the best interests of a free economy.
Should membership in the System continue to erode, the capacity of the
Federal Reserve to retain the independence n e c e s s a r y to perform its
functions would almost certainly be l e s s e n e d .
Just how s e v e r e has the decline in Federal Reserve membership

In 1945, almost half the banks in the country were members of the

Federal Reserve System.
banks were m e m b e r s .

At the end of last year, only 39% of the country's

In 1945, member banks held 86% of all domestic

At the end of l a s t year they held only 74%.

- 3 -

Furthermore, the rate of decline has accelerated in the past few

Since 1973, banks have been withdrawing from the System at a rate

of almost one a week.

All of which underscores the severity of the problem

and the urgency of finding an early solution.
What has caused m e m b e r banks to withdraw from the System?


is obvious that the principal factor is the relative cost of membership as
compared with non-membership.

That cost, simply stated, is the cost of

maintaining non-earning a s s e t s as required by the Federal Reserve.
Although non-members must maintain some manner of r e s e r v e s for purposes
of liquidity, they can frequently do s o at a l e s s e r cost than incurred with
Fed membership.

The problem is very much a pocketbook i s s u e .

As such,

any solution, to be meaningful, must be designed to reduce the cost
differential that has caused the problem.
A number of solutions have been suggested.
One approach would be to eliminate the differential between the
c o s t s of membership and non-membership by requiring all financial
institutions that directly or indirectly use Federal R e s e r v e s e r v i c e s to hold
r e s e r v e s with the Fed.
Another suggested solution would be for the Federal Reserve to
expand s e r v i c e s to give m e m b e r banks more for their money.
A third possibility would be to lower member bank r e s e r v e r e quirements.


4 -

Still, another solution would be to lower the cost of membership
by allowing members to earn a return on their required r e s e r v e s .
The first of these approaches, that i s , to require all banks to
maintain r e s e r v e s with the Fed, has been suggested in the past.

In fact,

in 1974, the Board of Governors of the Federal R e s e r v e System sent to
Congress draft legislation to apply r e s e r v e requirements set by the Federal
R e s e r v e to demand deposits and negotiable orders of withdrawal at all
financial institutions.
That bill never got out of committee.
The extension of r e s e r v e requirements to all financial institutions
would almost certainly face widespread opposition.

Financial institutions

not presently subject to Fed r e s e r v e requirements would almost certainly
oppose the proposal.

Such opposition has been s u c c e s s f u l in blocking

l e g i s l a t i v e authorization for universal r e s e r v e requirements in the past;
there is little reason to believe that such proposals would fare better today.
The second possible approach I mentioned is for the Fed to offer
m e m b e r banks more in terms of expanded s e r v i c e s .
A study by our r e s e a r c h staff at the Federal R e s e r v e Bank of
St. Louis indicates that smaller member banks which maintain r e s e r v e s at
the Fed use the s e r v i c e s of correspondent banks a l m o s t as extensively as
s m a l l e r non-member banks.

This means that many Fed m e m b e r s do not

take advantage of the full scope of s e r v i c e s offered by the Fed.

And, of

c o u r s e , certain s e r v i c e s available at larger correspondent banks are not


offered by the Federal R e s e r v e ,

5 -

It is conceivable that something could be

done to encourage s m a l l e r member banks to use Federal Reserve s e r v i c e s
m o r e extensively in order to receive more for the cost of membership.
However, our research staff has concluded that without completely changing
the nature of the central bank and without s e r i o u s l y altering the established
pattern of correspondent bank relationships, the Fed cannot expand its
s e r v i c e s enough nor attract enough additional use of its s e r v i c e s to make
any significant change in the current balance between membership costs and
The alternative of lowering r e s e r v e requirements is an interesting

It would enable m e m b e r banks to gain maximum flexibility in converting

r e s e r v e s into earning a s s e t s .

It would be among the l e a s t expensive options

available to the Federal R e s e r v e in that Fed earnings would drop only to the
extent that the Open Market sold securities to offset the reductions in
r e s e r v e requirements.
This proposed solution, however, has s e v e r a l significant disadvantages.

It could create serious problems for monetary policy and could

not be fully implemented without enabling legislation.

More importantly,

it would provide little relief for s m a l l e r banks for which r e s e r v e requirements
a r e presently at or near the statutory m i n i m u m s .

Moreover, if the Fed were

to rely on this avenue for solving the membership problem, it could be
difficult to raise r e s e r v e requirements should future economic and financial
conditions warrant.

For these r e a s o n s , this alternative probably should not

be given serious consideration*

- 6 -

Which leaves us with the fourth p o s s i b l e approach to the problem:
authorizing earnings on required r e s e r v e s .
Several methods for accomplishing this have been suggested.
Some students of the membership problem have proposed authorizing the
Fed to pay direct interest on required r e s e r v e s .

Others have proposed

granting m e m b e r s p e r m i s s i o n to hold their r e s e r v e s , or s o m e part of their
r e s e r v e s , in interest-bearing government s e c u r i t i e s .

Still others have

suggested various s c h e m e s for granting m e m b e r s borrowing privileges at
artifically low interest r a t e s , thus providing them with an opportunity for
earnings through reinvestment of such borrowings.
All of these proposals have one thing in common; they would have
the effect of increasing income to member banks * T h i s , unfortunately,
r a i s e s political as well as economic p r o b l e m s .
Payment of interest on member bank r e s e r v e s would require
legislation by Congress in the form of an amendment to the Federal Reserve

Political opposition to any such proposal could be expected from a

variety of s o u r c e s for a variety of r e a s o n s .
Correspondent banks, for instance, might view payment of interest
on r e s e r v e s as an inducement for small banks to seek Fed membership,
thereby reducing their demand for correspondent s e r v i c e s .

Actually there

a r e few grounds for such concern on the part of large correspondent banks
for, as I mentioned a moment ago, studies show that s m a l l e r member banks
presently use the s e r v i c e s of commercial correspondents to almost the same


extent a s s m a l l non-member banks.

7 -

So, even if payment of interest on r e -

quired r e s e r v e s were to attract more s m a l l non-member banks into the
F e d e r a l Reserve System, correspondent banks probably would not find the
market for their s e r v i c e s much reduced.
Further opposition to interest on r e s e r v e s could be expected from
non-member banks which would probably view such action as a l o s s of the
competitive advantage they now enjoy.
But the primary cause for opposition would undoubtedly a r i s e
f r o m the fact that payment of interest on r e s e r v e s would have the effect of
reducing the amount of funds presently being returned by the Federal
R e s e r v e S y s t e m to the U. S. T r e a s u r y .
In 1976, member bank r e s e r v e s averaged about $34 billion.


an interest rate of 4. 5%, interest on those r e s e r v e s , if it had been paid,
would have amounted to approximately $ 1 . 5 billion.

Thus, Federal Reserve

earnings, which presently amount to upwards of $6 billion annually, would
have been reduced by $ 1 . 5 billion.

And, since the Federal R e s e r v e transfers

all its "profits" to the Treasury, Treasury revenues from the Fed could be
expected to d e c r e a s e with payment of interest on r e s e r v e s .
Of c o u r s e , Treasury revenues wouldn't d e c r e a s e by the full
$ 1 . 5 billion because member banks would return a portion of that sum to the
Treasury in the form of t a x e s .

But, still, they would be reduced substantially.

The fact that funds currently going to the Treasury would increase
earnings of c o m m e r c i a l banks would almost certainly spark opposition from

- 8 -

s o m e m e m b e r s of Congress and certain segments of the general public who
a r e frequently suspicious of anything which i n c r e a s e s bank profits.


the effect of opposition from these s o u r c e s cannot be minimized.
Thus, any solution to the membership problem involves immense
inherent complications.

And, l e s t you have not already become totally d i s -

couraged,let m e point out still further factors complicating the solution of
the membership problem.
As you know, thrift institutions in s e v e r a l northeastern states
have been authorized to offer their c u s t o m e r s interest-bearing accounts that
do not substantially differ

from checking accounts.

Negotiable orders of

withdrawal, or NOW accounts, as they are commonly called, s e e m destined
to spread nationwide.
The extension of NOW accounts could further exacerbate the
m e m b e r s h i p question, for member banks, when subjected to the increased
c o s t of paying interest on NOW accounts, would be even m o r e resistant to
bearing the cost of Fed membership.

It can safely be a s s u m e d that, unless

a way is found to reduce the cost of Fed membership prior to, or simultaneous
with the extension of NOW account authority, the erosion of Fed membership
will continue at an accelerated pace.
Which brings us to still another complication:

the issue of a c c e s s

to Fed s e r v i c e s by non-member financial institutions.
While thrift institutions are threatening to compete nationwide with
c o m m e r c i a l banks for checking account b u s i n e s s , thrifts and other nonm e m b e r s are also pushing for a c c e s s to Federal R e s e r v e s e r v i c e s without

having to

bear the costs of membership.

Concurrently, the Department of

- 9 -

Justice is p r e s s i n g the Federal Reserve S y s t e m to provide its clearing and
transfer s e r v i c e s without discrimination on the basis of membership, and
to p r i c e these s e r v i c e s in such a way as to permit competition from private
f i r m s that may want to offer similar s e r v i c e s *

Obviously, if present

membership requirements remain unchanged, and if all financial institutions,
m e m b e r or non-member alike, have a c c e s s to Fed facilities and s e r v i c e s
without being subjected to r e s e r v e requirements, the incentive for maintaining
membership would be all but eliminated*
All of these i s s u e s have a bearing on proposals for solutions.
a r e obstacles to an easy solution*


The membership problem, which in itself

is complicated, becomes part of an extremely complex set of related i s s u e s ,
each of which affects many groups in many ways*
The Board of Governors and the R e s e r v e Banks have been working
diligently to devise legislation to e a s e the membership problem.


draft legislation will be forthcoming for consideration by Congress


too long.

But any draft legislation is only a first step toward solving the

membership problem.

Any such proposals will be subjected to the legislative

p r o c e s s , and along the way the many diverse interests i n v o l v e d - - l a r g e banks,
s m a l l banks, correspondent banks, member banks, n o n - m e m b e r banks,
thrift institutions, and public interest groups — a l m o s t certainly will want to
be heard from*
Each of these groups has special interests*
on to e x p r e s s their own points of view vociferously*
come e a s i l y .

Each can be counted
A consensus may not

- 10 -

Yet, a solution must be found.

The Federal Reserve System must

maintain the strength n e c e s s a r y to defend its ability to effectively perform
its functions.

If the Federal R e s e r v e , through e r o s i o n of its membership

b a s e , were to be weakened so as to l o s e its ever present traditional
independence, we, as a nation, will be unable to maintain the economic
strength which has provided the bulwark

for our growth.and prosperity. If

that were to happen, every financial institution and, in fact, every individual

of the United States would suffer the terrible consequences, just as

the people of Great Britain today endure the harsh economic conditions that
have stemmed to a large extent from the l o s s of independence of the Bank of
So, I say, we must solve the Federal R e s e r v e membership prob l e m and I have absolutely no doubt that we will.

But to do s o will require

a spirit of "give and take11 and a willingness of all parties concerned to
compromise a portion of their own interests for the good of all.
The American free enterprise has elevated us from a weak nation
at the time of the Revolution into the greatest agricultural and industrial
power on earth.

So successful is our s y s t e m that we define poverty at an

income level higher than the average income l e v e l of the world's second
m o s t powerful nation, the Soviet Uniono .
I believe that we can maintain the economic p r o g r e s s we have made
and build upon it.

A strong Federal R e s e r v e S y s t e m is an e s s e n t i a l element

- 11 in accomplishing that objective.

For the Fed to function with optimum

effectiveness, it must have a constituency of m e m b e r banks .which support
the objective of the System and which are not penalized by reason

of their

membership in the System,
This is a critical time for you as c o m m e r c i a l bankers and for us
as representatives of our central banking system*
be made that are certain to have an impact on
into the future*.

Important decisions will

our nation's economy long

Whether we are able to reconcile our differences and work

together to resolve them in the interest of a stronger and a greater A m e r i c a
will determine the course and quality, not only of our l i v e s , but of the l i v e s
of future generations for years to c o m e .