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THE FEDERAL RESERVE MEMBERSHIP PROBLEM Address by Lawrence K. Roos President Federal Reserve Bank of St. Louis Before the ARKANSAS BANKERS ASSOCIATION CONVENTION 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 non-member. 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 founding. 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 been? 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 . deposits. 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 yearso 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? It 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 benefits. The alternative of lowering r e s e r v e requirements is an interesting one. 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 Act. 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. At 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. And 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* All 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. Hopefully, draft legislation will be forthcoming for consideration by Congress before 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 citizen 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 England. 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 .