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37 Speech delivered before North Dakota Bankers Association Fargo, Worth Dakota June 1937 ' • THE FEDERAL RESERVE SYSTEM I flew here. North Dakota - the portion over which 1 flew looks excellent for this time of the year, and since I arrived I have been gratified to hear that after the terrible drouth experiences the people of this state have been through in recent years, the prospects now are very bright in a greater portion of the State. Snowfall was considerable last winter and so far this spring you seem to have had sufficient rain in most sections. Improved conditions are not uniform, of course, and some areas are less well off than others, but for a large proportion of you things seem definitely better. I have been particularly impressed by the reports which the officers: of the Federal Reserve Bank of Minneapolis have given me of the splendid spirit shown by your people in their adversity. They have not given up. Some have been disposed to move to other regions, but the majority have persisted in looking for a return of better conditions. It is noteworthy, moreover, that the possibility of altering the old farming methods to advantage has not been overlooked. The courage and enterprise that you people have shown strengthens one's faith in human nature. Along with the others, you bankers have had excessive discouragements. You have found little demand for credit and in too many cases applications have had to be refused. You have 3een the income of your communities cut off and their savings exhausted. I want to assure you that the difficulties you have been through as a result of nature's unkind treatment of your region in recent years is not unappreciated. Yet conditions have not been such as to make it necessary for bankers to borrow to any great extent at the Federal Reserve Bank and. accordingly those of you who are members of the Federal Reserve System have not had to make much use of the credit facilities of the Federal Reserve Bank. I hope, however, that you have realised the readiness of the Reserve Bank to be of use to you in this respect as it was during the days of 1920-1925. The spirit of your organization is exemplary. You have my sincerest congratulations. Probably the majority of you represent banks which are not members of the Federal Reserve System, since there are only about sixty member banks in North Dakota out of a total of about two hundred; but I hope you are nevertheless interested in hearing a description of the System's functions. The System serves not only member banks, but the public at large, including non-member banks. It is to the public interest that its functions and purposes be as widely known and understood as possibj.e. As you know frotn the visits that you receive from time to time, the officers of the Federal Reserve Bank try to keep in close touch with 38 banks, both member and non-member, in order to insure that the service of the Federal Reserve Bank is satisfactory and that its facilities' are fully known. The officers of the Federal Reserve Banks as well as the members of the Board welcome criticism and.constructive suggestions, for it is their desire to do everything within their authorized powers to make the services of the Federal Reserve BanKS useful and valuable. Prior to the establishment of the System an outstanding weakness of our banking was the lack of satisfactory facilities for reserves. The panic of 1907 - which played a large part in bringing about the establishment of the Federal Reserve Banks - was-largely due to this condition.,:. At that'time each country national bank was required to have reserves of 15 percent, 6 percent as cash on hand and 9 percent on deposit in correspondent banks'in reserve cities or central reserve cities. National banks in reserve cities were required to keep reserves of 25 percent, at least 12-1/2 percent in cash and 12-1/2 percent on deposit with correspondent tanks in central reserve cities.. New York, Chicago, and St. Louis constituted the three central reserve cities, and the banks in these cities had to keep reserves of 25 percent — all in vault cash. • The reserve needs of banks all over the country converged therefore on a relatively few large banks in the money centers, but these banks were not always prepared to meet the full responsibilities of such a situation. They had their own local interests to protect. They were not primarily reserve banks, but banks serving their own communities and operated for profit. It was not to be expected, even if it had been legal, that they would abandon the purposes for which they were organized and voluntarily play the role which the Federal Reserve banks now play. As things stood, therefore, banks in general had no certain means of augmenting their reserves except when conditions were easy. The. Federal Reserve Banxs, however, not being organized or operated for profit, having no local interests other than those of their member banks and of the public, and having been legally endowed with specific powers for the purpose, are under no such limitation. They are expected to do what the city correspondents could nob be expected to do, that is, maintain themselves in readiness at all. times to replenish member banks' reserves by the rediscount of paper and the purchase of securities' coffered by the member banks from their portfolios. As you will recall, however, originally the rediscounts were limited to certain classes of paper, for it was the purpose of the original Federal Reserve Act to encourage banks to make commercial loans. The Act definitely discriminated in favor of such loans by limiting the paper eligible for discount (in the words of the Act) to "notes, drafts, and bills of exchange issued or drawn for agricultural, industrial or commcr-. cial purposes." This paper, moreover, had to mature in three months or less from the time of discount, with the exception of agricultural paper, which might mature in six months. This limitation did not in fact result in an abundance of such paper in the portfolios of banks; on the contrary such paper, for many years, has shown a tendency to occupy a relatively small place among bank assets. In 1929 it amounted to about 12 percent of loans and investments of member banks. At the end of last year it was less than 8 percent. This reflects the fact that banks, instead of specializing in any one 39 type of credit, have dealt in all kinds of credit - long term as veil as short - according to the requirements of their communities. The result, therefore, has been to limit the power which it was originally intended that the Reserve Banks should have of discounting for member banks which wished to replenish their reserves. The Banking Act of 1935 sought to correct this condition by an amend ment authorizing the Federal Reserve Banks to make advances to member banks for not to exceed four months on any security satisfactory to the Reserve Banks. This change made it possible for a member bank to discount any sound asset at the Reserve Bank regardless.of type, end had the effect, under existing member bank lending practice, of enlarging the lending powers of the Reserve Banks. In recent years conditions have been such that the Reserve Banks have had relatively little occasion to lend to member banks. There.are two other services of the Reserve Banks that are always active, however. These are the services of currency supply and domestic exchange. With both of these activities, so essential in effecting the payments entailed in the business life of the country, you. are entirely familiar, since they bring you into your most frequent contact with your Federal Reserve Bank. And I need not remind you how important it is to you bankers that currency and coin be always available in adequate volume and that checks and similar items be collected and cleared as expeditiously as possible. Currency and coin are used in only about 10 percent of the volume of payments we make as a people, but that 10 percent includes the small and indispensable payments which everyone is making constantly with coin and small bills. Checks are used in the other 90 percent of payments and their use to this extent is largely due to our development in this country of nation-wide means for their collection and clearance. At the center of the Federal Reserve System facilities for domestic exchange is the Interdistrict Settlement Fund operated by the Board in Washington, through which sums running into millions of dollars are transferred daily by wire between the- Federal Reserve Banks, for their own account, for the account of the Treasury, and for the account of local banks. It is doubtful if any country in the world has a more efficient and comprehensive means of settling the balances between domestic institutions and • money centers. Next I wish to mention a Federal Reserve Bank function whose existence and importance are frequently overlooked. As you know, the Federal Reserve Act provides that the Federal Reserve Banks "when required by the Secretary of the Treasury shall act as fiscal agents of the United States." The duties which the Federal Reserve Banks perform under this provision always have been extremely important to the government, and in recent years they have come to absorb a larger and larger part of the attention and time of the Federal Reserve Bank personnel. In addition to servicing the public debt, providing currency, and acting as depositary of the United States Treasury, the Federal Reserve Banks perform a large amount of work for various government agencies, such as the Recon-. struction Finance Corporation, the Federal Farm Mortgage Corporation, the Federal Land Banks, the Federal Intermediate Credit Banks, the Federal Home Loan Banks, the Hbme Owners' Loan Corporation, and the Public Works Administration. In the year 1936 the Federal Reserve Banks handled almost 60,000,000 Treasury checks and over 87,000,000 work relief checks. This was an average of about 40,000 government checks a day at each of the twelve Federal Reserve Banks. The transactions involved in servicing government securities are of great importance; they comprise receiving applications for new issues, delivery of securities to subscribers, exchanging securities of different denominations, meeting maturities, and paying interest. During the year 1936 the Federal Reserve Banks delivered to subscribers almost 900,000 bonds, notes, certificates, and bills sold by the Treasury or other government agencies, and redeemed over 800,000 different obligations. They exchanged almost 2,000,000 obligations for the convenience of their holders and paid almost 19,000,000 interest coupons. Last year they prepared and mailed over 25,000,000 bonus bonds to veterans, or practically the entire issue, and they are now engaged in redeeming these bonds. In addition to the services I have described, namely, holding the reserves of the United States banking system, making loans to member banks, furnishing an elastic currency which automatically increases or decreases according to the public demand, facilitating the clearance of checks and the inter-regional transfer of funds, acting as fiscal agents of the government in connection with the issue and retirement of government securities, the Federal Reserve System makes it possible to influence national credit conditions. This can be done through discounts, through open market operations, through direct action, through changes in reserve requirements, and through margin requirements. Discounts Rates of discount, under the terms of the Federal Reserve Act, must be established from time to time by each Federal Reserve Bank, subject to review and determination by the Board of Governors of the Federal Reserve System. The Banking Act of 1935 added the requirement that such rates shall be established "every fourteen days, or oftener if deemed necessary by the Board." This does not require that such rates must be changed every time, but they must be regularly and frequently reviewed. At the time of the passage of the Federal Reserve Act it was the expectation that banks would borrow at the Federal Reserve Banks as a regular thing, since the rate they could charge their customers would be higher than the rate they would have to pay. Assuming this readiness of the banks to borrow, the rate of discount would of course influence them very positively; they would be encouraged to borrow by low rates and deterred from borrowing by high rates. But in fact, as you know, bankers do not follow such a principle. They are reluctant to borrow under any circumstances and as a rule will do so only when they must in order to maintain their reserves. The fact that the rate is high or low is not sufficient of itself to determine their action. Instead, the rate of^ discount is mainly significant as an index of the cost of money. It is not usually a very effective means of influencing credit conditions. Open Market Operations It must be obvious that the power of a Federal Reserve Bank to grant credit at predetermined rates of discount and interest can be exercised only when credit is asked for. Consequently, if the Reserve la Bank had no other means of credit control than the power to discount the paper of member banKs at given rates, or to refuse to discount, it would nave to wait passively and idly until individual member banks decided that they would J.ike to borrow. . Then only would it have opportunity to act. As a consequence of the need of meeting the Federal Reserve System's responsibilities more positively, two other means of credit controj have been developed. These are open market operations and direct action. Both are outgrowths of experience, primarily. Open market operations consist of the purchase and sale by the Reserve Banks of certain classes of securities, mainly government obligations, for the purpose of increasing or decreasing the supply of credit . available in the money market as a whole. By selling securities the Heserve banks withdraw funds from the market and less credit becomes available. The reason for this is that in the process of paying for the securities that are sold the reserves of member banks become diminished, because every payment means a debit sooner or later to some member bank'?, reserve account. And as a member bank's reserves decline toward the legal minimum it is less able to make extensions of credit. On the other hand, by purchasing securities the Reserve Banks place funds into the market and more credit becomes availablej because the funds which are released in payment flow directly or indirectly into the reserve accounts of the member banks and enlarge) them. P.nd as their reserves expand, they are in a position to extend more and more credit. In principle, therefore, the Reserve Banks can increase or decrease the funds available for lending by local banks, accordingly as they buy or sell securities. Of course, there are,vin practice many limitations on the effectiveness of open market operations, but their tendency is to enable the Federal Reserve Banks to take corrective action with respect to abnormal credit conditions ori their own initiative. The powers of the Reserve banks to buy and sell securities in the open market were granted in general terms in the original Federal Reserve Act, and at the time were not generally considered to be of very great importance. The first operations were carriod on by the Federal Reserve Banks independently of one another, but it was soon found that action would have to be coordinated; otherwise the banks would be buying or selling in competition with one another and following different, and perhaps conflicting, policies. To avoid this, a committee was formed for the purpose of directing the operations. ADout the same time the purpose of the operations was clarified. For some time purchases had been made with the idea of providing income to meet expenses, but it was eventually realized that such an objective was in conflict with that of moderating a given condition of the money market, and must, therefore, be subordinated or even abandoned. The Banking Act. of 1933 gave specific recognition to open market operations as a System matter and established a Federal Open Market Committee of twelve members, one representing each Federal Reserve Bank, to take the place of the former non-statutory committee. At the seme time the law adopted substantially the statement of purpose which had already governed open market operations. This was to the effect that they be conducted "with a view to accommodating commerce and business h2 and with regard to their bearing upon the.-general credit situation of the country." The Banking Act of 1935 made a further change by providing that the Federal Open Market Committee should comprise the members of the Board of Governors of the Federal Reserve System and five representatives chosen by the twelve Federal Reserve Banks. The law also makes the decisions oi this committee obligatory upon the Federal Reserve Banks and provides that the record of the Committee's actions shall be included in the annual report of the Board submitted to Congress. Thus an activity which was barely recognized in the original Federal Reserve Act, and which was gradually develooed in the process of administration of the System, has come to be emphasized in the law as one of the System's most important functions. Direct Action I also mentioned direct action as a means of credit control. Direct action means efforts by the Federal Reserve Banks or the Board to discourage credit policies of given member banks in given circumstances. Opportunity for it occurs on various occasions, but particularly when a member bank is being examined, and when it is seeking to rediscount some of its paper. In this sense, direct action is aimed at the correction of specific conditions in particular banks. It may also be resorted to, however, with reference to general conditions and for the purpose of enforcing general credit policy. Power to Change Reserve Requirements Recent legislation has also established two other new forms of general credit control which previously did not exist. The first of these is the power given the Board to change reserve requirements. This power was first given the Board in 1933, under limitations which wore later removed by the Banking Act of 1935. The Board is now authorized to change the reserve requirements "in order to prevent injurious credit expansion or contraction's but it is not permitted to lower them below the original reauirements nor increase them to more than twice those requirements. Under this authority the Board has now taken action twice to increase the requirements, the first increase being effective August 15, last, and the second being effective in part the first of March and in part the iirst of May of this year. On the basis of the excess reserves that had accumulated, almost entirely as a result of the enormous imports of gold into the United States, the possibility existed for an expansion ot credit^ which was quite beyond the present or prospective needs of commerce, industry, and agriculture, and which might be extremely injurious, xhe Board bv its action in reducing the amount of excess has diminished tne possibilitv of such an injurious credit expansion. I quote the following from the Board's statement of January 30, 1937, with respect to the action taken: "The Board estimates that, after the full increase has gone into effect, member banks will have excess reserves of approximately £500,000,000, am amount ample to finance further recovery and to maintain easy money conditions. At the same time the Federal Reserve System will be placed in a position where such reduction or expansion of member bank reserves as may be deemed ii3 "in the public interest may be effected through open-market operations, a more flexible instrument, better adapted for keeping the reserve .position of member banks currently in close adjustment to credit needs." Consistent with this statement as a preventive influence against a possible disorderly market and to provide means by which to effect an orderly readjustment in meeting the increased reserve requirements by member banks and not as reversal of policy, the Federal Reserve System just prior to May 1 increased the System's portfolio by purchasing government securities in the open market. ' Under the law, the Board may reduce reserve requirements from their present level to the original legal requirements - and not below, but it cannot increase them beyond the present requirements which went into effect on May 1 of this year. Margin Requirements The second new form of general credit control recently authorized pertains to margin accounts and loans made for the purpose of purchasing or carrying registered securities. Authority for the Board to issue regulations in this field was granted by the Securities Exchange Act of 1934.. This grant of authority was in line with various provisions of the Federal Reserve Act, such as 1 have already referred to, aimed at restricts the use of credit for speculative purposes. Pursuant to these provisions the Board has issued twin Regulations, T and U. Regulation T, following Sections 7 and 8(a) of the Securities Exchange Act of 1934-> governs the extension and maintenance of credit by brokers and dealers in securities for the purpose of purchasing or carrying securities. Regulation U, following Section 7(d) of the Act, governs loans made by banks for the purpose of purchasing or carrying stocks registered on exchanges. As you will recall, one of the conditions at which the original provisions of the Federal Reserve Act were aimed was the use of bank funds to finance stock market speculation. It has always been clear that the Act sought to make credit ample for commercial, industrial, and agricultural purposes without encouraging its speculative use; but the difficulty has been to make measures of control work in one field without producing corresponding but undesired results in the other. A discount rate that was advantageous to agriculture was advantageous to speculation, and a rate that was disadvantageous to speculation was disadvantageous to agriculture. This difficulty in the way of discriminating between the possible uses to which credit might be put was characteristic of attempts to reach the objective by control from the angle of supply. It appears to be obviated in the new provisions, which, as I have said, attempt to reach the objective from the angle of demand. This power which has been given the Board to impose and relax restraints upon the demand for credit for speculative purposes is definitely selective. It is aimed at a particular use of credit and at the specific channels through which demand becomes effective. For this purpose, the powers of the Board are extended outside the Federal Reserve System to hh reach directly, also brokers and even nonmembe.r banks.. The new powers differ from those of discount, because while.; the latter may be. exercised to discriminate against paper directly involved,,in speculative uses, they cannot prevent the speculative use of funds' procured by the discount of paper not directly involved in speculation. ' The new povrers also differ in effect from the power to conduct open market .operations,, which influence the total amount of funds .but not the uses to which they Q b n be put. The same thing .' is true of the power to alter reserve requirements. The power to take direct action can be used to discriminate against the speculative use of credit, but only in individual cases. The new powers with respect to margin requirements, however, are under no such limitations. Conclusion - Limitation on Means of Credit Control • . i ,. . •, , Although the five means I have discussed by which credit control may be exercised - discounts, open market operations, direct action, reserve requirements, and margin requirements - appear to be very comprehensive and powerful, it would be a mistake to convey the impression that a perfect • control of credit will be effected through them. In the first place, their application cannot be mechanical nor governed by simple unvarying rules. Credit and economic relationships are extremely intricate, and the circumstances under which the need for action arises are always to some extent different and special. Let me mention a few things that complicate the task of credit control. For one thing, there has never been .a time when the membership of the Federal Reserve System included as many as half the banks in the country. It does not now. The majority of b,anks in the United States are outside the System, although it is true that the System includes most of the large banks and that it, therefore, includes the bulk of the banking business of the country. For another thing, United States Treasury activities must be taken into account. These have to do in part with the operations' of the Exchange Stabilization Fund and the issue of circulating media, e . g . , coins, silver certificates, and United States notes; and in part with the public debt, and the government's receipts and expenditures. These operations involve large suras and intimately affect the'banking and credit situation. Finally there are conditions that arise not only outside the System, but outside the country, and yet affect the domestic banking situation powerfully. There is, for example, the recent great movement of gold from abroad which I have already mentioned - a movement that in the last three years has added four billion dollars, to the reserves of,member banks. These factors, among others, necessarily limit arid modify the exercise of credit control. As you know, the Board in Washington is constantly in touch, through the Federal Reserve Banks, with the general credit conditions of the country. The Board has data supplied to it by the Federal Reserve Banks' statistical departments, and it has its own research and statistical department in Washington, which presents facts and figures constantly, so that it may know what is going on. The Board compiles and publishes information bearing on banking and'credit conditions, here and abroad, and includes data on production, employment, trade and prices. No other central banking organization in the world makes available such comprehensive information on domestic banking and business developments. Those of you who are member bankers receive this information monthly in the Federal Reserve Bulletin. This is one of the services that comes with membership in the Federal Reserve System. Its purpose, as is true of all the services of the Federal Reserve System, is to improve the business of banking. I say "improve" not because I think the business of banking is handled badly, but because in our complex, world-wide business life there are changes going on which are beyond our control and which are constantly making improvement necessary. The banking business must constantly be adapting itself to these changes, and this it cannot do without knowledge and understanding of the facts.