View original document

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

87
Speech delivered before
Convention of Polish Physicians, Dentists and Lawyers
Pittsburgh, Pennsylvania
August 25, 1938
WHAT IS THE FEDERAL RESERVE SYSTEM?
As created by the Federal Reserve Act the Federal Reserve System consists of five parts. These are: the member banks, the Federal Reserve
Banks, the Board of Governors, .the Federal Open Market Committee, and the
Federal Advisory Council.
The characteristic functions of the System as a central banking organization devolve upon three of these parts, which for most purposes of
explanation can be spoken of as if they were one. In some casesthe lav;
puts the primary responsibility upon the Reserve Banks, in some cases
upon the Board, and in some cases upon the Committee. Your own contacts,
however, are directly with your Federal Reserve Bank and so for the sake
of simplicity I wish to disregard the divisions of responsibility established by the law and speak of whatever is done as done by the Federal
Reserve Bank.
The purpose of a central banking organization is to exercise a sta~
bilizing influence upon the supply and cost of credit. Thus the operations of the Federal Reserve Banks as central banking institutions differ
profoundly from those of privately managed and competitive institutions
operated for profit. When the Federal Reserve Bank makes a loan or purchases securities, the transaction is in one sense like that of a privately managed, bank, but its purpose and motivation are quite different.
The transaction of the privately managed bank is one of competitive profitseeking enterprise. The transaction of the Federal Reserve Bank is essentially govermental, being aimed at the regulation of credit conditions
in the general interest. For this reason the powers possessed by the
Federal Reserve Banks are special and such as are not possessed by privately managed institutions. Both in purpose and in powers, therefore,
Federal Reserve Banks are essentially unlike the institutions which you
as commercial bankers have under your control.
1
In spite of these essential differences, the tendency to think of
the Federal Reserve Banks in terms applicable to the operations of privately managed banks is almost irresistible, particularly among bankers.
This was recently brought to my attention by the statement of a banker
to the effect that when the Federal Reserve Banks make loans they use
funds supplied by member banks. Such a statement represents a view of
the matter that I am afraid is very common. The idea seems to be that the
reserves which the member banks are required to maintain with, the Federal
Reserve Banks constitute the funds which the Federal Reserve Banks lend,
and that the ability of the Federal Reserve Banks to lend depends upon the
amount of the member bank reserves. This is far from the truth.
The ability of the Federal Reserve Banks to lend arises from their
statutory authority to exchange their own liabilities for the liabilities
of others - in other words, to enter credits to the reserve accounts of

88
member banks and to issue Federal Reserve notes in exchange for promissory
notes, bills, bonds, and other forms of obligation. Consequently, the Federal Reserve Banks could make loans and purchase securities without having
a penny of member bank reserves to start with.
You all are familiar with the fact that if you procure funds from the
Federal Reserve Bank - either by the sale of securities or by borrowing you receive the proceeds of the transaction in the form of funds credited
to your reserve account. It is obvious that in such a transaction the Federal Reserve Bank parts with nothing. When it acquires one of your obligations, it does not pay-for it in cash as a merchant would do when he acquires
inventory assets; instead it balances the increase in its earning assets by
a corresponding increase in its liabilities. This increase in its liabilities is not wiped out until the obligation is settled. If, after having the
proceeds of your borrowing credited to your reserve account, you withdraw
Federal Reserve notes, the liabilities of the Federal Reserve Bank are not
thereby reduced; they are merely shifted from one form to another - from a
deposit liability to a note liability. Similarly, if your reserve account
is drawn down by a net balance of clearings against you, the liabilities of
the Federal Reserve Bank are not thereby reduced; there is merely a shift
of. deposit liability from one bank's reserve account to another bank's reserve account.
The same transaction by which the Federal Reserve Bank enlarges your
reserve account in exchange for earning assets acquired from you may of
course be repeated with member bank after member bank, and in the process
Federal Reserve Bank deposits will be continuously expanded. This process
might be begun, as I said, without the Federal Reserve Bank having a single
penny of deposits to start with. Under the law the Reserve Bank would need^
to have only a stock of gold, v.hich it might acquire by the sale of its capital stock, and this gold would have to be a little more than a third of the
amount to which the Reserve Bank's liabilities were expanded. This requirement of the lav/ - that the Federal Reserve Bank's reserves, which consist
mainly of gold certificates, shall be not less than .35 per cent of their
deposit liabilities and not less than UO per cent of their note liabilities is the only limitation upon the power of the Federal Reserve Banks to build
up their own assets and the reserves of their member banks. It is a limitation that under present circumstances would permit expansion far beyond any
probable need.
You are familiar with the process I have been describing because it is
one which in principle you follow when you make loans to your own customers.
Your pun institutions, however, are under natural limitations v.hich in practice make the operation quite different from what the Federal Reserve Banks
can do. You can, for example, accept the promissory note of one of your borrowers and give him credit in his checking account for the amount thereof.
You increase your assets and your liabilities simultaneously and the transaction involves not a penny of cash nor any deposits you may or may not have
already. Up to this point the situation is the same as v;hen a Federal Reserve
Bank makes,a loan to one of you and credits your reserve account with the
ceeds. But here.the difference arises. The proceeds of the loan made by the
Federal Reserve Bank will not be checked out and the Reserve Bank will lose
none of its reserves. The proceeds of the loan that a member bank makes will
be checked out.and the member bank will lose reserves; for a member bank's

89
customer borrows because he needs the funds and he must be expected to
check out the greater part of what he borrows. For this reason when you
make extensions of credi t you always have .in mind the question whether
your reserves are adequate or not to meet the withdrawals that you must
expect will follow. When your reserves are being built up you feel free
to lend and to purchase securities, but when your reserves begin to decline you realize that your extensions of credit must be curtailed and
collections effected.
It is a paradox of competitive banking that though bank deposits are
increased by the loans which a bankers makes to "his customers, it is not
his own deposits but those of his competitors that are increased. In
other words, bankers increase each other's deposits. The First National
makes a loan to a customer, and he checks the money out to someone who
deposits it in the Second National. The Second National makes a loan to
a customer, and he checks it out to someone who deposits it in the First
National. Occasionally funds may for a time stay in the bank that lends
them, but that is unusual; on the whole, funds are undergoing too active
a use to stay long at the point where they originate. It is their nature
not to stand still but to circulate.
Because there are many banks and because they are in active competition, any active circulation of the funds created by them is from bank to
bank. But because in a given district there is only one Federal Reserve
Bank, any active circulation of the funds created by it is merely from
one reserve account to another without ever leaving the Reserve Bank's
books. There is an exception when funds leave the Federal Reserve district in which they originate, but the bulk of the circulation is intradistrict rather than inter-district; and even in the case of inter-district movements the Reserve Banks can make adjustments among themselves so
that none will have inadequate reserves.
Accordingly, it is possible for the Federal Reserve Bank to expand
its deposit liabilities - i.e., your reserves - almost indefinitely, and
in its power to do so, being a central bank, it is not dependent upon its
depositors. Both from the point of view of power therefor as well as from
the point of view of purpose, its operations are by no means analogous to
those of a privately managed bank. A loan or a purchase of securities
by the Federal Reserve Bank is always to be thought of as resembling only
superficially, and as a bookkeeping transaction, a loan or a purchase of
securities which you as commercial bankers may make; in purpose and in the
conditions under which it is ef fected it does not resemble but essentially
differs from such loans and purchases.
A few moments ago I spoke of your reserves as indicators of your
ability to lend. That fact holds universally just as a sane and necessary
rule of good, banking; it was observed by bankers before there were legal
requirements 'is to reserves, and it would continue to be observed if there
we re no such requirements now.
•Since extensions of credit depend upon adequacy of reserves, it is
evident that control over reserves - with the power to expand and contract
them - is control over the expansibility of bank deposits. In a very
significant sense, therefore, the word "reserve" is a key word that by its

90
presence in the terms "Federal Reserve System", "Federal Reserve Bank!',
and "Federal Reserve'Act" indicates iwhere the emphasis should lie in .consideration of what the System is. "'''he reserves' which member banks maintain
with the System are the means by which the supply and cost of credit are
regulated. It is to facilitate such regulation that reserves are maintained
with the Federal-Reserve Banks and that the.Federal Reserve Banks are given
very special powers to expand and contract those reserves through lending
and open market operations* Accordingly, instead of saying that the lending
powers of the Federal Reserve Banks depend upon the reserve deposits lodged
with them, it is more accurate to say that the volume of those reserve deposits depends upon the Fedeial Reserve Bank's use of its powers, which by the
deposits can be either enlarged or reduced.
In recent years two conditions liave made it difficult to "observe the
central banking powers of the Federal Reserve Banks in normal operation.
One is the enormous volume of reserve funds that have come into the possession of American banks as a result of the inflow of gold into this country from abroad. The other is the reluctance of you bankers to borrow.
Taken together these two things mean that at present bankers have relatively
little occasion to use the lending facilities of the Federal Reserve Banks
and abstain as much as possible from using them even when there is occasion.
Under normal conditions of central bank operation this will not be true.
Banks will have ample reserves to meet an active but essentially stable credit
demand, but they will have no great excess of reserves; their funds vail be
employed and turning over efficiently and profitably. When on occasion there
are seasonal or other legitimate increases in the demand for credit, the reserve funds available to meet the increased demand will be enlarged by central
bank action - funds will be lent to individual banks or open market purcnases
of securities will be made. When the seasonable demand has passed, the additional funds will disappear - securities or bills will be sold in the open
market and the member bank borrowings will be paid off.
Such recourse to the central banking organization should be regarded as
normal and desirable. When the legitimate seasonal requirements of a given
community are in excess of the local supply of funds, it is proper that the
banks concerned should turn to the central banking organization for additional funds. At such times it is no reflection upon a bank that it is indebted to the Federal Reserve Bank. On the contrary, it is evidence that
the bank is making normal and proper use of the institutions established for
the purpose of enabling it at all times to meet the legitimate credit needs
of its customers. Such recourse to the Federal Reserve Bank will, of course,
as I have indicated, be seasonal and occasional. It will not mean that the
bank in question is embarrassed any more than the seasonal borrowings of a
merchant or a farmer are signs of embarrassment.
But, as I have said, conditions prevailing in recent years have given *
little opportunity for what we think of in principle as the normal and typical working of central bank functions. The volume of discounts has remained
small, the inflow of gold has lessened the need for open market purchases, and
at the same time occasion has not arisen for open market sales of securities.
Instead,: the System has had to be preoccupied with the problems presented by
abnormal conditions - notably, of course, the state of business activity prevailing in recent years andthe immense expansion of bank reserves resulting

91
from increases in the gold stock. In this situation the System has sought
on the one hand to maintain the easy money policy which it believed was
called for by the economic condition of the country and on the other hand
to maintain the effectiveness of the normal powers of credit regulation
entrusted to it by Congress.
Meanwhile the other functions of the Federal Reserve Banks - the
provision of currency, the clearance and collection of checks, bank supervision, and fiscal agency for the Federal Government - have continued.
They make up the bulk of the System's routine, and constitute the channels of more irequerit contact between the institutions you manage and the
Federal Reserve Banks. But, in considering in a broad sense what the
Federal Reserve System is, these routine functions should not obscure the
fact that the fundamental concern of the Federal Reserve System is reserves.
The functions and purposes which I have been speaking of are stated
in the Federal Reserve Act, which makes it an aim of the System's operations to accommodate commerce and business in the interest of the general
credit situation of the country. The Act also mskes it an aim of the System to discriminate against the speculative use of credit. These objectives have been emphasized by Congress in various ways - not only in the
statement of purpose which is to govern the System's operations, but in
the conditions governing the appointment of members of the Board and directors of the Federal Reserve Banks. The functions of the System, as
stated in the let, also include the issue of currency, the clearance and
collection of checks, the examination of member banks, and fiscal agency
of the United States government.
In carrying out these purposes for which the law created it, the
System has recourse not only to its own statistical and research services,
but to the assistance of outside groups. It seeks at all times to inform
itself as carefully as possible as to the conditions to which its regulations are to apply. Its object is to serve, as the law requires, the interests of industry, commerce, and agriculture, and in pursuance of this
objective it draws on the experience and the judgment of all the interests
involved.