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X-9356 "THE FEDERAL RESERVE SYSTEM AND THE BANKING ACT OF 1935." Address by M. S. SZYMCZAK, MEMBER BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM before the Cleveland Chapter, American I n s t i t u t e o f Banking, Cleveland, Ohio. Thursday, November 7, 1935 6:15 p. m. B a l l Room, C a r t e r H o t e l Released f o r P u b l i c a t i o n November 7, 1935 A f t e r 6:15 p. m. X-9356 I am glad of this opportunity to be with you this evening, for most of you I understand are students of banking, and that i s what I am myself. No matter what our positions i n the banking world, we are s t i l l students of banking i f we are sincere. For banking i s not a simple thing, and i t s principles cannot be understood without experience and patient study. Speaking personally, I have always found that i n the process of studying any i n s t i t u t i o n , or function, or problem, i t i s important to keep referring back to fundamentals. Otherwise i t i s easy to go wandering o f f into details without knowing what they are a l l about. For that reason, I should l i k e to review a few basic things i n spite of the fact that we are a l l familiar with them. I should l i k e to brush away the great mass of details f o r a l i t t l e while and discuss some of the elementary facts about the Federal Reserve System and the functions i t performs for the country. I believe i t i s particularly worth while to do this before considering the new and important l e g i s l a t i o n i n the Banking Act of 1935. The Federal Reserve Act, which in 1915 established the Federal Reserve System, is one of the most important pieces of financial legislation ever passed i n this country. I t represented the decision reached after many years of dis- satisfaction with our banking and currency f a c i l i t i e s , brought to a head by the panic of 1907; a f t e r a thorough study of banking here and abroad by a National Monetary Commission established by Congress i n 1908; and a f t e r long and earnest public discussions of banking reform over a period of twenty years or* more. Since 1913, on the basis of actual experience and i n response to new developments, numerous amendments have been made to the o r i g i n a l Federal Reserve Act. During the depression changes were made by the Glass-Steagall Act of 1932, - 16 - X-9356 the Emergency Banking Act, the Banking Act of 1933, the Gold Reserve Act of 1934, and other acts. The most recent as well as the most important of these i s the Act approved August 23, 1935» Federal Reserve banks The work of the System may be considered f i r s t from the point of view of the Federal Reserve banks i n t h e i r relations with the banking institutions of the country, and then from the point of view of the broader responsibilities for credit policy which come under the central organization in Washington, now known, under the Banking Act of 1935, as the Board of Governors of the Federal Reserve System. The location of the Federal Reserve banks was not determined by Congress, but by the Secretary of the Treasury, the Secretary of Agriculture, and the Comptroller of the Currency acting as the Reserve Bank Organization Couimittee. To this Committee Congress delegated the authority to designate not less than eight nor more than twelve reserve c i t i e s and to divide the continental United States into a corresponding number of reserve d i s t r i c t s . These d i s t r i c t s , according to the law, were to be apportioned with due regard to the convenience and customary course of business. They may be readjusted by the Board of Governors of the Federal Reserve System. I n addition to the twelve reserve banks there are now i n a l l twenty-five branches and two agencies. The Federal Reserve Bank of Cleveland has a branch i n Cincinnati and one in Pittsburgh. A l l National banks were required to become members of the System, subscribing to the capital stock of the Reserve banks, and depositing t h e i r reserves therein. State banks were permitted to become members on similar terms, provided they f u l f i l l e d certain requirements as to capital structure and as to the general nature of t h e i r business. This division of the banks of the country into National and State banks, with d i f f e r e n t laws, powers, and supervisory -3- X-9356 authorities, was a basic condition upon which the Federal Reserve System was superimposed, and i t i s a basic condition to which i t s operations have always had to be adjusted. About forty percent of the banks in the country now belong to the Federal Reserve System and these banks account for about seventy percent of the country's banking resources. The member banks include 5,425 national banks and 985 State banks and trust companies. The State banking institutions which are s t i l l outside the System are for the most part small. There are about 9,000 non-membersj about 1,400 of them have deposits of less than $100,000, and about 2,600 have deposits of less than $250,000. Under provisions of the Banking Act of 1935 State non-member banks, with certain exceptions, having average deposits of $1,000,000 or over, must become members of the System a f t e r July 1, 1942 or lose the right of having their deposits insured with the Federal Deposit Insurance Corporation. The Federal Reserve banks d i f f e r from ordinary commercial banks i n both their organization and their functions. not deal directly with the public. Generally speaking, as you know, they do Their customers are the member banks who make deposits with them and secure credit or currency just as the public does with the local banks. The capital stock of the Federal Reserve bank i s owned by the member banks, which are required by law to subscribe to capital stock equal to six percent of t h e i r capital and surplus. One-half of such subscription is paid i n cash and the other half is subject to c a l l . The management of the reserve bank is i n the hands of a board of directors which represents not only the member banks but other business interests of the community. Of the nine directors of each Federal Reserve bank, three known as Class C directors are selected by the Board of Governors of the Federal Reserve System and six are selected by the -4- X-S556 member'banks, three known as Class A directors representing the stock holding member banks, and three known as Class B directors representing commerce, a g r i culture, or industry i n the d i s t r i c t . The chief executive o f f i c e r of the bank, designated as president under the new banking act, i s appointed by the board of directors of the bank subject to the approval by the Board of Governors of the System. The legal requirements for ownership and management of the Reserve banks, therefore, recognize that their functions must be performed i n the public interest and that their management must take account of both the banking and the general business interests of the region. Holding member bank reserves One of the purposes of the Federal Reserve Act was to provide institutions which would hold the reserves of the nation's banking system. I t i s necessary for a l l banks to keep a certain proportion of their deposits available to meet the current demands of their customers. Before the establishment of the Federal Reserve %-stem, National banks were required to keep part of their reserves i n their own vaults and part on deposit i n other banks, usually metropolitan banks. Banks i n the central reserve c i t i e s , however, of which there were then three, New York, Chicago and St. Louis, had to hold a l l their reserves in cash. When there was a general and heavy demand for funds, especially at crop moving times, for example, and country banks everywhere drew down their balances with their city correspondents, a situation was developed i n which a currency and credit crisis of greater or less magnitude might readily occur. Country banks then had d i f f i c u l t y i n getting money from the city banks, and the public i n turn ha4 d i f f i c u l t y in getting money from the country banks and from the city banks as well. -5- X-9356 Now a l l member banks are required by law to keep t h e i r reserves on deposit i n the Federal Reserve bank of t h e i r d i s t r i c t and i t i s the business of the Reserve banks to supply member banks with credit or cash i n such emergencies. The required reserves bank. vary with the type of deposit and the class of Banks i n central reserve c i t i e s , which now are only New York and Chi- cago, are required by law to maintain reserves equal to t h i r t e e n percent of demand deposits, that i s , deposits which can be withdrawn without advance notice. For example, i f a customer of a Chicago bank borrows $1,000, his deposit balance i s credited with $1,000 and the bank i n turn must provide for $130 of reserve deposit a t the Federal Reserve Bank of Chicago, unless prior to the loan i t already had excess reserves of that amount or more. Banks i n so-called reserve c i t i o s , of which there are about s i x t y , are r e quired to maintain reserves of ten percent against demand deposits, and a l l other banks are required to maintain reserves of seven percent. Reserves of three percent against time deposits are required to be maintained by a l l banks. Member bank reserve balances on deposit with the twelve Reserve banks amount today to over $5,600,000,000. Because of unusual conditions, the t o t a l of these balances i s about twice as much as the banks are required to have. The Reserve banks serve as the credit reservoirs of our banking system. Local banks no longer need have any fear that they w i l l be unable to draw on t h e i r reserves when needed, as used to be the case before the Reserve System was established. Accordingly, one important r i s k has been eliminated from commercial banking. -6- X-9356 Loans to memfrer franks Equally important with their function of holding member bank reserves i s the power of the Reserve banks to make loans to member banks. Through these loans the member banks are able to increase their deposit balances and thus provide the reserves necessary for the expansion of credit. The Reserve banks may supply funds to member banks by rediscount- ing paper or by making advances to member banks, as provided by law and Board regulations, or by purchasing b i l l s and securities, and entering corresponding credits to the account of the member banks, thus increasing their reserve balances. Member banks i n turn can increase their loans to the public i n the aggregate by an amount several times the amount of the additional reserves. The Federal Reserve Act, however, places limitations on the character of paper on which loans may be obtained from the Reserve banks. For many years Reserve banks have had the power to discount only short-term self-liquidating commercial paper, that is notes, d r a f t s , b i l l s of exchange and bankers1 acceptances arising out of commercial, industrial and a g r i cultural transactions, and to make advances to member banks on their promissory notes backed by paper e l i g i b l e for discount or purchase or iy United States Government obligations• They were not authorized to make advances on a wide range of other assets which made up an important part of the t o t a l earning assets of banks. These included r e a l estate loans, securi- ties other than those of the United States Government, and loans to business men which did not meet the requirements of the narrowly-defined e l i g i b l e commercial paper. -7- X-9556 As a result of many developments i n our financial organization, paper which qualified for borrowing from the Reserve banks has constituted a constantly decreasing proportion of the t o t a l assets of member banks ever since the System was established. I n 1929 i t was only about twelve percent of t o t a l loans and investments of such banks, and i n 1954 i t was but eight percent. Consequently, i n 1931 and 1952 when the great liquidation occurred, many banks with assets which were good but techn i c a l l y i n e l i g i b l e for borrowing at Reserve banks, were obliged either to dump them on a f a l l i n g market, suffer severe loss and contribute to the deflation i n values or to close their doors. The new banking act corrects this situation. I t authorizes the Reserve banks to make advances to member banks for periods not exceeding four months on any security satisfactory to the Reserve bank, at a rate of interest a t least one-half of one percent above the highest discount rate i n e f f e c t at the particular Reserve bank. This amendment modifies and makes permanent the emergency l e g i s l a t i o n which i t was necessary to pass i n 1952, I n addition to the foregoing general powers of discount and purchase the Federal Reserve banks have special powers with respect to loans to commerce and industry for working capital purposes« granted ty Section 13b of the Act, These powers are Under this section the Reserve banks are authorized to discount loans made by member banks and other financing institutions to established industrial and commercial businesses for the -8- X-9356 purpose of supplying working c a p i t a l . t i e s of not to exceed f i v e years. Such loans are to have maturi- The Reserve banks are authorized to discount these loans without recourse for as much as 80 percent of any loss thereon. The Reserve banks also have authority to grant com- mitments to discount such loans. This makes i t possible for a member bank to hold i n i t s portfolio loans which the Reserve bank i s under obligation to take over upon request, and upon which the Reserve bank assumes 80 percent of any loss. I n other words the member bank has an earning asset which i s insured 100 cent as to loss. percent as to l i q u i d i t y and 80 per- This arrangement i s not restricted to member banks; i t i s open to non-members as well. Under the same section the Reserve banks are authorized i n except i o n a l cases, and when credit is not available from the usual sources, to make such loans for working c a p i t a l purposes direct to the borrower. As of October 25, the Federal Reserve Bank of Cleveland had r e ceived 55S applications for working capital loans aggregating $17,000,000. Of these, 141, aggregating $6,500,000, had been approved. The Reserve bank's outstanding advances on that date were $1,800,000 and at the same time i t had commitments outstanding for another #1,800,000. These loans have been made to a l l kinds of enterprises, indust r i a l and commercial. I n many cases they have been loans which bankers have not been accustomed to making, and which would not be made were i t not for the fact that the Reserve bank stands behind the bank which makes them. But as i t i s , they constitute secure and l i q u i d assets, yielding a good rate of i n t e r e s t . X-9356 - 9 - Currency Issued by Reserve banks Another a c t i v i t y of the Reserve banks i s the issuance of Federal Reserve notes. These constitute the paper money authorized by the Reserve Act for the purpose of supplying the country an elastic currency - that i s , a currency whose volume can be readily increased or decreased according to the public demand for i t . Federal Reserve notes are obligations of the United States and are secured by specific c o l l a t e r a l pledged by the Reserve bank. The bank i s required to keep reserves i n gold certificates at least equal to forty percent of the notes i n actual circulation. The Federal Reserve banks, of course, do not supply the entire currency of the country. The Government issues silver dollars, minor coin and some paper money and, u n t i l July of this year, the National banks continued to have the privilege of issuing National bank notes. The larger part of money in circulation, however, consists of Federal Reserve notes. A member bank that has satisfactory assets can always secure a l l the currency that i t needs. I f i t has a demand for more cash than i t has i n i t s vault, i t can readily obtain Federal Reserve notes at i t s Reserve bank. I t can borrow and take the proceeds i n notes or i t can draw against i t s account and, i f necessary, restore the account to the required l e v e l by borrowing. I f i t receives on deposit from i t s customers more currency than i t needs to keep on hand for current requirements, i t can send the excess to the Reserve bank to be added to i t s reserve balance. The function of supplying elastic currency i s important, but i t i s less important than the lending power, because, as you know, currency does not - 16 - play a major role i n present-day business transactions. X-9356 About ninety percent of our business i s conducted by the use of checks. Currency i s used, for example, for purchases a t r e t a i l stores and f i l l i n g stations, for car f a r e , and for payrolls, but such uses account for only about ten percent of the t o t a l monetary transactions i n the country. Such f l u c - tuations i n the demand for currency as appear regularly on pay days, during the period of Christmas shopping, and near holidays, are met completely by the machinery provided by the Federal Reserve Act. Other a c t i v i t e s of Reserve banks Beside their work i n holding the banking reserves of the country, i n making loans to member banks, and in supplying currency when needed, the Reserve bonks have other important functions which f a c i l i t a t e the smoother working of our financial machinery. The Reserve banks have greatly simplified the procedure whereby banks collect checks drawn on other banks. This has been very useful to busi- ness in general because i t has permitted more prompt and cheaper s e t t l e ment of monetary transactions. The Reserve banks i n effect act as a nation- wide clearing house, not only for checks, but for other credit items such as notes, drafts, bonds and coupons. In order to effect the prompt transfer of funds from one part of the country to another without actual movement of currency, the System maintains an i n t e r - d i s t r i c t Gold Settlement Fund i n Washington. The fund was es- tablished by deposits of the twelve Federal Reserve banks, and transfers from one d i s t r i c t to another are made daily by debits and credits to the X-9356 -11- respective accounts of the Reserve banks. The Federal Reserve System has centralized the work of the f i s c a l agencies of the United States Government. The Reserve banks act as f i s - cal agents i n connection with the issue and retirement of Government debt and as depositaries of Government funds i n administering deposit accounts of the Government i n the Reserve banks. Central control of I wish to turn now from this discussion of the functions which the Federal Reserve banks perform f o r the local banks and consider how these a c t i v i t i e s t i e i n with the general responsibility of the System, through i t s Board of Governors, for the nation's credit policy. When the Federal Reserve System was established i t was realized that for certain a c t i v i t i e s , particularly those related to local banking conditions, a regional organization was necessary* Only i n this way could the System meet local bank needs in a country as large as the United States, with economic conditions varying so much from one section to another. Each regional bank would have intimate knowledge of developments i n agriculture, commerce and industry i n i t s d i s t r i c t and of the d i s t r i c t ' s special credit needs and problems. The principle was also established ty the original Federal Reserve Act that under the authority of the Act and of regulations of the Board i n Washington the Reserve banks should have f i n a l responsibility i n their dealings with member banks. At the same time, i t was also realised that the credit policy of the different Federal Reserve banks must be coordinated so that policies adopted i n one d i s t r i c t would not be harmful to another. More than that, X-9356 -12- there should be a credit policy for the country as a whole which would take account of general business and credit conditions. The direction of this policy i s the duty of the Board of Governors of the Federal Reserve System, which i s the central organization located i n Washington. The Board i s aided by other organizations which work closely with i t , the Federal Advisory Council and the Federal Open Market Committee. Bo^rfl of Governors of the Federal Reserve System Experience has indicated that this power of the Board to affect the expansion and contraction of the general supply of credit i s of v i t a l importance to the country, since the volume of credit i s a factor i n determining the course of business, and proper changes i n the cost and volume of credit may tend to moderate excessive expansion or contraction of business, o r , i n other words may reduce the danger of i n f l a t i o n and deflation. The Boardfs a b i l i t y to influence the volume of credit rests on three important powers: the power to determine discount rates, the power to change reserve requirements, and the power, exercisable through i t s majority of members on the Federal Open Market Committee, to determine open-market policies. Discount rates Discount rates are the rates charged by the Federal Reserve banks on loans to member banks. These rates determine the cost of borrowing by member banks and consequently have a bearing on the cost at which the public can borrow from these banks. I n d i r e c t l y they affect other rates -13- i n the money market* X-9356 Under the Federal Reserve Act changes i n discount rates are made by the various Federal Reserve banks but are subject to review and determination by the Board of Governors. This gives the Board f i n a l responsibility over the discount rates, and enables i t to keep the cost of borrowing i n the d i f f e r e n t sections of the country consistent with general credit conditions for the country as a whole. The new banking act strengthens the Board's power to control these rates fcy making the further provision that discount rates must be submitted to the Board of Governors every fourteen days. This insures frequent review of the rates. Reserve requirements The Board of Governors also has the power to change the reserve requirements of member banks. The volume of credit which any member bank may extend i s limited by the amount of reserves which are required by law to be maintained against i t s deposit l i a b i l i t i e s . An increase i n the reserve requirements reduces and a decrease increases the potential volume of member bank c r e d i t . Consequently the power to change reserve requirements gives the Board an important means of controlling the general volume of credit. Formerly this power could be exercised only i n the event of an emergency arising out of credit expansion and then only with the approval of the President of the United States. these conditions are omitted. Under the new act The power i s to be exercised i n order to prevent injurious credit expansion or contraction, provided that reserve requirements may not be reduced below the present requirements specified i n the law nor increased to more than twice the amount of these legal r e quirements. X-9356 -14- Open-market operations The third important means of control over the supply of credit are the so-called open-market operations, responsibility for which under the new banking act w i l l be vested i n a new Federal Open Market Committee. This com- mittee w i l l consist of the seven members of the Board of Governors and f i v e representatives of the Reserve banks selected by the Reserve banks i n d i f ferent regions. Open-market operations consist of the purchase and sale by Reserve banks of certain classes of securities, chiefly Government obligations. These operations have the e f f e c t of increasing or decreasing the supply of credit available i n the market. By selling securities the Reserve banks withdraw funds from the market and there i s a decrease i n the supply of credit. Through a purchase of securities a Reserve bank puts funds into the market, thus tending to ease credit conditions. Purchases and sales of securities by the Reserve banks were unimportant i n the early days of the System. enough to a f f e c t the money market. I t was not u n t i l 1922 that they were large At that time i t became necessary to take steps to coordinate purchases and sales so that credit conditions for the country as a whole would not be adversely affected. Gradually these purchases and sales have become one of the most important means whereby the System can take the i n i t i a t i v e i n influencing credit conditions. The responsibility for determining what security transactions should be undertaken and the authority for enforcing a program were not clearly defined by law u n t i l the new banking act. At the time this act was passed an -15- X-9356 Open Market Committee consisting of representatives of the twelve Reserve banks v/as authorized to propose purchases and sales. I t s proposals were then submitted to the Federal Reserve Board, which had the authority to approve or disapprove but not to i n i t i a t e a policy. Even a f t e r purchases or sales by the Reserve banks had been agreed upon by the committee and the Board, the boards of directors of the twelve Federal Reserve banks throughout the country could frustrate the policy by refusing to participate i n i t s execution. The new act clearly places responsibility for determining open-market transactions on the new Open Market Committee and directs the Reserve banks to carry out the transactions determined by this committee. This i s one of the most important changes i n the Federal Reserve System which the new act introduces. Other work of the Board The Board of Governors has a variety of other duties which t i e i n with i t s general responsibility for supervision of the System. These include the examination of Reserve banks, passing on applications of State banks and trust companies for membership in the System, obtaining condition reports from State member banks, administration of those provisions of the Clayton Anti-trust Act which relate to interlocking bank directorates, regulation of the maximum rate of interest to be paid by member banks on time and savings deposits, regulations under the Security and Exchange Act governing the margin requirements for loans on securities l i s t e d on the stock exchanges, and maintenance and operation of the i n t e r - d i s t r i c t Gold Settlement Fund. In carrying out i t s responsibilities i t i s essential that the Board -16- X-9356 keep i n touch with banking developments i n d i f f e r e n t parts of the country. I n the organization of the System provision was made for regular contacts between the Board and the various Federal Reserve d i s t r i c t s . One of the class C directors a t each Reserve bank, designated by law as the Federal Reserve agent, represents the Board a t the bank and maintains an office of the Board a t the bank. The Federal Advisory Council, also provided by law, i s made up of representatives of each Federal Reserve d i s t r i c t and meets at least four times a year i n Washington to confer with the Board and to make recommendations. The Board also has meetings i n Washington with the chief executive officers of the Federal Reserve banks and with the Federal Reserve agents. Information bearing on credit policy I t has always been a part of the System's work to watch credit trends and to develop a better general understanding of the facts bearing upon credit policy. Information bearing on banking conditions throughout the country and on production, employment, trade and prices, has been regularly collected. In i t s monthly publication, the Federal Reserve B u l l e t i n , and i n i t s Annual Reports, the Board has undertaken from the beginning to give the public a comprehensive view of current banking and financial developments a t home and abroad and also to furnish detailed information on conditions of banks throughout the country and on the business situation. Each of the Federal Reserve banks also publishes a monthly review of the business and banking conditions i n i t s district. There i s no central bank i n the world which makes available such exhaustive information on domestic banking and business developments and on the