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THE FEDERAL RESERVE SYSTEM ME- THE BANKING ACT OF 1955 ADDRESS BY M. S. SZYMCZAK, MEMBER BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM DELIVERED AT THE FORUM DINNER OF THE TRENTON CHAPTER OF THE AMERICAN INSTITUTE OF BANKING NOVEMBER 18, 1936 TRENTON, NEW JERSEY Z-ll Mr. Chairman and fellow members of the American I n s t i t u t e of Banking: I t gives me the greatest pleasure to v i s i t chapters of the American I n s t i t u t e of Banking and see the e f f o r t and interest devoted to improvement of the technique of banking. The a c t i v i t y of the i n s t i t u t e ' s chap- ters i s evidence of an i n i t i a t i v e that makes for progress. Bankers as never before are studying the technique of their business and developing their knowledge of the conditions affecting i t . Supervision of banking i n the public interest i s no deterrent to i n i t i a t i v e , for the desire of the supervisory authorities i s not to interfere with the banker's i n i - t i a t i v e but to cooperate with him i n every possible way for the improvement of American banking. A r e a l s p i r i t of cooperation is characterized i n the relations of your I n s t i t u t e , the American Bankers Association, and the Federal Reserve authorities. Out of the day to day contact of bankers with their customers in banking offices throughout the country, there arise certain broad questions of policy and practice, which, i n the public interest need to be followed by especially constituted authorities. These are questions that can only be seen i n the large and when one detaches himself s u f f i c i e n t l y from the day to day routine. I t i s from this point of view that I wish to speak to you about the Federal Reserve Banks and the Board of Governors and the duties they exercise with respect to the interest of the public as a whole i n the banking business. The Federal Reserve System i s not a commercial banking system, nor a savings bank system, nor an investment banking system. serves. I t deals with r e - I t i s a system which does not work for individual banks, but for the banking system as a whole. I t i s not a system operated for p r o f i t ; -2- Z-415 i t deals with reserves which must be held back a t certain times and u t i l i z e d at others i n order to correct extreme tendencies one way or other i n credit conditions. I t i s operated i n the public i n t e r e s t - as created by Congress - crossing a l l state l i n e s and covering the nation as a whole. I t s organization i s such that responsibility i s p a r t l y centralized and p a r t l y decentralized. Certain general r e s p o n s i b i l i t i e s are entrusted to the Board of Governors i n Washington and to the Federal Open Market Committeej regional r e s p o n s i b i l i t i e s are entrusted to the twelve Federal Reserve Banks. The cooperation between the central Board of Governors and the twelve regional Banks i s i l l u s t r a t e d by the f a c t that f i v e of the members of the Federal Open Market Committee are elected from the Reserve Banks and by the f a c t that discount rates originate in the d i s t r i c t s , even though they are subject to review and determination by the Board i n Washington. The System i s represented in the Federal Advisory Council which now consists of twelve bankers elected by the Boards of Directors of twelve Federal Reserve Banks. I t i s represented also in the conferences of presidents of the twelve*Federal Reserve Banks which are held periodically in Washington. There are many other System conferences i n the law department, exam- ination department, economic department, operating department and i n other fields. The System consists of 6,400 member banks. t i o n a l banks and 1,032 member state banks. These include 5,368 na- As you know a l l national banks are required to be members of the System. State banks may volun- t a r i l y make application for membership, and i f they q u a l i f y , are accepted -3- into the System. Z-415 Although the number of member banks i s less than half the banks in the country, they do about two-thirds of the banking business of the country. As you also know the member banks hold stock in the Federal Reserve Bank of their d i s t r i c t . Each subscribes to six percent of i t s capital and surplus - three percent of which is paid i n a t once and the other three percent may be called at any time. There are twelve Federal Reserve Banks located i n different sections of the country. There are also twenty-five branches of these twelve Fed- eral Reserve Banks, and two agencies. At each Federal Reserve Bank i s a Board of Directors, consisting of nine men. Six of these men are elected by the member banks and three are appointed by the Board of Governors of the Federal Reserve System i n Washington. One of these three men appointed by the Board of Governors in Washington, i s designated as Chairman of the Board and Federal Reserve Agent. The Federal Reserve Bankshave the power of selecting their presidents and vice-presidents. The Board has no power to force an unnacept- able candidate on the Federal Reserve Banks, but those selected by the Federal Reserve Banks must have approval of the Board of Governors i n Washington. This results in a more harmonious operation of the System, which naturally requires a meeting of minds between the directors of the bank and the Board in Washington in the selection of key o f f i c i a l s . The officers of the Federal Reserve Banks keep i n close touch with -4- Z-ll their member banks in order to insure that the service of the Federal Reserve Banks i s satisfactory and that their f a c i l i t i e s are f u l l y known. The officers of the Federal Reserve Banks as well as the members of the Board welcome criticism and constructive suggestions, for i t i s their desire to do everything within their authorized powers to make the services of the Federal Reserve Banks useful and valuable to their member banks. V i s i t s are also made to nonmember banks, i n order that no bank interested in becoming a member of the Federal Reserve System need f e e l doubtful as to what the conditions and advantages of membership are. Prior to the establishment of the System i t was f e l t that an outstanding weakness of our banking was the lack of a satisfactory system of reserves. As I said before the fundamental purpose of the Federal Re- serve Banks i s to hold reserves of member banks. Just prior to the panic of 1907 - which played a large part i n bringing about the establishment of the Federal Reserve Banks - each country national bank was required to keep reserves of 15 percent, six percent of which was to be kept as cash on hand. The rest was on deposit in corre- spondent banks in reserve c i t i e s or central reserve c i t i e s . National banks in reserve c i t i e s were required to keep reserves of 25 percent, at least 12 1/2 percent i n cash and 12 1/2 percent on deposit with correspondent banks in central reserve c i t i e s . New York, Chicago, and St. Louis constituted the three central reserve c i t i e s , ana the banks i n these c i t i e s had to keep reserves of 25 percent - a l l in vault cash. The percentage of reserves which such banks are now required to keep on demand deposits i s 10 1/2 percent for country banks, 15 percent for -5- Z-415 reserve c i t y banks, and 19 1/2 percent for central reserve c i t y banks. A l l banks must keep 4 1/2 percent on time deposits. The great difference, however, i s that whereas at the time the banks partly kept their legal reserves i n their own vaults and partly kept them with one another, they had no certain means of augmenting their reserves except when everything was easy. The banks now have to keep their legal reserves with the Reserve banks and they have i n the Reserve banks a means of augmenting their reserves by the discount or sale of assets. I t was the purpose of the original Federal Reserve Act to encourage banks to make commercial loans. I t d e f i n i t e l y discriminated in favor of such loans by limiting the class of paper e l i g i b l e for discount ( i n the words of the Act) to "notes, d r a f t s , and b i l l s of exchange issued or drawn for agricultural, industrial or commercial purposes." This paper, however, had to mature i n three months or less from the time .of discount, with the exception of agricultural paper, which might mature in six months. This l i m i t a t i o n did not in fact r e s u l t in an abundance of such paper in the portfolios of banks - on the contrary such paper, for many years, showed a tendency to occupy a r e l a t i v e l y smaller place among the bank assets. I n 1929 i t amounted to about 12 percent of loans and investments of member banks. I n 1934 i t was 8 percent. This shows that the American banks, instead of specializing i n any one type of c r e d i t , have dealt in a l l kinds of credit - long term as well as short - according to the r e quirements of their communities. The effect of this was to l i m i t the power which i t was originally intended that the Reserve Banks should have Z-ll of discounting for member banks which wished to replenish t h e i r r e serves • The Banking Act of 1935 sought to correct t h i s condition by amendment, which would authorize the Federal Reserve Banks to make advances to member banks f o r not to exceed four months on any security satisfactory to the Reserve Bank. Previous l e g i s l a t i o n had enlarged the lending powers of the Reserve Banks, but t h i s change made i t possible for a member bank to discount any sound asset a t the Reserve Bank regardless of type. Now you might ask - how can reserves be augmented o r , i n other words, b u i l t up - how can the banking system increase the amount of reserves available to i t at the Federal Reserve Bank? F i r s t , i t can do so by depositing currency, but t h i s i s not a practicable means, because the amount of currency required by the public i s a d e f i n i t e amount a t a given time and the banks cannot very well change that amount. Second - i t can do so by depositing gold. However, the a v a i l - a b i l i t y of gold i s not dependent on the action of the banks, but on the international flow of funds and the output of domestic mines. Sub- s t a n t i a l l y . therefore, increase of reserves can be brought about only by member banks borrowing a t the Federal Reserve Banks, or by the Fede r a l Reserve Banks buying securities or acceptances. of Federal When the amount Reserve credit increases, member bank reserves increase, and when member bank reserves increase, there i s o r d i n a r i l y a corresponding increase of several times that amount i n the volume of member - Z-ll 7 ~ bank deposits as the result of loans or purchases of investments by the member banks. On the other hand, when the volume of reserve bank credit diminishes either through the repayment of discounts by a member bank or through a sale of securities by the Federal Reserve Bank, there i s a loss of reserves which i n the absence of currency or gold movements can be made up only through a decrease in the banks1 loans and investments of several times the amount of the decrease i n r e serves. This i s the leverage through which the Federal Reserve System can influence the volume and cost of money. 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 Re- serve 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 c e r t i f i c a t e s at least equal to f o r t y percent of the notes i n actual circulation. The Federal Re- serve 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 l a s t year, the National banks continued to have the privilege of issuing National bank notes. The larger part of money i n circulation, however, consists of Federal Reserve notes. - 8 ~ Z-ll 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 f o r more cash than i t has i n i t s . v a u l t , i t can r e a d i l y 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 f o r 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 e l a s t i c currency i s important, but i t i s less important than the lending power, because, as you know, currency does not play a major r o l e i n present-day business transactions. About ninety percent of our business i s conducted by the use of checks. Currency i s used, f o r example, f o r purchases a t r e t a i l stores and f i l l ing s t a t i o n s , ' f o r car f a r e , and f o r payrolls, but such uses account for only about ten percent of the t o t a l monetary transactions i n the country. Such fluctuations i n the demand f o r currency as appear reg- u l a r l y on pay days, during the period of Christmas shopping, and near holidays, are met completely by the machinery provided by the Federal Reserve Act* Next I wish to mention a function of the Federal Reserve Banks whose existence and importance i s frequently overlooked. what they do as f i s c a l agencies. I r e f e r to As you know, the Federal Reserve Act provides that the Federal Reserve Banks "when required by the Secretary - 9 ~ Z-ll of the Treasury shall act as f i s c a l agents of the United States. 11 The duties which the Federal Reserve Banks perform under this provision always have been extremely important to the government, and i n recent years they have come to absorb a larger and larger part of the attention and time of the Federal Reserve Bank personnel. I n addition to servic- ing Or 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 Reconstruction Finance Corporation, the Federal Home Loan Banks, the Federal Home Owners1 Loan Corporation, the Farm Credit Administration, the Public Works Administration, the War Department, Veterans Administration and exi additional number of government agencies and bureaus. In the year 1935 the Federal Reserve Banks handled almost 69,000,000 Treasury checks and over 16,000,000 checks issued to work r e l i e f employees. This was an average of about 20,000 checks a day a t each of the twelve Federal Reserve banks. The transactions involved i n servicing government securities are of gre$t importance; they comprise receiving applications for new issues, delivery of securities to subscribers, exchanging securities of d i f ferent denominations, meeting maturities, and paying i n t e r e s t . During the year 1935 the Federal Reserve Banks delivered to subscribers a l most 1,600,000 bonds, notes, c e r t i f i c a t e s , and b i l l s sold by the Treasury, and redeemed over 4,000,000 d i f f e r e n t government obligations. Z-ll - 10 ~ 'They exchanged over a million obligations for the convenience of their holders and paid over 14,000,000 interest coupons. In the same year they prepared and mailed over 24,000,000 bonus bonds to veterans. Were i t not for the Federal Reserve Banks, the government vjould have to provide other agencies for the purpose of handling these operations at a substantially increased cost. I n addition to holding the reserves of the United States banking system, making loans to member banks, furnishing on elastic currency rchich automatically increases or decreases according to the public demand, simplifying the procedure whereby banks collect checks drawn on other banks, acting as f i s c a l agents of the Government i n connection with the issue and retirement of Government securities, e t c . , the Federal Reserve System has a certain national credit control through d i s counts, open market operations, direct action, reserve requirements, and margin requirements. DISCOUNTS: The Federal Reserve Act provides that each Federal Reserve Bank establish from time to time rates of discount, 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 i f deemed necessary by the Board." This does not require that such rates must be changed ev- ery time, but they must be regularly and frequently reviewed. The presumption behind discount rates i s that member banks w i l l -11- Z-415 borrow at the Federal Reserve Bank, and when they are borrowing, of course, discount rates have some force. The lower the r a t e , naturally the easier i t i s to borrow, and the more funds are supplied to the public, through the member banks, and through the nonmember banks. The higher the r a t e , the more d i f f i c u l t i t i s to borrow, and, therefore, the less funds are made available through the banks to the public. Originally at the time of the passage of the Federal Reserve Act, i t was thought that the banks would borrow, as a regular thing, a t the Federal Reserve Bank, and, therefore, the discount rates had more meaning. The rate was the thing that everybody watched f o r . Today the rate has significance of the cost of money, and l i t t l e more. As a matter of f a c t , banks do not borrow a t the Federal Reserve Bank unless they have to. When they have an excess reserve, they natu- r a l l y w i l l not borrow at a Federal Reserve Bank. When their reserves are just above, they w i l l not borrow, but when they get down to the point where they are below the required percent, they begin to watch the discount r a t e . OPEN MARKET OPERATIONS: The Banking Act of 19S3 gave specific authorization for the Federal Open Market Committee and adopted the following statement for the purposes of open market operations: "The time, character, and volume of a l l purchases and sales of paper described i n the section 14 of this Act as e l i g i b l e for open-market operations shall be governed with a view to accommodating commerce and business and with regard to their bearing upon -12- Z-415 the general credit situation of the country.11 The Act further provided that the seven members of the .Board of Governors of the Federal Reserve System should be members of the Committee and that there should also be f i v e members representative of the 12 Fedderal Reserve Banks. The Federal Open Market Committee meets i n Washington at least four times a year. Of course, i t also meets upon c a l l when conditions exist that must be met. Open Market Operations consist of the purchase and sale by the Reserve Banks of securities, mainly government obligations, for the purpose of increasing or decreasing the supply of credit available i n the money market as a whole. By selling securities the Reserve banks withdraw funds from the market and less credit becomes available. On the other hand, by purchasing securities the Reserve Banks place funds into the market and more credit becomes available. When the Reserve Banks s e l l securities the reserves of member banks become diminished i n the process of paying for the securities that are sold, whereas when they purchase securities, the funds which are released in payment flow d i r e c t l y or i n d i r e c t l y into the reserve accounts of the member banks and enlarge them. The Banking Act of 1935 gave statutory recognition to the Federal Open Market Committee. I t also prohibited any Reserve Bank to engage i n open market operations except in accordance with regulations of the Board. The purpose of the open market operations is not to make p r o f i t for -13- Z-415 the Federal Reserve Banks. DIRECT ACTION; Another means of credit control is by direct action. By this 1 mean efforts to discourage credit policies of given member banks i n given circumstances. This i s a policy of warning banks not to conduct certain operations or engage in certain credit practices, and of directing them to l i m i t the amount of money that they lend for certain purposes, particul a r l y speculative purposes. I f a bank continues to engage i n practices about which i t has been warned, there i s power given to the credit to the bank concerned. Board to stop further extension of And i f the bank continues with the practice c r i t i c i z e d , there i s power granted to effect the removal of the officers responsible. Direct action i s aimed a t the correction of specific conaitions i n particular banks; also for the purpose of enforcing general credit policy. RESERVE REQUIREMENTS: The Banking Act of 1935 gives the Board of Governors power to i n crease, when necessary, the reserve requirements, and thereby to check at any time an excessive use of c r e d i t , but the Board i s not permitted to lower them below the original requirements of thirteen, ten, seven percent on demand deposits, and three percent on time deposits, nor increase them to more than twice that amount. Naturally the result of raising the rates would be to decrease the lending power of member banks and the ajnount of available credit, whereas -14- Z-415 the lowering of rates enlarges the lending power and the amount of a v a i l able credit. This power formerly could be exercised only in emergencies and with the approval of the President of the United States. I t i s now one simply of the Board's discretion. MARGIN REQUIREMENTS: There i s s t i l l another means of credit control - i t has to do with the lending of money on registered securities, by brokers, dealers, and by member and non-member banks. Authority for the Board to issue regu- lations governing this form of credit control was granted by the Securi t i e s Exchange Act of 1934. Under this authority the Board has issued Regulations f? T" and tfU". Regulation "T" governs the extension and maintenance of credit by brokers and dealers i n securities for the purpose of purchasing or carrying securities. Regulation "U" governs loans made by banks for the purpose of purchasing or carrying stocks registered on exchanges. The power given the Board to impose and relax restraints upon the demand for credit for speculative purposes is aimed at a particular use of credit and at the specific channels through which demand for i t becomes e f f e c t i v e . I t extends the powers of the Board outside the Federal Reserve System to reach directly brokers and nonmember banks. I t d i f f e r s from the powers of discount, because while these powers may be exercised to discriminate against paper d i r e c t l y involved i n speculative uses, they cannot -15- Z-415 prevent the speculative use of funds procured by the discount of paper not directly involved i n speculation. I t also d i f f e r s from the power to conduct open market operations which influence the t o t a l amount of funds, but not the uses to which they can be out. true of the power to a l t e r reserve requirements. The same thing i s Direct action can be used to discriminate against the speculative use of credit, but only i n individual cases. I n margin accounts, however, the regulation i s directed at an unmistakable objective and cannot miss affecting the speculative use of credit. Although the means I have discussed by which credit control may be exercised might appear comprehensive and powerful, I do not wish to convey the thought that a perfect control of credit is effected through them. Their application cannot be mechanical nor governed by unvarying rules. Credit and economic relationships are extremely i n t r i c a t e and circumstances under which the need for action arises are always to some extent different and special. 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. Although i t i s true that the System includes most of the large banks and that i t , therefore, includes the bulk of the banking business of the country, s t i l l from the point of view of the communities they serve and of relations with other banks, the importance of the thousands of small banks which are outside the System is not negligible. For another thing, United States Treasury a c t i v i t i e s must be taken -16- into account. Z-415 These have to do i n part with the operations of the Ex- change Stabilization Fund and the issue of circulating media, e . g . , coins, silver c e r t i f i c a t e s , and United States notes; and i n part with the public debt, and the government's receipts and expenditures. These operations involve large aumeg 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 i s , for example, the recent great movement of gold to the United States from abroad - a movement that in the l a s t two years has added over three b i l l i o n dollars to the reserves of member banks and created a quite unprecedented credit situation. These factors, among other?, necessarily l i m i t and modify the exercise of credit control. Credit control i s a very technical matter. I t i s essential, how- ever, and i f the important objectives of credit control are to be achieved, their general purpose must be understood. ?Jhile I have uiscussed the more important changes effected by the Banking Act of 1935, there are a few others that might be mentioned for the sake of completeness. 1) The chief executive officer*, of each Federal Reserve Bank i s designated president instead of governor, and the deputy governors are designated vice-presidents. 2) The Board has authority to waive in whole or in part the statutory -17- Z-415 requirements relating to the admission of State banks to membership i n the Federal Reserve System, i f such waiver i s necessary to f a c i l i t a t e the admission of any State bank which i s required to become a member i n 1942 i n order to be an insured bank or to continue to have i t s deposits insured. 3) The old designation of the Board as the Federal Reserve Board i s changed to Board of Governors of the Federal Reserve System. At the same time an important change i n the composition of the Board was brought about. The Secretary of the Treasury and Comptroller of the Currency are no longer members of the Board. The number of members i s whose terms are for fourteen years. now seven, No member having served a complete term of fourteen years can be reappointed. The Act provides that such members shall be appointed by the President with the advice and consent of the Senate, and the President i n making the selection shall have due regard to a f a i r representation of tho f i n a n c i a l , agricultural, industrial, and commercial interests, and geographical divisions of the country. The t i t l e of the chief executive o f f i c e r of the Board i s now Chairman, i n stead of Governor. 4) Each of the seven Board members is a Governor. The Board i s required to keep a complete record of the action taken by i t and by the Open Market Committee upon a l l questions of policy, ;:aid of the reasons underlying such action, and shall include a copy of the records i n i t s annual report to Congress. 5) Provision i s made for the purchase and sale by the Federal Re- serve Banks of direct obligations of the United States and obligations which are f u l l y guaranteed by the United States without regard to -18- maturities, only i n the open market. Z-415 This prevents purchases of issues of government securities from the Treasury. 6) National banks may make real estate loans up to 50 percent of the appraised value of the mortgaged property for periods not exceeding five years; except that i f the loan i s on an amortization basis i t may be made up to 60 percent of appraised value and for a term of not longer than ten years. Real estate loans must not exceed the capital and sur- plus of the bank, or 60 percent of the bank's time and savings deposits, whichever i s greater. As you know, the Board i n Washington i s constantly in touch, through our Federal Reserve Banks, with the general credit conditions of the country. We have data supplied us by the Federal Reserve Banks1 s t a t i s - t i c a l departments, and we have our own research and s t a t i s t i c a l department in Washington, which presents facts and figures constantly, so that we know what i s going on. We compile and publish information bearing on banking and credit conditions, here and abroad, and include data on production, employment, trade, and prices. We also publish the Federal Reserve Bulletin, a monthly publication, and the Annual Report of the Board, i n which is presented information on the current banking and financial situation. Each of the Federal Reserve Banks also publishes a monthly review and an annual report. No other central banking organization i n the world makes available such comprehensive information on domestic banking and business developments. -19- Z-415 This information i s of v i t a l importance, especially to bankers. I wish to emphasize particularly the importance of i t as related to the operations of the Federal Reserve System. I n that connection I am glad to know that many chapters of the American I n s t i t u t e of Banking are giving courses on the Federal Reserve Systemj and at the I n s t i t u t e graduate school of banking at Rutger ! s a course on the System w i l l be given beginning next summer by Dr. Burgess of the Federal Reserve Bank of New York. I t has been a genuine privilege to be with you this evening. I hope my v i s i t i s evidence of the sincere desire of the Board of Governors and of the Federal Reserve Banks to cooperate with you as individual bankers, as members of the American I n s t i t u t e of Banking, and as members of the American Bankers Association in the development of an ever improving technique of banking i n the interest of the public.
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