View original document

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

75
Speech delivered before . . .
• ,, , ,
Seattle Convention, vAmeric&ri,TinstiT.ute of Ranking
Seattle, Washington
June 9. 1936

THE FEDERAL RESERVE SYSTEM AND THE BANKING ACT OF 1935
In speaking before the American Institute of Banking it is appropriate to stick to facts and fundamentals.
I want to describe the Federal Reserve System from the point of view
first of the Federal Reserve Banks and then from the point of view of the
Board of Governors in Washington, and in passing to .indicate such changes
as were effected by the Banking Act of 1935.
Federal Reserve Banks
The Federal Reserve Banks have direct relations with about 6,4.00
banks which are members of the Federal Reserve System. This is less than
half the banks in the country. However the banks which belong to the
System do about 70 per cent of the banking business of the country; and
the proportion of the total banking business handled by them has shown in
recent years a strong tendency to increase.
Holding Member Bank Reserves
The fundamental purpose of the Federal Reserve Banks is to hold reserves of member banks. Before the establishment of the System it was
long recognized that one of the greatest weaknesses of our banking was
the lack of a scientific system of reserves. The requirements for national banks thirty years ago, for example, just before the panic of
1907, - which had much to do with bringing about the establishment of the
Federal Reserve Banks - was that each country bank should keep reserves
of 15 per cent, of which at least 6 per cent was to be kept as cash on
hand and the rest on deposit in correspondent banks in reserve or central
reserve cities. National banks in reserve cities had to keep reserves of
25 per cent, at least 12g- per cent in cash and 12b per cent on deposit
with correspondent banks in central reserve cities. There were three
central reserve cities: New York, Chicago, and St. Louis. The banks in
these cities had to keep reserves of 25 per cent - all in vault cash.
The percentage of reserves which such banks are now recmired to keep
on demand deposits is 7 per cent for country banks, 10 per cent for reserve city banks, and 13 per cent for central reserve city banks; and on
time deposits all banks must keep 3 per cent.
The great difference, however, is that whereas at that time the banks
partly kept their legal reserves in their own vaults and partly kept them
with one another, and 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 in the Reserve Banks a means
of augmenting their reserves by the discount or sale of assets.
The Federal Reserve System substitutes a flexible arrangement for a
rigid one; and a bank with sound assets can no longer find itself without
the means of maintaining its reserves.

76
These conditions remain the same substantially as-1 they were in the
original act. With respect to the assets which a bank can discount at
the Federal Reserve Bank, however, the law has made important changes.
Lending Powers
The original act sought to encourage banks to make commercial loans
and it therefore definitely discriminated in favor of such loans by
limiting the class of paper eligible for discount. This comprises, in
the words of the act, "notes, drafts, and bills of exchange- issued or
drawn for agricultural, industrial or commercial purposes." Moreover,
such paper, to be eligible, had to mature in three months or less from
the time of discount, except that agricultural paper might mature in six
months.
Whatever the intention, this limitation did not in fact result in
a preponderance of such paper in the portfolios of banks. On the contrary eligible paper has showed for many years a tendency to occupy
relatively a smaller and smaller place among bank assets. In 1929 it
was only about 12 per cent of loans and investments of member banks, and
in 193^ it was only 8 per cent. This change is due to a variety of
factors. In the large it represents the fact that American banks, instead of specializing in any one type of credit, have tended to deal in
ail kinds of credit, .long term as well as short, required by their communities. The effect of this was to limit the power which it was originally intended that the Reserve Banks should have of enabling banks
with sound assets to maintain their reserves. Consequently, banks which
still needed to convert assets into reserves after having discounted
their eligible paper were often forced to dump other sound assets on the
market and get what they could.
The Banking Act of 1935 sought to correct this condition by amending the Federal Reserve Act1to authorize the Federal Reserve Banks to
make advances to member banks for nbt to exceed four months on any security satisfactory to the Reserve Bank. Previous legislation had already enlarged the lending powers of the Reserve Banks, but this change
went farthest by making it possible for a member bank to discount any
sound asset at the Reserve Bank regardless of type.
Currency
At the time the Federal Reserve Act was adopted, probably its most
important purpose in most people's minds was to furnish an elastic currency. The difficulties at which the System was aimed were thought of
mainly as currency problems and not as credit problems. It is now generally recognized, however, that the supply of currency is principally
a routine matter that presents no difficulties so long as credit and
banking conditions are 3ound.
This brings me to the matter of general credit control and to the
functions which pertain largely if not mainly to the Board of Governors
of the Federal Reserve System.

77

Discount Rates
The establishment of discount rates as authorized by the Federal Reserve Act is partly the responsibility of the Federal Reserve Banks and
partly the responsibility of the Board, of Governors. The Reserve Banks,
in the words of the act, are to establish the rates "subject to review
and determination of the Board". Since discount rates affect other rates
in the money market and since the rate in one district should take into
account the rates in other districts, the Board has to consider the question from the point of view of general credit conditions. It has, therefore, the final responsibility.
The Banking Act of 1935 strengthened the Board's power by requiring
that rates be established every fourteen days or oftener. It is not
necessary that the rates be changed every time, but they must, at least be
reviewed.
The great limitation upon discount rates as a means of general credit
control is that they are not effective except as banks voluntarily seek
to discount their paper. When the Federal Reserve.Act was adopted the importance of this limitati.on was not fully realized, and discount rates
were generally regarded as the most prominent means of credit control. At
the same time a device that is now regarded as most important received at
that time very little consideration. This is open market operations.
Open Market Operations
Open market operations are now regarded of great importance because
they are not subject to the limitation just referred to. They enable the
central banking organization to take the initiative instead of having to
wait on individual banks to take the initiative. Moreover, their effect
is comprehensive rather than local.
Open market operations consist of purchases and sales of securities mainly government securities - by the Federal Reserve Banks. By selling
securities the Reserve Banks withdraw funds from the market and there is
a decrease in the supply of credit, because as the securities are paid for
the reserves of member banks are diminished. By purchasing securities the
Reserve Banks put funds into the market, and tend to ease credit, because
their payments increase the reserves of member banks.
It was not till 1922 that open market operations became large enough
to affect the money market. As a result of war financing the Federal debt
had increased from one to twenty-six billions with a correspondingly large
volume of government securities. It then became necessary for the individual Reserve Banks to coordinate their purchases and sales. Accordingly a
committee was formed for that purpose. At the some time it was definitely
established that the purpose of the operations was not profit but control
of credit. The principle was as follows:
That the time, manner, character, and volume of open
market investments purchased by Federal Reserve Banks be
governed with primary regard to the accommodation of commerce
and business and to the effect of such purchases or sales on
the general credit situation.

78
The Banking Act of 1935 gave statutory recognition to the Federal
Open Market Committee, end forbade any Reserve Bank to engage in open
market operations except in accordance with regulations of the Board.
At the same time the Act adopted substantially the same statement oi
purpose as had already, governed the operations.
The Banking Act of 1935 went still further. It directed that the
Federal Ooen Market Committee should consist of all the members of the
Board of Governors and- five representatives chosen by the Federal Reserve
Banks regionally. This was a definite centralization of control.
Reserve Requirements
The Banking Act of 1935 increased the Board's power in another respect also by authorizing it to change the statutory reserve requirements,
which have already been mentioned. The Board may increase them to as
much as twice the present requirement, but may not lower them below x-he
present. This is a very important power because the volume of credit
which any member bank may extend is limited by the amount of reserves it
is required to hold.
Formerly this power could be exercised only in emergency and with
the approval of the President of the United States. The matter.is now
one simply of the Board's discretion.
Other Changes
The most important changes effected by the Banking Act of 1935 have
been covered in the foregoing. A few others may be mentioned.
The title "president" was given to the chief executive officer of
each Federal Reserve Bank instead of the former title "governor".
The o3d designation "Federal Reserve Board" was changed to "Board
of Governors of the Federal Reserve System", and the title of the chief
executive officer of the Board, which was formerly "governor", was
changed to "chairman".
The ex officio membership of the Secretary of the Treasury and the
Comptroller of the Currency was discontinued and appointment of seven
appointive members was authorized.
Other Activities
•

' The Federal Reserve Banks and the Board of Governors have a variety
of duties which cannot be mentioned in brief space. Notable among these
is the compilation and publication of information bearing on banking and
credit conditions, here and abroad, and including data on production,^employment, trade, and prices. In the Federal Reserve Bulletin, which is
published monthly, and in the Annual Report of the Board, a comprehensive
view is presented of the current banking and financial situation. Each
of the Federal Reserve Banks also publishes a monthly review and an annual report.

|
}

79

I
No other central banking organization in the world makes available
such comprehensive information on domestic banking and business developments, and on the considerations taken into account in formulating credit
policy, as does the Federal Reserve System,