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For release on delivery
September 26, 10:00 AM (E.D.T.)

Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs

United States Senate

September 26, 1979

I am pleased to be here today to testify on several
bills designed to assure the capacity of the Federal Reserve
to conduct effective monetary policy over the years ahead.
Each of these bills aims to achieve that objective in a manner
consistent with fair and equitable ground rules for financial
institutions competing in providing depository services to the
The issues involved are old ones.

There have been many

proposals to deal with the so-called Federal Reserve membership problem and to restructure Federal reserve requirements
through the years, going back in my personal experience on the
Commission on Money and Credit twenty years ago.

The matter

has been under active, and sometimes contentious, consideration
in the Congress for more than three years, as the need has
become more evident.

Financial innovations, shifting competitive

patterns, strong inflationary pressures and related high interest
rates have all exacerbated existing competitive inequities,
have led to declines in membership in the Federal Reserve, and
ultimately threaten our ability to conduct effective monetary
Now, it is time to act.

Moreover, it is possible to act

with a minimum of controversy and maximum effectiveness.


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circumstances —
decades ahead.

not just in the immediate future, but for
This legislation would provide the most

important structural change in the Federal Reserve since its
foundation; once passed, it will not be lightly amended.


we look ahead in that long perspective, effective monetary
control will significantly benefit from broad coverage of
competing depository institutions and a reserve base sufficient
to support and transmit the effects of Federal Reserve monetary
actions through the financial system.
At the same time, we need to work toward evenhanded
treatment of all depository institutions insofar as they
compete directly and bear a reserve burden.
a matter of fairness.

It is not only

Evenhanded treatment, including broader

access to System services, rationally priced, can bring about
greater efficiency and more effective competition in financial

We should also assure that institutions bearing the

implicit cost of reserves do not gradually lose, for that
reason, business to others, thus narrowing the scope of Federal
Reserve control.
The manner in which reserves are presently applied is the
source of our present problem.

Members of the Federal Reserve

System are currently subject to a special burden —

from their

point of view, the equivalent of a special tax -- because they
must maintain substantial levels of reserves in non-interest
bearing balances at Federal Reserve Banks. Nonmember commercial
banks or other depository institutions —

even when their


business overlaps —

have no comparable requirement.


banks receive some offset to this burden due to their access
to System services, but all studies that have been made indicate
the value of these services is, for the bulk of members, not
sufficient to compensate for the earnings foregone on required
sterile balances.

In these circumstances, members leave the

System, narrowing our base of control.
The specific bills before you originating with members
of this committee have very different points of departure in
dealing with these issues.

S. 85, proposed by Chairman

Proxmire, would place mandatory reserve requirements on all
depository institutions, at the same time opening access to
Federal Reserve services to all depository institutions.
S. 353, proposed by Senator Tower, would instead preserve a
fully voluntary system, but would attempt to remove the burden
of membership by mandating that all balances held with the
Federal Reserve to meet such requirements earn interest at
nearly a market rate; access to System services would remain
restricted to members and other depository institutions
voluntarily maintaining reserves.

The legislation passed

by the House, H.R. 7, is a hybrid, initiating a mandatory
reserve structure and open access to services if a revised
voluntary structure fails to stem membership attrition.


This threshold question —

mandatory against voluntary

has been at the center of much past debate.


The voluntary

approach has always had a certain appeal to me and others —
it is the way the Federal Reserve has operated, and I suspect
it has helped encourage professionalism and efficiency within
the Federal Reserve.
I would not want to see those attributes lost.

But a

purely voluntary approach toward reserve requirements does
not seem to be practicable or possible at this time.
cost of eliminating the burden of reserves —
necessary in a voluntary system —
high —


as would be

would be relatively

apparently higher than the Administration or the

Congress would find tolerable.
to our services —
and elsewhere —

Full pricing and open access

a key consideration to many in Congress

would not be feasible.

Consequently, I

believe it is more fruitful to concentrate attention on the
mandatory approaches to reserves: S. 85, and the basic provisions
of H.R. 7.

That is consistent with the preferred position of

the Federal Reserve Board over a long period of time.
These two bills have consistent common elements.


common elements, with one important exception, provide an
appropriate framework for speedy resolution of the remaining


To the extent reserves are required, both
bills would apply them on a consistent basis
against comparable deposits or other accounts
in competing depository institutions.

The reserve structure would focus mainly on
transactions balances, the central element
in the money supply and monetary control..
Access to Federal Reserve services would be
open to all depository institutions, and the
Federal Reserve would be expected to recover
the full cost of those services from pricing.
Voluntary membership in the Federal Reserve
System, which would continue to have implications
for certain supervisory and regulatory matters
and for election of Federal Reserve Bank directors,
would remain.

My own understanding is that these basic, common approaches
have wide support among affected institutions.

What remains

to be done is to reconcile remaining differences and to provide
assurance that the Federal Reserve will in fact have an adequate
base of reserves in all foreseeable circumstances for the effective
conduct of monetary policy.


The Treatment of Transactions Balances
Both bills would extend reserve coverage of transactions
balances to all established depository institutions.


change is clearly consistent with the emergence of transactions
accounts at thrift institutions, the growth of which can be
expected to accelerate as the powers of those institutions
to operate such accounts are enlarged.

Such coverage assures,

first, that larger and larger portions of the basic money
supply of the nation will not escape direct Federal Reserve
influence; and second, that future competition in markets for
transactions deposits will be conducted without one institution
or another enjoying an unfair competitive advantage.

I would

note in that connection that financial technology does not
stand still, and the definition of a transactions balance


in principle, an account from which payments to third parties
can be made —

is critical.

For instance, we can now observe

burgeoning growth of money market mutual funds, many of which
now offer facilities for transfer by draft, raising the question
of whether such funds do not perform the economic function of
a transactions account.
Providing the Federal Reserve has authority to define
transactions balances, I believe concentrating the focus of
reserve requirements on those accounts is appropriate.



are, together with currency, the most active element in the
nation's money supply.

However, we need to remember that

non-interest bearing reserves do have the characteristic of
a tax on those deposits; a high tax will discourage use of
transactions accounts over time relative to other outlets for
liquid funds, lead to innovations in payment


outside the perimeter of the definition of defined trans- '
actions accounts, and promote the growth of money substitutes
entirely outside the traditional domestic banking system,
gradually impairing the base upon which the Federal Reserve

For that reason we should be wary of setting the

requirement too high.

The 12 percent ratio initially set

in S. 85 is slightly higher than the 11 percent of H.R. 7.
Even if the initial ratio were to be set as high as provided
in S. 85 in the interests of preserving Treasury revenue, I
believe that should also be the top of the permissible range,
as already specified in the House bill.
An important difference in the two bills lies in exemption

In S. 85, the reserve requirement would apply to all

transactions deposits regardless of the aggregate size of the
balances in an institution, although the reserve ratio is set
at only 3 percent for the first $5 million of such deposits.
In H.R. 7 the first $35 million of transactions deposits in
an institution are exempt from reserve requirements, and that


exemption would be ratcheted upward as deposits grow.


universal, virtually uniform ratio of S. 85 seems to us in
the Federal Reserve more congenial to the basic thrust of
both bills toward placing competing institutions on an equal

In practice, monetary control would not be significantly

impaired by exemption of a very small amount of transactions
balances for each institution.

However, at some point, an

exemption does have adverse implications for the reserve base
and effective monetary control.
This Committee and the Congress will need to resolve
this practical and philosophical question about the exemption
level; a requirement graduated downward for small balances is
one obvious possibility.

I would emphasize that most institutions

holding relatively small amounts of transactions balances
for commercial banks up to $10 to $15 million —


will in practice

be able to use cash held in their vaults to satisfy the requirements of S. 85 without cost; a more smoothly graduated reserve
ratio would in practice exempt even more.
Treatment of Time and Savings Deposits
Both bills would exempt all savings and personal time
accounts from reserve requirements.

Because of the strong

competition from other savings outlets outside the banking
system, that approach is strongly and understandably urged
by both banking and thrift institutions and is acceptable to


the Federal Reserve.

Both bills also provide authority to

apply such reserves against nonpersonal time deposits, but
there are important differences.
S. 85 seems to envisage a more or less permanent requirement on nonpersonal time deposits, starting at the substantial
initial level of 6 percent.

Such a permanent requirement poses

an important substantive problem.

Competition for funds flowing

into nonpersonal time deposits is intense and growing.


competitive handicap for covered institutions would be significant,
as it is today, when the commercial paper market, the Eurodollar market, and money market funds are growing rapidly.
A substantial permanent reserve requirement would also place
new burdens on thrift institutions.
For these reasons, the more practicable and desirable
approach would be to maintain limited authority for the use
of reserve requirements on short-term nonpersonal time deposits
on a standby basis as seemed to be contemplated by H.R. 7.
The circumstances for use should be exceptional, but not so
extreme as stated by a colloquy on the House floor which would
confine such use only to circumstances in which other countries
agreed with the U.S. to impose parallel requirements on Eurodollars.

For instance, there may be occasions when such authority

would be extremely useful to restrain excessively rapid growth
near-money and of bank credit, particularly by large institutions.
Moreover, the borderline between a transactions balance and a
very short-time deposit may become so fuzzy as to suggest more
equal reserve treatment.


The Question of Monetary Control and the Reserve Base
The key problem I have with the reserve structure
specified in H.R. 7 or in S. 85 (assuming, in the latter
case, no initial requirement on time deposits) concerns the
volume and distribution of reserve balances that would be held
in Federal Reserve Banks.

It is these balances, and only these

balances, that provide the "fulcrum" for the efficient conduct
of monetary policy.
A few numbers will give you a sense of the potential

Today, some 5,600 banks hold about $30 billion of

reserves at the Federal Reserve Banks, and those banks account
for some 70 percent of all commercial bank deposits.


H.R. 7, only 450 banks would keep any required reserves with
the Federal Reserve; reserve balances would total only about
$7-1/2 billion; and those 450 banks, while the largest in the
country, would account for only 54 percent of total commercial
bank deposits.
While S. 85 would provide much higher coverage, it would
achieve that result in large part by extending substantial
reserves to time deposits.

That arrangement, as I have just

noted, would create other serious problems if contemplated as
Viewed in another light, the ratio of reserve balances
at the Federal Reserve Banks to the total of deposits at all
commercial banks would drop to well below 1 percent under H.R. 7,
and to about 1-1/2 percent under S. 85 (without time deposits



These percentages are uncomfortably low, even on

operational grounds, considering the enormous volume of
clearings that go through the Federal Reserve Banks every

Large and erratic day-to-day fluctuations in such

operational factors as currency in circulation or "float"
arising from check clearings could, with a relatively low
reserve base, have magnified effects on the money supply
and weaken monetary control.
I know that the Committee has already heard theoretical
debates about whether reserve requirements are essential at
all to the conduct of monetary policy —
in such theorizing myself.

indeed I have engaged

But we in the Federal Reserve

have the practical responsibility of operating monetary policy,
and you will properly hold us accountable.

We are not interested

in committing ourselves to the conduct of monetary policy on the
basis of untested and controversial theorizing.
In that connection, foreign experience has often been
cited, including the fact that some industrial countries do
not impose legal reserve requirements.

A few of those countries

approach monetary control either by keeping their banks continuously in debt to the central banks, and maintaining close
control over the level of indebtedness as a method of control,
or by relying heavily on direct, quantitative controls on
bank liabilities on assets.
experience and traditions.

Both methods are foreign to our
Other leading countries, whether

by statute, convention, or tradition, de facto maintain a
significantly higher proportion of total commercial bank
deposits in central bank balances than would be provided by


the transactions account requirements of either H.R. 7 or
S. 85.
We cannot be certain precisely how large reserve balances
need to be to assure effective monetary control and a well
functioning banking system.

I feel quite sure we can do with

a smaller reserve base than we now have.

It is conceivable

that the reserve requirements implicit in a modified S. 85 or
in H.R. 7 may be sufficient, but I have grave doubts.


H.R. 7, 97 percent of the nation's banks would either be
exempt entirely or hold more than enough reserves in the form
of vault cash to meet their requirements.

Some technically

covered banks would voluntarily wish to hold more reserves
than required/ and that uncertain "excesi/1 differing from
bank to bank and varying over time, would loosen the relationship between reserves and deposits. As a consequence, the
ability of the Federal Reserve to control deposits by adjusting
the reserve base could deteriorate, perhaps severely.
I have discussed both with members of this Committee and
with representative industry leaders a practxcal approach for
dealing with this problem.

This approach would provide the

Federal Reserve with the assurance we need that reserve balances
will be adequate for monetary control and to support the nation's
depository system, while not significantly adding to costs of
banks and other depository institutions, disturbing competitive
relationships among them, or draining revenue from the Treasury.


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Committee, and the determination by the Board is renewed at,
say, 2 year intervals.
Arrangements would be made for nonmember banks and
thrift institutions to respond to a call for supplementary
deposits by dealing through established banking correspondents.
The law should, for instance, specify that such supplemental deposits
could be held with the Federal Home Loan Banks, in the case of
their member institutions, or the Central Liquidity Facility
of the credit unions.

The thrift institutions could, in turn,

be permitted to count these deposits toward meeting their
existing liquidity requirements, but the deposits would be
"passed through" to the Federal Reserve Banks so the funds
could become part of the reserve base.

Possible arrangements

of this kind have been reviewed with, and in principle are
supported by, the Federal Home Loan Bank Board and the National
Credit Union Administration Board.
It would make relatively little difference from the standpoint of monetary control whether these supplementary deposits
are determined as a percentage of transactions balances or of
all deposits held at institutions.

The maximum percentage

requirement would, of course, have to be judged against the
base of deposits to which it applied. For instance, a limit as
low as 2 percent would be adequate if the base were to be total
deposits, transactions and time. If transactions balances alone
are covered —
whole —

which account for only about 20 percent of the

the upper limits would need to be proportionately


higher, depending on exemptions and the level of requirements
determined elsewhere in the legislation, to assure an equivalent
reserve base. We would be glad to work with the Committee in
developing precise legislative language to meet the need in
the way best suited to all interests.
I would emphasize the receipt of earnings on the supplementary deposits at a market rate will/ over time, mean
that institutions should suffer very little, if any, loss in
earnings from any call for such balances.

If earnings are

determined by the return in the Federal Reserve portfolio,
those earnings will reflect a mix of long- and short-term

Yield fluctuations would be less volatile than

the yield on shorter-term securities alone because the portfolio yield varies less over time than does, say, the 3-month
bill rate.

In years of relatively high short-term-rates,

banks would be able to earn more by investing in the market
short-term, but the reverse is likely to be true in years of
relatively low short-term rates.
I must also emphasize a call for supplementary deposits
would have no effect on Treasury revenues.

In effect, the

Federal Reserve would simply add to existing security holdings
to match the increased liabilities to banks and other depository
institutions incurred from supplementary deposits held at
Reserve Banks.

These new security purchases would provide the

income to be transferred to the banks. And, the banks would
pay taxes to the Treasury in about the same amount as if there
had been no supplementary deposits.


Provision and Charge for Services
Both S. 85 and H.R. 7 provide broadened access to System
services, including the discount window, and a mandate to
charge for those services at prices adequate to cover costs,
including imputed capital costs and taxes.

In principle,

these provisions are acceptable to the Federal Reserve.
Intelligently implemented, we believe this approach can contribute to the efficiency, competition, and safety of the
financial system.

I would emphasize, however, that open

access and pricing is practicable only after reserve requirements are restructured and applied to all depository institutions
if we are to avoid exacerbating the cost burdens now placed on
member banks.
Substantial progress has been made within the Federal
Reserve toward developing pricing policies and schedules for
Reserve Bank services.

Those efforts will be pursued with

vigor. I should note that in this process, a number of difficult technical and policy problems —

problems familiar to

those engaged in the pricing of other public services where
there is an obligation not only to cover costs but to maintain
a minimum service level —

are apparent.

For that reason, I

would urge that the legislative language not unduly limit our
flexibility in pricing particular services, while retaining the
goal of full cost coverage.
Open access and pricing of System services likely will
induce major changes in existing banking relationships.

It may

have differential effects on large and small, or city and rural,



Moving too precipitously to put this new system

into place could cause disruptions in banking markets. Consequently, I would urge that the pricing provision allow some
flexibility in timing and implementation.

Moreover, it should

be clear that the Federal Reserve need not precisely match
costs and revenues for every service.

Indeed, the Board

questions whether a charge for the receipt and disbursement
of currency is appropriate at all.

The Government might-

normally be expected to provide that service, and in any event,
the Treasury already earns some $7 billion per year from the
provision of currency through securities held by the Federal
Reserve as collateral.
Collateral for Federal Reserve Notes
A technical problem regarding collateral against Federal
Reserve notes does arise in the bill.

Under existing law,

currency issued by the Federal Reserve must be secured by
certain assets of the Federal Reserve specified in the Federal
Reserve Act.

If no changes were to be made in this requirement,

the reserve reductions implied by the bills before you could be
technically unworkable for they might result in insufficient
amounts of government securities and other eligible financial
assets to meet the collateral requirements against these notes.
In mid-197 9, for instance, collateral in excess of currency was
only $13 billion.

In terms of deposits outstanding at that

time, balances at Federal Reserve Banks would be reduced about
$24 billion under H.R. 7 and roughly $14 billion under S. 85


without the reserve requirement on time deposits.


reduction in government security holdings in the Fed portfolio
that would have to accompany the decline in reserve requirements would leave the System with too few eligible securities
to meet the legal collateral requirements.
S. 85 would meet this collateral problem by permitting all
financial assets held by Federal Reserve Banks to stand behind
the Federal Reserve's currency liability and by eliminating the
requirement to collateralize notes remaining in the vaults of
Federal Reserve Banks.

This approach, while clearly meeting

the need, was rejected by the House apparently on the grounds
that it might open the way to the Federal Reserve acquiring a
broader range of assets.

To meet that objection, assets

eligible for collateralizing currency might be confined to
certain enumerated market-type assets that may already be held
by the Federal Reserve.
I would suggest.adding to the present list only
assets acquired abroad arising from time to time out of our
foreign currency operations —
amount —

a relatively small but fluctuating

while removing the requirement for collateral against

notes held by the Federal Reserve itself.

In that connection,

the Federal Reserve Act already permits us to hold foreign
bank deposits and bills of exchange; it would be helpful to us
operationally if short-term foreign government securities could
be added to our authorized holdings —

an omission at the time

of the original Federal Reserve Act when such securities were
not widely available.



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S.85 as modified would be quite moderate, if there were any
drain at all, after account is taken of the losses that would
be incurred by the Treasury due to that attrition.
the modification


I have proposed to S. 85 would probably

still leave the Treasury with a net gain in revenue over a
reasonable period of time. Moreover, I would also note that
the Federal Reserve has indicated its willingness to transfer
to the Treasury part of its $1 billion surplus to cover revenue
losses during the transition period.
This Committee has before it, in S. 85 and H.R. 7, nearly
all of the essential elements of constructive legislation.


hope you will agree that the major new provision I have proposed
today —

standby authority for "supplementary deposits" —


a useful and possibly essential "insurance policy" for monetary

I do not believe it should be controversial.

Consequently, the way seems to me clear for promptly
enacting legislation with the following main features:
First, reserve requirements should be placed
on transactions balances at all depository institutions.
Both S. 85 and H.R. 7 adopt this principle; what remains
is only satisfactory resolution of exemption levels and
the price level of the requirement.
Second, to assure an adequate reserve base for
monetary control and to support the nation's depository


system, legislation should provide an insurance policy
in the form of standby authority for "supplementary
deposits" at Federal Reserve Banks, with those
deposits earning a market rate of return.
Third, initial reserve ratios on nonpersonal time
deposits should be set at zero, as in H.R. 7, but with
the understanding that the Federal Reserve would have
some flexibility to apply reserves to short-term iioripersonal time deposits if needed to "protect" the
dividing line between transactions and time accounts
or for cyclical purposes.

There should be no reserves

on personal or long-term time deposits.
Finally, there should be full pricing and open
access to Federal Reserve services, with adequate
flexibility, in timing and application, to minimize
the risk of disruptions in banking markets and to
protect the availability of a basic level of payments
services to all institutions.
In passing through the lobby of the Federal Reserve Building
recently, I read again a quotation from Woodrow Wilson on the
wall referring to the original Federal Reserve Act:

"We shall deal with our economic system as it is
and as it may be modified, not as it might be if we had
a clean sheet of paper to write upon, and step-by-step
we shall make it what it should be."


A constructive blending of S. 85 and H.R. 7, combined
with the safety valve I have requested, can take a big step
toward developing a reserve structure as it should be.


basic issue is preserving a strong and effective central
bank able to discharge its responsibilities for monetary

The questions have been long debated, and I sense a

convergence of views.

Now, this Committee has the chance to

bring the long process to the edge of conclusion.
you to seize that chance.


I urge

(Based on December 1977 deposits; does not include effect
on Treasury revenue of halting membership attrition)


Nonpersonal Time
Other Time











H.R. 7
H.R. 7
Actual Mandatory Voluntary
Reserves (billions)

S, 85

Mod. 85




















Reserves Released


Cost of Reserve Requirement Changes (millions)—
Revenue from Service Charges
Revenue from Float ChargeH.'


Net Cost after Taxes (55 percent marginal rate)—
Number of Commercial Banks






With Required Reserves






With Reserves at Fed











Percent of Total Deposits
At Banks holding balances at Reserve Banks

Percent of Transactions Deposits
At Banks holding balances at Reserve Banks
£/ Members only.
b/ Includes $300 million of reserve balances of thrifts.
c/ Includes vault cash shift for members.
d/ Based on float outstanding of $3.8 billion in December of 1977.
el Cost estimate does not include offsetting benefit of halting membership attrition which
would result in a loss of Treasury revenues of about $200 million annually by 1985, assuming
attrition at midway between that experienced in the nation and that in New England during
September 25, 1979

Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102