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The Present Credit Situation ROY A. YOUNG Governor, Federal Reserve Board Published by F E D E R A L R E S E R V E B A N K of P H I L A D E L P H I A The Present Credit Situation Address delivered by ROY A. YOUNG Governor, Federal Reserve Board before the I N D I A N A BANKERS ASSOCIATION at its Annual Convention at Gary, Indiana September 20, 1928 The Present Credit Situation of Federal reserve banks have appeared before audiences so many times to describe currency, discount and other operations of the System that today I am going to digress somewhat and talk about the present credit situation. This is a large subject, but inasmuch as I am speaking to an audience that is quite familiar with banking practice, I feel I will be able to get over to you a concise story in the time that has been allotted to me. I n order to bring the picture up to date, it is necessary to review what has happened during the past eight years. Gold is the basis of our credit structure and while the gold standard, perhaps, has some faults, it is the best basis that has yet been devised and public faith in its efficiency has been demonstrated conclusively during the past five years by the willingness and eagerness with which many countries have returned to some form of gold standard. All that has happened for the past eight years, therefore, can best be reviewed by referring to gold movements. Since September 1920 and up to December 1924, gold flowed into the United States continuously, the net import movement for the period aggregating approximately $1,660,000,000. From September 1920 to the spring of 1922, the gold received from abroad was used largely by member banks to reduce their REPRESENTATIVES  The Present Credit Situation borrowings from the Federal reserve banks and thus improve the general condition of the member banks and the reserve position of the reserve banks. Generally speaking, gold received during this period did not, therefore, become a part of the reserves of member banks and did not form the basis of credit expansion. Between 1922 and 1924 gold imports were sufficient to meet the country's growing demand for currency, and in addition, to increase the reserves of member banks which were thus enabled to expand their loans and investments without increasing their borrowings at the Federal reserve banks. From 1924 to the spring of 1927 the gold imports just about offset gold exports, so that the total increase in gold holdings of our country between September 1920 and the spring of 1927 aggregated, as I have stated before, approximately $1,660,000,000. With this addition to the gold basis, through the inverted pyramid principle of credit, banks were able to expand tremendously. All of this growth, however, could not go into the old-fashioned forms of credit based upon production and distribution otherwise known as eligible paper, and therefore the banks had to seek other forms of credit. Naturally they turned to the investment credit market. With this stimulus and support from the banks throughout the country, the investment bankers accepted the opportunity and financed not only new enterprise by long-time credits,  The Present Credit Situation but old established enterprise as well, with the result that the proportion of eligible paper diminished in the portfolios of the banks while the proportion of investment credit held by the banks increased rapidly. For all the banks of the United States as of June 30, 1928, the figures are approximately as follows: U . S. Government bonds Other stocks and bonds Loans on securities (Of which amount $3,000,000,000 is represented b y so-called brokers' loans) Loans on real estate security Loans t o customers (Of which amount i t is estimated t h a t approximately $5,000,000,000 is eligible paper held b y member banks . Total loans and investments $ 6,000,000,000 12,000,000,000 13,000,000,000 5,000,000,000 20,000,000,000 $56,000,000,000 There has been some complaint of late that investment and speculative credit have not received their proportion of the bank credit available, but it seems to me from these figures—when you add the total amount of bonds to the total amount lent on securities and arrive at the total of $31,000,000,000— that these forms of credit have been treated liberally by the banks. All of this expansion of credit, up to May 1927, was accomplished without increasing the amount of Federal reserve credit, because the figures show that except for seasonal and holiday currency requirements, the total assets of the Reserve System have continued around $1,000,000,000 since 1922. I n May of 1927, however, something happened to which the American business public and financial  The Present Credit Situation interests did not attach sufficient importance. This was a reversal in the direction of gold movements. From May until the early part of November the Reserve System offset the exports of gold by purchases of U. S. Government securities, feeling that the time was not opportune to disturb our own domestic situation when the regular seasonal agricultural requirements were on and stabilization plans for some of our foreign friends were not completed —and stabilization of foreign currencies, indirectly, was of great importance to our domestic situation. During November and December, when gold continued to flow from this country, the System did not offset the export movements. This should have had the effect of retarding the rapid growth of credit, but it did not, largely because any increase in Federal reserve bank credit at that time was interpreted by the banks and the public as being in response to customary seasonal requirements, even though it had gone $200,000,000 higher than the year before. The return flow of holiday currency in the latter part of December and early part of January was greater than it had been in any year for five years and therefore the System sold additional Government securities to partly offset this return flow. Gold holdings changed but little during the months of January and February but credit expanded at more than the normal rate, and certainly there was no evidence that this additional credit was required for business.  The Present Credit Situation There is an impression i n the minds of m a n y people, including some bankers, t h a t a member bank deliberately borrows f r o m its reserve bank at a low rate t o enable i t to lend at a higher rate solely for the profit i n the transaction. I have been associated w i t h the System for ten years and I can say w i t h o u t fear of contradiction t h a t this seldom happens. W h a t does happen generally, however, is t h i s : A member bank accumulates deposits i n the ordinary course of its business and, if i t expects t o continue its business at a profit, i t must employ those funds almost instantaneously i n the credit field t h a t offers the best rates consistent w i t h safety. L a t e r i t has a reduction i n deposits and must replenish its reserve i n one of t w o ways. One is b y borrowing f r o m the Federal reserve bank and the other is by selling some of its readily marketable assets. I n the great m a j o r i t y of cases the member bank which has wide fluctuations i n its deposits borrows f r o m the reserve bank. B y doing this the bank avoids disturbing its portfolio and uses the reserve bank for the legitimate purpose of bridging over a temporary shortage i n reserves. N a t u r a l l y , when the rediscount rate is low and the open m a r k e t rate high, there is an incentive for the banker t o continue to borrow rather t h a n to curtail his investments. W h e n this practice becomes simultaneously general i t furnishes one reason, b u t only one, for raising the rediscount rates. There was evidence of this i n February, w i t h the [7) The Present Credit Situation result that a 4% rate was initiated by the directors of the various Federal reserve banks. However, credit continued to expand and the banks continued to borrow from the Federal reserve banks on rediscounts to make up the loss in gold and the sale of Government securities. No one particular bank was in debt any great length of time; in fact, the information we have in Washington is that the bank that borrowed to cover a loss of deposits got out of debt by liquidating some of its ineligible assets. When it did so, however, directly or indirectly, it made it necessary for some other bank to borrow and so the borrowings of member banks were passed around from one bank to another without reducing the total indebtedness of the member banks to the Federal reserve banks, but on the contrary, increasing it. Again, in April, the directors of one of the Federal reserve banks initiated a rediscount rate of This was eventually followed by all of the other reserve banks. By June the member banks owed the System approximately $1,000,000,000 upon rediscounts and were in a position where they could not get out of debt so readily by shifting the load from one bank to another; in fact, the load centered mostly in the larger cities. There was a rapid increase in discounts in the latter part of June and also in July, some of which, of course, represented currency requirements, but the increase had the earmarks of further pyramiding of credit and not of being the old The Present Credit Situation fashioned credit based upon production and distribution, with the result that some of the Federal reserve banks, where many of their member banks were heavy borrowers, initiated a rediscount rate of 5%. This action, however, was not taken in the four strictly agricultural districts west of the Mississippi River where a 4}/2% rate is still maintained, largely because the member banks were not heavy borrowers and because it was at the time of the year when legitimate seasonal agricultural requirements had to be met. From June up to the present time there has been but little change in the gold holdings of the United States. The System has not sold additional Government securities since that time and has undertaken no open market operations, except of a temporary nature. To summarize, the banking system of America built up a credit structure by resorting to the inverted pyramid principle of credit on $4,600,000,000 of gold which we held in May 1927, and today, on $4,100,000,000, it is not only supporting that credit structure but a much larger one. This is shown by the June 30 reports of member banks which indicate an increase above last year of $2,500,000,000 in loans and investments. To support this credit structure, member banks have found it necessary to increase their borrowings at the Federal reserve banks approximately $500,000,000. From this it seems to  The Present Credit Situation me t h a t the reserve banks are functioning j u s t as the law intended t h a t they should function. Miscalculations as t o the f u t u r e always have and perhaps always w i l l occur w i t h the banks and the business public and t h a t is one of the reasons w h y we need reserve banks, i n other words, institutions w h i c h enable the public t o adjust their miscalculations i n an orderly and systematic way. So m a n y factors have an influence on banking t h a t i t is a mistake t o arrive a t the conclusion t h a t the Federal Reserve System alone, t h r o u g h its policies, makes credit situations. I t is reasonable t o believe f r o m w h a t I have cited t h a t conditions, over m a n y of which the System has no control, f o r m the basis of reserve bank credit policies and rates. M a n y people i n America seem t o be more concerned about the present situation t h a n the Federal Reserve System is. I f unsound credit practices have developed, these practices w i l l i n t i m e correct themselves, and if some of the over-indulgent get " b u r n t " d u r i n g the period of correction, they w i l l have t o shoulder the blame themselves and not a t t e m p t t o shift i t t o someone else. Great concern is expressed over the mystery of Federal reserve policies. Dissatisfaction is expressed because the Federal Reserve System refrains f r o m prediction and can n o t always anticipate. I have stated to y o u t h a t conditions, to a large extent, b r i n g about Federal reserve policies rather than t h a t Federal reserve policies b r i n g about conrlO] The Present Credit Situation ditions. That is just the position of the System at the moment. If past experience means anything, we know that the additional reserve credit needed between now and December 31 will aggregate approximately $300,000,000. This will come from the usual seasonal requirements of agriculture and business. I t is the expectation of the System that this additional credit will be secured by the member banks rediscounting without hesitancy to take care of these requirements and that they will lend to their customers at reasonable rates. I t further expects that this additional reserve credit will not be used in further expanding a bank credit situation that grew up when our gold reserves were $500,000,000 larger than they are now and which has continued to grow while the reserves have been shrinking. If after January 1929 following the return flow of holiday currency, the banks still owe the System approximately $1,000,000,000 in rediscounts, I , personally, will feel that the situation has been handled admirably and I shall have no cause for concern, because with the tradition which the member banks have about borrowing continually from the Federal Reserve System, a debt to the System of $1,000,000,000 will have a more moderating effect upon the too rapid growth of bank credit than any other single condition that I know of. uu