THE FEDERAL RESERVE SYSTEM
THE FEDERAL RESERVE ACT[287]
THE SPIRIT AND OBJECTS OF THE ACT
The primary purpose of the Federal Reserve Act of December 23, 1913, is
to make certain that there will always be an available supply of money
and credit in this country with which to meet unusual banking
requirements. Banks of a new class, to be known as Federal Reserve
Banks, are to be established, and upon these banks is to rest the heavy
responsibility of supporting the structure of credit in periods of
financial strain. The new banks are expected to keep themselves in a
condition of such strength in ordinary times that the other banks may
safely rely upon them for all needed cash and credit in emergencies. In
the past, the banks in this country, when subjected to financial
pressure, have relied mainly upon loan contraction and the selling of
securities. In future it is expected that they will resort to the
Federal Reserve Banks, securing additional funds from these by
rediscounting commercial loans. If the new arrangements work well, loans
in future will not be reduced merely for the purpose of strengthening
the banks. Loan contraction will take place only when there is evidence
of an over-extended condition of business; and even then contraction
will be carried through gradually, so as to conserve all interests so
far as may be possible. Under the new system a most important influence,
if not the most important single influence determining the character of
banking operations, will be just the reverse of what it has been in the
past.
To meet the heavy responsibilities placed upon the Federal Reserve
Banks, two things are absolutely essential--good management, and ample
powers and resources. Good management cannot be secured with certainty
by means of legislative provisions, however carefully designed with that
end in view. In the particular instance of the Federal Reserve Act, an
ingenious combination of government and banking influence in selecting
the management is provided. Purely banking operations are very largely
to be handled by boards of directors, a majority of the membership of
which is to be chosen by banks. General supervision, and for some
purposes control, is placed with the Federal Reserve Board, which is to
be appointed by the President of the United States, by and with the
advice and consent of the Senate. Experience alone can determine the
wisdom of these arrangements for securing effective management.
The Federal Reserve Banks are to exercise wide powers, and would seem
likely to have ample resources. The country is to be divided into not
less than eight, nor more than twelve districts, in each of which a
federal reserve bank is to be established.[288] All national banks are
required, and qualified state banking institutions are invited, to
subscribe to the capital of the reserve bank in their district.
Subscribing banks, to be known as member banks, are required to keep a
part of their reserve with their Federal Reserve Bank. These banks will
presumably receive most if not all of the general funds of the United
States Government. They will provide an elastic currency, issuing notes
secured by their commercial assets. They are also empowered to undertake
the business of collecting, and clearing checks throughout the entire
country, thus providing an organization for making settlements between
banks in different places, the lack of which has been one of the most
serious defects in our banking system.
Each Federal Reserve Bank will be a central bank for the section of the
country which it is to serve. It will have all the responsibilities and
most of the powers of central banks in the various European countries;
but largely because the system is to be superimposed upon a fully
developed banking system, some important provisions of the Federal
Reserve Act are unlike anything to be found in European legislation. The
Federal Reserve Banks are to receive deposits from the Government and
from member banks only. Ordinarily they will lend to member banks only.
All European central banks, though the bulk of their business is with
banks and bankers, may deal with the general public and do so. The most
striking divergence from European example, however, is the really novel
plan of a system of regional banks in place of a single central bank.
But the extent of this divergence is generally exaggerated. Political
boundaries are indeed in large measure economic and financial boundaries
as well; but central banks in the European countries do act and react
upon each other, often working in harmony, and yet at times very much at
cross purposes. If all Europe were brought under a single government,
very likely the various existing central banks would be merged into a
single institution. In some respects this would be advantageous, but it
would not be absolutely necessary. Certainly European arrangements are
not so fundamentally unlike those of a system of regional banks in a
single country of great size, as to afford ground for the opinion that
in setting up this system foreign experience has been altogether
disregarded.
The various considerations which led to the adoption of the plan for
regional banks, rather than a single central institution, deserve
careful attention, since they indicate the spirit and purpose of the
Federal Reserve Act. A single central bank was the solution of the
banking problem reached without a dissenting voice by the members of the
National Monetary Commission. The bill which the commission prepared was
a notable achievement. Pioneer work though much of it necessarily was,
very few defects on the technical banking side were disclosed in the
discussion which followed the statement of the proposed measure. Its
provisions regarding banking operations, including relations with other
banks, are embodied with few changes of an essential character in the
Federal Reserve Act. Most of the important differences between the bill
and the Federal Reserve Act reflect differences in spirit and purpose
rather than in methods. A central bank and also the system of regional
banks necessarily involve placing somewhere very extensive power to
influence and control credit. In the present temper of public opinion,
the possession of great economic power is not tolerated in the absence
of a large measure of government supervision and control. But
unfortunately, in framing its measure the monetary commission failed to
realize the fundamental importance of this consideration as a factor in
securing general public approval. In devising a form of organization,
competent management and approval in banking circles were evidently the
controlling factors. An organization was proposed under which out of
forty-five directors, but three were to represent the Government, the
remainder being selected in various ways by bankers. Support from some
who were the most bitter opponents of the measure might have been
secured if the bill had provided for a larger measure of government
control; but an equal or even greater number of adherents would probably
have been lost. Under the plan of the commission and indeed under any
central bank plan, government supervision and control cannot be made
effective without at the same time placing the details of operation in
charge of government officials. Few of the most ardent advocates of a
central bank were prepared to take this extreme step.
Under the plan of organization of regional banks, the difficulty of
combining government control and private management vanished. Purely
banking matters, such as the granting of loans, could be placed with
boards entirely or mainly composed of persons selected by the bankers
whose funds were to provide most of the necessary resources. On the
other hand, supervision and whatever measure of control might be deemed
advisable, could be placed with a board mainly or entirely appointed by
the President of the United States. Differences of opinion may be
entertained regarding the particular arrangements in the Federal Reserve
Act for selecting the various administrative bodies, and regarding the
division of power between the directorates of the federal reserve banks
and the Federal Reserve Board. If experience should disclose defects in
this form of organization, it is flexible enough to permit at any time
an extension of government or of banking influence.
Another important advantage of the regional system is to be noted. The
operation of a central bank would be far more likely to give rise to
sectional antagonism. This danger was apparently fully realized by the
members of the National Monetary Commission, and elaborate arrangements
for selecting the management were devised in order to make certain that
each section of the country should be properly represented. But
obviously regional banks, managed by local people, are very much more
certain to meet this requirement. Apparently it was an endeavor to
remove still further the danger of sectional dissatisfaction that led
the Monetary Commission to make its one serious departure from sound
banking principle in framing its bill. A provision was inserted
requiring rediscounts to be made at a uniform rate throughout the entire
country, regardless of the wide differences in the demand and supply of
capital, which occasion the existing wide differences in lending rates.
Under the regional plan no such indefensible provision was found
necessary. This important feature of the Federal Reserve Act outweighs
such advantages in economy of resources and effectiveness in management
as were sacrificed in substituting for a central bank the regional
banks.
The Monetary Commission in framing its bill seems to have been guided by
two principles generally wise in legislation--the scope of the measure
was limited to the single purpose of removing purely banking defects in
our banking system, and no greater departure from existing arrangements
was proposed than was essential for the purpose in hand. The Federal
Reserve Act certainly runs counter to the first of these principles. Its
primary purpose is similar to that of the bill of the monetary
commission; but a secondary purpose evidently exercised a potent
influence. This purpose was to decentralize credits by lessening the
concentration of banking funds in a few large banks in the chief
financial centers, and especially in New York. The regional system
itself gained much support because it was believed by many that it would
lessen the financial predominance of New York City. No comprehensive
scheme of legislation with this object in view was inserted in the bill;
but wherever two or more means of accomplishing the primary purpose of
the bill were open, that one was evidently selected which it was
believed might tend toward decentralization. In general the desire to
decentralize credits explains why the act makes very much greater
changes in existing arrangements than were proposed in the bill of the
Monetary Commission. In the latter, the practice of depositing a part of
the required reserves of the banks with reserve agents was left
undisturbed. Under the terms of the Federal Reserve Act, such deposits
are to be reduced by successive installments, and discontinued entirely
three years after the passage of the act. From a purely banking point of
view, much can be said for this great change; but it was certainly not
absolutely necessary in order to secure the desired improvements in the
working of our banking system.
The new banking institutions for which the Federal Reserve Act makes
provision cannot be put in successful operation (and in this it
resembles the bill of the Monetary Commission) unless a considerable
number of the existing banks enter into relations with them. An
institution might have been established with large capital, and a
monopoly of the right of note issue, authorized to act as government
fiscal agent, and to deal with the general public. Such an institution
would presumably in the course of time have become a central bank, the
main reliance of other banks in emergencies. In order to avoid
competition with existing banks, the act provides that the receipt of
deposits by the Federal Reserve Banks, and their normal lending
operations shall be confined to those banks which subscribe to the
capital and maintain balances with them. Obviously, then, if banks in
large numbers do not accept the arrangement, subscribing to the capital
and relying upon the new banks for accommodation, the system cannot be
put into effective operation. Moreover, it is necessary that many banks
shall enter the system at the outset. An attitude of hesitation would
change to one of positive distrust, if the initial response were
inadequate.
In the case of the bill of the Monetary Commission, reliance was placed
simply upon the attractiveness of the measure. No bank would have
suffered positive loss from failure to enter the system, though certain
slight inducements were held out to those banks which accepted the
arrangement at the outset. Whether a sufficient number of banks would
have entered that system, if it had been established, may be thought
probable but is not certain. Bankers are naturally and properly a
conservative class and the inclination of many would have been to wait
until the system was in successful operation. The attitude of bankers
toward the Federal Reserve Act while it was passing through Congress was
distinctly unfavorable. Most of its provisions already referred to, as
well as others in which it differed from the Monetary Commission bill,
were disliked. It was evident that in the absence of positive pressure,
the number of banks which would accept its terms would be too small to
make successful operation possible. No attempt was made, however, to
insert provisions which would bring pressure upon state banking
institutions. Perhaps it would be possible, either under the inter-state
commerce or the postal clause in the Constitution; but it would have
been contrary to the constitutional traditions of the party in power,
and it was not necessary. If the national banks very generally enter the
system, the resources of the Federal Reserve Banks will be sufficient to
test the effectiveness of the measure. Accordingly the Federal Reserve
Act contains a number of provisions designed to bring pressure to bear
upon these to enter the system immediately. Failure to accept the terms
of the act within one year after its passage involves forfeiture of the
national charter. This alone would be no great business sacrifice, since
banking in most States is quite as profitable under a state as under a
national charter. Loss of the national charter, however, involves a loss
of the right to issue bank notes and calls for the deposit of lawful
money in Washington equivalent to the amount of outstanding circulation.
Most national bank notes are secured by 2 per cent. government bonds,
the price of which, in the absence of the circulation privilege, would
be perhaps about two-thirds of the price (somewhat above par) at which
they were purchased by the banks. No considerable number of national
banks could refuse to enter the system without involving themselves in a
heavy immediate loss. A further provision in the act puts more immediate
pressure upon the national banks in reserve cities. If within sixty days
after the passage of the act, a reserve agent bank fails to signify
acceptance of its terms, it must cease to exercise the reserve-holding
right upon thirty days' notice from the Federal Reserve Board.
Many bankers bitterly condemned the compulsory features in the act while
it was on its passage through Congress. This feeling was perfectly
natural, but it was not very generally shared outside banking circles.
Impartially considered, the act imposes no unreasonable burden upon
those who have invested capital in national banks. No one fears the loss
of the funds which may be subscribed to the capital stock of the federal
reserve banks or placed on deposit with them. If loss should be
incurred, it would be primarily due to unsound banking on the part of
the boards of directors of the Reserve Banks, a majority of the
membership of which is to be chosen by the banks themselves. Some
bankers have doubted whether the act would prove an effective measure of
banking reform; but few if any have felt that results under its
operation could possibly be more unsatisfactory than those under the
present system; and all agree that it is a long step toward a perfected
system.
ORGANIZATION
The new system is to be organized under the supervision and direction of
the "Reserve Bank Organization Committee," consisting of the Secretary
of the Treasury, the Secretary of Agriculture, and the Comptroller of
the Currency. The most important function of this committee is to
determine, "with due regard to the convenience and the customary course
of business," the number and area of the Federal Reserve districts into
which the country is to be divided, and to designate the city in each
district in which a Federal Reserve Bank is to be established. Not less
than eight, nor more than twelve districts are to be created. This is a
most difficult task. However carefully the initial lines of demarcation
may be drawn, more or less modification is to be expected after there
has been some experience with the working of the system. Changes in area
of districts, and additional districts if the organization committee
designates less than twelve, may be made at any time in the future by
the Federal Reserve Board. While the rivalry of cities may tempt the
committee to start the system with a larger number, it is to be hoped
that it will be found feasible to begin with no more than eight or nine
districts. The problems which will confront the management of the
Federal Reserve Banks are in many respects unlike those with which our
bankers have had experience. A somewhat higher average of capacity in
the management may more confidently be looked for if the smaller number
of banks is established. Moreover, especially at the outset, mere size
will contribute not a little to the prestige of the banks, and so
inspire public confidence in the new system. A greater variety of
occupations in large areas will lessen, though not much, extremes of
seasonal variation in demands for accommodation upon the federal reserve
banks. Then, too, the task of the Federal Reserve Board in supervising
and co-ordinating the system will be materially simplified, if the
minimum rather than the maximum number of federal districts is decided
upon.
Within sixty days after the passage of the act, in other words before
February 22, 1914, national banks are required, and properly qualified
state banks are invited, to signify their acceptance of the terms of the
act. Within thirty days after the reserve districts have been
designated, each national bank must subscribe to the capital of the
reserve bank of its district an amount equal to 6 per cent. of its
capital and surplus. One-sixth of this subscription is to be paid at the
call of the organization committee, another sixth within three months,
and still another within six months thereafter. The remaining half of
the subscription may be called at any time by the Federal Reserve Board.
All these payments are to be made in gold or in gold certificates. It
will be observed that the exact time when the system will be established
is uncertain. The organization committee is only required to designate
the reserve districts as soon as is practicable; thirty days is then
allowed for the banks to subscribe; and payments will begin sometime
thereafter at the call of the committee....
After the minimum capital (four million dollars for any federal reserve
bank) has been subscribed, the certificate of organization is to be
executed by any five member banks designated for the purpose by the
organization committee. The final duty of the committee will be to
supervise all arrangements for the election of the six of the nine
directors of each Federal Reserve Bank, who are to be chosen by the
member banks. For electoral purposes the banks of each district are to
be divided into three groups--each group to "contain as nearly as may be
one-third of the aggregate number of the member banks ... and as nearly
as may be banks of similar capitalization." While the number of banks in
each group will be the same, the capitalization will be very different.
All the banks with a capitalization above the average in a district will
certainly be in one group; those of somewhat less than average capital,
in the second group; while the third group will be composed of banks
having a very small capitalization. Under this ingenious arrangement, it
is evident that the direct influence of the banks of the large cities in
selecting the directorates of the Federal Reserve Banks is limited.
Local alignments are also avoided. On the other hand, this is not a
grouping to which the banks have been accustomed in the past, and
therefore there is some uncertainty as to whether at the outset it will
be conducive to the selection of capable directorates.
Each group of banks is to choose two directors: a Class A director, who
is to be an active banker representing the stock-holding banks, and a
Class B director, who must be actively engaged in commerce, agriculture,
or some other industrial pursuit in his district. The board of directors
of each member bank is to elect a district reserve elector. Candidates
for the position of director of a Federal Reserve Bank may be nominated
by any member bank; but nomination is not necessary. Electors are to
signify their first, second, and other choices for one director in each
class on a preferential ballot.
In addition to the six directors chosen by the banks, three directors
(Class C) are to be appointed by the Federal Reserve Board. Two of these
must be persons of "tested banking experience," one to serve as chairman
of the board of directors and district reserve agent, the other as
deputy chairman and deputy reserve agent. These reserve agents are the
official representatives of the Reserve Board, through whom it will
exercise its powers of supervision and control over the reserve banks.
The act contains no provision regarding the officers to whom the
operation of the banks will be entrusted. Presumably each board of
directors will appoint one of its members (probably one of the Class A
directors) as president and manager. The term of office of all directors
is three years, but at the outset they are to be classified so that the
term of one director of each of the three classes shall expire annually.
The appointment of Class C directors will be the first duty of the
Federal Reserve Board; inasmuch as the organization of the system can
hardly be completed before the beginning of the summer, the appointment
of this board could be deferred until that time. The selection of these
directors for each of the eight or more Federal Reserve Banks is,
however, no small task in itself; and since public confidence in the new
system will largely be based at the outset upon the character of the
Federal Reserve Board, its early selection is much to be desired.
The Federal Reserve Board itself is to consist of seven members: the
Secretary of the Treasury and Comptroller of the Currency _ex officio_,
and five members appointed by the President of the United States by and
with the [advice and] consent of the Senate. Of the five appointed
members, at least two must be persons experienced in banking or finance.
Not more than one shall be appointed from any federal reserve district,
and due regard is to be given to the different commercial, industrial,
and geographical divisions of the country. The term of office of the
appointed members is ten years; but those first selected are to serve
one for two, one for four years, and so on, so that the term of office
of one member may expire every two years.
Under this arrangement a majority of the board, in the absence of death
and resignation, will never be reconstituted at any one time. Each
President will select two of the appointed members: one in the second
year of his term of office, and one in the fourth. The Secretary of the
Treasury will, of course, be a new member appointed at the beginning of
each presidential term. The term of office of the Comptroller of the
Currency is for five years, so that here a variable element is
introduced. It may happen that some Presidents will never appoint more
than three members during their term of office. Generally, however, each
President will appoint four members; but the last appointment, giving a
majority on the board, will not be made until his final year of office.
Lack of continuity and the possibility of a political board were much
greater under the provisions for selecting the Federal Reserve Board
which were in the measure at various stages while it was passing through
Congress. The arrangements finally adopted would seem to make it
reasonably certain that the Federal Reserve Board will be free from both
these defects.
Organization of the system will be complete[289] with the selection of
the members of the Federal Advisory Council. This Council is to consist
of as many members as there are Federal Reserve districts, the board of
directors of each Federal Reserve Bank selecting one member. The
function and powers of the council are purely consultative. It is to
meet regularly four times each year at Washington, and at other times
there or elsewhere if deemed necessary by the Council itself. It is
authorized to confer directly with the Federal Reserve Board, to call
for information, and make oral or written representations concerning
matters within the jurisdiction of the Federal Reserve Board. It may
prove to be an important part of the organization, but this does not
seem probable. With a scattered membership and holding regular meetings
only at long intervals, it is not to be expected that the Council will
be in close touch with the Federal Reserve Board, or in a position to
formulate policies and urge them effectively. From individual members of
the Council, the Federal Reserve Board should secure valuable
information regarding conditions in different parts of the country; but
the work of the council itself as an organized body seems likely to be
of a formal and perfunctory nature. The importance of the Council would
doubtless have been measurably increased if the proposal had been
adopted that its chairman should sit, even though without a vote, on the
Federal Reserve Board.
CAPITAL, EARNINGS, DEPOSITS OF THE FEDERAL RESERVE BANKS
Since the capital stock of each of the Federal Reserve Banks is to be
exactly 6 per cent. of the capital and surplus of the member banks in
its district, it will always be subject to slight variations. If all
national banks enter the system at the outset, the total subscribed
capital of the Federal Reserve Banks will be a little more than one
hundred million dollars. Subscriptions may perhaps fall somewhat below
this amount, since with the exception of the reserve agent banks, no
penalty attaches to failure to subscribe until twelve months after the
passage of the act. Few state banking institutions will enter the system
at the beginning. In many states legislation is necessary to permit them
to invest in the stock of the Federal Reserve Banks, and to enable them
to count balances with the Federal Reserve Banks as a part of their
required reserves. It is to be presumed also, that such institutions,
since they can enter at any time, will wait to see whether the system is
working to the satisfaction of neighboring national banks.[290]
There will always be wide differences between the capital and other
resources of the various Federal Reserve Banks. Neither the capital nor
the resources of existing banks can be made the basis for dividing the
country into Federal Reserve districts. Geographical consideration will
necessarily require the creation of a number of districts in sparsely
settled parts of the country, in which banking resources are
comparatively small. No Federal Reserve Bank may, however, be
established until it has a subscribed capital stock of at least four
million dollars. It would, therefore, seem to follow that the
organization committee is precluded from forming any district in which
6 per cent. of the capital and surplus of the national and state banks
is less than this minimum amount. There are indeed provisions in the act
designed to meet the contingency of failure by banks to subscribe in
sufficient numbers to provide a minimum capital; but they would not seem
to authorize the organization committee to create districts in which
resort to these provisions would be inevitable.[291]
Whether the capital of the Federal Reserve Banks is large or small is a
matter of no great importance. Subscriptions to capital provide a
comparatively small part of the resources of banks. The capital is an
indication that those conducting a bank have something at stake, and is
also a margin of safety against loss to depositors. These Federal
Reserve Banks are, however, to accept deposits from banks only, and are
ordinarily to confine their dealings to the banks. In these
circumstances, there is practically no difference between the funds
which the federal reserve banks will secure from member banks in payment
of subscriptions to capital stock, and the funds which will be deposited
with them by member banks. The depositors are the stockholders and,
therefore, there is no separate interest to be protected by a margin of
safety.
Shareholders in the reserve banks are entitled to a cumulative dividend
of 6 per cent. A limited dividend is obviously wise, since it tends to
eliminate the profit-making motive in the management. Whether all the
Federal Reserve Banks will regularly earn the 6 per cent. dividend is,
of course, not certain; but it seems highly probable, since the danger
of serious losses is remote, and interest will presumably not be paid to
the member banks on their balances. All earnings in excess of the
dividend are to be paid to the Government of the United States as a
franchise tax; but half of these surplus earnings are to be paid into a
surplus fund until it has become 40 per cent. of the capital stock.
Whatever is received by the Government from the Federal Reserve Banks is
to be used at the discretion of the Secretary of the Treasury, either to
increase the gold reserve against United States notes or for the
reduction of the interest-bearing debt.
The federal reserve banks will doubtless secure very large resources
through the deposit with them of the moneys held in the general fund of
the Treasury of the United States, although no power over the
disposition which shall be made of these funds is granted either to the
Federal Reserve Banks or to the Federal Reserve Board. Entire discretion
remains with the Secretary of the Treasury. He may continue the
independent treasury system without change; he may continue to deposit
funds with member banks, just as hitherto he has placed deposits with
national banks; and finally he may deposit with any or all of the
Federal Reserve Banks, using them as government fiscal agencies. The
responsibility of the Secretary of the Treasury is in no way changed.
Almost certainly in practice, however, the bulk of the free funds of the
Government will be placed with the Federal Reserve Banks, and doubtless
the opinion of the Federal Reserve Board will determine the distribution
of these funds between the various banks.
The lion's share of the cash resources of the Federal Reserve Banks will
come from the reserves and working balances deposited with them by
member banks. Under the terms of the act, part of the required reserves
of member banks _must_ be placed with Federal Reserve Banks. This is a
novelty in central banking legislation, but is based upon sound
principle, and is especially to be commended for this country where, on
account of the absence of branch banking, the number of banks to be
served by the regional banks will be very great. It makes certain some
increase in the resources of the Federal Reserve Banks, along with the
expansion of the credit liabilities of the member banks. It also lessens
somewhat the danger of unnecessary withdrawals of funds from the reserve
banks in emergencies.
Reserve requirements of the national banking law are radically changed.
In addition to the requirement that a part of the reserve of the banks
be kept with the Federal Reserve Banks, the reserve ratio is reduced for
all classes of banks: the practice of keeping a part of the reserve of
country and reserve city banks with reserve agents is to be
discontinued; and a distinction for reserve purposes is made between
time and demand deposits. Some of these changes become effective as soon
as the new system is established; others are to be made in a succession
of steps and completed three years after the passage of the act.
Time deposits are to comprise deposits payable after thirty days, and
are to include certificates of deposit and savings accounts subject to
thirty days' notice. A reserve of 5 per cent. is required against these
deposits, and no distinction is made between country and city banks.
This low reserve requirement will certainly lead the banks to encourage
the conversion of demand obligations into time obligations. A relatively
large part of the deposits of banks in most European countries is
payable at notice. It is obviously an arrangement which shields the
banks somewhat from the effects of sudden waves of distrust.
Against demand deposits the ratio of reserves is also to be reduced at
once; but the existing classification of banks is to be retained. The
required ratio for country banks is reduced from 15 to 12 per cent., for
reserve city banks, from 25 to 15 per cent., and for central reserve
city banks from 25 to 18 per cent. A provision in the bill excluding
from reserves the 5 per cent. fund held in Washington against
outstanding circulation is a slight offset to this reduction in reserve
ratios.
As regards the banks in central reserve cities, the initial arrangement
regarding the disposition to be made of their reserve is also the
_final_ arrangement. They must hold 6/18 of their reserve in vault, 7/18
in their Federal Reserve Bank, and the remaining 5/18 either in vault or
with their federal reserve bank. Other banks are allowed a period of
transition. Reserve city banks for three years must hold 6/15 of their
reserve in vault, thereafter 5/15; for twelve months they must keep with
their Federal Reserve Bank 3/15, adding an additional 1/15 every six
months; so that at the end of two years they will have a deposit of
6/15. During the three year period the remainder of the reserve may be
deposited with reserve agent banks in a central reserve city, or by what
would seem to be an inadvertent extension of existing practice with
those in reserve cities; but thereafter it must be either in vault or
with a Federal Reserve Bank. Country banks must hold in vault 5/12 of
their reserve for three years, thereafter 4/12; for twelve months must
deposit with their Federal Reserve Bank 2/12, and an additional 1/12
every six months until 5/12 are deposited at the end of two years. The
remainder of the reserve may be kept for three years with reserve agent
banks, but at the end of that period must be either in vault or in a
Federal Reserve Bank.
Whether these changes in reserves, together with payments by the banks
of subscriptions to the capital stock of the reserve banks, will make
necessary any considerable amount of loan contraction, cannot be
precisely determined. If numbers of state banking institutions enter the
system at the beginning, some strain may be occasioned, since, although
these requirements are less than those to which the national banks have
been subject, they exceed those imposed upon banks by the law of many of
the states. In order to enable the banks to avoid contraction, the act
contains a provision under which one-half of each instalment of reserve
to be placed in reserve banks may be received in the form of the kinds
of commercial bills of exchange which the reserve banks may purchase in
the open market. It is, however, most unlikely that the banks will be
able to make much use of this arrangement, because of the scanty amount
of such paper available.
FEDERAL RESERVE NOTES AND NATIONAL BANK NOTES
The power to issue notes is a useful but not indispensable resource for
institutions having the responsibilities which are placed upon the
Federal Reserve Banks. The issue of notes by a central bank enables it
to supply domestic requirements for currency without reducing its
holdings of reserve money. In the absence of the right of issue, it
would only be necessary to accumulate in ordinary times a somewhat
greater amount of reserve money, to provide for seasonal and emergency
needs. General public confidence in the Federal Reserve Banks would,
however, be far less secure if they were not empowered to issue notes.
This is because of the exaggerated importance almost universally
attached to the right of note issue, even in countries in which the
check has become a universal medium of payment.
The particular provisions in the act regarding the issue of notes are
extremely complicated, and are in some respects quite without precedent.
The notes for which provision was made in the bill of the Monetary
Commission were to be bank notes pure and simple, subject to a variety
of restrictions designed to keep the total amount issued within safe
limits. The notes which are to be issued under the provisions of the act
are certainly quite as well safeguarded in this respect. In addition,
the notes are made obligations of the Government of the United States,
which also undertakes to redeem them at Washington. The obligation of
the Government is in addition to and does not take the place of any
banking safeguard. It is designed to meet the desires of the very large
number of people throughout the country who believe that the issue of
money is a government function. To many bankers and others familiar with
our past financial history, this provision in the bill was most
distasteful. Their opposition, though natural, was, however, neither
very practical nor reasonable. It was based very largely upon the fear
that the government obligation on the notes would prove an entering
wedge for an issue of fiat money at some future time. But paper money
cannot be issued under the terms of the act for the purpose of meeting
government expenditures. Additional legislation would be necessary, and
the possibility of such legislation is not appreciably increased by
making the notes which are to be issued by the reserve banks an
obligation of the Government. On the other hand, this provision won many
friends for this important piece of banking legislation; it allayed
opposition which would always have been a serious menace to the
permanence of the new system.
The quantity of the new notes which may be issued is wholly within the
control of the Federal Reserve Board; but the initiative in taking out
circulation rests entirely with the boards of directors of the reserve
banks. Applications for notes may be made at any time by a reserve bank
to its district reserve agent, the member of its board of directors who
is the medium of communication between the bank and the Board.
Rediscounted commercial loans equal in amount to the notes applied for
must be deposited with the agent, and a reserve in gold of 40 per cent.
must be maintained. (A reserve of 35 per cent. in gold or lawful money
is required against deposits.) The Board may grant in whole or in part,
or reject entirely, applications for notes, and may also impose such
interest charge upon the notes as it may deem advisable. The notes are
to be a prior lien on the assets of the issuing banks, and there is,
therefore, no possibility of loss to note holders, nor any to the
Government on account of the obligation which it assumes.
Such part of the 40 per cent. gold reserve against the notes as may be
deemed advisable by the Secretary of the Treasury, but in no case less
than 5 per cent., must be deposited in the Treasury of the United States
for the redemption of the notes in Washington. Each Reserve Bank is
required to redeem not only its own notes but also those of the other
Reserve Banks either in gold or in lawful money; redemption in
Washington is in gold alone. In practice it is certain that Reserve
Banks will redeem the notes in gold over the counter; and it is also
certain that slight use will be made of the redemption machinery at
Washington. Member banks will certainly deposit the notes with their own
reserve banks, which are required to accept the notes of other banks at
par. The reserve banks, in turn, are required under the law to return
for redemption the notes issued by other reserve banks. Redemption at
Washington has apparently been provided because national bank notes are
redeemed there in large volume every year; a result of the circumstance
that the present number of issuing banks is so large as to make counter
redemption much more costly.
Various provisions in the act are evidently designed to keep the issue
of notes within safe limits; but not much reliance should be placed upon
them. Reserve Banks may not, under penalty of a prohibitive tax of 10
per cent., pay out the notes of other Reserve Banks. If these banks,
like the Scotch banks, were working in the same territory, regular
redemption would check over-issue on the part of any one of them. But
under a system of regional banks, each with its own territory, there
will be only a very irregular relation between the amount of notes put
out by any one and the amount which will be received by the others.
Moreover, it should be borne in mind that regular redemption is no check
whatever upon general expansion, either in the form of notes or of
deposits, when all banks are expanding credit at the same time.
Not much effect also in checking over-issue is to be looked for from
those provisions in the act which require a 40 per cent. reserve in gold
and impose a graduated tax upon reserve deficiencies. A considerable
part of the total reserves of the Reserve Banks is certain to be in
gold; and deposit liabilities are certain to be vastly greater than
those for notes in circulation. The circumstances are hardly conceivable
in which a Reserve Bank would not have an amount of gold in its entire
reserve ample to provide a gold reserve for such notes as it might
issue. The special tax on note reserve deficiency can therefore be
readily evaded by shifting the deficiency to the reserve against
deposits. Deficient reserves are only allowed when reserve requirements
are suspended by the Federal Reserve Board. The Board is to impose a
graduated tax on all deficiencies except in the note reserve. On note
reserve deficiencies, the tax imposed in the law is to be added to the
rate of discount of the reserve banks. The arrangement would seem to be
a most unworkable one, since there is no means of knowing to what extent
a borrowing bank will have occasion to use the proceeds of its loan in
the form of notes. Fortunately this provision of the act is never likely
to become operative.
After all, for proper use of the right of issue under the act the main
reliance must and should be on wise and experienced management for the
reserve banks, and above all on a conservative Federal Reserve Board.
Restrictions which would make over-issue impossible would also deprive
the right of issue of all usefulness as a means of extending credit.
Moreover, the danger of the over-expansion of credit in the form of
deposits is vastly greater than it is in the form of bank notes in any
country in which deposit credits have become the more important credit
medium.
One of the most perplexing questions that presented itself in framing
the act was the disposition to be made of the national bank notes and
the 2 per cent. government bonds which secure very nearly all of them.
When the measure reached the Senate, it contained provisions which
contemplated the gradual substitution of Federal Reserve notes for the
national bank notes. But when it was pointed out that this would require
the Reserve Banks regularly to rediscount at least seven hundred million
dollars of commercial paper, in order to support the existing volume of
currency, it was felt that some other arrangement must be made. A plan
to unify all the varieties of paper money now in circulation, with the
exception of the silver certificate, by the issue of an equal amount of
United States notes, backed by an ample gold reserve, found influential
support; but it was wisely decided to present this in a separate
measure. The particular provisions regarding the national bank notes and
the bonds contained in the act should be regarded, therefore, as a
temporary arrangement pending future legislation.
In order to avoid the contraction of the currency which would follow the
refusal of many national banks to enter the system, each Reserve Bank is
authorized to purchase bonds and take out circulation similar in all
respects to the notes issued by the national banks. After the end of a
period of two years, additional bonds may be purchased, but only from
member banks, and at the discretion of the Federal Reserve Board. Member
banks desiring to retire circulation and dispose of their bonds, may
make application to the Board, which may require the Reserve Banks to
purchase them. No more than twenty-five million dollars of bonds may be
purchased in any one year, and the amount purchased is to be distributed
among the various Reserve Banks in proportion to their capital stock.
Bonds thus purchased may be used as a basis for additional national bank
notes by the reserve banks, or they may be converted into 3 per cent.
government obligations--one-half into thirty-year 3 per cent. bonds, and
one-half into one-year 3 per cent. notes, both issues without the
circulation privilege. In taking the one-year notes, a Reserve Bank
enters into an obligation to purchase an equal amount at each successive
maturity for thirty years. The purpose of the notes is to provide the
Reserve Banks with a readily marketable asset, the sale of which abroad
may prove serviceable in periods of strain, and the domestic sale of
which will enable the Reserve Banks to make their discount rates
effective in the money market. Government short-term obligations are
used for these purposes by many of the European central banks.
The existing volume of national bank notes will not be reduced under the
terms of the act, except in so far as the Reserve Banks convert 2 per
cent. bonds into 3 per cent. bonds or notes. There may even be some
slight increase in the total of national bank notes in circulation,
since banks may use for this purpose the small quantity of bonds not
already absorbed in this way. Little concern, however, need be felt
because the national bank notes are not to be retired. Present
requirements for money to be used outside the banks are sufficient to
absorb all the notes at present; and with the growth in population a
somewhat greater quantity could be absorbed in future.
LENDING OPERATIONS OF THE FEDERAL RESERVE BANKS
The normal lending operations of the Federal Reserve banks are limited
to the rediscounting for member banks of commercial loans maturing
within ninety days. Commercial loans are generally defined in the act as
"notes, drafts, and bills of exchange arising out of actual commercial
transactions; that is, notes, drafts, and bills of exchange issued or
drawn for agricultural, industrial, or commercial purposes, or the
proceeds of which have been used or are to be used for such purposes."
The Federal Reserve Board is authorized to define more precisely the
nature and character of eligible paper. To make assurance doubly sure,
the rediscount of loans secured by stocks and bonds is specifically
prohibited. The act also provides that six months' maturities of paper
drawn and used for agricultural purposes or based on live stock may be
rediscounted.
In confining rediscounts to commercial loans, the act is more stringent
than that governing the operations of central banks in Europe. In
practice, however, the bulk of the loans of these institutions are in
connection with commercial transactions. While this restriction may in
some particular emergency hamper the Reserve Banks in giving assistance
to some threatened bank, it is upon the whole amply justifiable. Under
our banking system in the past the collateral loan has enjoyed a
prestige which it is hoped will be transferred to commercial loans.
Exclusion of collateral loans from rediscount will certainly contribute
much to bring this about. The restriction also gives the public greater
confidence that the resources of the Reserve Banks will be generally
available throughout the entire country.
One of the reasons which has been advanced for confining rediscounts to
commercial loans is based upon certain misconceptions of the true nature
of commercial paper--misconceptions which, if adopted by the management
of the Reserve Banks in formulating their policy, may have disastrous
consequences. It has been contended on all sides during the last few
years that commercial paper was from its very nature liquid; and
further, that credit could therefore safely be granted to an extent
limited only by the amount of such paper. Both of these contentions are
hopelessly fallacious. In an emergency, no kind of loan is liquid to any
considerable extent. Business cannot suddenly be deprived of the amount
of credit to which it has become adjusted. It is, indeed, often said
that loans based upon any commodity entering into general consumption
can be quickly liquidated. This can be done as regards any particular
loan; but supplies for the immediate and distant future must be in
process of production and they will require a new batch of loans. The
view that credit can be safely granted to the full extent of merchandise
in process of distribution and even in process of manufacture is equally
fallacious. Credit affects price. Liberal discounts may cause
speculative advances in commodity prices, stimulating excessive prices
by wholesalers, jobbers, and retailers, as well as by speculative
holders pure and simple. There is no mechanical or statistical test for
the amount of credit which may be safely granted, whether the loans be
commercial or collateral. Over-expansion is possible by both operations.
Commercial loans will become the most liquid asset that member banks can
hold, simply because they can be rediscounted with the Reserve Banks. A
smaller amount of Bank funds will be employed in the call loan market.
But whatever amount remains available for that use will be subject to
far less seasonal fluctuation both in volume and in rates. The retention
of fixed reserve ratios, even though they may be suspended by the
Federal Reserve Board, will probably lead many city banks to use the
call loan market to a moderate extent, since it will enable them to
avoid the necessity of resorting to the reserve banks for rediscounts
whenever reserves momentarily drop below legal requirements. A somewhat
larger proportion of time loans will doubtless be used in connection
with stock exchange dealings; but the available supply of call money
will presumably be sufficient to permit the continuance of the present
American practice of daily delivery of securities.
At the outset, on account of the widespread prejudice among bankers
against rediscounting, the demand for accommodation from the Reserve
Banks may not be large; but this prejudice will surely die away in time,
and most if not all of the Reserve Banks will suffer from no lack of
regular business, except in periods of business depression. Member banks
in those parts of the country in which the supply of credit is
inadequate for local requirements will lend more closely, while banks
which regularly have more funds than can be thus employed will purchase
more commercial paper from note brokers and perhaps rediscount for banks
in those parts of the country in which rates are normally high.
Aside from the government account, member banks are to provide the funds
for the reserve banking system. Competition with member banks would
therefore and justly occasion serious dissatisfaction. Managed by boards
of directors a majority of the membership of which is to be selected by
the member banks, there would seem to be little danger of serious
competition from the Reserve Banks. Nevertheless the act places such
restrictions upon dealings by the Reserve Banks with the general public
that little or no competition will be possible.
The Reserve Banks are permitted to engage in three kinds of open market
operations: (1) dealings in government securities, and also in
obligations of the states and local bodies, maturing within six months
and issued in anticipation of taxes; (2) dealings in foreign exchange;
and (3) dealings in domestic bills of exchange.
The purchase and sale of government bonds and notes and state and local
short-term obligations require no detailed consideration. In periods of
inactive demand for rediscounts, investments of this kind will doubtless
be made by the Reserve Banks in order to employ surplus funds.
The right to engage in foreign exchange dealings will also be similarly
useful, surplus funds being invested in foreign bills. Moreover, if any
of the Reserve Banks find that their resources are regularly in excess
of domestic requirements, they may be used to facilitate the financing
of the foreign trade of the country with domestic capital. It is also
very generally believed that the power to engage in foreign exchange
operations may be so used that it will be possible to rely upon securing
abundant foreign funds in periods of financial strain. This is most
unlikely. It is entirely possible for a small country to rely upon
holdings of foreign bills as a means of influencing the foreign
exchanges, and even for such supplies of gold as may be needed on
occasions when confidence is threatened. But the banks of a large
country must rely mainly upon domestic resources, since the amount of
cash and credit needed in an emergency is too great to be secured from
foreign money markets. It should be the policy of the Reserve Banks to
maintain themselves in a condition of such abundant strength as to be
wholly independent of foreign assistance. Moreover, if they maintain
strong reserves in ordinary times, they will not be disturbed on account
of gold exports. Gold exports amounting to fifty, or even a hundred
million dollars should not be made the occasion for obstructive measures
such as are adopted by many of the European central banks. Measures of
this kind are generally an indication that the credit structure rests
upon an inadequate foundation. New York has been a free gold market in
the past, and even under our imperfect banking system, there has always
been a sufficient amount of gold for every banking purpose. Moreover,
restrictions placed upon gold movements can have but temporary effects;
in the long run the distribution of gold among the various commercial
countries is determined by fundamental influences which override all
such artificial barriers.
The act permits only one kind of banking business between Reserve Banks
and the general public. They are allowed to buy and sell to or from
individuals, firms, and corporations, as well as domestic and foreign
banks, bills of exchange of the kinds which are made eligible for
rediscount. The purpose of this provision in the act is to enable the
Reserve Banks to secure some employment for their funds when the demand
for rediscounts slackens, and to develop a broad discount market. A
broad discount market may be developed under the new banking
arrangements; but the prediction is ventured that this provision in the
act will not contribute to its development and that in general it will
be barren of results. It should be observed that the promissory note,
the usual borrowing instrument in this country, although it may be used
for rediscounting purposes, cannot be bought and sold in the open market
by the reserve banks. Aside from foreign trade, the mercantile bill of
exchange, payable at a future date, has largely fallen into disuse in
most advanced commercial countries. More and more cash payments are
either insisted upon, or are favored by the offer of trade discounts for
cash considerably greater than bank discounts. When a purchaser pays
cash, obviously a mercantile time bill of exchange cannot come into
existence. In European countries, many purchasers who pay at once often
draw a bill of exchange on their own bank and, after it has been
accepted, discount it in the open market. In this country banks are to
be allowed under the act to accept only bills drawn in connection with
merchandise exports and imports. Material will, therefore, be lacking
for a broad discount market, if its development is dependent upon open
market operations by the Reserve Banks.
Fortunately the development of a broad discount market does not require
open market operations on their part. A broad discount market is one to
which many borrowers resort with full assurance that they will find many
lenders. Even under past banking arrangements, many borrowers and
lenders have been brought together through note brokers; but owing to
the lack of an available supply of cash and credit with which to meet
emergencies, this market has been subject to violent perturbations, and
at times dealings have been almost entirely discontinued. In the future
a solvent borrower will feel more certain that his paper can always be
marketed by his note broker; and banks will purchase more largely, since
they will prefer to use such paper for rediscounting purposes rather
than that of their own regular customers.
ADDITIONAL POWERS OF NATIONAL BANKS
Nearly half of the national banks have established savings departments
and now hold more than eight hundred millions of savings deposits. This
has been a recent development, and one for which there was no specific
authority in the national banking law; but under the liberal
interpretation of that law by the Comptroller of the Currency in recent
years, it has been permitted because it was not forbidden. Many have
doubted, however, whether the banks could enforce the thirty and sixty
days' notice of the withdrawal of deposits which, following the practice
of regular savings banks, appeared on the passbooks issued to
depositors. This uncertainty has been removed by implication by the new
act, which includes in its definition of time deposits, savings accounts
subject to at least thirty days' notice. It is of course a great
advantage to the national banks, that in the employment of these
deposits they are subject to much less restriction than is imposed upon
savings banks in many of the states.
Subject to the permission of the Federal Reserve Board, and when not in
contravention of state laws, national banks may act as trustees,
executors, administrators, and registrars of stocks and bonds. Many
banks will find this a useful extension of their powers. If trust
companies may properly engage in banking, there can be no good reason
why banks should not undertake trust functions. The department store
principle in banking has made rapid headway in most countries in recent
years. Under proper supervision every kind of reasonable and safe
financial business can be handled by a single institution safely and in
a way which is convenient for the business community. In some states
legislation may be necessary to permit national banks to undertake
trust functions. In Massachusetts, it seems to be the opinion among
lawyers that no legislation is required.
Inability to lend on mortgage security has been the most serious
disadvantage experienced by country national banks in competition with
state institutions. Land has been by far the best local security
available over large parts of the country. Rural bankers have, in fact,
taken it into account in making loans and by various devices have
succeeded in making it the security for many of the loans which they
have granted. Under the Federal Reserve Act all banks, except those in
central reserve cities, may lend for periods not exceeding five years 25
per cent. of their capital and surplus, or one-third of their time
deposits, on the security of unencumbered and improved farm land to 50
per cent. of its market value.
Two changes are made in the law for the purpose of facilitating
financial business with foreign countries. National banks having a
capital of at least one million dollars may establish foreign branches,
subject to the approval of the Federal Reserve Board, and to such
regulations as it may formulate for conducting this business. Banks may
also accept bills of exchange maturing within six months drawn in
connection with exports and imports of merchandise. These are desirable
changes in the law. It is not, however, probable that many foreign
branches will be established in the near future, and it is most unlikely
that the American acceptance will make rapid headway in foreign markets.
The scope of the following provision in the act is uncertain. "Other
than the usual salary or director's fee paid to any officer, director,
or employee of a member bank, and other than a reasonable fee paid by
said bank to such officer, director, or employee for services rendered
to such bank, no officer, director, employee, or attorney of a member
bank shall be a beneficiary of, or receive, directly or indirectly, any
fee, commission, gift, or other consideration for or in connection with
any transaction or business of the bank." This prohibition obviously
covers payments to bank directors and officers in return for aid in
securing accommodation from the banks. It may be held that all purchases
by a bank of commercial paper from a firm of note brokers, or of
securities from a banking house, are forbidden if any of the partners of
such firms are on its board of directors. In this event, a few banks
would lose valuable directors; but the question of the wisdom of such
exclusion is too complex to be given consideration in this paper.[292]
SUPERVISORY FUNCTIONS OF THE FEDERAL RESERVE BOARD
A variety of functions of a supervisory or administrative nature are to
be exercised by the Federal Reserve Board. It is to formulate detailed
regulations regarding various matters concerning which only general
provisions are contained in the act. Among important matters regarding
which the Board is to formulate regulations may be mentioned: rules for
conducting branch offices; the regulation of state banks which become
member banks; rules defining precisely commercial loans eligible for
rediscount; and the regulations for the operation of foreign
branches.[293] The Board is to exercise many supervisory functions over
the reserve banks which are similar to those which have long been
exercised by the Comptroller of the Currency over the national banks.
Examination of the Reserve Banks is under its direction. There must be
one examination each year, and additional examinations must be ordered
upon the application of ten member banks.[294] The Board is also to
publish once each week, a statement showing the condition of each
Reserve Bank, and a consolidated statement for all these institutions.
It is also given a number of important powers to be exercised at its
discretion. It may suspend reserve requirements for a period of thirty
days, and renew such suspension for successive fifteen day periods. For
violations of law, it may suspend the operation of a reserve bank, and
administer or liquidate it. The Board may also reclassify cities as
reserve or central reserve cities, or terminate their designation as
such.
The method of banking reform which has now been adopted, necessarily
involves placing somewhere enormous power to expand credit. This power
cannot be surrounded by sufficient safeguards to prevent all possibility
of its misuse, because in so doing, its wise use would be quite as
seriously interfered with. Competent management is therefore absolutely
essential if satisfactory results are to follow the passage of the
Federal Reserve Act. In the operation of the new system, the boards of
directors of the reserve banks may prove the most important part of the
organization; or that place may be occupied by the Federal Reserve
Board. The boards of directors will exercise all the ordinary powers of
such boards, except in so far as they are subject to control by the
Board. All the loans of the Reserve Banks are to be made by the boards
of those banks. In this matter, the Board has no power whatever, except
that it may require, on the affirmative vote of five members, one
Reserve Bank to rediscount paper for others. Here is a power that seems
to be designed merely to prevent any working at cross purposes among the
Reserve Banks. Few or no occasions for its use will present themselves
if all the Reserve Banks are well managed by their own boards. All rates
of discount are to be fixed in the first instance by the boards, subject
to review and determination by the Federal Board. Here again the
decision of the Reserve Bank boards is altogether unlikely to be
overruled if these banks are skilfully managed.
[Illustration: THE FEDERAL RESERVE DISTRICTS]
The power of the Federal Reserve Board to restrain the Reserve Banks is
vastly greater than its power to force them to take positive action
which might lead to the inflation of credit. This was clearly the
purpose in view in giving the Board the more important of its many
powers. It may, for example, reject applications of Reserve Banks for
notes, but this will not endanger assets, it will simply lessen power to
expand operations. Its power over the discount rates of Reserve Banks
will obviously be more effective when used to advance rates which it
deems too low than it will be if used to enforce a rate lower than the
management approves. The directors of the Reserve Bank would still
determine the amount of accommodation which it might safely grant to
member banks at the enforced low rate. Officers and directors of Reserve
Banks may be removed at any time by the Federal Board, which is merely
required to communicate its reasons for removal in writing; but the
right of member banks to choose successors will still remain.
While it is impossible to make any prediction as to the relative place
which the Reserve Bank directors and the Federal Board will hold, it is
evident that, in the absence of harmonious co-operation, the system will
not work smoothly, even if it can be made to work at all. If all the
Reserve Banks and the Federal Board adopt a wise and conservative
policy, the system will surely work well. If the Reserve Banks alone are
conservative, the system may work well but with much friction. If the
Federal Board alone is conservative, it may force good results from the
system. On the other hand, if some of the Reserve Banks and the Federal
Board are reckless, the system will probably break down; and if all the
Reserve Banks and the Federal Board adopt a reckless policy, the results
will be disastrous.
Both the directors of Reserve Banks, and the Federal Board will be
confronted with numerous problems, many novel and some intricate. The
possibilities of the new system cannot be foreseen, and the extent and
nature of the responsibilities resting upon the Reserve Banks cannot be
determined beforehand....
THE FEDERAL RESERVE ACT--AN EXPERIMENT
[295]Banking is the most delicate and sensitive of all businesses in
which men engage. It goes without saying that it is a business in which
the law maker should not needlessly interfere. Perhaps some of you may
not know that modern banking is a product of evolution. In this respect
it is like all great human institutions. No language worth while was
ever invented by a human being. Speech, with all its intricacies and
inconsistencies of grammar and syntax, was not planned by some master
mind centuries ago, but is the result of countless ages of effort on the
part of the human animal, guided only by his sub-conscious
intelligence--that which we call instinct in the lower animals--to give
expression to his emotions and his more or less hazy concepts. Language,
like the comb in which the bee stores its honey, has come to us as the
product of the labor of our ancestors through many millions of years.
Money, credit, and banking are in like manner evolutionary products. If
we attempt to tinker with them artificially without regard to the
lessons of experience and in disregard of the forces of evolution,
believing that our reason transcends the consolidated experience of our
ancestry, we shall meet the fate that we deserve, the fate of the
conceited bee who thinks he can improve the honey comb, or of the
conceited grammarian who would make me walk a literary Bridge of Sighs
for saying "it is me."...
I am quite willing to admit that in some of its details the Federal
Reserve Act[296] has taken leaves from the experience of banking
institutions of this and other countries, but in its essentials, in its
anatomy, in its bony structure as it has been called, it is an animal
absolutely unknown to the natural history of finance. Let me briefly
call attention to the following novelties in banking:
First. It provides for a system of twelve competing banking institutions
which shall control the currency supply of this country, and over which
there shall be no controlling body with power sufficient to compel them
to regard the national welfare in the issue of currency and in the
extension of their credit. It is taken for granted that the financial
welfare of the people will be safe provided that these competing
regional banks are required to hold gold or lawful money reserves of 35
per cent. against deposits and 40 per cent. gold (free from tax) against
notes, and are not permitted to issue notes except upon deposit of good
commercial paper.[297]
Second. The act provides that the Federal Reserve Banks shall have the
right to deal only with banks, nay more, they may deal only with such
banks as have contributed to their capital stock. This again is a
novelty in the banking world. If these banks are to be in touch with all
American business and industry and be powerful agents for the prevention
and alleviation of panic, why should they be thus restricted in their
operations?
Third. The capital of these regional banks is not a matter of voluntary
subscription. It is not founded on business principles. The framers of
the measure seemed to fear lest the banks they were planning might not
prove profitable investments, hence, they have provided that our
national banks must subscribe the necessary capital or forfeit their
charters. No country on this green and prosperous earth has ever found
it necessary to resort to such undemocratic compulsion in order to
persuade people to go into the profitable business of banking.
Fourth. The bank notes issued by these Federal Reserve Banks are called
government obligations and must be redeemed on demand by the United
States Treasury. In no country will you find that any such bank note has
ever been issued or even proposed, and I submit that in the United
States, whose people for half a century have confessedly been subject to
periods of anxiety and distress and panic because of the Government's
liability for the daily redemption of paper money, this provision of the
Federal Reserve Act is amazing, inexplicable, and indefensible. The
United States Treasury is not a bank and is not made one by this act. It
cannot control the issue of the notes, nor the credit operations of the
banks who do issue them. Why then should the treasury be compelled to
redeem these notes?
Fifth. The Federal Reserve Act provides for an arbitrary shifting of
bank reserves such as has never been attempted before. Nobody can
foretell what the result will be, but we know nothing of the sort has
ever been attempted before and we also know that many banks will be
obliged to reduce their loans and discounts, and that their customers,
the business men of the country, may suffer serious losses in
consequence.
The United States has tried many financial experiments--indeed, our
present national banking system was an experiment in finance and has
been found wanting--but the Federal Reserve Act, if it could be put on
exhibition in a world's financial museum, would, I feel sure, be voted
the newest and most spectacular thing we have yet constructed.
THE FEDERAL RESERVE ACT AND DEMOCRACY IN BANKING
[298]Beneath his skin every American citizen of every station and
avocation, and whatever party name he may wear, is a Democrat in all the
essentials and fundamentals. That is, he is attached passionately to the
principles of local self-government, of the widest individual liberty
compatible with the general weal and order of society. This new currency
measure is democratic essentially. It looks to decentralisation of
direct financial control, to financial local self-government, so far as
is consistent with stability and the general safety; to a currency which
will be worth its face value everywhere, which will be based on the
actual values it purports to represent, as well as the faith and credit
of the General Government, and which yet will be elastic, expanding to
meet needs where and when they develop, receding when not needed; a
system fitted to meet any emergency, moving smoothly and noiselessly for
the ordinary uses of business in tranquil times.
Too much money and too little money are alike evil and dangerous.
Opinions differ as to which is the worse. Probably one is as bad as the
other. The design of the new law is to supply just enough money or
credit, when and where business needs it, to create for our commerce, as
has been said, foundations so even, so broadly laid, and so deeply
planted that they can not be shaken.
As it is, the country bleeds and sweats to the big financial centres.
Take the South as an instance--and the conditions with which you here in
North Carolina are familiar exist everywhere in the country. Most of our
railway systems are controlled frequently through the trust known as the
voting trust--by men who are interested in the great banks in the three
central reserve cities. So it happens that the large deposits of the
railways, their collections from the Southern people, as also from the
Western people, are sent on largely to those banks. The same is true of
the telegraph and telephone companies, the life and fire insurance
companies, and of many of the larger manufacturing enterprises. The
merchants and manufacturers of North Carolina pay their freight bills to
the railways. The money goes largely and promptly to New York, and is
lent out and used there in stock-market operations, or as the directors
of the banks, who are also often the directors of the roads and other
corporations, may elect. Of course there is no law which provides for
the carrying of the reserves and bank balances of railways and
industrial corporations in the central reserve cities, where the
national banks of the country have also been accustomed to keep their
reserves.
When North Carolina needs money to move the cotton crop her banks must
call on New York for money which should be in their own vaults; for the
return of money paid in here in freight bills, insurance premiums, and
otherwise; and your banks sometimes think themselves lucky if they can
be allowed the use of any part of it....
It is not hard to see how centralization of financial resources and
money supply and concentration of financial power has been forced, and
the invisible and irresponsible despotism created by acts of Congress
and policies of government made necessary by those acts.
Now, we do not propose to use violence to force disintegration and
decentralization, to do anything with a jolt and a jerk. It is
understood clearly that to rush headlong and at full speed over an evil
or an obstacle may cause derailment or jarring, uncomfortable and bad
for passengers. The thought or plan, as I understand it, is to invite
decentralization, to encourage it, to give opportunity for it, to make
local self-government possible, to remove the influences which draw to a
few centres the money that is paid out to the corporations and deposited
in the local banks....
The law does not require a single business man to change his account
from the bank with which he has kept it or any business man or bank to
suspend dealings with the bank or banks in the central reserve or
reserve cities with which they have in the past been doing business. It
does offer to banks freedom of choice. It says to the banker that he can
follow his preferences, sentiments, or habit in selecting the source of
his borrowing; and the member banker of any federal reserve district may
feel free and peaceful and at ease when he knows that he has in his
portfolio notes, drafts, and bills of exchange arising out of actual
commercial transactions, which he can convert into money at his federal
reserve bank with greater ease and promptness than it has sometimes been
possible for him to withdraw his cash balances from his reserve agents
and almost with as much ease as it has ever been possible to draw on
credit balances with any correspondent. He is not dependent on the whims
or fortunes of any other bank. He need not shiver at the prospect of
abundant crops for fear he may not have available the funds with which
to meet demands for moving them. He will know that if he needs money to
accommodate the bank's customers he can, as a matter of right, call on
his federal reserve bank.
Among other benefits the new currency law, by its direct system of
clearances, will release and make available for purposes of trade and
commerce hundreds of millions of dollars which under the old system have
been tied up in tedious processes of collection. It will also save to
banks and to merchants and business men generally some millions of
dollars which they are now paying, directly and indirectly, for the
collection of country checks and checks on outside cities.
To refer more particularly to your own district, the fifth, I will try
to explain to you how the new method will work in transactions of
domestic exchange.
In this district, embracing the States of North and South Carolina,
Virginia, West Virginia (except four counties), the District of
Columbia, and Maryland, there are some 475 member banks.
A cotton mill at Columbia, S. C., under the old plan sends its check on
its Columbia bank for a shipment of coal to the coal company at
Bluefield, W. Va. The local bank at Bluefield forwards this check to its
correspondent in Richmond. This correspondent sends the check to its own
correspondent in Columbia, who makes the collection from the Columbia
bank and then draws a check on New York for New York exchange, which it
remits to Richmond. The Richmond bank thereupon notifies the Bluefield
bank of the collection of the item. The collection and exchange charges
on distant country banks amount usually to from one-tenth to one-fourth
of 1 per cent., or possibly more, and probably a week or more elapses
between the remittance of the South Carolina check to the Bluefield bank
and the time when the Bluefield bank gets its report that the item has
been collected and placed to its credit in Richmond.
Under the new currency act "every Federal Reserve Bank shall receive on
deposit at par from member banks ... checks and drafts drawn upon any of
its depositors." That means that the Bluefield bank receiving the check
on the Columbia, S. C., bank mails it to the federal reserve bank at
Richmond. The federal reserve bank at Richmond thereupon charges the
Columbia bank with the amount of the check, credits the Bluefield bank
with the proceeds, and notifies the two banks accordingly.
The Federal Reserve Act also provides that each federal reserve bank
shall receive at par, and credit accordingly, all checks and drafts
drawn upon any of its member banks, from every other federal reserve
bank; that all checks and drafts drawn by any depositor--that is to say,
by any member bank--on any federal reserve bank shall be received and
credited at par by every other federal reserve bank. This means that the
checks of the member banks in the country towns throughout these five
States are worth their full face value, without deduction for exchange
or collection charges, to every other member bank, and that the amount
of each check may be cashed at par immediately, without following the
devious and roundabout courses now observed in the collection of checks.
Virtually every bank in the fifth district is only one night distant
from Richmond, and a check mailed one afternoon in the most distant
portions of the district should reach Richmond the following day in time
to be included in that day's operations of the federal reserve bank.
Let us now consider another aspect of the new law: Under the old
National Bank Act a national bank with a capital of, say, $200,000,
deposits of, say, $1,500,000, bills receivable amounting to $1,200,000,
and $300,000 reserve, would only be permitted to borrow a total of
$200,000, the amount of its capital. If a run should start on such a
bank, the amount which it could raise by loans, if strictly held to the
old law, would be but $200,000, the amount of its capital, which might
be quite inadequate to meet a run, and the bank, though thoroughly
solvent, might be forced to suspend.
Under the new law, however, if a bank with $200,000 capital and deposits
of $1,500,000 should have loaned $1,200,000 to its customers on
commercial paper and should encounter an unexpected run, in addition to
borrowing $200,000, the amount of its capital, such a bank would have
authority to rediscount with the federal reserve bank of which it is a
member, notes, drafts, and bills of exchange issued or drawn for
agricultural, industrial, or commercial purposes, having not more than
ninety days to run, to any reasonable extent which may be approved by
the federal reserve bank to which application for such rediscounts may
be made....
We can not overestimate the value of the additional security which this
provision of the act confers upon every honestly, capably managed member
bank, and the relief from strain and anxiety and from the fear and
apprehension of panics and unreasoning runs which it gives to the
officers of every member bank.
Another important change provided by the Federal Reserve Act is the new
arrangement for the compensation of national bank examiners. Under the
present law the compensation of national bank examiners is based, except
as to reserve cities, on the capital stock of the bank examined. Under
the operations of this law a national bank examiner has been receiving
for the examination of a certain national bank in the fifth district,
with over $9,000,000 of assets and many thousands of accounts, the
munificent sum of $25. It is, of course, clear that an examiner could
make only an imperfect examination of such a bank in the space of three
days at a compensation of, say, $8 per day, out of which $8 allowance he
has to pay his own railroad fare, hotel expenses, as well as clerical
assistance. It is not unnatural that but few examiners would willingly
spend the ten days or two weeks which it might require to make a
thorough examination of such a bank when he is running personally in
debt in doing so.
Under the new currency law the Federal Reserve Board, upon the
recommendation of the Comptroller of the Currency, is given authority to
fix the compensation of bank examiners on the basis of annual salary, so
that those banks which need additional time and attention from the
examiner may receive the careful, close scrutiny which the case may call
for. It is believed that the new system of bank examinations will reduce
materially the number of bank failures and enable the department to
check up many abuses and correct many evil situations which in the past
have been ignored or glossed over by examiners in their hasty and
incomplete investigations.
I thank you, gentlemen, for the opportunity to address you. Approaching
the study of this new and revolutionary measure with the caution natural
to every man trained in banking under the system with which we have
grown up, I have become more thoroughly aroused to its merits and more
deeply impressed as I have watched the methods of construction, the
processes of growth, and have considered the underlying principles
directing those who did the work.
THE ELASTICITY OF NOTE ISSUE UNDER THE NEW CURRENCY LAW[299]
To anyone who has been interested in currency reform for, say, twenty
years, probably nothing is more striking than the change in emphasis
which has taken place among the advocates of reform during this period.
The typical reform plan of the earlier time, for example the so-called
Baltimore plan brought forward in 1894, devoted itself almost
exclusively to providing a thoroughly elastic note issue, based on
ordinary assets. In contrast, the new law has as its central, primary
object the organization into at least regional unity of something like
the entire banking system of the country. Doubtless this difference in
the two reform plans was not altogether due to a fundamental difference
of opinion with respect to what would be the ideal scheme. The reformers
of the earlier period were not indifferent to the need for centralized
organization in the banking system. But they considered any scheme
involving a central bank, like the old Bank of the United States, quite
chimerical; and they were probably right. But times change; and men
change with them. For one reason or another we have all become more
tolerant of centralization in business matters, as also more tolerant of
that increase in governmental control which increased centralization in
business seems to make necessary. With at least fairly general approval,
a system of regional organization has been set up, involving a very high
degree of centralization and a very high degree of governmental control.
But with this change in the method of reform, it became inevitable that
the more important ends which earlier schemes sought to accomplish by
giving the note a high degree of elasticity should be, in no small
measure, attained by other means. In consequence, the need for
elasticity in the note issue will be much diminished under the new law.
Nevertheless, it is admitted that this need will not disappear
altogether. Elasticity in the note issue will be wanted partly to assist
in utilizing the newer methods of dealing with the difficulties
involved and partly to supplement those newer methods. Accordingly, the
question "How far does the note issue under the new system seem likely
to prove an elastic one?" is still important.