Credit Policies of the Federal Reserve System

CHAPTER II

THE TECHNIQUE OF CREDIT CONTROL

In this chapter we sketch the technique used by the Federal Reserve system to influence the level of short-term money rates, the movement of gold into and out of the country, the volume of credit extended to the banks by the Reserve system, and the amount and form of credit operations of the member banks themselves. Our purpose is not at this point to appraise either the effectiveness of these methods, the soundness of the theories which underlie them, or the desirability of attainment of the ends which have been sought; questions of this character will be considered after we have surveyed in detail the attempts of the Reserve Banks and the Reserve Board to exercise a beneficent influence over the short-term money market.

The Federal Reserve system has used some of the well-known techniques which were developed in the pre-war experience of European central banks, and has also worked out some new techniques by study and experiment. The necessity for innovation arose partly from the fact that the organization and practice of the American banking system are somewhat different from those with which European banks have had to deal; partly from the fact that objectives of banking policy have changed everywhere since the war, especially in the direction of greater interest in the stabilization of business activity; and finally from the fact that in the post-war era a new set of specific issues have pressed for solution.

During the years since 1921 the Federal Reserve system has used four principal devices which are intended to influence the lending and investment policies of the member banks, through their effect on the degree of ease or tension in the short-term money market, and through this factor in turn to influence the state of commerce, industry, and agriculture. The first, and by far the most conspicuous, channel of influence is the determination of the cost of Reserve credit to the member banks; the second is control of the form in which Reserve credit is extended; the third is the issuance of warnings and propaganda directed to securing voluntary co-operation of member banks, and of the financial community; the fourth is “direct pressure”—the denial, or the threat of denial, of credit to member banks whose policies are disapproved by Reserve authorities.1 In this chapter we shall be concerned chiefly with the first of these channels of influence; we shall revert briefly to the others after analyzing the way in which the Reserve Banks exercise a direct influence on the cost and abundance of credit.

The possibility of any centralized control of a money market hinges on the extent of dependence of the commercial banks on the credit policy of the central bank, a dependence which is somewhat closer in America than in most other countries.

Member banks operate under rigid reserve requirements. These requirements are based on the volume of deposits, 3 per cent in the case of time deposits, and 7, 10, or 13 in the case of demand deposits. The average requirement for all deposits is between 9 and 10 per cent. These reserves consist entirely of deposits to the credit of member banks on the books of the Federal Reserve Banks. Even gold in a bank’s vault does not count, though of course it can be turned into reserve at any time by depositing it with the Federal Reserve Bank. The legally required reserve can be drawn upon temporarily if the demands of depositors for cash prove greater than anticipated, but it must be replenished immediately; it cannot be reduced for more than a few days except in proportion as the deposit business of the bank is liquidated.2

The administration of a commercial bank involves constant readjustment of the reserve ratio. Practically every transaction which passes through a bank’s books involves a change either in its actual reserves or in its reserve requirements. A bank may find itself short of reserves because it has to meet an unexpected volume of withdrawals of deposits in the form of cash; it may have to meet an adverse balance at the clearing house because its clients are transferring their accounts to other banks; it may even have a shortage without serious withdrawals simply because it has created an excessive volume of deposits by lending operations and has not provided reserves against the new liabilities. Vice versa, a bank may find itself in possession of excessive reserves either because it has received fresh deposits or because its clients have liquidated part of their indebtedness.

It is an important task of the management of every bank to see that reserves do not fall below the legal minimum, or exceed the legal minimum by such amount as to involve a material loss of income. The reserve deposits earn no interest, and of course cash in vault also earns nothing; hence in normal times member banks carry practically no surplus reserves for seasonal needs or for emergency use. Instead they rely on their secondary reserves—call loans, deposits with correspondents, salable securities—and on the facilities of the Reserve Banks.

A shortage or surplus in the reserve of an individual bank is ordinarily taken care of in ways which do not change the total supply of credit. A bank which is short of reserves may get help from other banks either by drawing down its balances with correspondents, by direct borrowings from other banks, by selling securities to banks or to persons who borrow from banks in order to pay for them, or by calling loans which are then taken over by other banks. Likewise a surplus in one bank’s reserves is quickly eliminated, either by purchases of securities, by direct interbank lending or by the making of open market loans. Such operations, in so far as they merely shift the credit load around from one bank to another, do not change the relation of reserves to deposits for the member banks as a whole. They do not create a major problem of Reserve system administration, though at times the Reserve Banks intervene to stabilize the market against disturbances which result from major shifts of funds between country and city, or from one section of the country to another.

An important junction of the Reserve Banks relates to the adjustment of the total volume of reserves of the member banks to changes in money market conditions. The shifting process just described is, of course, of no help in cases where the excess or deficiency of reserves arises from conditions which affect all the banks alike. The most important function of the Reserve system is, on the one hand, to supply needed elasticity in the total quantity of bank reserves and of currency; on the other hand, to prevent elasticity from becoming merely an opportunity for alternations of unnecessary and harmful expansion and contraction.

A general excess or deficiency of member bank reserves may arise in any one of several ways. For example, any of the following changes, if not offset by a change of opposite character, will reduce the proportion of reserves held to reserves required by the banks as a group, though not all banks will be affected:

1. A general expansion of credit by the member banks, which directly lowers the reserve ratio because it increases deposits and does not correspondingly increase reserves.

2. An increase in the demand of the public for currency. When a customer of a bank checks out cash in significant volume the bank’s stock of till money must be replenished by drawing against reserves. The deposit liabilities of the bank are reduced, but the total amount of its reserves is reduced by the same amount; hence the reserve ratio is impaired.

3. An export of gold. This operates in exactly the same way as an increase in the currency requirements of the public, since the only way banks can supply their customers with gold for export is by drawing against their reserve balances at the Federal Reserve Banks.

4. The sale by the Federal Reserve Banks of their holdings of United States government securities. The checks in favor of the Reserve Banks drawn by purchasers of such securities are charged directly against the reserve balances of the banks on which they are drawn, and do not create offsetting credits elsewhere.

5. Very similar to the case just mentioned is that of a reduction of the Reserve Banks’ investment in bankers’ acceptances (which is brought about, in practice, not by selling, but by failure to replace acceptances at maturity).

6. A reduction in the total amount of member bank borrowing at the Reserve Banks. Checks drawn by the member banks in payment of loans are charged directly against their reserves and there is no offsetting expansion.

7. A transfer of funds on government account from member banks to Federal Reserve Banks.

8. A transfer of foreign-owned deposits from member banks to the Reserve Banks.

9. An increase in the capital of the Reserve Banks.

10. Theoretically, a transfer of funds from time deposits to demand deposits, or from banks with low reserve requirements to those with high requirements.3

The last four possibilities are of minor importance. The first three constitute the important problems with which Reserve administration has to deal.4 A business boom is usually characterized by all three of these changes, and it is through the handling of such situations that the Reserve system becomes involved in responsibility for influencing the pace of business activity. A boom is always characterized by an expansion of bank credit in excess of the ordinary year-to-year growth, and usually by some increase in the demand for currency above normal requirements. Unless a boom is world-wide it is likely to result in an outflow of gold from the countries which are expanding credit—though many other factors enter into the determination of the gold movements. These three phenomena, especially the last two, compel the banks to seek credit from the Reserve system and give the System its opportunity to exercise a restraining influence.

In the converse case, when reserve requirements are contracted because of liquidation of credit, and especially when reserves are being replenished by gold imports or the return of currency from circulation, the Reserve Banks lose in influence. They can make Reserve credit cheaper at such times in the hope of checking liquidation, but they have no weapon against deflation which is as drastic as is an actual restriction of credit or the raising of discount rates to panic levels.

A demand for additional member bank reserves can be met in several ways, only two of which are of major significance. The fourth, fifth, and sixth items given on pages 22-23, the reverse operations, constitute the machinery of credit control. Practically speaking, for member banks to increase their reserves, either funds must be obtained from abroad or Federal Reserve credit must be expanded. Expansion may be effected through an expansion of member bank borrowing or through expansion of the Federal Reserve system’s holdings of acceptances and government securities.5 The release of cash from the United States Treasury affords a possible channel of relief, which was important before the Federal Reserve system was established, but is no longer significant.

Credit is obtained from abroad by selling securities, by decreasing short loans to foreigners, and by drawing down balances in foreign banks. Credit thus obtained is converted into reserve balances by importing gold and depositing it in the Federal Reserve Banks. Excessive reserves may of course be utilized by the reverse operations. In so far as needed reserve expansion and contraction is obtained in this way, the operation of our banking system is essentially the same as it was before the banking reform of 1913. Gold came in when money was tight and flowed out when it was easy. The creation of the Federal Reserve system did not impair the effectiveness of this method of adjusting the position of the banks to changes in the credit demands of the country, though the war and the post-war monetary disturbances did practically eliminate it for a number of years. What the new system did was to introduce as an alternative method the expansion and contraction of Federal Reserve Bank credit. The difference in the results of the use of the two methods lies in their effect, not on the reserve position of the member banks, but on that of the Federal Reserve Banks. But, as is shown elsewhere, since 1921 the reserve ratios of the Reserve Banks have been so far above legal requirements that changes in them have not been important factors in determining credit policy.

The Federal Reserve system influences the supply and price of credit through rediscount rates and through open market operations. Rediscounting, as the term is generally used, covers two types of borrowing transactions, namely, rediscounting in the strict sense of the term, in which the member bank brings to the Reserve Banks eligible commercial paper (acceptances and customers’ notes) and discounts it, incurring as endorser, of course, a contingent liability; and, second, direct collateral loans extended by the Reserve Bank to the member bank, occasionally secured by pledge of eligible paper, but usually by obligations of the United States government. The rate at which loans of these two types are extended is known as the rediscount rate and is usually uniform for all types of eligible paper, though at times in the past preferential rates have been given for certain maturities and for types of paper which it was desired especially to encourage.

The second type of credit transaction in which the Reserve Banks regularly engage is the purchase and sale of United States government obligations, chiefly United States Treasury certificates and notes. These operations differ from the rediscounting operations in that they are undertaken on the initiative of the Reserve Bank, whereas rediscounts are made on the initiative of the member banks. The Reserve system has the right to refuse to rediscount eligible paper, and has occasionally exercised that right either because the bank which requested rediscounts was considered to be borrowing too heavily or too steadily or, more rarely, because the bank’s lending practices were disapproved.

In the case of the purchase and sale of government paper, the so-called “open market operations,” the practice is entirely different. The Reserve system management decides on the amount which is to be carried; then the necessary securities are bought or sold at market prices.

Open market purchases put additional reserves into the possession of the banks of the country as a whole, but do not give the Reserve Banks any control over the allocation of the new funds to different banks. Rediscounts, on the other hand, put new reserves into the possession of the banks which ask for them, presumably those which have found themselves short. But credit flows from bank to bank so readily that the effect on the money market of an increased volume of rediscounting is not essentially different from that of increased open market purchases of securities.

The purchase of acceptances is intermediate in character between rediscounting and open market purchases of securities. In pursuit of a policy of encouraging the use of the bankers’ acceptance,6 the Reserve Banks stand ready to purchase eligible acceptances both from member banks and from acceptance dealers, at published rates. Such purchases are ordinarily referred to as open market operations, but the use of the term in this way is somewhat misleading, since the purchases are at the initiative, not of the Reserve system, but of the financial community. In this respect they are like rediscounts.

On the other hand, the sale of acceptances to the Reserve Bank puts a member bank in possession of credit without causing its name to appear as a borrower and therefore without any question as to whether the selling bank is appropriating more than its share of the total supply of Reserve Bank credit. In this respect, acceptance purchases are analogous to dealings in securities rather than to rediscounting.

The holdings of acceptances are subject to well-marked seasonal fluctuations. The market supply of acceptances, especially that of cotton bills, increases rapidly in the autumn, and this expansion coincides with an increase of the demand of the country for currency. Cash withdrawals deplete member bank reserves; the expansion of credit required to replenish them is conveniently effected by Reserve Bank purchase of the expanded supply of acceptances.

If open market holdings are not changed, a curtailment of rediscounting, whether stimulated by rate increases or otherwise, can only occur if the banks secure gold from abroad to replace the rediscount credit in their reserves or if there is a general reduction of the amount of bank credit in use in the country.

To a large extent the various types of reserve credit are supplementary. If the Reserve Banks increase their open market purchases without lowering the rediscount rates, much of the credit which they put into the market is quickly cancelled because member banks use the new resources to pay off their indebtedness. Vice versa, when securities are sold, an increase in rediscounting follows promptly.

Existing member bank reserve funds have been created in large part through Reserve Bank loans and investments. When a Reserve Bank buys a bond (or for that matter any other asset) from a member bank or from a customer or correspondent of a member bank, it creates a deposit credit which is just as good a reserve as if it had been created by the deposit of gold. The same thing happens, of course, when a Reserve Bank makes a direct loan to a member bank. Such operations account for a very large fraction of the existing mass of member bank reserves. For example, on December 26, 1923, the loans and investments of the Reserve Banks amounted to 69 per cent of the member bank reserves5 on June 30, 1926, the proportion was 52 per cent; on November 6, 1929, it was 64 per cent; and at the end of 1931, 94 per cent.7 Thus, if the Reserve Banks should sell out their investments and call in their loans, more than half the member banks’ reserve deposits would be cancelled. This would necessitate the cancellation of many billions of dollars of bank credit, or an enormous import of gold.

The fact that maintenance of the present volume of member bank credit requires continuous use of a considerable volume of Reserve Bank credit8 gives the Reserve system its control over member bank expansion. If there were no Reserve Bank credit; if the only member bank reserves were those created by the deposit in the Reserve Banks of gold and legal tender, the mere custody of the reserves would not give the Reserve authorities any power whatever to control credit. If the Reserve Banks are to exercise any control over either the volume or the quality of the credit extended by the banks, it is essential that they shall have power to enlarge and contract the reserve resources of the member banks through credit operations. It is equally essential that they shall not, except as a last resort, cut their own reserves close to the legal limit. If they utilize their power of expansion up to the limit, they are in the same position as were the commercial banks before the Reserve system was established. They are not free to expand or contract as they may consider the public interest demands; they are controlled by the necessity of protecting their reserves.

While the System during the past ten years has not encouraged such an extensive use of Federal Reserve credit as to bring its own reserve ratio down near the limits fixed by law, it has created a situation in which the member banks cannot stand on their own feet without substantial use of Federal Reserve credit, even in times of slack demand for funds. An enormous volume of Federal Reserve credit was manufactured during the war, and the liquidation movement of 1921 stopped with over a billion dollars still outstanding. Since that time, aside from a peak in December which was due to a seasonal increase in the use of currency, the amount has generally ranged from 8 50 million to a billion dollars in dull years, and from 1200 to 1400 million in good years.9

The ability of the Reserve Banks to influence the money market defends on the size of their surplus reserves as compared with the resources of the member banks. As we have noted, the fact that the Reserve Banks are the custodians of the member bank reserves is of no consequence (except as a way of compelling member banks to bear the expense of running the Reserve system). Reserves are created and cancelled by operations which could be carried out just as well if the custody of reserves were transferred elsewhere. If some multi-millionaire should be seized by a desire to exercise the function of control, he need only accumulate a fund of half a billion dollars, convert it into gold when he wished to tighten the money market, and invest it in high-grade bonds and commercial paper when he wished to create greater ease. By selling out his securities and taking the proceeds in gold, he could exercise as great a restraining influence on credit conditions as can the Reserve system with a similar expenditure, and by purchases of securities he could ease the situation equally well. To be sure, the Reserve Banks within the limits of their resources could offset the effects of his operations, but it is equally true that within the limits of his resources he could offset the effect of theirs. Victory in such a struggle, in the absence of interfering legislation, would be altogether a matter of the relative size of the resources at the command of our Croesus and of the Federal Reserve Banks. The dominance of the Reserve system—and the same point applies to the central bank of any country—rests entirely on the fact that it commands the only important body of funds which is alternately immobilized and invested without regard to the pecuniary gains and losses which result from such procedure.10

Reserve Banks can exert some influence by manipulating the form of Reserve credit. Shifts between open market holdings and rediscounts do not affect the total volume of credit, but they are an instrument of credit policy because of the existence of a tradition against continuous borrowing. Under our pre-war banking system, individual banks made good their deficient reserves by borrowing from correspondents, but such borrowing was generally regarded as a sign of weakness; hence banks were reluctant to show borrowings on their balance sheets. The discounting of customers’ paper was especially in disfavor. Under the new system for a time there was an effort to uproot the tradition and teach the banks to rediscount as a matter of routine, but in recent years the official doctrine has been that banks should rediscount only to make good temporary deficiencies in their reserves and should not obtain capital by continuous rediscounting even though the rates are so low that it is profitable to do so.11

To the extent that the prejudice and the official propaganda against borrowing is influential, the significance of rate policy is decreased. The rediscount rate would cease to count for anything if the prejudice should become strong enough so that any bank would immediately curtail its operations rather than remain in debt to the Reserve Bank, or to other banks which might serve as intermediaries between the ultimate borrower and the Reserve Bank.

On the other hand, the effectiveness of open market operations as an instrument of control over the banks is increased by the tradition against borrowing. When the Reserve Banks sell securities, if the member banks are unwilling to rediscount they must curtail their own credit operations or else borrow abroad; and when the Reserve Banks buy securities the operation has much more tendency to ease the market if there are virtually no rediscounts to be paid off than is the case if banks are getting a considerable proportion of their resources directly from Reserve Banks.

Finally, the Reserve system as a last resort can bring its influence to bear directly by exercising its discretion in refusing to lend to banks of whose policies it disapproves, or by discriminating against certain types of paper when offered for rediscount, even though they are technically eligible. For example, in 1929 some Reserve Banks curtailed credit extended to banks which were making call loans on the stock exchange. This phase of Reserve system policy is discussed in Chapters VII and VIII.

• 1The distinction between “banking policy” and “credit policy” is taken from Annual Report of the Federal Reserve Board, 1928, pp. 9-10.
• 2Compare pp. 132-40.
• 3This is, of course, in substance the position of the Banking School in the British banking controversy of the early nineteenth century.
• 4“. . . When increased credit demands can be met only by recourse to the Federal Reserve Banks, the volume of Reserve Bank lending is a sensitive indicator of credit conditions. . . .” (Federal Reserve Bulletin, 1923, Vol. 9, p. 411).
• 5Annual Report of the Federal Reserve Board, 1923, p. 10 (quoted below, pp. 79-80); Federal Reserve Bulletin, 1928, Vol. 14, p. 6.
• 6The omission of reference to price changes in the text is intentional and without prejudice. I believe that there is need of a thorough reexamination of the orthodox statement of the influence of gold movements on price changes and the extent to which in pre-war days changes in price levels were caused by gold movements and operated to check the gold movements.
• 7For fuller discussion of these points, see Chap. IX; compare also B. H. Beckhart, The Discount Policy of the Federal Reserve System, Chap. II.
• 8The cash balance carried in the United States Treasury was occasionally drawn upon to meet seasonal or crisis demands, either through the depositing of funds in banks or through the purchase of bonds by the Treasury, but the device was very crude and there was no continuity of policy in its management.
• 9Compare chart, p. 35.
• 10The possibility of temporary nullification of a central bank’s control through the mobilization of fresh resources is illustrated by an action of the Midland Bank, which in 1927 bought securities so heavily as to lower its own reserve ratio by several per cent. The amount involved was small enough so that the Bank of England was able to offset it. The net result was simply to increase the earning assets of the Midland Bank and decrease those of the Bank of England; not to ease the market.
• 11Compare p. 231.