Credit Policies of the Federal Reserve System

CHAPTER XIII

LIQUIDITY OF COMMERCIAL BANK ASSETS ELIGIBILITY FOR REDISCOUNT

It was hoped by some critics of our pre-war banking organization that the Federal Reserve system would bring about a change in the standards of commercial bank lending. Since it was anticipated that commercial banks would have to look to the Federal Reserve system for credit in order to meet the demands of their customers for currency, it was naturally supposed that the types of paper which were made eligible for rediscount or for purchase would be favored by the banks and would grow in use at the expense of the types which might be discriminated against. Standards of eligibility would tend to become standards of lending practice.

The special importance attached to the concept of eligibility arose from the fact that the lending practices of American banks did not meet with the approval of most students of banking theory.1 The banking assets of the country consisted in large part of loans and investments which were not of self-liquidating character. This mass of unliquid credit included much paper which was not even nominally self-liquidating, such as bonds, security collateral loans, and real estate mortgages; and also a vast number of single-name promissory notes of farmers and business men which were nominally short-dated but actually represented permanent working capital or fixed investment.2

There was much paper which was highly liquid in the sense that it would be paid off in the normal course of trade, but paper of this type was not distinguished in form from that which represented permanent business capital. The only documentary evidence of liquidity which ever accompanied such notes was the financial statement of the borrower. Such statements were commonly required by large city banks, and by smaller banks in the case of paper purchased in the open market, but they were not generally required of local customers in smaller communities, and were almost unknown in connection with farmers’ loans.

It was hoped that the eligibility standards of the new system would do two things; first, increase the proportion of commercial paper in the assets of the banks as compared with bonds and call loans; and, second, exert a beneficial influence on the actual liquidity of the paper which was nominally commercial in character. By excluding from rediscount all security loans to customers except those secured by United States government bonds (which then existed in very small volume), the law gave a preferential status to paper which was nominally short-time over what was admittedly of investment character. If the Reserve administration was to do anything further to reform the banking practice, its task was first to make eligibility valuable, and second, by eligibility restrictions, to increase the actual liquidity of the paper which was nominally of short-time character. The responsibility of fostering a more liquid type of loans was accepted by the Reserve Board, and it has been a factor of some importance in credit policy, especially in the earlier period of the System’s history, though never of dominating influence.

There were open to the Reserve authorities two ways in which credit policy might be used to influence the character of the assets of the member banks. The first step, and an essential one, was the issuance of eligibility regulations which would put a premium on paper which was actually liquid over that which was only nominally short-time. The second possible line of attack would have been the adoption of policies which would tend to increase the amount of rediscounting which the banks would have to do, thereby making it advantageous for them to keep their assets in the form of eligible commercial paper, rather than in ineligible investments and collateral loans. As we shall see, only the first of these methods was actually utilized.

An effort was made at the outset to establish a very strict standard of eligibility for rediscounted paper. This was done by requiring that every note presented for rediscount should bear on its face evidence that it grew out of a specific commercial transaction, or else bear a stamp certifying that the borrower had filed with the rediscounting bank a sworn financial statement which indicated that he possessed enough quick assets to make his short-time borrowing truly liquid.3

If this policy had prevailed permanently so that paper bearing no evidence of liquidity was excluded from Reserve Bank portfolios, it is probable that the standards of commercial banking would to some extent have been modified in the direction hoped for, even though, as we show later, rediscounting has turned out to be of less importance than was anticipated. The immediate effect of the attempt to enforce these standards, however, was to arouse a great storm of protest and, as it appeared, to keep the Reserve Banks from getting any considerable amount of business.

The protests centered on the technical difficulties involved in securing the type of credit statement demanded, bur a more serious difficulty was the discrepancy between the Board’s standards and the current practice of the country. It might have been possible to teach farmers and small-town business men to prepare financial statements, but such statements would only have made evident the inescapable difficulty of getting self-liquidating paper in communities where the banks’ principal customers were accustomed to look to the banks for a considerable share of their permanent capital.

Rediscounts at the end of the year 1914 amounted to only $9,900,000. This low figure was regarded as evidence of failure of the Board’s policy, but it is doubtful whether there would have been much rediscounting even if standards had been more liberal. Business had been depressed all through the year 1914, and especially so after the beginning of the World War. The lowering of reserve requirements had left a good deal of slack in the System, so that it was easy for banks which were short of reserves to get aid from other banks if rediscounting with the Reserve system was less convenient. The old system of correspondent relations, which the city banks were naturally anxious to keep alive, provided a convenient means of borrowing for the country banks.

The protests were so vigorous that the Reserve Board quickly withdrew from its position, and, early in 1915, waived the requirements of a credit statement except in the case of notes of $2,500 or more.4 The effect of this concession was practically to confine the requirement of a statement to open market commercial paper and to over-the-counter loans of large city banks. As has been noted, these were the loans which already were normally based on financial statements.

Loans and Investments of all Member Banks, 1925-315

I. In Millions of Dollars

Class	1925	1926	1927	1928	1929	1930	1931
Loans on securities	6,718	7,321	8,156	9,068	10,094	10,656	8,334
Loans on real estate	2,338	2,650	2,926	3,068	3,164	3,155	3,218
Securities investments	8,863	9,123	9,818	10,758	10,052	10,442	12,106
Miscellaneous loans	11,599	12,090	11,856	12,167	12,401	11,403	10,265
Total loans and investments	29,518	31,184	32,756	35,061	35,711	35,656	33,923

II. As a Percentage of Total

Loans on securities	22.8	23.5	24.9	25.9	28.3	29.9	24.6
Loans on real estate	7.9	8.5	8.9	8.7	8.9	8.8	9.5
Securities investments	30.0	29.2	30.0	30.7	28.1	29.3	35.7
Miscellaneous loans	39.3	38.8	36.2	34.7	34.7	32.0	30.2
Total loans and investments	100.0	100.0	100.0	100.0	100.0	100.0	100.0

The abandonment of the campaign for financial statements was a decisive defeat for the advocates of more rigid standards of technical liquidity in commercial bank lending, and little effort has been made since to substitute other methods of controlling liquidity. The importance of the incident can easily be exaggerated, however. Much more important is the policy of extending credit by buying securities and lending on collateral security, which has made the standards of eligibility relatively unimportant.

During the last decade there has been a great increase in the proportion of security loans in the holdings of the member banks. The table on page 268 indicates clearly how completely shattered have been the hopes of those reformers who 20 years ago looked forward to a revival of the ancient tradition that banks’ earning assets should consist chiefly of short-term commercial paper.

The increased volume of securities carried on bank credit reflects a corresponding change in the methods of American corporation finance. The increase in speculative call loans, to which so much attention has been given in the last few years, directly accounts for only a small fraction of the increase in the proportion of bank lending which is done on the basis of security collateral.6 Banks have been compelled to take on the character of investment institutions because they have been experiencing a diminishing demand for their services as makers of short-term business loans.

The accompanying table shows the increasing use of securities, and especially of common stock, as reflected in the balance sheets of 22 of the country’s leading industrial corporations.

Percentage Distribution of Capital of 22 Leading Industrial Corporations7

Capital Item	1918	1924	1930
Common stock and surplus	56.0	59.6	73.1
Preferred stock	14.4	17.4	13.5
Bonds and notes	13.2	13.7	6.5
Current debt	16.4	9.3	6.9

The relative decline in “miscellaneous loans” (which is generally interpreted as being substantially equivalent to borrowings to finance the short-time needs of business) has been motivated in part from the side of the lenders and in part from that of the borrowers. On the one hand, from 1922 until 1930 the condition of the investment market favored long-time financing. We had a sellers’ market first for bond issues and later for common stock issues. Concerns which have been able to sell their stocks on a 3 per cent basis have naturally been encouraged to obtain capital in this way to pay off their bank loans. On the other hand, business men have undoubtedly been influenced to refund their short-time obligations into stocks and bonds by a recollection of the widespread distress which prevailed in 1920 and 1921 because of the inability of business men to take care of maturing bank loans. So many businesses passed into the control of bankers at that time that a tradition was created in favor of securing working capital through stock issues—just as the great number of business failures which resulted in the nineties from inability to pay interest and principal of bonded debt created a bias in favor of short-time financing.

The official position of the Reserve system has been mildly hostile to the increase of investments and collateral loans on the part of the banks. However, the development has received surprisingly little attention in official literature. In its annual report for 1928, among other reasons for its policy of forcing member banks to withdraw their funds from the stock market, the Reserve Board cited the increasing proportion of security investments and security loans among the assets of the banks.

In recent years the most rapid expansion of bank credit has been in the direction of increasing use of bank funds in investments and in loans on securities. Between the middle of 1925 and the middle of 1928 member bank holdings of investments increased from $8,863,000,000 to $10,758,000,000 and their loans on securities from $6,718,000,000 to $9,068,000,000. At the present time, of the total volume of nearly $35,700,000,000 of loans and investments of member banks, more than 57 per cent are either in investments or in loans on securities. Securities thus underlie considerably more than half of the outstanding volume of member bank credit. The proportion of bank credit that is based on securities has been rapidly increasing.8

This was all that was said on the subject. There was no discussion of the question whether the increased proportion of bank credit based on securities was out of line with the increased proportion of commercial and industrial financing that was being done through security issuance, nor any citation of the advantages and disadvantages of such a tendency. The upward trend of the proportion of such credit to total bank credit had been evident for years and had apparently aroused no concern.9 Now the proportion is still higher10 but the change seems no longer to arouse misgivings.

Aside from the statement quoted above, I have noted in the official pronouncements of the Federal Reserve system no direct reference to the increasing absorption of bank funds in security investments and security loans. There are statements of principle which might imply hostility to a development in this direction,11 but except in connection with the attack on the stock market boom in 1928-29, these principles are not linked with policy.

The growth of the practice of financing investment through the use of bank funds has been facilitated by Federal Reserve practice both with regard to open market purchases and with regard to collateral loans. Open market investments put funds into the possession of the banks without giving the Reserve system any direct control over the use made of them by the member banks. If credit is extended chiefly by rediscounting it is necessary for banks to put their funds into use in ways which give rise to eligible paper. This is the prime objection to the open market operations, from the standpoint of those who deplore recent tendencies in the lending policy of the banks. Their expansion bears no necessary relationship to the volume of business done in ways which give rise to eligible paper. The extent to which open market purchases of government securities have created the credit base during the past ten years was indicated on pages 28-29.

In addition, since 1917 the member banks have been permitted to borrow on their collateral loans, secured by government obligations, and this type of borrowing has become much more popular than the rediscount of eligible paper. The proportion of member bank borrowings at the Federal Reserve Banks which is secured by United States government bonds and notes is indicated in the accompanying table.12

December 31	Percentage
1922	53
1923	48
1924	59
1925	60
1926	57
1927	72
1928	62
1929	56
1930	35
1931	50

The preference is not due to the relative scarcity of eligible paper. The total amount of eligible paper was estimated by the Federal Reserve Board at 2,996 million dollars as of September 29, 1931, of which amount less than 300 million dollars was actually rediscounted.13 If the eligible paper were evenly distributed, or if it could readily be redistributed through the open market, there would never have been any question of a shortage of eligible paper.14 Far more important in determining the way in which member banks borrow is the matter of convenience and economy in handling. Eligible paper must be sorted out and certified by the rediscounting bank; scrutinized by rediscounting officers; and withdrawn and replaced by other paper as it matures. Collateral loans against securities can be made with much less formality. Some banks keep their government securities permanently in the custody of the Reserve Bank and simply telephone or telegraph when they wish to borrow against them. Loans of this type require no credit analysis and involve the minimum amount of replacement of collateral.

These two practices, open market purchase and collateral lending, greatly simplify the task of Reserve Bank administration. If it is assumed that the significance of Reserve policy is in its effect on the volume of outstanding credit,15 they are more effective than is the rediscounting of commercial paper. On the other hand, if it is assumed that the Reserve Banks have a responsibility for the credit situation on its qualitative side, meaning by this the kind of instruments used by the banks as a basis of credit extension, collateral loans and security purchases are bad practice. So long as banks can obtain ample credit by the use of government paper, using it as collateral for short borrowings or selling it out if their needs are likely to be of longer duration, there is little pressure on the banks to revise their lending practice along the lines suggested by the regulations governing eligibility.

The drift of the commercial banks toward the status of investment trusts has been an indirect consequence of certain Federal Reserve policies. The fact that the bulk of the credit extended has taken the forms of open market purchases of government securities and collateral loans on government securities has made it unnecessary for the banks to hold eligible commercial paper. True, the Reserve Banks have not made, and under the Federal Reserve Act could not make, loans to members on the collateral of industrial securities; and it is industrial, rather than government, securities which have become increasingly the basis of the banks’ lending and investing operations. Therefore, looking at the matter from the standpoint of an individual bank it might appear that the Reserve system policies in question have had no influence on the volume of industrial securities bought or accepted as collateral. If a bank could not borrow on its government bonds it might have to sell them and buy commercial paper, but that would not necessarily affect the amount of industrial and real estate bonds in its portfolio.

But from the standpoint of the banking system as a whole the case looks very different. If the member banks of the Federal Reserve system had to hold a greatly increased amount of commercial paper, they could get it only by pursuing policies which would encourage business men to borrow on short-term liquid paper instead of issuing so many long-term securities. The supply of commercial paper could be increased readily if there were any inducement for the banks to give it preference over other methods of extending credit. As this took place the growth of the supply of investment instruments would be correspondingly checked. Government paper would be forced out of the portfolios of the banks only to the extent that a falling off in the issuance of industrial securities created a private investors’ market for the government paper.

However, the discrepancy between the Reserve system’s nominal standards and the actual loan and investment policies of the banks is due only in part to the facility with which the banks can borrow on the security of government obligations. To a larger extent it has been due to the open market operations, which give the member banks the use of credit without giving the Reserve Banks any control over the use which is made of them by the member banks.

In summary, questions regarding the eligibility of specific types of paper for rediscount, though they have received a great deal of attention from the Federal Reserve Board, are of distinctly minor importance. From the standpoint of Reserve system control of the quantity of credit extended, detailed restrictions on eligibility will be of no consequence so long as member banks are allowed to borrow on their collateral notes, and so long as Federal Reserve Banks continue to pursue a liberal open market policy. And, from the standpoint of qualitative control, eligibility restrictions can have no great significance so long as member banks are under no pressure to rediscount.

• 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).
• 5a Compiled from Annual Reports of the Federal Reserve Board and from Federal Reserve Bulletins, Vol. 18, pp. 186, 352, 358, 400.
• 6Annual Report of the Federal Reserve Board, 1923, p. 10 (quoted below, pp. 79-80); Federal Reserve Bulletin, 1928, Vol. 14, p. 6.
• 7a Facts and Figures Relating to the American Money Market, p. 61; Federal Reserve Bulletin, 1932, Vol. 18, p. 105.
• 8The 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.
• 9For fuller discussion of these points, see Chap. IX; compare also B. H. Beckhart, The Discount Policy of the Federal Reserve System, Chap. II.
• 10The 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.
• 11Compare chart, p. 35.
• 12The 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.
• 13Compare p. 231.
• 14Annual Report of the Federal Reserve Board, 1927, pp. 10, 16.
• 15See pp. 104-05.