CHAPTER XXXI

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.

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.

From the beginnings of agitation for currency reform the advocates of elasticity have recognized more or less clearly two kinds: (1) what we may call _seasonal_ or ordinary elasticity, and (2) what we may call _emergency_ elasticity. By the former was meant the power of a note issue to adjust its volume to those moderate changes in the need for money which show themselves in the course of an ordinary year. By emergency elasticity was meant the power of a note issue to adjust its volume to those extraordinary changes in need which connect themselves with the typical banking panic. The evils which it was believed that seasonal or ordinary elasticity would remedy were principally (1) the summer shortage of currency for moving crops, together with the temporary but more or less serious stringency in the New York money market which accompanies that shortage, and (2) the plethora or excess of currency which usually appears three or four months after the crop-moving period has terminated. The evils which emergency elasticity was expected to relieve were principally (1) the stringency which precipitates the panic, (2) the money famine consequent on general bank suspension after the panic has fully developed, and (3) the glut of currency which attends the depression following a panic, often leading to excessive exports of gold and thus endangering the whole credit system of the country.

Let us, now, take up seasonal or ordinary elasticity, and ask ourselves whether the new notes are likely to possess this characteristic. First, how about the expansibility needed to supply adequate funds for crop-moving? At this point, it must at once be admitted that the new currency does not meet the demands of the case in quite the thoroughgoing way which the earlier schemes thought to be necessary. The ideal of the earlier plans was to provide an adequate and easily utilized power of issue, located at the very place where the need for expansion is felt, _i. e._, in the local bank. The new law gives up this idea entirely. The local bank will not have power to issue the new currency at all. In so far as its customers are to get any benefit from that currency the benefit must come through two channels which the country bank could use in getting the needed funds, even if the currency had no expansibility, namely, (1) calling in its balances kept with banks more centrally situated, and (2) borrowing from such central banks. In other words, the new power of issue will help out in the crop-moving period merely because it will put the reserve banks in a better position to respond to the call of the country banks for the return of their own balances and for advances on discounted paper. Judged from this point of view only, the elasticity provided by the new law is doubtless adequate. If the reserve banks have not kept themselves in a position to meet the calls of their country members from money already in possession, they will surely be able to put themselves into such a position by expanding their issue of notes. In one sense, then, the new issue has adequate expansibility for ordinary needs. There still perhaps remains a doubt whether effective elasticity is after all assured, for it is not clear that the country bank which needs money for crop-moving purposes will have the wherewithal to get advances from the reserve bank--that is, that it will have paper of the proper kind and in sufficient amount for rediscount. However, it seems probable that the act as finally passed has met this need by providing that agricultural paper shall be admitted on rather more liberal terms than paper arising out of ordinary commercial or manufacturing business. If this be so, it would seem that the provisions of the new law for securing one phase of seasonal elasticity--expansibility--are fairly adequate.

Passing, now, to the other side of elasticity--_i.e._, contractility--can we say as much? Will the new issues promptly retire when their special task is over? _Prima facie_, the verdict here is less favorable than in the previous case. In general, there are two principal processes by which a note circulation may be contracted: (1) _driving_ the notes out of circulation, and (2) _drawing_ them out. In so far as the former process is depended upon, means are devised to make sure that the notes shall persistently return to the issuer even against his will--they shall have good homing power. By the second process, it is made to the advantage of the issuer of the notes to hasten their withdrawal himself.

As respects insuring contractility by the former of these processes, the act certainly cannot claim to promise high efficiency. The driving-out process requires roughly the fulfilment of two conditions: (1) keeping the channels for the return of notes to the issuer fairly open, and (2) supplying outsiders with a motive for sending the notes home. As regards the former of these conditions, the new system probably is all right. The return of the notes to the issuer seems not to be impeded by the inconvenience or expensiveness of the process. All member banks and all reserve banks must receive these notes; and the reserve banks will probably have branches within easy reach of any part of the district. Hence, any holder desiring to get notes back to the issuing bank will find the process easy and the way open. But good homing power requires more than this. It requires, namely, that adequate motives be supplied to people generally, or, at least, to banks generally, for seeing that the notes get back. It is not enough that the track be smooth; people must desire to use it. Now, earlier plans for securing elasticity relied on two principal motives for inducing holders to send notes back to the issuer: (1) the desire of such holders to make room for their own notes, and (2) their desire to exchange money which has various limitations imposed upon it for money which is free from those limitations. It is plain that the new system makes only a limited use of the former of these methods of procedure. _Within_ the district for which any particular reserve bank is the central bank, this particular force will be practically inoperative; for the power to issue notes on the basis of common assets is not given to any but the reserve banks, and the profitableness of the power to issue the old type of note has always proved too low to induce banks generally to take much trouble to get their own notes into circulation. As between the reserve banks of the different districts, however, this particular motive will, of course, be more or less in evidence, since these reserve banks will all be competitors for this opportunity. But even here the motive in question will not play a large part, since more effective means for insuring the return of the notes from outside reserve banks are provided in other parts of the law.

As regards the second motive for returning idle notes--that is, the desire to exchange a money subject to various limitations or disabilities for one not subject to those limitations--the new act does somewhat better than it does in respect to the first motive. It is, indeed, true that, within their own district, no special disability, like being forbidden to be paid out by other banks, is put on the new notes. But they are always subject to the disability of not being legal reserve money in the case of federal banks; and hence such banks will be more or less disposed to return the notes issued by their own reserve banks, in order to exchange them for reserve money. It may be doubted, however, whether in ordinary times this will prove a very potent force, since country banks will usually keep reserves considerably in excess of legal requirements, and so will not need to discriminate nicely between the two sorts of money. As between different districts, the case for the homing power of the new notes is rather stronger, since reserve banks are prohibited from paying out the notes of other reserve banks under penalty of a 10 per cent. tax. Even here, however, the provisions are none too adequate. While the notes of a particular reserve bank must not be paid out by the reserve banks of other districts, there is no prohibition against their being paid out by the member banks of other districts; and it is doubtful whether there is sufficient motive to induce said member banks of other districts to send in these notes to their own reserve banks and so start them on their homeward journey. The desire to exchange money which cannot be used as reserve for that which can be would have some force; but, under many circumstances, it would probably prove rather inadequate.

Another disability which contributes to the homing power of a bank note, and which is actually used in the case of our old note, is not used with this new note--I mean, the fact that they are not receivable for customs dues. The decision to omit this provision was perhaps wise; but it throws out a potent motive for sending notes home, and thus throws away an opportunity to make better provision for their contractility.

On the whole, then, it must be acknowledged that, in so far as homing power is dependent on giving to outsiders strong and persistent motives for sending notes home, the new law is not altogether satisfactory.

We have seen that there is very little in the new system to secure that the notes shall have good homing power--shall get home by what we have called the _driving-in_ process. Is the system better off as respects the _drawing-in_ process? Are matters so arranged that the issuing bank will have the power and the desire to withdraw its notes--or at least contract the currency proportionately--when the need for the notes has fallen off? As respects the first part--making sure that the issuing bank shall have the power to retire its notes, or at any rate to effect a corresponding contraction of the currency--the new system is practically perfect, as indeed was the old one. That is, any reserve bank desiring to contract its note obligations may at its discretion deposit with the federal reserve agent reserve notes, gold, or lawful money. Obviously, this, if not strictly a contraction of its note circulation, at least brings about the desired contraction of the general circulation.

When, however, we consider the provisions of the new law for insuring that reserve banks shall desire to contract their circulation when the special need has passed, we find that the law does not promise quite so well. The favorite device for accomplishing this result has been, of course, a tax on issues, similar to the 5 per cent. tax of the German system. Apparently, the new law provides for something equivalent to this in the shape of an interest charge by the Federal Reserve Board, the rate to be fixed by said board. How far this device will prove effective in practice it is not safe to predict. In order that it should induce the banks to contract their circulation, circumstances must have arisen under which the issuing bank would be earning on its outstanding notes a profit smaller than the tax itself. Now, it does not seem certain that an excessive issue of notes would necessarily bring about this condition. In the first place, in the absence of good homing power, a volume of notes in excess of business needs would not necessarily cause an accumulation of those notes in the vaults of the bank issuing them. Secondly, so long as member banks are free to keep their balances in banking institutions other than their reserve banks, an excess of notes would not necessarily cause the general cash holdings of reserve banks to be abnormally large. For, so long as the ordinary New York banks are permitted to pay interest on bankers' balances, country banks will to a considerable extent keep their balances with these outside New York banks; and it seems not unlikely that the excessive monetary stock thus accumulating in New York City would, instead of getting into the hands of the New York reserve bank, largely remain in the hands of the outside banking institutions and be employed more or less as it has been in the past, that is, in financing doubtful enterprises and supporting excessive speculation. But if the reserve banks do not feel the pressure of excessive issues in the shape of accumulations of notes or some form of money in their own vaults, they may conceivably be able to invest advantageously all the funds in their possession, and, in that case, the rate of interest charged by the Federal Reserve Board will not furnish an adequate motive for the retirement of their issues. Doubtless, however, this may in some degree be answered by saying that even an excess which was felt only outside the reserve bank would, after all, compel the reserve bank to contract its issues, since it would lower the rate of discount so greatly that reserve banks could not profitably invest their ordinary holdings, and consequently would wish to get rid of the interest charge. Perhaps this is true; but it would by no means insure the prompt and full contraction which most reformers have considered desirable.

From the foregoing it would seem that one of the devices for inducing the reserve banks to contract their issues after the need for them had passed--that is, charging interest upon such issues--is not certain, at any rate, to prove adequate; it will not surely eliminate the winter plethora in New York City which is supposed to stimulate and support excessive stock speculation. But the new law contains another provision which may be viewed as a device for supplying the issuing banks with a motive for contracting their issues, namely, the requirement that such banks shall keep a gold reserve equal to 40 per cent. of their issues. Is this likely to prove effective? Probably not. Whatever might be true in panicky times, it seems certain that in an ordinary year the gold holdings of a reserve bank will be much above 40 per cent. of its note issue. If this be true, the maintenance of this 40 per cent. could become difficult only when the excess of money was so great as to cause a dangerous exportation of gold from the country, and this surely would show a very inadequate degree of contractility. In short, the new law does not insure that issuing banks shall be sufficiently disposed to draw in their notes any more than it insures that outsiders will drive them in. It would seem, then, that the new law does not promise to give to the note issue the degree of contractility which has hitherto been considered desirable. In other words, there is some point in the fear expressed by many bankers that the new law will result in note inflation--at least in so far as the avoiding of this danger is dependent on the contractility of the note issue. Very likely, however, the possibility of such inflation is sufficiently guarded against by other provisions of the law.

We have discussed the adequacy of the new note issue in respect to seasonal or ordinary elasticity. We pass on now to consider its adequacy in respect to emergency elasticity--the elasticity which enables a currency to adjust itself to those extraordinary fluctuations in need which mark a banking panic and the depression that follows. Broadly speaking, it is pretty certain that at this point the new law will get a more favorable verdict than in the previous case. As pointed out in an earlier connection, the banking panic, when fully developed, gives rise to three difficulties and so to three needs: (1) funds to relieve the antecedent stringency which threatens a complete collapse of the credit structure; (2) a circulating medium for ordinary trade when a general suspension of payment by the banks has brought on a money famine; and (3) a prompt and thoroughgoing contraction of the circulation in the depression which follows the panic. Now, there surely can be no doubt that, under the new law, the availability of an issue sufficient in volume instantly to relieve the antecedent stringency, and so to put a stop to a panic before it had developed serious dimensions, is assured. In fact, it is not at all improbable that, under the new system, the reserve banks will be able to check the development of such a panic at the very outset without increasing at all their note issues. But, if this does not prove true--if it turns out that more currency is needed for this purpose--there would seem to be no shadow of doubt that the new system will insure the forthcoming of such currency both of a quality and in a quantity which will be fully adequate to the task put upon it. (1) The notes to be issued, being obligations of the Federal Treasury, will be as acceptable as gold even on the eve of a panic. (2) There is no limit to the absolute amount of these notes. (3) The practical limit set by the requirement that discounted paper shall be furnished as a basis for their issue is of no real significance, since such paper will undoubtedly be vastly greater in volume than any need which could arise. Accordingly, there can be no doubt that the new system provides all the expansibility needed to abort, or reduce to comparative harmlessness, any panic which might arise.

A word now with respect to the second need which an emergency circulation is supposed to meet, that is, an ordinary circulating medium for trade when banks have by common consent suspended payment. In the first place, if we are right in supposing that the new law will surely prevent any panic from reaching such a degree of intensity, it is obvious that we shall not have occasion to meet the particular difficulty here under consideration--that our note issue will not be called on to display this particular sort of elasticity. If, however, it be supposed that the foregoing prediction does not turn out to be correct--if experience proves that panics can still go so far as to cause banks generally to suspend payments, to hold on to every form of reasonably solid money, and to try to satisfy the public with substitutes--our verdict for the new currency would necessarily be less favorable. We should have to admit that the new law does little or nothing to relieve such a situation. Broadly speaking, the new money will be altogether too good to meet this particular need. Banks that had reached a stage of panic sufficiently intense to cause them to suspend payment--to hoard the ordinary forms of money--would be sure to hoard money as good as those notes are bound to be. That is, the new issue would immediately pass into hoards, as did the greenbacks which the Secretary of the Treasury reissued during the panic of 1873, and, therefore, would bring little if any relief to the currency famine which had developed. In fact, it is almost impossible to conceive any form of note fitted for this particular task except one which was so bad that there was no danger of its being hoarded. That is, the only proper way to meet this particular need of a severe panic is to make sure that it does not arise at all; and, in this respect, the new law promises well.

We come, finally, to the third need which emergency elasticity is supposed to meet, that is, a prompt and great contraction of the circulation when the panic has passed and the inevitable business depression consequent upon such a panic has set in. Here, again, though not in the same degree as in the last case, if the new law proves as successful as many conservative students expect, the need in question will be little, if at all, experienced. We shall usually escape the extreme business inflation of the antepanic period; the panic itself will be much abated, if not completely eliminated; and, in consequence, the trade reaction which naturally follows a panic will be much diminished in intensity. If this turns out to be true, the circulation will never again show such an extraordinary glut as characterized the winter of 1893-94. Nevertheless, it can hardly be doubted that, after even an incipient panic, there will be some reaction, and consequently a more or less plethoric condition of the currency will follow. Will the new issue have sufficient contractility to meet this need? Earlier in this paper we have seen that the conditions attached to the new issue are in general not favorable to contractility, in that they do not provide for either the prompt driving home or the prompt drawing home of the notes when the necessity for their issue is past. Outsiders lack adequate motives for sending the notes home; issuers lack adequate motives for calling them home. The case for emergency contractility, however, is somewhat better than the case for ordinary contractility. First, it is probable that the homing power of the note will prove greater at such a time than in an ordinary year, for, at such a time, outside banks will not be able to find investments for their funds, since speculative trading will disappear altogether and business generally will be at a very low ebb. Again, it seems certain that the issuing bank will, in this case, have more than the usual motive for bringing about a contraction of the circulation. The chief reason why such a bank may not be eager in ordinary times to hasten the retirement of its notes is the fact that, provided the notes do not accumulate in its own vaults, such a bank will gain more by using the funds in its possession to make loans than it would by using them to retire notes, assuming that the interest charge made by the Federal Reserve Board is not placed excessively high. But it is practically certain that, in the depression which follows a panic, no reserve bank will have opportunities for keeping all of its funds busy; and since, in that case, the interest charge, however small, will be a dead loss, the bank will have adequate motive for effecting, as promptly as possible, an adequate contraction of its note liabilities. This motive would be still further strengthened should the glut prove sufficient to cause a decided drain of gold, since, in that case, the reserve banks will find difficulty in maintaining the required 40 per cent. reserve. On the whole, then, we seem warranted in affirming that, as respects emergency elasticity, the new notes will give no serious disappointment.

Finally, as respects elasticity in general, though the note issue, viewed by itself, does not seem quite fitted to satisfy the tests which an old-fashioned advocate of elasticity is inclined to impose upon it, yet, when we take the new law as a whole, it seems not unreasonable to affirm that it promises to accomplish, directly or indirectly, most of the ends which we had hoped to attain through elasticity and hence promises to give us a system which in essentials is truly and adequately elastic.

NOTES PRINTED AND ISSUED

[300]During the year 1915 the circulation of Federal Reserve notes has increased to $188,817,000 as of December 31, 1915. Believing that the country should be prepared against any contingency, the Board had authorized the printing of about $700,000,000 of these notes. Almost one-quarter of the total supply printed has been placed in circulation. On December 31, 1915, however, only $16,675,000 of notes secured by commercial paper pledged with the Federal Reserve Agents was outstanding as an obligation of the Federal Reserve Banks. The liability of the Federal Reserve Banks as to the remainder has been discharged by the deposit with the Federal Reserve Agents of a like amount of gold and lawful money. This result has been achieved by the Federal Reserve Banks in responding to requirements, for currency by issuing Federal Reserve notes rather than by parting with gold. While the gold pledged with the Federal Reserve Agents represents a very valuable protection in case of a substantial demand for gold, it must be observed that the process is expensive without, at the same time, giving to the Federal Reserve Banks that additional strength and lending power which they would secure in case the law were amended so that the Federal Reserve Banks would remain liable for the outstanding notes, but, on the other hand, would retain property title to the gold delivered to the federal reserve agents, which, in that case, would not be paid in to extinguish the liability upon the notes but would be deposited as collateral security against them.

IMPOUNDING GOLD

[301]On November 16, 1914, the first shipment of Federal Reserve notes was received by the Federal Reserve Agent [of the Federal Reserve Bank of New York] from the Comptroller of the Currency. On November 19 the bank pledged with the Federal Reserve Agent $500,000 of commercial paper rediscounted by member banks and received from him a similar amount of Federal Reserve Notes. These notes were not required by the banks which made the rediscounts, as they had already withdrawn by checks the credits so established. They were taken by this bank for its general use. The issue of Federal Reserve notes gave the reserve bank the opportunity of affording to its member banks complete interchangeability between book and note credits. The bank therefore established the policy of issuing Federal Reserve notes freely to any member bank desiring them whether the credit thus withdrawn was established by it through rediscounting, or the deposit of checks, or the deposit of gold or lawful money. In practice, however, most credits withdrawn by notes have been established by the deposit of checks which have been collected by this bank in gold or lawful money through the clearing house. Accordingly, the accumulation of cover in the hands of the Federal Reserve Agent has been mainly gold, with but a small amount of rediscounts. The processes provided by the act for the issue of Federal Reserve notes to the reserve bank permit complete interchangeability between gold and rediscounts held by the agent. Gold may be substituted for rediscounts and rediscounts for gold, in accordance with the requirements of the reserve bank. During the entire period its requirements have been for notes with which it might exercise its statutory right to "exchange federal reserve notes for gold, gold coin, or gold certificates."

The policy of the Federal Reserve Bank has resulted in greatly strengthening its gold position and its ability to assist its member banks or other Federal Reserve Banks should they at any future time seek credit in order to withdraw gold for domestic or foreign uses. Through this policy also it has been able potentially, at least, to retard the expansion of credit by impounding in the hands of the agent a large volume of gold which might otherwise have found its way into bank reserves already superabundant.

Furthermore, through this policy it has been able to take the first step toward accomplishing one of the purposes of the act set forth in its title, _e. g._, "to furnish an elastic currency." There are two forms of elasticity, one of _quantity_ and the other of _quality_, both provided for in the act.

From the point of view of cover, the gold certificate is completely inelastic. It stands at one extreme of our currency, with a dollar of gold set aside behind each dollar of paper. At the other extreme stands the national-bank note, with only 5 cents of gold set aside behind each dollar of paper. The assets of the issuing bank make it good, but its elasticity is nullified by the requirement that it must be secured dollar for dollar by government bonds.

Between these two extremes the Federal Reserve note, a new form of currency, has been introduced. For each dollar of this paper there is set aside from 40 cents to $1 of gold. As in the case of the national-bank note, the obligation of the United States and the assets of the issuing bank secure it.

The process in which this and other Federal Reserve Banks have been engaged is the substitution, as a circulating medium, of a note which is elastic in quality for the inelastic gold certificate. Gold is the most uneconomical medium of hand-to-hand circulation since, when held in bank reserves, it will support a volume of credit equal to four or five times its own volume. What the reserve bank does in accumulating gold behind its Federal Reserve notes is to establish with the holder of each note a credit which may be availed of whenever the occasion requires. With this credit established it can convert at will its gold-covered notes into notes covered partly by gold and partly by commercial paper. In times when credit is becoming strained and bank reserves need strengthening or when gold must be exported, this conversion will take place, and after the strain is over the gold cover will be restored through the repayment of the rediscounts substituted for it. In this way elasticity of quality in our currency is obtainable. But it should not be construed as in any way a deterioration of the currency contemplated by the act. Quite the reverse is true. The act provides for the issue of Federal Reserve notes in unlimited amounts, with 40 cents of gold behind each dollar of paper. This is elasticity of quantity and it becomes operative with the minimum of gold cover. Elasticity of quality, on the other hand, operates with a gold cover always above the 40 per cent. minimum and ranging as high as 100 per cent.

In order to be prepared for any currency demands which might be made upon it, the Federal Reserve Bank of New York in the spring of 1915 adopted the policy of having printed and keeping constantly on hand a supply of Federal Reserve notes substantially in excess of the amount of emergency currency which, experience shows, this district might be called upon to supply. The maintenance of this policy and of the policy of issuing Federal Reserve notes freely has entailed a heavy cost upon this bank. Unissued Federal Reserve notes are carried at cost on the books of the bank, and at the end of each month the amount of notes issued to the bank during the month is charged off at cost. The shipment of notes unfit for circulation to the Comptroller of the Currency at Washington for cancellation and destruction is a further item of expense in connection with the maintenance of these policies. The directors and officers of the bank, however, feel that the results accomplished amply justify the expense incurred, and consider that the added strength furnished the bank by the gold thus accumulated is perhaps the most important result of the operations of the period.

Some reduction has already been made in the cost of printing Federal Reserve notes, and it is to be hoped that further experience and study will enable other substantial reductions to be made in the cost of preparing for issue what has already become an important element of the circulating medium of the country. The act provides that all expenses in connection with the issue and redemption of Federal Reserve notes shall be borne by the Federal Reserve Banks, and in view of the service the banks are performing in accumulating gold through the medium of these notes, the feeling is quite general among their officers that the notes should be furnished to them at the lowest possible cost consistent with the high quality of workmanship required.

The design of the notes is not altogether satisfactory for efficient handling. In sorting notes it is necessary to be able readily to distinguish between notes of this bank and notes of other reserve banks. This would be greatly facilitated if the printing of the distinctive number and letter of each bank were made more general on the face of the note.

THE FINANCIAL POLICY OF THE FEDERAL RESERVE BANKS[302]

It seems clear that the cardinal principle in the management of the Federal Reserve Banks will be to disregard the course which will lead to maximum profits, following instead the path which will lead to the greatest safety and which will permit these banks to be of the greatest service to the nation. Large reserves should be maintained, and these should consist chiefly of gold. The payment of interest upon bankers' deposits and government deposits should be avoided, if possible, for the reason that the payment of interest will force the keeping of smaller reserves, if the cumulative dividend is to be earned. The banks should be managed, not from the standpoint of profit, but from the standpoint of safety.

Yet this is but one side of the policy of the Federal Reserve Banks. Their power and influence can be made to extend much farther than would result solely from the wise management of their own affairs. These banks are the financial trustees of the nation. The country will look to them to see that they exercise over the member banks a closer supervision and discipline than has been possible in the past. Supplementing a negative control by the bank examiners, who are powerless so long as the letter of the law is observed, the federal reserve banks will be a great positive force. The Federal Reserve Banks, with the approval of the Federal Reserve Agent or the Federal Reserve Board, may conduct examinations of a member bank, both for the purpose of ascertaining its condition, and, what will be of equal importance, for the purpose of determining the lines of credit which are being extended by it.

In the long run, the greatest work which the Federal Reserve Banks can do for the business men of this country is to improve and standardize the methods of commercial borrowing. I believe it is possible for these banks, with the approval of the Federal Reserve Board, under the power just quoted, to establish a comprehensive credit information clearing service through which the aggregate loans of all large borrowers can be known by any bank official and through which excessive borrowing or the lending of money to concerns pursuing unwise financial policies can be checked before disaster overtakes them. This is one of the greatest needs of our banking system....

RELATIONS OF FEDERAL RESERVE BANKS WITH MEMBER BANKS[303]

The aim of this bank [Federal Reserve Bank of New York] at all times has been to maintain frank and friendly relations with its member banks. At every meeting of the New York or New Jersey Bankers' Associations, or of their groups, to which invitations have been received, one or more of the directors or officers have been present and discussed the development of the various functions of the system.

When the establishment of an intradistrict collection system was under consideration, the directors and officers invited representative member bankers from all parts of the district to confer with them at the office of the bank. The plan finally adopted was thoroughly discussed in all its aspects and a consensus of opinion seemed to prevail that it was a fair and reasonable plan.

When the conditions under which State banks should be admitted to the reserve system were under consideration three conferences were held by the directors and officers of the bank, one with national bankers, one with State bankers, and one with trust company officers, from various parts of the district, to ascertain their views upon the question at issue. In every case the policy has been pursued of dealing frankly with those present, in order that they might understand fully how the action under consideration would affect them.

The officers have expressed themselves at all times as desirous of establishing personal relations with officers of member banks and have invited them to call at the bank when in New York City. Yet a year has gone by and officers of probably not over 15 per cent. of the member banks have done so. Many of them still have the feeling that the bank is a branch of the Government. Their experience with the Government consists principally of the statutory and supervisory relationship which exists between them and the Comptroller's office. The conception of the relation of this institution with them as co-operative makes headway slowly. The fact that the national banks were practically compelled to join the system naturally retards the development of the co-operative idea. The change of attitude, upon which the success of the system will ultimately depend, will probably come slowly, but there are already signs, as we enter upon the second year of the system, that the banks are getting more accustomed to it and appreciate the results it has already accomplished. It is hoped that during the coming year, with organization pressure somewhat lessened, more time can be devoted by the officers to developing personal relations with the officers of member banks.

The present attitude of the member banks toward the reserve bank may be summarized as follows:

The New York City banks, upon which the strain of all crises first and chiefly falls, fully understand the value and benefits of the system. While regretting the loss of bank deposits which will probably be drawn from them (estimated to be as high as $250,000,000), they are nevertheless hearty supporters of the system, at all times co-operative in their attitude.

Many of the banks in other large cities are unable to take full advantage of the lowered reserve requirements, but in spite of the loss of interest on their reserve balance, most of them understand what the system in its larger aspects means for American banking and generally give it their support.

While the same may be said of many of the country banks, yet it is among the country banks as a class that most of the apathy and hostility to the federal reserve system which still persists is found. Their opportunities and earnings are relatively small, and in order to live they must figure closely. They feel the loss of interest on reserve deposits; the absence, as yet, of dividends on their capital contribution; and the prospective loss or decrease of the exchange they generally charge on remitting for checks drawn upon them. Many banks in industrial centres are precluded by the activity of their business from taking advantage of the reduction in the required reserve. They believe that they will, in fact, be required to carry an even larger reserve than heretofore in order to obtain collection service for notes, drafts, and non-member bank checks and the various other services now rendered by their reserve agents, but not yet undertaken, by the reserve banks. It is very natural that they should view with reluctance the termination or diminution of long-standing business associations with their reserve agents. Few of them, as yet, conceive of the reserve bank as their active reserve agent, performing all the services which go with the relationship. The dormant accounts most of the banks maintain with the reserve bank are, perhaps, indicative of their attitude toward it. Relatively few banks of this district are borrowers; in good times and bad they have been able when necessary to borrow from their city correspondents on bonds or on the indorsement of their directors, two avenues which are now to be closed to them. The rediscounting privilege has been little availed of and the larger functions of the Federal Reserve System, such as influencing domestic rates and international gold movements through the development of a discount market and by dealing in foreign bills, appear remote from their spheres of activity. They feel that the system has few advantages to offer in return for the cost it entails upon them.

All of these points will be felt with increasing acuteness by the country banker as his reserve transfers approach completion and as reduced balances result in reduced service from his city correspondent. His point of view is outlined thus frankly in order that the difficulties he sees may be clearly recognized and steps taken gradually to remove them. The development of a more satisfied relationship requires progress on the part of the reserve bank and a willingness to co-operate on the part of the country banker.

The reserve bank should organize a complete collection system embracing the handling of notes, drafts, and items on non-member banks, which eventually will bring all the members into daily active relations with the bank. It must be ready to act for member banks in the purchase, sale, and custody of securities; to supply credit information on names whose paper is offered by brokers; to give its members information concerning methods of developing the new functions which the act authorizes them to exercise; to perform the services now rendered by their reserve agents; and generally to assist them in every reasonable way.

The member banks should look upon the reserve bank not as an alien but as their own institution. They own all its capital and most of its resources, and they control its management through the directors they elect, subject always to the supervision of the Reserve Board. At the reserve bank they may borrow as a standing right and not as a favor which may be cut off. They no longer have to buy or carry bonds to serve as security for loans; the paper of their own customers, large or small, will now serve as their security. While panics in the past may not have affected them, they have been disastrous to the business interests of the country, who are their customers; and their contributions to the reserve bank should be recognized as a form of insurance not merely for themselves but for their customers as well. If this insurance is expensive and makes some changes in the nature of their business, the act should be carefully studied with a view to making the most of the new functions it provides. New avenues of activity should be looked for. The banks which will get the most out of membership are those which are the first to see and develop the opportunities it provides and to educate their customers to the protection and facilities they will enjoy through the system. The occasion is a favorable one also for the correction of abuses. Customers will do things in the name of the Federal Reserve System which they have never done before. The experience of banks in using the forms provided by the reserve bank to get statements from their borrowers is evidence of this. The occasion should be seized also to increase the balances of depositors who carry unprofitable accounts. To assist member banks in studying their accounts this bank has had under preparation by chartered public accountants a reasonably simple form for analyzing accounts which may be obtained by banks desiring to use it.

It is the duty of the directors and officers to understand not only the problems of the reserve bank but those of the member banks as well; and it has been their endeavor during the past year to give special study to those of the country bank. Several suggestions for the relief of the country bank have come to their notice.

One of these, which the American Bankers' Association at its 1915 Seattle convention favored, was to permit the 3 per cent. of reserve which the member bank may carry either in its vaults or in the reserve bank, to be deposited with member banks not more than 300 miles distant and count as reserve. This seems to be contrary to the spirit and intent of the act, which is primarily to centralize reserves in Federal Reserve Banks.

Another suggestion which seems more worthy of consideration is that the percentage of reserve required for country banks should be somewhat further reduced. When the reserve transfers are completed checks in transit can no longer count as reserves. It is clear, therefore, that the reserve reduction contemplated by the act will not be realized in practice. A further reduction in the reserve requirements would, in the case of many banks, result in a reserve less than the amount their business actually required, and would enable them to carry the amount thus freed wherever it would best serve their particular business, and, if they so desired, to maintain some relations with present city correspondents. It would lead away from the present rigidity of bank reserves toward greater flexibility and a better understanding of their meaning and purpose.

RELATIONS BETWEEN THE FEDERAL RESERVE BANK OF MINNEAPOLIS AND ITS MEMBERS

[304]The Ninth Federal Reserve Bank has sought to make the Federal Reserve Act fully operative within its district. During the spring of 1915 it had opportunity to demonstrate its effectiveness in meeting the requirements of agriculture in the Northwest during the planting season, and rediscounted liberally for member banks, in order to enable them to better satisfy the requirements of farmers. It relieved local pressure at a number of points where manufacturing enterprises and general business were depressed because of war conditions, and had opportunity to show that it can efficiently meet the demands of industry. Again, in the fall of the year, when an adverse season had created large amounts of immature corn, it was able to perform a very valuable service in assisting member banks to meet the requirements of farmers who were suddenly compelled to make provision for utilizing a valuable forage crop. During the prevalence of the foot-and-mouth disease it was able to come to the assistance of many banks in the western part of its territory, which had applications for loans from numerous stockmen who had cattle ready for market, but were unable to ship on account of quarantine conditions. The service above indicated, while not perhaps of notable consequence in any single case, consists in the aggregate of a very valuable degree of assistance, which would not have been available except for the Federal Reserve Bank, and without which, portions of the district would have encountered considerable hardships.

RELATIONS BETWEEN THE FEDERAL RESERVE BANK OF BOSTON AND ITS MEMBER BANKS

[305]Owing to the unusual conditions existing in the money market, and to the fact that the reserve city banks offer facilities to the country banks which this bank has not yet developed, more particularly in connection with the collection of checks and other items, the latter banks have carried only their minimum reserve requirements with this bank and have used its facilities only to a limited extent. The relations between country bank officials and the officials of this bank have been most cordial. While many of the banks in this district are borrowing, most of them find it much more convenient to go to their correspondent bank and borrow, either in the form of a demand loan, with or without collateral, or against a certificate of deposit.

The Comptroller's calls on the several dates show the total borrowings of member banks in the district as compared with their rediscounts with this bank, as follows:

_Total _Borrowed, Borrowed._ F.R.B._ Dec. 31, 1914 $4,738,416 $105,000 Mar. 4, 1915 4,047,708 234,531 May 1, 1915 3,969,796 410,723 June 23, 1915 4,284,445 270,441 Sept. 2, 1915 3,398,856 190,849 Nov. 10, 1915 2,985,406 131,725

The officials of the city banks on the other hand are apparently satisfied with the progress made in the development of this bank's functions. While but few of the Boston banks have rediscounted with us, almost all have intimated that should occasion arise they would do so. Furthermore, several Boston banks have entered into the acceptance business to a large extent, and the assistance that this bank has given in the matter of rates and market for acceptances has done much to bring it into favor with those banks. The Boston banks have also used this bank to a large extent in exchange transactions, and the services offered by the gold settlement fund have been used almost exclusively by those banks.

Thus far Boston banks have received more benefits from this bank than have the other banks in this district. A possible exception to this is in Aroostook County, Me., where, owing to an unusual situation surrounding the principal industry, the potato crop, banks have relied on this bank to a considerable extent to carry them through a trying period. The moral effect of having the Federal Reserve Bank of Boston stand behind them was not only appreciated by those banks, but enabled them to handle their business much more satisfactorily and to finance themselves without having to call upon this bank to an undue extent for rediscounts or without embarrassing their customers.

FEDERAL RESERVE BANKS AND THE ACCEPTANCE MARKET

[306]The right to accept drafts was conferred on New York State banking institutions by the act of April 16, 1914. Shortly afterwards a few acceptances were reported, principally against securities. It was not until the derangement of international credit facilities at the opening of the European war that American bankers' acceptances, especially those relating to foreign commerce, came into existence in substantial volume. At that time some of the trust companies with foreign connections extended credits freely to their customers to replace credits formerly granted by European banks which had been either withdrawn or reduced; they also accepted drafts in large volume. On and after May 18, 1914, member banks were authorized also to accept drafts drawn upon them involving the importation or exportation of goods....

The monthly purchases of acceptances by this bank [the Federal Reserve Bank of New York] in the New York market have been:

1915 _Number_ _Number_ _of pieces._ _Amount._ _of pieces._ _Amount._

_For itself._ _For other reserve banks._ February 41 1,659,740.21 86 1,263,871.25 March 140 3,343,143.17 250 3,799,809.42 April 86 1,272,694.36 84 1,700,396.57 May 46 867,420.18 48 1,305,873.80 June 132 3,083,261.75 34 602,558.89 July 106 2,496,865.67 147 2,348,050.89 August 103 1,597,630.63 89 1,910,417.47 September 89 1,769,880.50 172 1,948,243.05 October 68 2,199,679.95 163 2,028,098.36 November 115 1,899,606.56 246 2,594,951.04 December 310 5,648,708.78 313 2,809,823.59

Total 1,236 25,833,631.76 1,632 22,312,094.33

The policy pursued by this bank thus far has been to purchase good acceptances whether or not the acceptor was a member bank....

The reserve bank and the market rate for the discount of such bills in New York has been for nearly a year, and is now, lower than the rate for similar bills in London. The relatively small volume of such credits which American banks have succeeded in making operative even under the unusually favorable opportunity which the war presents for their extension, is evidence of the difficulty which will be encountered in developing the acceptance business in the United States. Some of the fundamental difficulties are:

(1) The disinclination to break old banking connections.

(2) The difficulty of educating handlers of bills in distant places as to American credits.

(3) The lack of bill buyers in foreign countries who will quote as low rates on dollar as on sterling bills.

(4) The natural prejudice of bill buyers in foreign countries in favor of a bill of known currency and against a bill of as yet unknown currency.

(5) The lack of men trained to exercise the judgment and financial responsibility required of them as managers of branches or agencies which American banks might establish in foreign countries.

(6) The inferior communications for both goods and mail between the United States and foreign countries as compared with those between Great Britain and foreign countries.

Only time, experience, and patient effort will remove these handicaps to the elevation of dollar exchange to its proper position in international finance. The business, however, is developing and will continue to grow as our banking machinery and connections extend throughout the world.

The Act permits member banks to accept an amount of bills not exceeding 50 per cent. of their capital and surplus. By the amendment of March 3, 1915, under certain conditions they may be authorized by the Federal Reserve Board to accept up to 100 per cent. of the capital and surplus. The following banks in this district have received such authorization:

_Amount of capital and surplus._ Bank of New York, New York $6,000,000 Mechanics & Metals National Bank, New York 12,000,000 Atlantic National Bank, New York 1,600,000 American Exchange National Bank, New York 8,000,000

As this bank has probably been the largest single purchaser of bankers' acceptances, it has been able, as it gained experience, to exert some influence toward standardizing practice and form....

The amended regulation[307] issued September 7, 1915, considerably broadened the field of acceptances eligible for purchase and encouraged an increased volume of these instruments. The further amended regulation issued December 4, 1915, covering the purchase of bankers' acceptances arising out of domestic transactions relates to a class of bills which national banks are not authorized to accept. When accepted by institutions of high credit they have a ready market, though at a fractionally higher rate than acceptances based on foreign transactions.

[308]New England imports a large volume of hides and wool from South America and cotton and jute from the Orient and other sections of the world. These shipments in the past have been financed through credits drawn on European centers. Since the opening of the Federal Reserve Banks these foreign trade transactions have been financed to a large extent through dollar credits drawn on this country and the acceptances arising there from have found a ready market in the Federal Reserve Banks. Several of the member banks in this district have entered this new field of finance and the Federal Reserve Bank of Boston has used every effort to further and develop that business, not only by buying a large amount of that class of paper, but also through furnishing favorable forward discount rates to assist in protecting its member banks. The following member banks have entered this field:

1. First National Bank, Boston, Mass. 2. Fourth-Atlantic National Bank, Boston, Mass. 3. Merchants National Bank, Boston, Mass. 4. National Shawmut Bank, Boston, Mass. 5. Old Colony Trust Co., Boston, Mass. 6. Second National Bank, Boston, Mass. 7. Merchants National Bank, Worcester, Mass.

Under special permission of the Federal Reserve Board the First National Bank, of Boston, and the National Shawmut Bank, of Boston, have been given authority to accept up to 100 per cent. of their capital and surplus. It is of interest to note that the former bank has reported the largest amount of acceptances of any member bank of the Federal Reserve System.

CLEARINGS AND COLLECTIONS IN PRACTICE

[309]Section 16 of the Federal Reserve Act made general provision for the establishment of a system of clearance of checks throughout the United States, each Federal Reserve Bank being required to act as a clearing house for its members if directed by the Federal Reserve Board, while the Federal Reserve Board was authorized to clear for the reserve banks themselves.

The Board had from the first recognized its duty to make this provision of the law effective as fully and at as early a date as conditions would permit; and in its first report spoke of this as "one of the most important responsibilities with which it is charged under the Act." So, regarding its duty in this particular, it undertook early in 1915 the preparation of a general circular and regulations intended to provide for the clearing of checks within the several Federal Reserve districts, while it also took under advisement the establishment of a gold settlement fund at Washington for the purpose of clearing obligations between Federal Reserve Banks. The latter undertaking has been carried to a successful conclusion and the gold settlement fund has been in full and satisfactory operation since about the first of June. The Board, however, had not advanced far with its work relating to the intradistrict branch of the clearance system before technical and other difficulties began to make their appearance. Many banks, both city and country, throughout the system were opposed to the enforcement of the provisions of the law because of the loss of exchange charges which would thereby be entailed upon them. Legal questions were also raised, it being argued that there is no power to compel a member bank not located in a Federal Reserve city to pay or have charged to its account at the Federal Reserve Bank of its district a check which it had not seen and approved prior to the time of presentation at its own counter. For the purpose of ascertaining the Board's powers in this connection the opinion of the Attorney General has been requested.

While the Board was not inclined to attach undue importance to objections based upon self-interest, it felt that it must take cognizance of all legal objections, and it recognized that the clearing question was essentially a reserve problem rather than a technical question or a mere matter of administration. Inasmuch as the Federal Reserve Act had granted a period of three years within which to effect the final transfer of reserves to Federal Reserve Banks (balances with correspondents counting as reserves in the meantime), there was a certain ground for objection to the immediate introduction of complete clearance at Federal Reserve Banks. As is well known, reserve balances in some reserve cities have heretofore been used for the purpose of providing for exchange and collection operations, and so long as this function on the part of city correspondents continued there was some argument in favor of deferring any compulsory application of par clearance at the reserve banks. Study of the problem, moreover, shows that, pending the time when state banks enter the system in larger numbers, it may be necessary for some member banks to collect and clear through their correspondents in reserve cities.

So complex was the situation and so serious the difficulty involved in the compulsory application of any system, however carefully conceived, that the Board felt it would be well if member banks could be brought to recognize of their own free will the advantages of a general and nation-wide clearing system--advantages which would inure not only to the benefit of the public at large, but ultimately to the direct benefit of the member banks themselves from the purely business standpoint. It therefore took under favorable consideration the question of a voluntary clearing system. Both the difficulties of a compulsory plan and the probable merits of a voluntary system had been strongly represented to the Board by the governors of the respective Federal Reserve Banks who at various meetings had thoroughly canvassed the whole situation. Under a plan, proposed by the governors, which in most districts became effective during June, 1915, provision was made for the acceptance at par by the Federal Reserve Bank of each district of checks drawn upon any member bank of that district which had previously assented to the provisions of the scheme. It was hoped that a very large number of member banks would promptly affiliate themselves with the new system of clearing and that the natural force of economic competition would ultimately attract to it those who at first might hesitate.

This system, as already stated, became operative in most districts during June, 1915. Prior to this whole discussion, however, two districts had already undertaken the application of the clearing provision of the law. Early in December, 1914, district No. 10 and district No. 8 (Kansas City and St. Louis) had sought and obtained permission to apply to their members a complete system of required clearing. This system had been in full operation in both districts prior to the general application of the voluntary system. Upon the inauguration of the latter the directors of the Federal Reserve Bank of St. Louis deemed it wise to offer to their member banks the option of withdrawing from the clearance system if they so desired; but so successful had been the working of the plan that comparatively few retired, about 80 per cent. of all continuing their membership. The Federal Reserve Bank of Kansas City continued its required system as before for the benefit of all its member banks, numbering 950. As about 365 banks continued their membership in the St. Louis district, a total of approximately 1,300 was included in the clearing system of the two districts in question. Outside of these two districts about 1,100 member banks voluntarily affiliated themselves with the clearing system within a short time after its inauguration, and there was a subsequent net inward movement of about 50 additional members, making approximately 1,150 banks which of their own free will have assented to the voluntary clearing plan. This is considerably less than 25 per cent, of the institutions eligible for membership, and the proportion has been so small as to prove a severe disappointment to those who had confidently expected that the foresight and enlightened self-interest of the member banks would speedily accomplish the desired result. Some progress has been made through the action of the banks, both member and non-member, in improving exchange conditions and in providing for the clearance of country checks at points where this practice has never before prevailed; but in the main comparatively small advance has thus far been made in rendering effective the provisions of the law requiring the standardization of exchange and clearance practices. This slowness is largely due to the failure of jobbers and merchants to appreciate the advantages of the clearance system and to enlarge its membership by insisting that their own banks join and co-operate in the plan. The subject has recently been reopened at the conferences between the governors of the Federal Reserve Banks, the Federal Reserve Agents, the transit managers of the reserve banks, and the Board itself, with a view to extending the present system not only in the several districts themselves but as between the various districts. For many years it has been lawful for banks to count as reserves deposits with other banks. It was never the intention of the Federal Reserve Act that member banks should continue the maintenance of these reserve accounts. On the contrary, the full meaning of the act is manifestly opposed to such an idea. It is the plain conception of the Act that the reserve banks should, to a very large extent, if not entirely, perform the work that is now being done by correspondent banks in this respect. This means that the reserve balances to be carried in the future by the reserve banks instead of by the correspondent banks should serve as the basis for a system of clearing and collecting the exchanges of the country. Whatever can be done to bring about the prompt and effective use of this new system of bank settlement will be done.

BRANCHES AND AGENCIES

[310]The question of branches of federal reserve banks has received careful attention during the past year. There has been intimation from several quarters that the establishment of a branch at a given point would be acceptable to the banks of that place. Only in one instance--that of New Orleans--did the Board receive a definite request from a Federal Reserve Bank to establish a branch. Believing that New Orleans and the adjacent territory could make advantageous use of this additional banking machinery, the Board authorized the establishment of a branch of the Federal Reserve Bank of Atlanta to be located in New Orleans, and this branch was opened for business on September 10. Operations at the New Orleans branch have proceeded satisfactorily, and the institution has been of considerable use to the local banks. The branch is already more than self-supporting.

Investigation and experience have seemed to show that, at least for some years to come, the organization of branches with completely equipped offices, vaults, and the like, and with a full staff of salaried officials, will be too heavy an expense for most of the reserve banks, yet, that valuable service could be performed by local offices of the several banks in not a few places. The Board has, therefore, had under consideration the question whether establishing local agencies might not meet the requirements of the case better than the more fully organized branch office. Competent legal opinion is to the effect that the creation of such local offices is permissible under the terms of the law, and the Board believes that it may prove practicable to meet banking necessities in many sections of the country by this means.

PROPOSED AMENDMENTS TO FEDERAL RESERVE ACT[311]

A year's experience in the operation of the Federal Reserve Act has confirmed the Board in its profound conviction that the act has been one of the most beneficial pieces of legislation ever adopted by Congress. Not only have its fundamental principles been fully vindicated but in most details the working of the measure has been successful. The act, however, is a progressive piece of legislation and creates new conditions as the result of its own operation. Modification in its terms growing in part out of these new conditions will subsequently be required from time to time.

For the present the Board presents the following suggestions for amendments to the act:

(1) In addition to powers now possessed in this connection by Federal Reserve Banks and national banks, the latter should be permitted to subscribe for and hold stock in banks organized for the special purpose of doing a banking business in foreign countries.

(2) With the approval of the Federal Reserve Board the issue of Federal Reserve notes to Federal Reserve Banks should be permitted either against the deposit of an equal amount, face value, of notes, drafts, bills of exchange, and bankers' acceptances acquired by Federal Reserve Banks under sections 13 and 14 of the Act, or of gold, or of both, provided, however, that gold so deposited with a Federal Reserve Agent shall count as part of the reserve required by the Act to be maintained by the bank against such notes outstanding.

(3) The acceptance system, provision for which is made in foreign trade operations by the Federal Reserve Act, should be extended to the domestic trade in so far as relates to documentary acceptances secured by shipping documents or warehouse receipts, covering readily marketable commodities or against the pledge of goods actually sold.

There can be but little question of the safety of such acceptances, and their use will tend to equalize interest rates the country over and help to broaden the discount market.

(4) Permission should be granted to national banks to establish branch offices within the city, or within the county, in which they are located.

(5) In order to enable member banks to obtain prompt and economical accommodations for periods not to exceed fifteen days, the Federal Reserve Banks should be permitted to make advances to member banks against their promissory notes secured by such notes, drafts, bills of exchange, and bankers' acceptances as the law at present permits to be rediscounted or purchased; or against the deposit or pledge of United States Government bonds, the purchase of which is now permitted under the law.

(6) The Board furthermore recommends that the power of national banks to make loans on farm lands as provided in section 24 be extended so as to permit any national bank not situated in a central reserve city to make loans secured by improved and unencumbered farm land situated within its Federal Reserve district, or within a radius of 100 miles from the place in which such bank is located, irrespective of district lines. It also recommends that the powers of national banks be further extended to permit any such bank to make loans on any improved and unencumbered real estate located within 100 miles of the place in which such bank is located, irrespective of district lines; provided, however, that the aggregate of farm land loans and other real estate loans made by any national bank shall not exceed 25 per centum of its capital and surplus or one-third of its time deposits; and provided further, that no such real estate loan, as distinguished from a farm land loan, shall exceed a period of one year nor exceed 50 per centum of the actual value of the property offered as security.

It is believed that the enactment of these amendments will, besides enlarging the usefulness of the national banks, result in greatly strengthening the operation of the Federal Reserve Act, and more completely realize the purposes of its framers. The text of the amendments designed to carry out these recommendations will be submitted by the Board at an early date. The Board has under consideration other suggestions for amendments to the Federal Reserve Act concerning which no conclusions have yet been reached, and regarding which the Board will take occasion to submit its views to the Congress at an appropriate time in the future.

STATEMENT OF CONDITION OF FEDERAL RESERVE BANKS.[312]

_Combined resources and liabilities of all Federal Reserve Banks as at close of business on the last Friday of each month during 1915._

RESOURCES. [In thousands of dollars.] ---------------------------+---------+---------+---------+---------+---------+ | Dec. | Jan. | Feb. | Mar. | Apr. | | 31. | 29. | 26. | 26. | 30. | | 1914. | | | | | ---------------------------+---------+---------+---------+---------+---------+ Gold coins and certificates| | | | | | in vault | 228,641 | 235,417 | 248,256 | 241,344 | 237,278 | Gold settlement fund | | | | | | Gold redemption fund | 428 | 488 | 653 | 824 | 950 | +---------+---------+---------+---------+---------+ Total gold reserve | 229,069 | 235,905 | 248,909 | 242,168 | 238,228 | Legal tender notes, silver,| | | | | | etc. | 26,578 | 20,882 | 29,085 | 23,098 | 26,518 | +---------+---------+---------+---------+---------+ Total reserve | 255,647 | 256,787 | 277,994 | 265,266 | 264,746 | Commercial paper | 9,909 | 13,955 | 18,577 | 22,001 | 22,774 | Bankers' acceptances | | | 1,892 | 9,682 | 13,812 | United States Bonds | 205 | 2,015 | 5,406 | 6,639 | 6,813 | Municipal warrants | 734 | 11,165 | 12,011 | 14,940 | 18,656 | Federal Reserve notes, | | | | | | net assets | 5,418 | 3,179 | 3,215 | 6,091 | 6,909 | Due from other Federal | | | | | | Reserve Banks, net | 7,930 | 7,421 | 8,088 | 5,573 | 9,468 | All other resources | 5,931 | 7,712 | 4,550 | 3,019 | 4,425 | +---------+---------+---------+---------+---------+ Total resources | 285,774 | 302,234 | 331,733 | 333,211 | 347,603 | ---------------------------+---------+---------+---------+---------+---------+ LIABILITIES. ---------------------------+---------+---------+---------+---------+---------+ | Dec. | Jan. | Feb. | Mar. | Apr. | | 31. | 29. | 26. | 26. | 30. | | 1914. | | | | | ---------------------------+---------+---------+---------+---------+---------+ Capital paid in | 18,051 | 20,440 | 36,069 | 36,105 | 39,669 | Government deposits | | | | | | Reserve deposits, net | 263,948 | 279,516 | 290,336 | 288,217 | 294,832 | Federal Reserve notes, | | | | | | net liability | 3,775 | 2,278 | 5,328 | 8,889 | 11,038 | All other liabilities | | | | | 2,064 | +---------+---------+---------+---------+---------+ Total liabilities | 285,774 | 302,234 | 331,733 | 333,211 | 347,603 | ---------------------------+---------+---------+---------+---------+---------+

RESOURCES. (continued) [In thousands of dollars.] ---------------------------+---------+---------+---------+---------+---------+ | May. | June | July | Aug. | Sept. | | 28. | 25. | 30. | 27. | 24. | | | | | | | ---------------------------+---------+---------+---------+---------+---------+ Gold coins and certificates| | | | | | in vault | 219,187 | 222,746 | 212,988 | 211,145 | 229,972 | Gold settlement fund | 23,426 | 31,360 | 52,140 | 55,930 | 59,050 | Gold redemption fund | 1,027 | 1,081 | 1,064 | 1,104 | 1,202 | |---------+---------+---------+---------+---------+ Total gold reserve | 243,640 | 255,187 | 266,192 | 268,179 | 290,224 | Legal tender notes, silver,| | | | | | etc. | 31,989 | 47,848 | 22,092 | 19,878 | 22,920 | +---------+---------+---------+---------+---------+ Total reserve | 275,629 | 303,035 | 288,284 | 288,057 | 313,144 | Commercial paper | 24,747 | 25,996 | 29,102 | 29,275 | 31,373 | Bankers' acceptances | 9,204 | 10,379 | 11,625 | 13,564 | 13,058 | United States Bonds | 6,947 | 7,601 | 7,923 | 8,836 | 9,328 | Municipal warrants | 23,094 | 11,509 | 16,107 | 25,808 | 24,945 | Federal Reserve notes, | | | | | | net assets | 7,765 | 9,124 | 11,029 | 12,491 | 14,866 | Due from other Federal | | | | | | Reserve Banks, net | 7,435 | 8,311 | 7,078 | 6,990 | 7,409 | All other resources | 5,426 | 5,501 | 5,904 | 4,962 | 3,577 | +---------+---------+---------+---------+---------+ Total resources | 360,247 | 381,456 | 377,052 | 389,983 | 417,700 | ---------------------------+---------+---------+---------+---------+---------+ LIABILITIES. ---------------------------+---------+---------+---------+---------+---------+ | May | June | July | Aug. | Sept. | | 28. | 25. | 30. | 27. | 24. | | | | | | | ---------------------------+---------+---------+---------+---------+---------+ Capital paid in | 54,158 | 54,200 | 54,181 | 54,689 | 54,748 | Government deposits | | | | | 15,000 | Reserve deposits, net | 292,050 | 311,349 | 306,183 | 316,989 | 329,941 | Federal Reserve notes, | | | | | | net liability | 10,921 | 12,617 | 14,965 | 16,738 | 15,348 | All other liabilities | 3,118 | 3,290 | 1,723 | 1,567 | 2,663 | ---------------------------+---------+---------+---------+---------+---------+ Total liabilities | 360,247 | 381,456 | 377,052 | 389,983 | 417,700 | ---------------------------+---------+---------+---------+---------+---------+

RESOURCES. (continued) [In thousands of dollars.] ----------------------------+---------+---------+--------- | Oct. | Nov. | Dec. | 29. | 26. | 30. | | | ----------------------------+---------+---------+--------- Gold coins and certificates | | | in vault | 218,224 | 245,986 | 266,546 Gold settlement fund | 61,960 | 73,830 | 77,293 Gold redemption fund | 1,222 | 1,252 | 1,124 +---------+---------+--------- Total gold reserve | 281,406 | 321,068 | 344,963 Legal tender notes, silver, | | | etc. | 37,058 | 37,212 | 13,525 +---------+---------+--------- Total reserve | 318,464 | 358,280 | 358,488 Commercial paper | 30,448 | 32,794 | 32,368 Bankers' acceptances | 13,619 | 16,179 | 23,013 United States Bonds | 10,505 | 12,919 | 15,797 Municipal warrants | 25,014 | 27,308 | 12,220 Federal Reserve notes, | | | net assets | 19,723 | 19,176 | 21,910 Due from other Federal | | | Reserve Banks, net | 8,533 | 14,053 | 20,767 All other resources | 3,645 | 4,633 | 6,547 |---------+---------+--------- Total resources | 429,951 | 485,342 | 491,110 ----------------------------+---------+---------+--------- LIABILITIES. ----------------------------+---------+---------+--------- | Oct. | Nov. | Dec. | 29. | 26. | 30. | | | ----------------------------+---------|---------+--------- Capital paid in | 54,838 | 54,846 | 54,915 Government deposits | 15,000 | 15,000 | 15,000 Reserve deposits, net | 343,554 | 397,952 | 400,012 Federal Reserve notes, | | | net liability | 13,918 | 13,385 | 13,486 All other liabilities | 2,641 | 4,159 | 7,697 ----------------------------+---------+---------+--------- Total liabilities | 429,951 | 485,342 | 491,110 ----------------------------+---------+---------+---------

FOOTNOTES:

[287] O. M. W. Sprague, _The Federal Reserve Act of 1913_, _The Quarterly Journal of Economics_, Vol. 28, No. 2, February, 1914, pp. 213-254.

[288] [The country has been divided into twelve districts in each of which a Federal Reserve Bank began operations November 16, 1914.]

[289] After the Reserve Banks have been in operation long enough to be running smoothly, not a few branches will doubtless be organized. Branches are to have boards of directors, three of the members of which are to be chosen by the Federal Reserve Board, and four by the directors of the parent Reserve Bank. Branches are to be operated under rules and regulations approved by the Federal Reserve Board.

[290] State banks and trust companies are eligible for membership, if they have a sufficient capital to entitle them to become national banks in the places where they are situated. On becoming member banks, they must comply with the provisions of the national banking law regarding reserves, examinations (the state examinations may be accepted), and various other general provisions of the national banking law.

[291] In case subscriptions by the banks of a district are inadequate, stock is to be offered to the general public; and if the response of the public is inadequate, the stock is to be taken by the Government of the United States. Neither privately owned nor government stock is entitled to voting power. [In no district were subscriptions by the banks "inadequate."]

[292] The inability of the Pujo money trust committee to secure desired information from the banks evidently occasioned the following clause: "No bank shall be subject to any visitatorial powers other than such as are authorized by law, or vested in the courts of justice, or such as shall be or shall have been exercised or directed by Congress, or by either House thereof, or by any committee of Congress of either House duly authorized."

[293] [Several of the more important regulations of the Federal Reserve Board are contained in Appendix B.]

[294] The law regarding the examination of national banks is recast. The only important changes are that hereafter all examiners are to be paid salaries, and that the Federal Reserve Banks are empowered to conduct special examinations of member banks.

[295] Adapted from Joseph French Johnson, _Fundamental Weakness of the Glass-Owen Bill_, an address delivered before the Economic Club of New York City, Monday evening, November 10, 1913.

[296] Although the address in part here reproduced was delivered as a criticism of the Glass-Owen Bill, one of the measures that led up to the passage of the Federal Reserve Act, that criticism, as a result of a few slight changes made, applies with almost equal force to the Federal Reserve Act itself. The preceding article by Professor Sprague answers with striking directness Professor Johnson's trenchant argument.--EDITOR.

[297] [It is commonly held that ample controlling power has been conferred upon the Federal Reserve Board by the act as finally passed. It is of interest that Senator Owen listened to the address of which an adaptation is here given.]

[298] John Skelton Williams, Comptroller of the Currency, "Democracy in Banking," an address delivered before the annual convention of the North Carolina Bankers' Association in the House of Representatives at the capitol at Raleigh, May 13, 1914. Printed in _Congressional Record_, 63d Congress, 2d Session, Vol. 51, pp. 10150-53.

[299] F. M. Taylor, _The Elasticity of Note Issue under the New Currency Law_. _The Journal of Political Economy_, Vol. 22, No. 5, May, 1914, pp. 453-463.

[300] _Second Annual Report of the Federal Reserve Board_, p. 16. 1916.

[301] _First Annual Report of the Federal Reserve Bank of New York_, pp. 19, 20. 1916.

[302] Thomas Conway, Jr., _The Financial Policy of the Federal Reserve Banks_, _The Journal of Political Economy_, Vol. 22, No. 4, April, 1914, pp. 319-331.

[303] _First Annual Report of the Federal Reserve Bank of New York_, pp. 34-36. 1916.

[304] Second Annual Report of the Federal Reserve Board, pp. 313, 314. 1916.

[305] _Ibid._, pp. 134-6.

[306] _Ibid._, pp. 23-25.

[307] [For regulations issued by the Federal Reserve Board see Appendix B.]

[308] _Second Annual Report of the Federal Reserve Board_, pp. 134. 135, 1916.

[309] _Ibid._, pp. 14-17.

[310] _Ibid._, p. 18.

[311] _Ibid._, pp. 21, 22.

[312] _Ibid._, pp. 45, 46.