COMMERCIAL BANK RESERVES IN THE UNITED STATES--THEORY AND PRACTICE. (2 VOLUMES)

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Murray George, 1912Commercial bank reserves in the United States: theory and practice. New York, 1950. 2 v 0(xix, 097 typewritten leaves) table So 2 9 cm, Thesis (Ph0D 0 ) - N e w Yoi^c Univer­ sity, Graduate School, 1950o Bibliography: v,2,p.8 6 7 -8 9 7 0 C57657,v,l C57658,v.2

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V

COMMERCIAL BANK RESERVES IN THE UNITED STATES! THEORY AND PRACTICE

MURRAY GY LEE

Submitted in

partial fulfillment of the

requirements for the degree of Doctor of Philosophy

in the Graduate School of Arts and Science of New York University

1950

PREFACE

The question of reserves has been a troublesome one In our banking system*

After more than a century of

state and Federal banking regulation, disagreement still exists with respect to such questions as why reserves need te be kept by commercial banks, how much, and In what form* Ever since the Federal Reserve System was established In 1913 the regulatory authorities have been vexed by such problems as the treatment of till money, the classification of deposits for reserve purposes, and the reserve classification of cities* Again and again the whole problem of the appropriateness of our present system of reserve requirements has come up*

This

system has long been recognized as Inequitable In certain respects; Indeed, the Federal Reserve authorities have en­ gaged In many studies of schemes to improve It*

A survey of

the functions and operation of our reserve arrangements Is especially timely at the present moment, when proposals for major reforms in these arrangements are being considered by a subcommittee of the Joint Committee of Congress on the Economic Report* The author believes that a thorough review of the matter of legal reserves Is long overdue*

The present study

Is an attempt to discover the various philosophies underlying the regulation of bank reserves, to Indicate the numerous

70

11

problems that arise In devising a regulatory scheme, and to suggest possible solutions of these problems*

Although con**

elusive answers will not always be possible, we can at least lay bare the considerations Involved and Indicate the al­ ternative lines which policy can take and of which further study Is needed* This is not a statistical study*

The author has

preferred to confine himself to an Investigation of the the­ oretical issues Involved*

Such statistical data as are pr e ­

sented do not represent original Investigation by the author and are generally of a rather fragaentary nature*

It Is

recognized, of course, that many of the problems discussed cannot be satisfactorily resolved without elaborate statistical Investigations which the author has not the facilities nor the time to undertake*

The author has believed, however, that

there is much theoretical spadework to be done before such Investigations can profitably be undertaken*

In particular, we

need to thresh out the question, what is the function of legal reserves?

As will appear again and again In the chapters of

this book, the answers to the multiplicity of specific ques­ tions that arise depend very often upon a clear-cut answer to this broader query*

The theoretical lines need to be disen­

tangled and the problems "thought through" before the job of collecting enqplrlcal data can profitably commence* Another limitation of this study should be made clear at the outset*

We are concerned, as the title indicates,

with commercial bank reserves, and especially with reserves of

111

the member banks of the Federal Reserve System*

Some con­

sideration is given to nonmember bank reserve requirements under state laws* since they have a bearing on the effective­ ness of Federal Reserve policy*

With the reserves of nonmember

savings banks* trust companies* etc** we are not concerned* Nor are we concerned with the reserves of the twelve Federal Reserve Banks*

The Reserve Banks are central banks* and the

matter of central bank reserves raises many problems which are completely Irrelevant to the matter of reserves for ordinary banks*

This is not to say that central bank reserves

are not important*

They are* of course*

But the problems

connected with central bank reserves raise a separate set of Issues which differ a very great deal from those raised in the case of ordinary banks*

The author has chosen* therefore* to

confine the scope of his study to the special problems associ­ ated with the reserves of the commercial banks* with special emphasis upon the reserves of the member banks* Likewise* little attention will be paid to reserves against notes*

The original puzpose of legal reserves in this

country was not so much the protection of depositors as the regulation of state bank note Issues so as to Insure their redemption in specie*

But as time went on payments came more

and more to be made by check instead of by currency and coin* Hence about the middle of the last century the emphasis began to shift from the protection of noteholders to the protection of depositors*

Since 1913 the Issuance of bank notes has been

iv

largely confined to the twelve Federal Reserve Banks,1 so that the problem of reserves against notes has merged Into the general Issue of central bank reserves.

The matter of

commercial bank reserves against note liabilities Is, there­ fore, of only historical Interest today, and when we speak of bank reserves we shall be referring (unless otherwise specifically Indicated) to reserves against deposits. Despite the vast amount of public discussion of the reserve problem, there has been a puzzling paucity of published studies on this subject.

Except for the study by Robert G.

Rodkey for the Bureau of Business Research of the University of Michigan and a few studies of the 100 per cent reserve plan, there have been no published books on the subject of legal reserves.

Most of the periodical literature has been frag­

mentary In character and rather superficial,

it is hoped,

therefore, that the present study will meet a very real need by organizing the thinking that has been done on this matter and placing the whole problem In perspective. The author does not claim very much In the way of originality for the study, although he has not hesitated to present his own views on controversial matters.

The main

1. The Federal Act of 1913 provided for the retirement of the national bank notes, but war financing prevented their withdrawal. Bonds Issued during and following World War I could not be used as security for national bank notes, and so the eligible bonds outstanding were limited to less than $900 million In the 1920's. In 1932 the national banks were permitted to use all Government bonds bearing 3 3 /Q per cent Interest or less as backing for national bank notes for a three-year period, but the banks did not take full advantage of the privilege. Provision for Issuing national bank notes ceased on August 1, 1935* and since that time the notes have been In the process of being retired.

contribution has been in gathering together the views of others, analyzing them, and trying to sift out what seems worth while*

Nor can it be said that the study is definitive*

It is Intended to serve only as a point of departure for further studies of a very difficult subject*

If it clarifies

the Issues involved it will have served its purpose* In view of the length and complexity of some of the chapters, the author has thought it helpful to include sum­ maries at the end of these chapters*

M* G. Lee New York City January 1950

vi

TABLE OF CONTENTS Chapter

Page Preface

.......

11

PART I - INTRODUCTION I

II

Issues In Reserve R e g u l a t i o n ..... Importance of the Issues .................... The Purpose of Legal Reserve Requirements ... Reserve Classification of Banks ........... Classification of Deposits ........ Treatment of Correspondent Balances ......... Treatment of Vault C a s h ........ Reserves of Nonmember Banks ................. Other P r o b l e m s ......... Studies of Reserve Problems by the Reserve Board and Other Agencies ......... Caution Required In Changing Reserve Arrange­ ments ..........................

2 2 3 6 7 8 11 12 16

The Meaning of "Reserve” ........ The Reserve as a Fund ....................... Bank Reserves Distinguished from Accounting Reserves ...................... . Reserve Ratios and Capital Ratios ......... Legal R e s e r v e s ....................... Primary, Working and Secondary Reserves .... Reserves and L i q u i d i t y ..... Working Reserve and "Real” Reserve ..........

29 29

17 26

31 32 33 34 39 39d

PART II - HISTORY AND CURRENT STATUS OF RESERVE REQUIREMENTS IN THE UNITED STATES III

Legislation on Reserve Requirements Eefore the 4l Civil W a r ................................. Laxity of Bank Regulation in Early Nineteenth Century ......................... ....... . 4l Reasons for Early Emphasis on Notes ........... 42 Other Explanations of the Emphasis on Notes . 47 Early State Legislation Relating to Bank Notes .................................... 50 Early State Laws Requiring Reserves Against Bank Notes .............................. 55 Legislation Relating to Deposits in Louisiana and Massachusetts ............. .......... 58 Increasing Importance of Deposits ........... 59 The Reserves Situation in New York City ..... 6l vii

Chapter III IV

V

VI

Page (Continued) Concentration of Funds in New York ..........

63

Bank Reserves During the Period of the National Banking System ......... Dominant Purpose of the 1863 Legislation .... The National Currency Act of 1863 ....... The 1864 R e v i s i o n ............... Acts of July 12, 1870 and June 8 , 1872 ..... Act of June 20, 1874 ......................... Act of March 3, 1887 ..... Gradual Reduction of Reserves ............ State Legislation, 1 8 6 3 ~ 1 9 1 3 ...........

70 70 71 74 78 79 82 83 86

91 Defects of the National Banking System ........ Decentralization of Reserves ........... 91 Pyramiding of Reserves ......... 91 Reserve Motive as a Factor In Pyramiding •... ' 93 Reserves of the New York City Banks ......... 99 Lack of Cooperation Among the New York Banks 100 ..... 103 • Inelasticity of Reserves Fictitious Reserves .......................... 108 Lack of Any Effective Organization of ...... 108 Reserves 110 Reform Proposals, 1894-1913 ................. ............. 114 Summary The Federal Reserve A c t ....... Fundamental Changes Made by the Act ..... Legislative History of the Act .............. Reserve Requirements Under the Original Federal Reserve A c t .......... Partial Centralization of Reserves ...... Amendment of September 7> 1916 .............. New Powers Requested by the B o a r d Amendment of June 21, 1 9 1 7 ......... Amendment of September 26, 1918 ............. Reserve Requirements After 1917 ............ Reduction In Legal Reserve Requirements Under 1913 and Later Acts ...................... Decrease in Operating Reserves ............ Adequacy of Reduced Reserves Pressure for Further Reduction of Reserve Requirements .......... Dissatisfaction with the Present System of Reserves ............. State Reserve Requirements Since 1913 ....... Summary and Conclusions ......................

viii

117 117 118 120 127 132 135 138 l4l l4l 142 145 150 152 153 157 158

Chapter VII

Page Reserve Requirements of State Nonmember Banks . l6 l Scope of C h a p t e r ........................... l6 l Emphasis In State Laws on Liquidity Function of Reserves ............. l6 l Status of State Banking Laws in 1910 ..... 162 Changes in State Laws After 1 9 1 3 ......... 163 Applicability of State Reserve Requirements to Member Banks ..... 164 Size of Required Reserves under State Laws .. 165 Composition of Required Reserves ............ 168 Conclusion ...... 170 PART III - RESERVES UNDER THE FEDERAL RESERVE SYSTEM

VIII

IX

Calculation, of Reserve Requirements: Deposits Subject to Reserve .......... Provisions of Law and Regulations Regarding Computation of Reserves ........... Reserves Against Government Deposits ........ Deduction of "Balances Due From Other Banks" Deduction of Collection Items ............... Different Treatment of Time and Demand ....... Deposits Definition of Time Deposits .................

173 173 175 179 182 183 185

Reserve Deficiencies: Computation, Penalties, and Effect on Bank Lending P o w e r .......... Penalties for Deficient Reserves ............ ............... Utilization of Reserves Suspension of Reserve Requirements .......... Method of Computing Legal Reserve Require­ ments Advantage of A v e r a g i n g ....................... Weekly Averaging before 1928 ........ Semi-weekly Settlements, 1928-19^2 .......... Recommendationsof The Committee on Member Bank Reserves ........................ Reversion to Weekly Averaging in 1 9 ^ 2 ....... Selection of Computation D a t e ............... Reserve Requirements Computed as of Close of Business D a y .............................. Waiver of Penalties for Deficiencies in Reserves ....... Effect of Reserve Deficiency on Lending Power Credit for Collection Items ....... Federal Reserve Float

203 204 208 210

Bank Reserve Management ........................ Factors Affecting Reserve Balances .......... How Banks Adjust Their Reserve Positions ....

213 213 215

ix

189 189 190 190 191 • 193 195 196 197 198 199 201

Chapter X

Page (Continued) Periods of General Reserve Stringency ....... 221 The Excess Reserves Problem of the 1930's ... 222 Federal Funds . •. •.............. .............. 223 Wartime Problems ............................. 228 PART IV - THE THEORY OF LEGAL RESERVE REQUIREMENTS

XI

Legal Reserves and Bank L i q u i d i t y .............. Lack of Agreement as to Real Function of Legal Reserves ........................... Reserves as a Guarantee of Confidence . •.... .... The Liquidity Function of Reserves Criticisms of the Liquidity T h e o r y .......... Liquidity a Matter of Quality of Assets .... Liquidity as a Matter of Availability of Central Bank Credit ...................... Liquidity and Solvency ....................... Liquidity and Convertibility ........ S u m m a r y ................................... .

231 231 232 234 237 239 245 249 249 252

XII

Legal Reserves as an Instrumentality of Central Bank Credit Control ........................ 25b New View of Reserves as Credit Control Device 256 Evolution of the Credit-Control Conception of R e s e r v e s .... ................ . 258 Necessity of Maintaining Working Reserves a Check on L e n d i n g ............ ............ 26l Additional Safeguards Supplied by Legal ........... . 262 Reserve Requirements How Legal Reserve Requirements Facilitate Control by Central Bank ........ 264 Techniques of Central Bank Control .......... 266 Leverage Effect of Central Bank Actions .... 268 Relationship of Reserve Policy to Central Bank Control ................. .'.......... 270 Effectiveness of Central Bank Control ....... 273 Rediscount Rates as an Instrument of Control 278 Increasing Emphasis on Open-Market Operations 280 Attitude of Member Banks Toward Borrowing from Central B a n k ......... ............... 233 "Perverse Elasticity" of the System ......... 285 Summary .............. ........ 290

XIII

Other Views Concerning the Function of Legal Reserves ............................... 292 Reserves as a Contribution to the Resources of the Central B a n k ............... ...... 292 Criticisms of the Theory by Hawtrey and Harris 295 Appraisal of the Contribution Theory ........ 296 x

Chapter XIII

Page (Continued) ......... .... Clearing Function of Reserves Efficient Clearing and Centralization of Reserves ................................

300 303

PART V - SOME IMPORTANT PROBLEMS CONNECTED WITH LEGAL RESERVES XIV

XV

Advantages and Disadvantages of Fixed Reserve Requirements ............ Disagreement as to Wisdom of Fixed Reserve Requirements ............................. 1. Fixed Reserve Requirements and Liquidity . Traditional Justification of Reserve ....................... Regulation Reserve Requirements as an Interference with Banking Judgment ............... Reserve Requirements as a Factor Making for Bad Banking ..................... Inability to Use the Legal Reserve ..... Rigid Reserve Requirements as a Breeder of Crisis ..... Administration of Reserve Provisions of ....... the National Bank Act Criticisms by Sprague and Others of Reserve Provisions of the National Bank Act ......... Changes Made by the Federal Reserve Act . C o n c l u s i o n ......... 2. Fixed Reserve Requirements and Credit Control ........ Views of Hawtrey and Keynes ..... Other Advocates of Fixed Reserve Requirements ............. C o n c l u s i o n ....... Centralization of Reserves in the Central Bank Centralized Reserves a Feature of the-Federal. Reserve Act .................. Centralization of Reserves under Foreign Banking Laws ............... Historical Development of Central Reserve B a n k i n g ....... Agitation for a Return to Decentralized Reserves .................. 1. Centralization of Reserves and Bank L i q u i d i t y ......................... 339 Views of Jevons and Bagehot Compared .... The Concepts of ’’Pooling” and "Mobiliza­ tion” of Reserves ............ Shortcomings of the Pooling Concept ..... xi

309 309 311 311 312 313 315 317 318 319 324 324 325 325 327 332 334 334 334 336 339 339 341 346

Chapter XV

XVI

XVII

Page (Continued) Liquidity Not Primarily a Matter of P o o l i n g ............................... Centralized Reserves as a Means of Strengthening the Resources of the Central B a n k ......................... 2. Centralized Reserves and Central Bank Control of Credit ...................... Effective Credit Control Generally Assumed to Require Centralized Reserves ........................ Various Aspects of the Issue Examined ... Reserve Provisions of Philippine Central Bank A c t ........ 3. Centralization of Reserves and the Clearing P r o c e s s ................ Centralized Reserves Needed for an Efficient Clearing System ........... 4. Summary and Conclusions ................

3^9 351 352 352 357 360 361 361 363

366 The Controversy Over Vault C a s h ............... Proposals to Count Vault Cash Toward Legal 366 Reserves ....... Reserve Provisions of the Original Federal Reserve A c t ....... 367 The 1917 Amendment to the Federal Reserve Act 370 Criticism of the Amendment by Willis and Others ....... 372 Agitation in the 1920's for Repeal of 1917 ..... 375 Amendment The McFadden Bill to Repeal the 1917 A m e n d m e n t ......... 378 Continued Pressure from Country Banks to Include Vault Cash in Reserves .......... 383 1932 Recommendations of the Board Relating to Reserves ........... 384 Revival of the Proposal in 1945 ............. 386 Proposal to Deduct Vault Cash from Gross Deposits ..................... 387 Conclusions ................................... 390 Interest on Member Bank Reserve Accounts ..... Agitation for Payment of Interest on Reserve Balances .................................. Rationale of the Fulmer Bill ................ Arguments Against the Payment of Interest ... Effect of Reserve System on Member Bank Earnings ..... Interest on Balances as a Control Device ....

xii

393 393 394 394 398 400

Chapter XVIII

XIX

XX

XXI

Page Investment of Member Bank Reserve Funds ........ 403 Proposals to Permit Investment of Legal Reserves . •........................... 403 ................. 405 Bearing on L i q u i d i t y Bearing on Credit Control by the Reserve Banks ..................................... 408 Provisions of Philippine Central Bank Act ... 4ll C o n c l u s i o n s ........ 4ll The Problem of Time Deposits: Historical Background .............. '.................. Provisions of National Bank Act and Original Federal Reserve A c t ....... .............. Differences Between Time and Savings Deposits Notice of Withdrawal Not Insisted Upon ...... Rapid Growth of Time Deposits After 1913 .... Divergent Views as to Reasons for the Rise in Time D e p o s i t s .......... Consideration of the Problem by the Reserve ............... Authorities Recommendation of the Committee on Member Bank Reserves ............................ The 1932 Glass Bill ......................... The Banking Acts of 1933 and 1935 ............ Amendment of Regulation D .... ....... Provisions of Regulation Q ................... Reserves Against Time Deposits: Protecting the Time D e p o s i t o r ....... .......... ........... Why Time Deposits Have Been Thought to Require ............. Lower Reserves Protecting the Bank Against Sudden Withdrawals of Time Deposits ............. Protecting the Savings Depositor ...... Another Argument for Segregation ........ Conclusions ..... Complications in Credit Control Arising From Time Deposits ........................... Time Deposits Considered from the Point of View of Credit Control .................... Views of Lauchlin Currie .................... Views of Lawrence Towle ............... Opposing Views .................. An Argument for Lower Reserves Against Time Deposits ................... An Argument for Abolishing Reserves Against Time Deposits ........ Comparison of the Various V i e w s Conclusions ..........................

xiii

4l3 413 4l3 4l5 4l6 422 425 428 428 434 435 436 439 439 44l 446 452 454 457 457 457 460 462 466 470 472 475

Chapter XXII

XXIII

Page The Reserve Classification of Banks ........... Conflict of Views Regarding Geographical Classification of Banks .................. Origin of the-Present Classification ........ Incorporation of the System in Federal .................... Reserve Act Criteria for Reserve Classification of Cities Changes in Member Bank Classifications ..... Banks in Outlying Districts of Reserve or Central Reserve C i t i e s ........... Banks with Branch or Head Offices in Reserve or Central Reserve Cities ............... Sprague's Proposal for Classification of Banks .......... Recommendations of the Federal Advisory C o u n c i l ......... Lack of Logic in Present Classification ..... Consideration of the Problem by the Reserve Authorities .............. Attempts to Effect R e c l a s s i f i c a t i o n ...... New Classification Criteria Adopted 1947 .... Rationale of the Present S y s t e m ........... .. Criticisms of the Theory Underlying Classi­ fication of Cities .......................

477

The Treatment of Bankers' Balances ...... 1. Background of the Problem ............. Reserve Problems Raised by Bankers' Balances ............................. Evolution of Correspondent Banking Relationships ........................ Bankers' Balances and the National Bank Act ................... Interbank Balances Since 1913 ........... 2. Bankers' Balances as Legal Reserve ....... State Legislation Before the Civil War .. The National Bank Act ................... Sprague's Criticisms of the National Banking S y s t e m ...... Report of the Indianapolis Convention ... The Aldrich Bill ......................... The Federal Reserve A c t ......... State Laws Relating to Nonmember Banks .. 1947 Proposal of the Board of Governors . Objections to Counting Bankers' Balances as Reserve ................. Complications for Credit Control ........ Deduction of "Due From" Items in Calculating Net Deposits ............

506 506

xiv

477 478 482 484 485 487 488 488 489 491 494 497 498 501 504

506 507 509 511 516 516 517 520 521 522 522 527 528 530 531 532

Chapter XXIII

XXIV

XXV

Page (Continued) 3. Reserve Requirements Against Balances Due to Other Banks ................ 533 Volatility of Bankers1 Balances ........ 533 Higher Reserve Requirements for Banks Carrying Bankers' Deposits .... 534 Higher Reserve Requirements for Bankers1 Deposits ...... 537 Consideration of the Proposal by the Reserve Board .................... 541 The Problem Considered from the Point of View of Credit Control ....... 542 4. Deduction of Balances Due from Other Banks in Computing Net Deposits Subject to Reserve Requirements ................ 545 Reasons for Allowing the Deduction ..... 545 Views of Lauchlin Currie on This Question ......... 547 Views of R. G. R o d k e y ................... 548 5. Summary and Conclusions ................... 549 The Variable Reserve Ratio: History of Its Use In the United States .............. 1916 and 1917 Recommendations of the Board .. Recommendations of the British Macmillan Committee .................. 1933 Recommendations of the American Bankers Association .................. The Thomas Amendment ...... The Banking Act of 1935 ...................... Use of the Power, 1935-1937 ................. The Problem of Excess Reserves, 1937”194l ... The Amendment of July 7 > 1942 ............... High Reserve Requirements During the War .... Additional Powers Requested After the War ... Consideration of Credit Controls by the Senate Banking and Currency Committee in July-August 1948 ......................... Amendment of August 1 6 , 1948 ........... Reduction of Reserve Requirements in 1949 ••• The Variable Reserve Ratio as a Credit Control D e v i c e ........ Adoption of the Variable Reserve Ratio in Various Countries ......... Effectiveness of the Instrument ............. Limitations on Use of the I n s t r u m e n t ........ Other Limitations of the I n s t r u m e n t Disagreement Among Economists on the Problem Conclusions ............ xv

553 555 556 556 557 560 564 566 569 571 573 577 581 584 587 587 589 592 596 600 601

Chapter XXVI

The Ceiling Reserve Proposal . • •............ . Need for Stronger Credit Controls after World War II ............................. Advantages of the Ceiling Reserve ........... Possible Disadvantages of the Plan .......... Philippine Central Bank Act of 19^8 ......... Guatemalan Bank Law of 1 9 ^ 6 .........

XXVII

Reserve Problems Resulting from the CoExistence of Member and Nonmember Banks ... Reserve Requirements as a Factor Discouraging Membership ............ ........... Disadvantages of a Dual Banking System ...... Proposed Solutions ................. ......... PART VI - MAJOR PROPOSALS FOR RESERVE REFORM

XXVIII

The Velocity Reserve Proposal ................. Report of the Committee on Member Bank Reserves ............ ..................... History of the Velocity Proposal ............ Details of the Plan .... ......... .......... Reserve Requirements Not Directly Geared to V e l o c i t y .......... ............ ........... Benefits Claimed for the Velocity Reserve Scheme ••••.......................... . Reactions of B a n k e r s ...................

XXIX

Criticisms of the Velocity Reserve Scheme .... Need for Careful Evaluation of the Velocity Reserve P r o p o s a l ............ ............. Effects on Individual Banks ......... '...... Failure to Distinguish Among Different Types ............................ of Spending Effectiveness of the Plan as a Check on Speculation ............................... Timeliness of Increases in Required Reserves under the Plan ........................... Possible Accentuation of Money Market Disturbances ............................. Behavior of Velocity in Financial Panics .... Secular Rise in V e l o c i t y ............ ...... .. Suitability of the Plan to Conditions of the 1930's .................................... Too Great Reliance on Automatic Rules ....... Irregularity of Accounts More Important than Activity .................................. Practical Effects on the Banks .............. Summary and Conclusions ......................

Chapter XXX

XXXI

XXXII

Page The 100 Per Cent Reserve P l a n .................. 673 General Nature and Aims of the 100 Per Cent 673 P l a n ................................... 1. History of the P r o p o s a l .... '.......... 67^ Views of Von Mises, Hayek and Machlup ... 67^ Frederick S o d d y ................. ........ 673 The Chicago Plan • •••..... ............... 676 Other Advocates ............... 673 Congressional Rejection ofthe Proposal . 679 Precedents .................. 68l 100 Per Cent Money and the Currency School ..... 683 2. Different Versions of the 100 Per Cent 687 P l a n ................................... Important Variations in the Various Versions ................... 687 The Chicago P l a n ....... 688 Lauchlln C u r r i e ............. 688 Irving F i s h e r ........ 690 J. W. Angell .............................. 697 Comparison of the Different Versions .... 706 3» Alleged Deficiencies of the Present System 710 Inadequate Control Over the Supply of 710 M o n e y ......... Manufacture of Money by the B a n k s ....... 711 Objectives of Monetary Planning ......... 715 Defects of the 100 Per Cent Plan ..... Benefits Claimed for the P l a n ............... Better Protection for Depositors ...... Prevention of Deflation Due to R u n s ......... Possible Reduction of Carrying Charges on the Government D e b t ....... Better Control Over the Money S u p p l y Irrelevant Criticisms of the Control Argument ................. Control Arguments Examined: (l) The Angell P l a n ............................. Control Arguments Examined: (2) The Standard Version of the P l a n ........ Control Arguments Examined: The Standard Version, ctd. ............... Stabilization of the Volume of M o n e y Overemphasis on the Quantity of Money ....... Confusion of Cause-and-Effect Relationships • C o n c l u s i o n .................................... Transitional and Operational Difficulties of the 100 Per Cent Plan ........... Practical Disadvantages of the P l a n ......... Curtailment of Short-Term Lending Service ... Effect on Capital M a r k e t s xvii

717 717 717 721 723 726 729 731 7^1 7^6 751 75^ 756 758 762 762 762 767

Chapter XXXII

(Continued) Possible Shift of Loan Business to Savings Banks .................................... Rise of New Types of Lending Institutions ... Effects of Transition to the 100 Per Cent P l a n ............................... . Bank Earnings a[nd the Problem of Service C h a r g e s ......................... . Problem of Administering Bank Assets Sold to the Government .............. ............ Use of Inconvertible Currency ............... Summary and Conclusions ................. ..

XXXIII

Proposals for a Security Reserve ............... 1. Origin and History of the Security Reserve P l a n .................... ................ Postwar Support of the Government Bond Market The Search for. New Credit Control Devices The Original Seltzer Plan (19^0) ...w...» Federal Reserve Proposals, 19^5“19^9 •••• 2. Various Versions of the Plan ............. Roland I. Robinson ....................... The C.E.D. Proposal ......... Lawrence H. Seltzer ...................... Simeon L e l a n d .............. ........... .. A. G. Hart ................................ Woodlief Thomas and Ralph A. .Young..... The Question of Bank Earnings Application of the Security Reserve Idea Abroad .... ...... ........ . 3» The Board's Proposal of December 19^7 •••• Main Features of the Proposal ....... Assets to be Included in the Reserve .... Effects on Different B a n k s .... Benefits Expected from the Plan .........

XXXIV

Criticism of the Security Reserve Plan ........ Questions to be C o n s i d e r e d ........... ....... Effectiveness of the Plan as a Means of Checking Bank Credit E x p a n s i o n •••• Practical Consequences of the Proposal ..... Possible Alternatives .............. ......... Shifting the Debt to Non-Bank Holders ..... Criticisms of Other Versions of the Security Reserve Proposal ..... ............ Conclusions .............. ............... .

xviil

Page

Chapter XXXV

The Uniform Reserve Requirements Plan ........ Origin of the Uniform Reserve Requirements P l a n .......... Elements of the Plan ...... Proposed Classification of Deposits ........ Treatment of Vault C a s h ..... Treatment of Correspondent B a l a n c e s Evaluation of the'Proposal ......... Bibliography

.......................

851 851 853 854 857 859 86l

867

LIST OF TABLES Page

Table No. I II III IV V VI VII

Reserve Requirements Specified in Original Federal Reserve Act ........................

122

Reserve Requirements for Member Banks, Enacted or Considered by Congress ..................

124

Reserve Position of Member Banks, November 17 j 1916 ........................................

127

Member Bank Reserve Requirements

.......

142

Reduction in Working Reserves of National Banks under the Federal Reserve Act .............

149

Growth of Time and Savings Deposits Relative to Demand Deposits 1915“1930 .................

420

Percentage of Time Deposits to Total Individual Deposits in National and State Banks 1915“ 1930 ........................................

421

xix

PART I INTRODUCTION

CHAPTER I ISSUES IN RESERVE REGULATION

Ippprtanvff q£ tbs. ipgMgg, Legal minimum ratios for cash reserves of commercial banks have long been a part of our banking tradition.

As

Willis and Chapman point out, "the question of required re­ serves for banks has been, historically speaking, one of the leading controversial Issues in American banking for genera­ tions past*"1

Laughlin characterized the reserves problem

In 1912 as "undoubtedly*•.the foremost problem In the present system of banking, Inasmuch as the control of his reserves, and the general condition of the reserves of the country, as a whole, Is always the chief anxiety of the careful and farmo

seeing banker*"

The controversies connected with the recast­

ing of the National Banking System largely centered around the reserve question, and much of the banking legislation since 1913 has been more or less directed toward the regulation of bank reserves, with an eye to the maintenance of liquidity and the protection of depositors, the facilitating of credit control, or some combination of these objectives In practice* In spite of all this legislation and a vast amount 1* H. P. Willis and J. M. Chapman, The Banking Situation (Columbia University Press, New York, 1934), p* 444* 2* J* L* Laughlin, Banking Reform (The National Citizens' League for the Promotion of a Sound Banking System, Chicago, 1912), p* 29*

3

of discussion of the subject, the issues involved in the whole question of reserves have remained largely unsettled, urgent as they are, and today these Issues still stand in the forefront of American banking discussion.

As R. G. Rodkey

points out, the existing reserve ratios for member banks of the Pederal Reserve System do not appear to have been de­ termined "by any scientific statistical m e t h o d s H .

P.

Willis, writing in 1936, deplored the lack of "any systematic and thorough study of reserves, with the determination to bring them into harmony with scientific requirements and with the needs of a practical and effective banking system."

Neither

the banking community nor the Reserve authorities seem to have been satisfied with the system as it has stood since 1913» and changes in banking conditions and in Federal Reserve pol­ icy since the first World War have underscored the desirability of giving consideration to a thoroughgoing revision of reserve arrangements. ZfeS. Purpose of. Legal R m w m

RgflBlrsngDfeg.

In any consideration of legal reserve requirements there arises at the outset the question, what is the funda­ mental purpose of legal reserves?

According to the traditional

view, cash reserves are held in order to assure ready con­ vertibility of bank deposits into more widely acceptable forms 3. R. G. Rodkey, Legal Reserves l a American Banking. Michigan Business Studies, Vol. 6, No. 5 (University of Michigan, Ann Arbor, 193*0 » P* 95* *. H. P. Willis, ThSL Theory asi Pgtgftlg.g of. Cgntr& l BfiOklflg. (Harper & Brothers.Publishers, New York, 1936), p. 272.

4

of money*

Their purpose Is "to assure***a mass of value over

against the time when (the hanker) may be called upon to pay a balance. "** The purpose of laws prescribing a fixed propor­ tion of reserves, on this view, Is to ensure "that a bank shall always have on hand such an amount of lawful money as will enable It under normal conditions of business to meet the current demands of Its depositors*N^ In recent years the so-called "liquidity" view of reserves has been seriously questioned*

It Is realized that

reserves alone are not an adequate protection to bankers and depositors*

No reasonable amount of reserves would be suf­

ficient to meet a large-scale withdrawal of deposits*

A bank

which Is faced with substantial withdrawals must depend upon the central bank for sizable amounts of currency*

The con­

vertibility of deposits Is thus assured, In the last analysis, by the ability of banks to borrow on their assets from the central Institution, or to sell their assets to the central Institution*

It Is true, of course, that a bank's cash reserves

(both legal and "working") have a bearing on the ultimate safety of the bank*

But as Dr* Woodlief Thomas points out,

"the other assets make up the larger part of the assets of the bank, so that it Is more Important that (these other assets] be safe ythan It Is that (the banks ] have to depend entirely on their reserves. 5* W. G. L* Taylor, The Credit System (The Macmillan Company, New York, 1913), p T 4 6 * 6* Comptroller of the Currency, Annual Report. 1893, p* l8* 7* Joint Committee of Congress on the Economic Report, Hearings on Credit Policies. 80th Cong., 2nd Sess. (19^8). p. 132. (Hereafter cited as Hearings o & greflik E.9llfiigg-*)

5

Hence commercial bank reserves have Increasingly come to be thought of, not primarily as a guarantee of con­ vertibility or "liquidity," but as the basis of the supply of bank credit which can be operated upon by the deliberate policy of the central bank.

Reserve requirements limit the

ability of the banks to expand credit.

By making the banker

immobilize a part of his assets in the form of vault cash or balances with the central bank, we limit the amount which he can lend or invest.

By raising or lowering the reserve re­

quirements we can reduce or Increase his ability to lend or invest.

In this view, member bank reserves constitute the »

pivot of central bank control of the money supply— an essen­ tial element in the mechanism through which the total volume of bank credit (and, therefore, deposits) may be brought under some over-all control. The problem of the primary purpose of legal reserve requirements is of basic Importance, since the conclusions reached on most of the practical Issues connected with reserves necessarily depend upon our underlying conception of the func­ tion of reserves.

It is the author's opinion that much of the

confusion and disagreement on many of these issues stems from the absence of agreement as to the purpose of legal reserves. In Part IV of this book we shall examine several different philosophies of reserve requirements.

In Part V, which deals

with a number of specific problems connected with reserves, it will be seen that different solutions may be offered for many of these problems, depending upon what theory of reserves we accept.

6

Rgservg. ClassJLfJLsa.tl.on s L Banka One of the most troublesome problems encountered In connection with current reserve arrangements has been the classification of member banks for reserve purposes.

Under

the National Banking System the national banks were divided for reserve purposes Into three categories, on the basis of their geographical location.

This geographical classification

has been retained, with minor changes, down to the present day.

Historically, the classification of banks Into central

reserve city, reserve city, and country banks dates from the time when the first two groups were redemption centers for state and (later) national banks' notes, but they dropped this function In 1874 when the task of redemption was taken over by the Treasury.

Later on the principle of basing reserves on

the location of the bank was Justified on the ground that the banks In the larger centers held a large volume of highly vol­ atile bankers' deposits and should therefore be required to maintain larger reserves as a safeguard In the event of sudden withdrawals of these deposits. Since 1913 the opinion has become more and more widely held that the old classification of banks has lost much of its former significance.

Critics of the system have

pointed out that there Is no sharp line of distinction between the three classes of banks, nor are the reserve responsibili­ ties within each group uniform.

As the Institute of Inter­

national Finance recently pointed out, new financial centers have arisen since 1913 which rival In importance those In the

7 i

central reserve cities*

“The resources of many banks outside

the Reserve cities have increased considerably, and, although the nature and volume of their business is similar to those of banks in the larger cities, their reserve requirements are lower because of the present method of grouping member banks for reserve purposes*

Under the changed conditions it is ob­

viously inequitable to base reserve requirements on geographic location*

«8 The problem of reclassifying banks for reserve pur­

poses has occupied the attention of the Board for many years* The Board has power to disestablish central reserve and reserve cities and to raise other centers to those levels, but has done little in this direction*

The problem of the reserve

classification of banks is closely related to that of the class­ ification of deposits*

In recent years many have urged that

reserve requirements should be uniform for all member banks, and that reserve requirements should vary solely with the type of deposit* Classification o£ ltep,qptt& Under the old National Banking System all types of deposits were treated alike for reserve puiposes.

The Federal

Reserve Act, following the example of several of the states, Introduced a distinction between "time* and "demand" deposits* This distinction gave rise to difficulties in the first twenty years of the System, due to the tendency of banks to Induce 8* Institute of International Finance, Bulletin No* 163 (October 31, 19^9), P* 22*

8 their customers to carry in the "time" category accounts which were really demand deposits*

As a result some economists

urged abandonment of the distinction between "time" and "demand" deposits, since it was thought there was no entirely practicable way of defining the two categories so as to prevent evasion of the spirit of the reserve regulations* Since 1935 the Board has tightened up the definitions of "time" and "savings" deposits in order to ensure that the form of a deposit shall more closely coincide with its true nature*

Dissatisfaction with the present classification of

deposits still exists, however*

One school of thought favors

uniform reserve requirements for all classes of deposits*

At

the other extreme, it is maintained that the present classifi­ cation should give way to a new, more detailed classification of deposits, based on such characteristics as turnover, vola­ tility, size, and the economic activity of the depositor (whether bank or nonbank, business or nonbusiness, etc*)*

Both

of these proposals have been challenged from the point of view of principle and of administrative feasibility*

A new classi­

fication of banks has recently been proposed by a staff com­ mittee of the Federal Reserve System, under which interbank deposits would carry a higher proportion of reserve than other types of demand deposits* Treatment

q£_

Correspondent

As Dr* Karl Bopp of the Federal Reserve Bank of Philadelphia told the Joint Committee of Congress on the

9

Economic Report in 19^8, "the relation between correspondent balances and reserves has created some of the knottiest prob­ lems of monetary policy* "9 history*

it is a problem with a long

Under the old National Banking System national banks

in the "country bank" and "reserve city" categories were per­ mitted to count toward their legal reserves balances carried with other banks.

This led to the "pyramiding" of reserves,

with the result that the basic cash reserves of the system were far less than the legal reserves*

Moreover, the decisions

of bankers to change the form in which they kept their reserves --i*e* as between cash and correspondent balances— affected the total volume of deposits that a given cash reserve would sup­ port* The Federal Reserve Act of 1913 provided that after a specified transition period balances with correspondents would no longer be counted as part of the legal reserve of any member banke

This change did not completely eliminate

pyramiding, since nonmember banks still carry a substantial part of their reserves in the form of deposits with other banks* Fortunately, however, the great bulk of nonmember bank balances is deposited in member banks, where the process of pyramiding stops* Balances due from both member And nonmember banks are deducted from gross demand deposits in computing a member bank's reserve requirements*

Hence a percentage of such bal­

ances is in effect still counted as reserves* 9. Hearings o& Credit PpUcjcgL, p. 1^8.

10

At the time the Federal Reserve Act was adopted It was widely predicted that correspondent balances would soon become a thing of the past* alized*

This expectation has not materi­

As one banker told the Joint Committee on the Economic

Report in 1948, correspondent balances are a very important part of a bank's "working reserve."

He pointed out that re­

quired balances with the Reserve Banks are "absolutely frozen," since they cannot be withdrawn.

"We can dip below for a day or

so, but It is necessary to pay a penalty if It lasts for any length of time."

As a result, he added,

Our real reserves for all of us are our accounts we keep with larger banks* That Is what we check on, and that is what has a flexibility* And we have to hold, in addition to our reserve balance with the Federal Reserve, I think it is fair to say, at least half again as much on deposit with larger banks*10 Under the present reserve classification of banks, movements of funds into and out of bankers' balances affect the total volume of reserves required by the system as a whole* Moreover, the percentage of "reserve credit" which a member bank receives on account of its balances due from another bank does not directly reflect the ultimate reserve held against such balances at the Federal Reserve Bank* bank which

Thus, a country

is today required to hold a 12 per cent reserve

receives "reserve credit" of 14 per cent of its "due from" account (by virtue of being permitted to deduct its "due from" account from its gross deposits in computing its required re­ serve), although the depositary bank carries 18 or 22 per cent

10. Loc*~~cit*, p* 70.

11

against the deposit; while a reserve city bank has an 18 per cent "reserve credit" for any balance it has in deposit in a country bank, even though the latter carries only 12 per cent reserve against the deposit. The question whether correspondent balances should be counted as legal reserve and, if so, to what extent, is tied into the problem of the classification of banks and de­ posits for reserve purposes.

It raises issues of considerable

complexity, not only from the point of view of equitable treat­ ment of individual banks but from the point of view of effect­ ive monetary control as well.

The problem has recently been

under study by a staff committee of the Federal Reserve System, which in 19^8 recommended important changes in the Federal Reserve Act as respects the treatment presently accorded to correspondent balances. Treatment o£ Yftigfe CfiSk Another vexing question is the treatment of vault cash.

The role of vault cash in the banking system has changed

fundamentally in the past fifty years •

Before the Federal

Reserve System was established, vault cash was the ultimate reserve in the banking system, since it alone was available to meet cash Withdrawals.

With the establishment of the Fed­

eral Reserve System the function of supplying currency for circulation devolved upon the twelve Federal Reserve Banks. Since 1917 the legal reserve of member banks has consisted solely of net balances with the district Reserve Banks, with the member banks left free to decide for themselves how much

12

"till money" they shall carry for their every-day needs*

The

original reason for excluding vault cash from legal reserves was that the Reserve authorities wanted to encourage the move­ ment of cash* especially gold* Into the Reserve Banks*

Today

this purpose no longer has any significance* since gold and gold certificates cannot be held by the commercial banks* During the 1920's there was considerable agitation on the part of country bankers to amend the Federal Reserve Act so as to count vault cash as part of the legal reserves of member banks*

The 1931 report of the Committee on Bank Re­

serves of the Federal Reserve System recommended that member banks be given some "reserve credit" for vault cash*

This pro­

posal was revived again In 1948 by a staff committee of the Federal Reserve system* Reserves

Nonmember Saokfi. Reserve requirements for nonmember banks are now

generally lower than those for members of the Federal Reserve System*

Since 1945 the Board of Governors has repeatedly urged

Congress to subject nonmembers to the same reserve requirements as members*

Uniform reserve requirements for all commercial

banks* It Is argued* would not only make control of credit more effective but would also strengthen the System by removing the discriminatory reserve advantage of banks remaining outside the System* Reserves and Credit CPfltrPl. With the shift In emphasis from the liquidity to the

13

credit-control concept of the function of legal reserve re­ quirements, much thought has been given to methods of making reserve arrangements a more effective Instrumentality of con­ trol over the credit policies of the member banks*

Economists

like Currie have pointed out certain elements of "perverse elasticity" in the reserve structure which, it is claimed, hamper the Federal Reserve authorities in their efforts to regulate the volume of deposit money*

The potentialities of

the variable reserve ratio have been intensively explored* Just before World War II a proposal for a "ceiling reserve" came in for a good deal of discussion*

In 1931 a plan was

promulgated by the Board of Governors for a new system of re­ serve requirements which would take into consideration the activity as well as the volume of deposits, but on subsequent analysis of the manner in which the scheme would apply to dif­ ferent banks and different cities, it was found (to quote a member of the Board's staff) that "the administrative problems involved were very tremendous*"11

A more radical proposal for

tightening control over the supply of money, still urged from time to time,12 is the "100 per cent reserve" plan, which, it is alleged, would prevent the creation of deposits except in accordance with reserves placed at the disposal of member banks by the central bank*

11. Loc.~cit*, p. 137* 12* The adoption of the 100 per cent reserve plan was recently urged by Dr. Arthur P. Becker of the University of Wiscon­ sin in an article entitled "The Case for 100# Money" in The Commercial and Financial Chronicle (July 28, 19^9), Vol. 170, No. 4824, pp. 6, 24, 25.

14

One of the perennial problems connected with reserves is the leverage factor In our present system of fractional reserves.

Assuming average reserve requirements of 20 per

cent against deposits, a dollar added to reserves may result In an expansion of deposits ranging all the way from zero to nearly 5 dollars, depending, among other things, on whether the banks are lending to the full extent of their capacity. Many students of banking, including the advocates of the 100 per cent plan, have contended that the phenomenon of multiple credit expansion on a given reserve base unduly complicates the task of the central monetary authority.

The question Is

raised, therefore, as to whether higher reserve requirements, which would have the effect of cutting down the ratio of poten­ tial expansion, might be desirable.

This question was recently

raised by Mr. Allan Sproul, who pointed out that "there may well be reasons, taking the long view, for an Increase In the reserve requirements of the commercial banks of the country, and of the limits within which the requirements can be varied by the Federal Reserve System."

Mr. Sproul added:

I am Inclined to believe that this could be a progressive step in our monetary-banking organization, especially if there should continue to be a persistent and substan­ tial inflow of gold. With a modern central-banking system operating in a highly developed deposit-banking system, and with a decreasing reliance upon gold, much of the need for low reserve requirements and consequent economizing In the provision of money by commercial banks has disappeared. In these circumstances there may well be a balance of advantage In higher reserve requirements as a means of reducing the dangerous expansibility and, at times, destructive contractlbillty of a money supply based on a low reserve ratio of commercial banks. There may be too great an element of leverage In our present system to be left at the disposal of 14,000 banks. We

15 /

should try to discover whether there Is some practical way, as a long-term Improvement and not as an emergency device, to Increase reserve requirements so that the ratio of expansion on a given base would be less than It Is now* Perhaps the answer would be found in a modi­ fied celling reserve plan, which would authorize an in­ crease in reserve requirements— whether primary or special— on any Increase In deposits after the effective date***** These are the directions in which I believe Federal Reserve study and the consideration of Congress­ ional committees should be taking us*3-3 Proposals for higher reserve requirements invariably meet with strenuous resistance on the part of the banking community, since legal reserves, as at present constituted, represent non-earning assets*

Hence the question arises whether

interest should be paid by the central bank on all or some part of the reserve balances maintained with it by the member banks, or whether the members might feasibly be permitted to keep part of their required reserves in the form of earning assets such as Government securities* In 19^7* when the Inflationary dangers of bank credit expansion were causing grave concern, a novel proposal was advanced by the Board of Governors for a temporary "security reserve" which was intended to serve the double purpose of preventing further monetization of the Government debt through sales of Government bonds by the banks to the Federal Reserve Banks and reducing the ratio of multiple credit expansion on a given base of cash reserves*

As the Joint Committee on the

Economic Report observed in its report of May l8, 19^8, "there is substantial question whether any increase in reserves can have any effect on bank credit so long as the banks hold such Hearings on grgfllt,FflULsAfig.* P* 98*

16

a large proportion of their assets in Government bonds, and so long as the Federal Reserve System maintains the policy of supporting the Government bond market at not less than 4 par. ■L The security reserve proposal seemed to the Board to offer a way out of the dilemma.

It has now been abandoned,

but may be rfevived again if inflationary tendencies reassert themselves. Other Problems The foregoing outline of issues connected with re­ serve arrangements is by no means conqalete.

A host of sub­

sidiary issues will be examined in Part V of this book.

Con­

siderable attention will be paid to such mechanical problems as the method of computing reserve deficiencies and the deter­ mination of penalties for deficiencies, for example.

The

extent to which banks should be permitted to trade in "Federal Funds" will be discussed.

The broad issue, whether reserve

requirements are necessary at all, will be explored. Many of these Issues overlap and most of them are interconnected in various ways.

In general, the procedure in

dealing with them will be to set forth the historical back­ ground of the problems, to trace the evolution of present policy, and to analyze the diverse viewpoints and solutions which have been put forward.

14. Report of tljg. Joint nommrttoft o£ Congress SH tllSL EcongnHs. Report on. tbs. January 1948 Economic BfiBPlJL thSL President (Senate Report Ho. 1358), 80th Cong., 2nd Sess. (1948), p. 7*

17

S.frufllCg O L Reggrvg Prablgffig feX the Reserve Board and Other Agencies In 1925 the Economic Policy Commission of the Amer­ ican Bankers Association appointed a sub-committee to study all phases of the Federal Reserve System, including reserve requirements, and to evaluate proposed amendments.1^

So far

as the author has been able to ascertain, this committee never agreed on a program, and the results of the study were never made public.

In 1930 other committees representing the Asso­

ciation of Reserve City Bankers and the Bank Management Com­ mission were giving consideration to several proposals which had been advanced to remove uncertainties and inequities from the method of calculating reserves, and were circulating questionnaires among the banks of the country in an effort to learn the attitude of bankers on various questions connected with reserve requirements.

While a great deal of research was

done and a vast amount of data assembled, these studies do not seem to have reached a stage where definite recommendations could be made.

A number of studies concerned with the reserve

and other banking problems were made during 1929“1935 by various committees of the Chamber of Commerce of the United States.

References to these studies will be made in subsequent

chapters. The various problems connected with reserves seem to have been under more or less constant study by the Board of Governors of the Federal Reserve System during the past twenty 15. American Bankers Association Journal (May 1925)* Vol. 17, p. 65Q: ibid.. (November 1930). Vol. 23, PP. 421, 452.

18 years.

Professor Harris states (on the basis of unpublished

memoranda which were made available to him from the files of the Board) that in 1928 the Board had under consideration several radical amendments to the reserve provisions of the Federal Reserve Act; but that, although the Board apparently favored such amendments, it was not considered expedient to encourage tampering with the Act by Congress at that time.*6 The changes under consideration Included the amendment of Section 19 of the Act to write Into It a more complete defi­ nition of what constitutes time and savings deposits, a revi­ sion of the list of "reserve" cities to Include In it some cities which were located within a short distance of a Reserve Bank or branch and others in which a large volume of bankers' balances were carried, and a change in the Board's Regulation D to require member banks to calculate and adjust their legal reserves dally instead of on an average semi-weekly basis. The Federal Advisory Council was not enthusiastic concerning these proposed

changes

The stock market collapse of 1929 and the ensiling d e ­ pression Intensified Interest in the reform of the banking system.

The Committee on Bank Reserves of the Federal Reserve

System, in its report in 1931 (reprinted in the 1932 Annual Report of the Board of Governors), recommended uniform reserve requirements for all member banks and all classes of deposits. 16. S. E. Harris, Twenty Ygft£g ° L Fgflsr&l RMffTO. P.9JL1.93E (Harvard University Press, Cambridge, 1933) $ Vol. 1, pp. 384-385. 17* Board of Governors of the Federal Reserve System, Annual Report. 1928, p. 228.

19

It proposed a reserve of 5 per cent against all deposits, plus an additional reserve equal to 5 per cent of average dally debits to deposit accounts.

Certain other less important

changes in reserve requirements were put forward at the same time, including one which would permit part of the reserves to be held In the form of vault cash. will be considered in Chapter places In this book.

These various proposals

XXVIII and at various other

Enactment of the proposals into law was

urged upon Congress by the Board in 1932-1934, but intensifi­ cation of the banking emergency deflected the attention of the legislators to a number of emergency amendments to the banking laws and the matter of reserve "reform" was pushed aside. The Banking Act of 1933 made a number of important changes in the system of member bank reserves.

One of these

permitted the deduction from gross demand deposits of balances due from other banks and cash items in process of collection in computing net deposits subject to reserve requirements. Another authorized the Board to define the terms "demand de­ posits," "time deposits," etc., for reserve purposes.

A third

extended and enlarged the power given to the Board by the 1933 Thomas Amendment to alter the reserve requirements of the mem­ ber banks.

The latter authority proved very useful during

1936-1937* when the existence of large excess reserves hampered the control of credit policies of the member banks by orthodox measures.

Reserve requirements were lowered slightly in 1938

to give the member banks more excess reserves, and then raised

20

to the maximum again In late 19^1 to damp somewhat the boom accompanying our rearmament program*

From 19^1 up to the end

of the war the only change was a slight lowering of the reserve requirements against demand deposits at central reserve city banksJ all the other requirements remained at the maximum levels permitted by law. The war years brought some minor changes In reserve arrangements*

The Board of Governors was given the power to

alter the reserve requirements of central reserve city banks separately from other classes of member banks, some changes were made In the regulations relating to the method of comput­ ing reserve deficiencies, and the provision of Section 19 forbidding a member bank to make new loans or to pay dividends while there Is a deficiency in Its reserves was deleted from the Federal Reserve Act.

These changes were aimed at reliev­

ing the strain on bank reserves occasioned by Treasury financ­ ing, increasing the power of the System to absorb Government securities, and facilitating the smooth operation of the System under war conditions* After World Wat II attention again shifted to the cow trol of inflation, and a number of proposals were put forward by the Board to enhance the control of the Reserve authorities over member bank credit*

One of these was the so-called

"security reserve" proposal, which will be discussed in Chap­ ters XXXIII and XXXIV.

The adoption of this plan, the Board

maintained, would Immobilize a considerable quantify of short­ term Government securities In member bank portfolios and thus

21

reduce the power of the banks to obtain new reserves and ex­ pand credit through the sale of Governments to the Reserve Banks,

It would also decrease the ratio of multiple credit

expansion by the banking system on the basis of newly acquired excess reserves* by Congress*

The security reserve proposal was not adopted

As a compromise, legislation was adopted In

August 1948 permitting the Board to raise cash reserve require­ ments for a limited period*

This temporary authority expired

in June 1949* Meanwhile the Board had had under consideration certain more fundamental changes In reserve arrangements*

In

1942 Chairman Eccles, in the course of his testimony before a Congressional committee, expressed dissatisfaction with the present reserve structure*

"I agree...,** he said, “that this

whole question of reserve requirements is not very scientific and if the whole subject were not so controversial I certainly would like to see this whole subject of reserve requirements and bank membership and quite a number of other things that don't make very much sense, considered, but I don't believe no* is the time to undertake any fundamental overhauling of the banking picture which could be done, I think, with value to the public*"1® In May 194-3 a staff committee of the Federal Reserve System presented to the Joint Committee of Congress on the Economic Report a plan for changing the basis for the determinalS* House Committee on Banking and Currency, Hearings on H.R* 7158, T g Amend j&e Federal Reserve &&£, 77th Cong*, 2nd Sess. (1942), p 7 6 l .

22

tion of reserve requirements— the Uniform Reserve Requirements 19 Plan* Under this plan the present classification of banks for reserve purposes Into central reserve city, reserve city, and non-reserve city banks would be abolished#

For purposes

of reserve requirements the deposits of commercial banks would be grouped into interbank, other demand, and time deposits, and all commercial banks (including nonraembers) would be re­ quired to hold Initially 30 per cent reserves against interbank deposits, 20 per cent against other demand deposits, and 6 per cent against time deposits#

Banks would be permitted to count

as part of the legal reserve vault cash and that portion of their balances held at other banks which those banks In turn are required to hold as reserves against such balances#

The

Board of Governors would continue to possess authority to change the reserve requirements within limits established In the law# In his statement before the House Banking and Cur­ rency Committee on August 2, 19^8, Chairman McCabe said:

"The

Congress might well find it desirable#••to reconsider the whole structure of reserve requirements, possibly along the lines developed recently before the Joint Committee on the Economic Report.**20

And at pages 6 and 7 of its 19^8 Annual Report

the Board said: It Is inequitable to have member banks bear the entire burden of credit action taken in the public Interest#•••• 19. Hearings on Credit Policies.# pp. 131-151* 20. Senate Banking and Currency Committee, Hearings SSL I n H & r tlon Control. 80th Cong#, 2nd Sess# (19^8), p# 23#

23

What Is needed for an effective and flexible national monetary policy Is a system of bank reserves that will apply to all commercial banks enjoying the benefit of Federal and State chartering and supervision of banks.•••• Differences In reserve requirements should be based more largely on the nature of deposits than on the location of banks. It Is essential.•.that reserve requirements for all Insured banks be as uniform as practicable In order to apportion bank reserves equitably In the banking system as a whole and to regulate their amount to accom­ modate the needs of commerce, industry, and agriculture. Dissatisfaction with the present system of reserve requirements was expressed by Mr. M. S. Szymczak of the Board of Governors in April 1948: Our present reserve requirements have come to be what they are by a process of legislative changes that have never caught tg> with the facts. For a long time this condition made little difference, but we are now getting to the point where an arrangement originating in Civil War times is altogether too far out of line for present day needs. The arrangement I mean is that which deter­ mines the required reserves of banks on the basis of their location. As a matter of fact a bank's location Is under m o d e m conditions a pretty poor criterion for d e ­ termining the reserves It should maintain. The Important thing Is the kind of deposits, no matter where the bank is.....21 And Mr. Allan Sproul of the Federal Reserve Bank of New York told the Joint Committee on the Economic Report in 1948 that "it is time to give serious consideration to a system of reserves related to the character of deposits rather than to their location."22 In his Economic Report to Congress of January 6, 1950, President Truman said: To eliminate the competitive disadvantage of Federal Reserve membership, the authority of the Board of Governors 21. M. S. Szymczak, "Current Credit Problems," The Commercial and Financial Chronicle (April 8, 1948), Vol. 167* p.1567. 22. Hearings, on Qpgflte. Ppllplsfl., p. 98.

24

of the Federal Reserve System should be revised. The Board should have broader powers than It now has to Increase bank reserve requirements in a period of infla­ tion. This would be a protective measure for the entire banking system, and accordingly should be applicable to all banks insured by the Federal Deposit Insurance C orp orat ion.2 3

Exploration o£ £hs. Reserve Problem fcx Congress On June 2, 1949, the Senate approved a bill to set up a National Monetary Commission to survey the entire frame­ work and functioning of the financial system and the role of banking therein.

The proposed commission would have the

authority to determine "what changes are necessary or desir­ able in the banking and monetary system of the United States, or in the laws relating to banking and currency by reason of domestic or international considerations or both.

«24

In the

course of his testimony endorsing the establishment of such a commission Chairman McCabe of the Board of Governors pointed out in May 1949 that "in any such review, the role and function of reserves will Inevitably receive prominent consideration." "As you know," he said, "the System has been conducting ex­ tensive studies of this subject and believes that a more scientific formula for establishing reserves can be determined by Congress."2^ During the summer of 1949 a subcommittee of the Joint Committee on the Economic Report waB eshablishedunder chairmanship of Senator Paul H. Douglas ofIllinois

the

to conduct

2*3. The ifew York Times. January 7, 1950. 24. His. X2£k Times. June 3, 1949. 25. Federal Reserve Bulletin (May 1949), Vol. 35, No. 5, P. 479.

25

a comprehensive study relating to the effectiveness and coordi­ nation of the nation's monetary, credit and fiscal policies.2^ This subcommittee has been holding hearings since November 16, 19^9, and has sent out a series of questionnaires to bankers, economists, Federal Reserve Bank presidents, and members of the Board of Governors asking their views on specific questions* In their testimony before the subcommittee both Mr* McCabe and Mr* Eccles have urged a sweeping revision of the present system of reserve requirements along the lines of the Uniform Reserve Requirements Plan, laying particular stress upon the adoption of uniform reserve requirements for member and non27

member banks* ' As Mr* Chester C* Davis, President of the Federal Reserve Bank of St* Louis, pointed out in an address before the National Bank Division of the American Bankers Association's annual convention in San Francisco on October 31 * 19^9, there is a real need for such a comprehensive study of national mone­ tary and banking arrangements at this time*

No such survey has

been undertaken since 1913* We have had a Topsy-like growth of agencies to deal with new problems— now we need to sit back and take a hard look at our money situation to see if we can come up with a better organized system* I should like to ask the national bankers of the United States to give openminded consideration to these problems in the light of the vastly changed conditions of today* We need a thorough-going reappraisal of the new set of circumstances that have evolved in the monetary 26. The New York Times. September 4, 19^9* 27* The Mew York Times. November 23, 19^9? The New York WorldNovember 16, 19^9.

26

field in the past few years Our banks today are very different from the banks of fifty years ago.*... No central bank today can operate as it did prewar..... The problem of harnessing the country's gigantic money supply to serve a dynamic economy is a continuing and ever-changing one..... A national monetary study by an impartial and competent commission would be worth­ while if it only threw light upon an area which to most of us is hopelessly dark and confused.28 SfiHtlon Required i n Sh&nglnK BffOHOa. Arrangements The problem of overhauling the reserve structure is one of great delicacy and considerable complexity.

As Gover­

nor Strong pointed out more than twenty years ago, "any change in our reserve requirements is very largely experimental in its effect.

You can make the closest calculation of the sup­

posed effect of a reserve change and find you are wrong, and, frankly, I do not believe in monkeying with the reserves. They are now fixed, and when you come to make changes in the required reserves you are making a very Important change in the base on which that inverted pyramid rests. to be done without the utmost study.••••

It ought not

When we come to con­

sider changing reserve requirements, I first want to get care­ ful statistics for the reserve system and see where it lands us before saying yes or no.

It Is a very Important move to

make any change in reserve requirements."2^ With this position the author agrees.

As the ensuing

chapters will show, most of the major reserve reforms which 28. Chester C. Davis, "Banks and Central Banks." reprinted in Ihg. Commercial and Financial Chronicle (November 10, 1 9 W T Vol. 170, N o 7 4 8 5 4 , p. 44. 29* House Banking and Currency Committee, Stabilization. Hearings on H. R. 7895# 69th Cong., 1st Sess. (1926), PP. 370, 347.

27

have been suggested in the last twenty-five years are of very doubtful merit*

Some would entail disadvantages which would

far outweigh the benefits*

A good example is the "velocity

reserve" proposal advanced by the Board of Governors in 1931" 1932 and subsequently abandoned*

Under this proposal, which

will be analyzed at length in Chapters

XXVIII and XXIX, cash

reserves would have been related automatically not to deposit liabilities alone but to a combination of deposits and bank debits*

Reserve regulation was thought of as a way of pr o ­

viding an automatic control of the volume of credit, putting the brake on bank lending activities in times of expanding bank credit (when both debits and deposits would be rising) and encouraging lending in times of contracting trade (when deposits and debits would be falling)*

The adoption of the plan was

strongly urged upon Congress, and had the banking emergency not supervened it seems likely that the scheme might have been written into law*

In retrospect, it is clear that a change of

this kind would have been retrogressive in that, whatever its theoretical attractions, it would not only have given rise to serious practical difficulties but would have lent support to the view that reliance may be placed on the automatic opera­ tion of a specific formula for regulation of the monetary system, rather than on the discretion of central banters exer­ cised under changing conditions for the attainment of changing objectives* The ensuing chapters will demonstrate that there are serious faults and inequities in the present reserve

arrangements.

Nevertheless, in the author*s opinion, it

will behoove us to "go slow" in adopting "reforms" the con­ sequences of which are likely to be highly complex and very difficult to predict.

CHAPTER II THE MEANING OF "RESERVE"

The Reserve as a. Fund The term "reserve" is used in the United States loosely and with a variety of meanings.

We speak of "cash

reserve," "deposited reserve," "legal reserve," "actual r e ­ serve," and "secondary reserve."

Usually the meaning that

is used depends upon the problem at hand, the term possessing one connotation in one connection and an entirely different one in another. For our purposes bank reserves are to be viewed as a particular type of bank assets, ordinarily cash or its equivalent, which a bank keeps at its command to meet demand liabilities— deposits and notes.

Palgrave defines the banker's

reserve as "that portion of his resources which he holds u n ­ invested."

"In ordinary times," he adds, "the daily receipts

may be roughly reckoned to provide for the day's demands, but there is the possibility of extra requirements, and for these a fair provision of cash in hand Is necessary."^In a broad sense the term would include all cash items, whether on deposit with the central bank or with other banks, or cash in vault, which are available to pay obligations 1. Palerave's Dictionary of Political Economy, ed. by Henry Higgs (Macmillan and Co. Ltd., London, 1926), Vol. 3, P« 291.

30

to depositors and note-holders when these obligations are demanded in the form of money.

A still broader usage of the

term would give consideration to the successive component parts of other assets of the bank (loans, investments, real estate holdings, etc.) which possess varying degrees of li ­ quidity and which could be utilized to meet claims that are presented.

O

On the other hand, as Kemmerer points out, "in

the strictest and narrowest sense of the term, although not in the sense in which the term is most commonly used, a true bank reserve would consist solely of legal tender money actual­ ly in the possession of the bank, for it is only in such money that a bank may legally pay its creditors— depositors and noteholders--if they so i n s i s t . However, without drawing any distinctions that are too fine, we may accept the view that the reserve is the amount of funds which a bank keeps on hand either in the form of acceptable money in its own vaults or on deposit with other banks (including the central bank) to pay such of its obligations as must be met in cash.

The form

in which the reserve must be kept— in the absence of legal 2. "The term 'reserve' fixes attention upon that part of the bank's assets which consist of cash. Under some conditions, however, the solvency or safety of a bank depends as much upon the character of the other securities it holds as upon the amount of cash on hand. There are second and third lines of reserve " David Kinley, "The Specie Reserve in a Banking System," Journal of Political Economy (January 1912), Vol. 20, pp. 12-13. 3. E. C. Kemmerer. Money (The Macmillan Company, New York, 1935)> PP* ^ 5 “46. Victor Morawetz also held that "for the ultimate payment of bank-deposit liabilities, the only true reserve is legal-tender money." The Banking and Cur­ rency Problem in the United States (North American Review Publishing Company, New York, 1909), P« 19*

31

requirements— depends mainly upon the character of the busi­ ness done by the bank (domestic and foreign) and the probable requirements of its customers, depositors, and checkholders. Apart from legal provisions to the contrary, any cash item (including balances with other banks) may be regarded as part of the reserve. Of course, most of the payments demanded of a bank are called for not in the form of currency or specie but of cancellation of book indebtedness, or transfer of some of its obligations from one creditor to another.

If none of its d e ­

positors or checkholders demanded cash and if adverse balances did not arise among banks, a bank would need to keep little or no currency in its vaults. Bank Reserves Distinguished from Accounting Reserves Bank reserves are to be distinguished from reserves in the ordinary accounting sense, like reserves against con­ tingencies.

A bank can, of course, set up a reserve of the

latter type, as part of its capital account, against asset losses or depreciation, but this would be an entirely differ­ ent type of reserve than the reserve funds2*' with which our study deals.

Most banks do, of course, set up accounting r e ­

serves to enhance their ability to absorb losses, in the same manner as insurance companies and other business enterprises. Such reserves are designed to protect the solvency of the bank, 4. The use of the term "reserve funds" to distinguish bank re ­ serves from ordinary accounting reserves is suggested by H. L. Mann, "Reserves," National Auditgram (March 19^2), Vol. 18, N o . .3, p. 22..

32

not to guarantee liquidity.^ Reserve Ratios and Capital Ratios The banking legislation of many countries limits the total volume of bank demand liabilities (notes and deposits) to a specified multiple of paid-in c a p i t a l . 6

Restrictions of

this type were in force in some of the states over a century ago and are still imposed in several s t a t e s F r o m time to time proposals have been made to amend the Federal banking laws to fix a definite capital-deposit ratio.®

At one time the

Federal Deposit Insurance Corporation favored a l-to-10 ratio but in recent years it has backed away from insistence on any specific ratio.^

Both the Federal Reserve Board of Governors

and the Comptroller of the Currency have observed a capitaldeposit standard for some purposes but have not insisted upon a rigid adherence to it.l° 5. As R. S. Sayers points out, "the depositor looks for 'safety' of two kinds. He looks to ready availability of his money, and he looks to availability eventually of all his money. The first type of safety has to do with liquidity, the second with solvency. American Banking System (Clarendon Press, Oxford, 19^8), p. 112. 6. The provisions of the laws of various foreign countries relating to bank capital are discussed by M. H. De Krock, "The Functions and Activities of Commercial Banks in D i f ­ ferent Countries," Journal of the Institute of Bankers in South Africa (June 1 9 ^ ) , Vol. 4l, p. 33 ff. 7. The provisions of the various state laws are examined by R. I. Robinson, "The Capital-Deposit Ratio in Banking Supervision," Journal of Political Economy (February 1941), Vol. 49, pp..41-57. 8. E.g., the Glass Bill (S. 4115), introduced March 17, 1932. 9. The history of the F. D. I. C.'s position on this matter is traced by Robinson, op. clt.. pp. 44-47. 10. Robinson, op., clt.. pp. 44-47.

33

The purpose of maintaining a specific relationship between capital and liabilities is to ensure that the capital will always be available for the satisfaction of the claims of creditors.

The larger the capital the greater the margin

of safety which will exist in the event of depreciation of assets.

Thus depositors are likely to fare better on liquida­

tion. The purpose of such regulations, however, is entirely different from that of regulations relating to reserve funds. Capital-deposit ratios have a bearing upon the solvency of the bank and upon Its ability to liquidate its assets without loss to depositors, but they have nothing to do with the li­ quidity of the bank.

Capital, unlike reserve funds, is not

analogous to, or synonymous with, any particular asset or group of assets which is available for the prompt payment of claims as they are presented to a going banking concern. Legftl Reserves "Legal reserves" refers to the funds which are r e ­ quired by law to be maintained by the bank, in vault cash or some other form, against its deposit (and note) liabilities. The requirement of a specific minimum reserve against deposits Is peculiarly American and has not been a feature of bank regu­ lation in foreign countries until recent years.

The legal

reserve requirements of member banks of the Federal Reserve System are specified by Section 19 of the Federal Reserve Act and by Regulation D of the Board of Governors of the Federal

34

Reserve System, entitled "Reserves of Member Banks."

Since

1917 the entire legal reserve of any member bank has been r e ­ quired to be kept on deposit with the Federal Reserve Bank of its district.

State laws also prescribe reserve requirements

for both member and non-member banks. Clearing house associations in the interest of i n ­ creased safety may require a higher percentage of reserves than that required by law.

For example, the Clearing House Associ­

ation in New York City adopted an amendment to its constitution in January 1908, requiring all banks belonging to the Associa­ tion thereafter to maintain in their own vaults a cash reserve of 25 per cent against deposits, although it had been the general practice of New York City banks to keep a 25 per cent reserve.

This requirement was made a condition of admission

for both commercial banks and trust companies.^-1 Primary. Working and Secondary Reserves Legal reserves are to be distinguished from other kinds of reserves kept by banks. 1. Primary reserves of a bank consist of cash in vault and demand deposits in other banks, i n ­ cluding the reserve account in the central bank. 2. Working or operating reserves, consist of (l) cash in vault, (2) demand deposits with other banks (exclusive of the central bank), and (3) deposits with the central bank in excess of the legal r e ­ quirement. Legal reserves are not included in working reserves because the law generally re­ quires them to be maintained at the proper figure, so that the bank is loath to pay out funds when 11. J. G. Cannon, Clearing Houses. U. S. Nat. Mon. Com. Eubs ., 6lst Cong., 2nd Sess., Sen. Doc. No. 491 (1910), p. 179»

35 by doing 30 it impairs its legal reserve position. In other words, legal reserves are actually used in cases of bank liquidation only. 3. Secondary reserves consist of highly liquid earn­ ings assets (i.e. loans and investments; which the banker can dispose of so as to increase his cash holdings quickly, easily, and without loss should the need arise. (Of course the line of demarcation between secondary reserves and other assets of the bank is arbitrary and relative. What we have is a hierarchy of assets, of varying degrees of liquidity, shading off by degrees from the most liquid to the least.) All banks need to carry working and secondary r e ­ serves.

Every commercial bank receives currency every day as

a result of deposits of currency, payment of loans, etc.

At

the same time, there is also a perpetual, though fluctuating, flow of currency from the bank.

If the Inflow of funds exactly

coincided with the outflow, it would be unnecessary for the bank to hold any currency for till money purposes.

They do not

exactly coincide, however; hence a reserve of "vault cash" is required. There is a second and (normally) much more important sense in which banks are constantly gaining and losing funds, viz. through the clearing house.

Clearing Is a process of

offsetting, and in an economy in which approximately 20 per cent of all pecuniary transactions are handled by bank checks the volume of items to be offset is necessarily very large.

Clear­

ing entails the maintenance by each participating bank of a balance at some central place, to which credits and debits are made accordingly as the offsets against other banks are favor­ able or adverse.

As we shall stress later on, the reserve

36

accounts at the Federal Reserve Banks serve this function. They constitute reservoirs in and out of which payments are made continuously, while the general level remains about the same. Now if its credit and debit items at the clearing always exactly balanced, a bank would not need to maintain (in the form of vault cash, balances with other banks, or excess reserves with the Reserve Bank) any extra funds to take care of a possible drain of funds to other banks. 1P normally the c a s e . c

But such is not

Hence working reserves are required to

absorb the day-to-day variations in the rate of acquisition and loss of funds through the clearing. We have, then, two reasons for working reserves, one growing out of the necessity of anticipating an over-thecounter demand for currency and the other resulting from the need for anticipating adverse balances at the clearing.

The

function of working reserves, in both cases, is to absorb any short-time net changes in the cash position of the bank.

The

working reserve must be maintained at some reasonable level in order that the bank's business may proceed smoothly and without interruption.

Just how large a working reserve a bank will

12. In a_ purely static society, as B. M. Anderson, Jr., points out, the need for such reserves would not arise. Apart from dynamic changes, from frictional elements which create uncertainty and irregularity and lack of 'normality,' there would be no occasion for bank reserves at alii To the extent that static conditions are realized, bank cash reserves may be, and are, dispensed with The static law of bank reserves is that none are needed.” The Value of Money (The Macmillan Company, New York, 1917)» PP» 538, 543-544.

37

require, and in what form (balances with correspondents, excess reserves at the Reserve Bank, or vault cash) will depend upon the operations of the individual bank, and the decision on this point is best left to the banker, who is, after all, in the best position to know the quantity and type of funds that are required to facilitate day-to-day banking functions.

The amount

of vault cash that is required from day to day, for example, is a problem that each banker will have to decide for himself, since it depends on factors which vary from one bank to the next: the number of depositors; the nature of the depositors (business or non-business, other banks, etc.); the type of deposit (time, etc.); regularity of withdrawals, etc.

A bank

that is located near a Reserve Bank will probably need to carry less cash in vault than one which is located at a distance. And a bank whose portfolio includes a large quantity of call loans or short-term Governments will feel free to operate on a smaller working reserve than one whose portfolio is dominated by commercial loans and mortgage investments, or which is lo­ cated at a considerable distance from the money market.

Simi­

larly, there may be reasons why a bank should prefer to maintain sizable working balances with other banks, instead of keeping the funds in the form of vault cash or excess reserve with the Reserve Bank. The working reserves are needed to cope with the minor day-to-day pulsations in the inflow and outflow of funds. The more substantial variations (seasonal, cyclical, etc.) are cared for through drawing on the secondary reserve.

The

38

secondary reserve, as has been noted, Is really a hierarchy of assets, of varying degrees of "liquidity," which the banker can convert Into cash with varying degrees of speed, varying degrees of ease, and varying possibilities of loss.*3 recent years standards of bank practice have developed around this part of a bank's earning assets.

Here, again, the policy

of the bank will depend upon its peculiar circumstances, in ­ cluding the type of business it does.

For example, each indi­

vidual banker is likely to encounter certain peculiar seasonal patterns as respects the Inflow and outflow of funds.

Able

management is largely a matter of scheduling portfolio maturi­ ties In such a way that the funds will be available when needed. At times the banker may choose to carry a smaller working reserve and invest the funds in secondary-reserve assets.

At other times he may let his secondary reserve run

down and hold larger quantities of "cash."

As Dr. B. M. A n d e r ­

son, Jr., points out, The difference between cash and liquid paper is a matter of degree. There is a large possibility of substitution of the. one for the other, as it becomes more profitable to use one or the other. When money-rates are low, it may well be worth while to carry large (working) reserves; when money rates are higher, the gains to be made by s u b ­ stituting paper for cash in the bank's assets are much greater. 13» P. Atkins offers the following definition of "secondary reserve": "A secondary reserve is a reserve which may be drawn upon to replenish the primary reserve when necessary. It is composed of those Income-producing assets which in one way or another may be used to obtain cash when neces­ sary." Bank Secondary Reserve and Investment Policies (The Bankers Publishing Company, New York, 1930), p p . 3 9 ^ 0 . l4. Anderson, op,, cI t . . pp. 529“530.

39

To the extent, therefore, that banks deliberately vary their cash ratios, it may be in response (apart from legal requirements) to either actual or anticipated demands for cash or to a variation in the availability of other bank­ ing assets. Reserves and Liquidity From the banker's standpoint, then, the reserve question is an auxiliary to, or corollary of, the problem of liquidity or liquidating power.

It is simply a question of

having a reserve of such credit currency, or of power to produce such credit balances, as will provide an acceptable means of satisfying depositors.

To this end, the banker maintains a

working reserve of cash and a secondary reserve of "liquid" assets ranked qualitatively according to their varying degrees of "money-ness." Professor Bradford believes that there is a tendency, in writing about banking operations and bank "liquidity," to over-emphasize legal reserves.

It is the working and secon­

dary reserves, he maintains, that depict "the real reserve situation in the country."*5

whether, and to what extent,

legal reserves are to be viewed as contributing to the liquidity of a bank, will be discussed in a later chapter. In speaking of the connection between reserves and liquidity, it may be well to distinguish between two schools of

15. F» A. Bradford. Money and Banking (Longmans, Green and Co., New York, 19^1 rev. ed., p. 277*

),

39a thought about the meaning of "liquidity."

According to one

school of thought, liquidity is mainly a matter of the ability of the bank to sell assets on short notice and without loss. As Berle and Pederson point out, liquidity in this sense rests on the functioning of a financial machinery which makes possible the shifting of non-cash bank assets to other investors or to 1

a central bank.

/T

The Federal Reserve System today provides

liquidity for practically every sound bank asset through the machinery of rediscounts and advances. The second school of thought about liquidity views it as a matter of the quality and basic character of bank assets. According to this view, some types of loans are "self-liquidat­ ing" in the sense that the proceeds of the loan will be trans­ formed into salable goods and services which will return to the borrower the funds with which to repay the loan.

The position

of many writers on banking theory is that commercial banks should confine themselves to making loans to finance the short time current working capital needs of commerce and industry.

17 1

Such loans are secured, it is held, by underlying assets which move toward the consumer market and will shortly be sold for cash which can be used to repay the loan.

A loan the proceeds of

which are to be used by the borrower to acquire fixed capital goods might be viewed as self-liquidating if the loan were to 16. A. A. Berle and V. J. Pederson, Liquid Claims and National Wealth (The Macmillan Company, New York, 1934), PP» 1 9 “2l. IT. Numerous writers are quoted to this effect by W. F. Mitchell, "The Attack Upon the Theory of the Liquidity of Bank E a r n ­ ing Assets," Journal of Political Economy (April 1923)» Vol. 31, No. 2, pp. 245-254.

39b run for a period of time sufficient for the capital goods to earn back the interest and principal of the loan. thing might be true of a loan on real estate.

The same

But long-term

loans of these types, it is held, are not appropriate for c o m ­ mercial banks, whose liabilities are mainly payable on demand. On this view, liquidity is mostly a matter of skillful asset management.

The b a n k ’s assets should consist mainly of short­

term commercial loans, and the maturities of these loans should be so arranged as to bring in cash as it is likely to be re­ quired. Both kinds of "liquidity" are likely to be illusory in a period of general liquidation and credit contraction.

At

such times the individual bank may find itself unable to shift assets to other banks or to non-bank investors, and even the highest quality commercial paper may turn out to be very far from "self-liquidating" if the borrower cannot dispose of his output or collect from his own debtors.

Both the marketability

of bank paper and the marketability of the underlying assets behind it depend upon the continued availability of bank credit in the system as a whole.

In other words, liquidity of the

individual bank is a question of its ability to draw funds from other banks by selling assets when the need arises, and of the ability of its debtors--or of its debtors' customers or debtorsto obtain normal credit accommodations from the banking system. Which of the two basic concepts of liquidity is adopted will affect to a certain extent our ideas about what types of assets that can properly be classified as secondary

39c reserve.

18

In the one case the emphasis will be placed upon

the marketability of the paper; in the other, upon the matur­ ity date and character of the underlying asset.

Whichever view

is adopted, however, the need for "primary" and "working" r e ­ serves of cash remains the same.

Such reserves are needed to

take care of periodic discrepancies between the cash income and outgo of the bank, and thus have an important bearing upon its ability to meet demands upon it by depositors and check­ holders. At the same time, it must be borne in mind (as Berle and Pederson point out) that "it is not the reserve which the banker depends upon or which the public depends upon" in the last analysis,

"in the case of the commercial bank, or the

savings bank, or the insurance company, what is really expected is that there will be an inflow, in the form of new deposits or premiums [and of repayments of loans and investments], match­ ing the outgo to all payments to depositors or policy holders. The reserve is merely to cover the contingency that perhaps at any particular moment of time the inflow will be less than the outflow.

If an Inflow could be guaranteed and the outflow

controlled, there Would be no need of a reserve at all."1^ 1 8 . The different views about the proper composition of the secondary reserve are ably summarized by R. G. Thomas, Our Modern Banking and Monetary System (Prentice-Hall, Inc-,, New York, 1946), pp. 144-149* The method of computing the needed secondary reserves for any particular bank is discussed by Elmer Hartzel, "The Measurement of a Bank's Secondary and Investment Reserves," The Journal of. Business of the University of Chicago (October 1934), Vol. 7» No. 4, PP» 339“363. 19. Berle and Pederson, op., pit.., p. 131 •

39d Working Reserve and “Real” Reserve Palgrave draws a distinction between "real11 and ’’nominal” reserves.

The latter consist of the "till money"

which the banks require for their routine operations and of the balances carried with other banks (mainly the Bank of England) for settling the daily clearing demands— their "working b a l ­ ances."

He says:

Taking the amounts held on deposit by the bankers in London,...it would appear that the balances which they keep with the Bank of England rather represent what should, with strict accuracy, be called their "Till Money" than their "Reserve. "Till Money"...is the amount which every banker is bound to keep close at hand ready to meet the calls of the moment as cheques are p r e ­ sented over the counter. An adequate supply of "Till Money" is indispensable to the proper conduct of a bank­ ing business, but it cannot be looked upon as a "Reserve." A reserve," though equally needed to meet immediate calls, must be on a far larger scale than the mere amount of cash necessarily held in the "till." And taking into consideration, as just mentioned, the vast amounts of d e ­ posits held by London bankers, and the demands which may be made on them at any time, the balances which they keep with the Bank of England must be considered.as the cash needed for immediate requirements— that is to say, the "Till Money"— transferred for convenience sake to the custody of the Bank of England, rather than a really a d e ­ quate banking reserve.

This would be seen immediately if business in the city were conducted now as it used to be up to the date when the clearing demands were still settled by the p a y ­ ment of the actual notes, not by means of a cheque drawn on the Bank of England. No one could call the sums held in bank notes in the safe, or the drawer near the counter, for that purpose, a "reserve." The notes were merely "till money," and "till money" the amounts which represent them still remain, though for their own convenience the banks have advanced a step beyond their primitive practice, and have agreed to divest themselves of the actual custody of the notes, and to keep the money itself in Threadneedle Street. It is impossible to call the sums thus held by the Bank, which represent cash merely held to meet immedi­ ate claims on the bankers, a reserve The bankers

39e have frequently large sums on their accounts beyond what they require for settling the dally clearing d e ­ mands. These sums, and they are often very large, are a real reserve to them. Palgrave's statement calls attention to the Importance of distinguishing between the bank's working reserves, which are designed to facilitate its day-to-day routine operations, and its "real" reserve of cash and other assets upon which it can rely in an emergency.

It is perhaps unfortunate that the

term "reserve" is used to cover both.

In the United States the

confusion is added to by the fact that legal reserves, which are-generally viewed as a fund available for emergencies, actually include the balances maintained for clearing purposes with the Reserve Banks and (under most state laws, though not under the Federal) the "till money" required for meeting routine payments over the counter.

In practice, of course, it is e x ­

tremely difficult to say what part of a bank's primary or legal reserve should be viewed as purely working reserve.

The sums

required for meeting payments over the counter or at the clear­ ing house vary from day to day and from month to month, and what may be viewed as "normal" demands today may be considered "abnormal" tomorrow, or vice versa.

20. R. H. I. Palgrave, Bank Rate and the Money Market (E. P Dutton and Company, New York, 1903), PP« 23, ^6.

PART II HISTORY AND CURRENT STATUS OF RESERVE REQUIREMENTS IN THE UNITED STATES

/

CHAPTER III LEGISLATION O N RESERVE REQUIREMENTS BEFORE THE CIVIL WAR

Laxity of Bank, Regulation l a Early Nineteenth Century

The first commercial banks chartered In this country were not required to keep reserves against either deposits or notes.

The first legislative requirements for reserves In

this country were enacted In 1837* when Virginia adopted legislation calling for a 20 per cent specie reserve against bank notes .1

The acts Incorporating the First and Second

Banks of the United States laid down no requirement as to rep serves. In the wildcat days of the 1840*8 and 1850*s reserves^, were In many Instances non-existent.

There are amusing anec­

dotes describing the manner In which a single box of coin circulated among the banks of a remote community and served to satisfy the examining authorities that each bank In turn 1. Laws of Virginia, 1836-1837* Chap. 82, sec. 3* 2. 1 U.S.Stats, at Large 191, approved February 25* 1791* 3 U.S.Stats, at Large 266, approved April 10, lol6 . Both of these acts provided that the capital stock subscriptions should be paid In specie and limited the total amount of debts (In the form of notes or otherwise) which the Bank could contract. In addition, the 1816 law forbade the Bank to "at any time suspend or refuse payment In gold and sliver, of any of Its notes, bills or obligations; nor of any moneys received upon deposit In said bank.....M The acts chartering these banks recognized the resemblance of deposits to notes to the extent that the two were lumped together In the provisions above noted.

42

had something In the nature of a cash reserve*

One of these

is related by Dewey: A notable example of banking In Its worst form may be found In the annals of Michigan; tricks were employed to deceive the official bank commissioners as to the amount of specie on hand; the same boxes or bags of specie were quickly transferred from one Institution to another, to perform a continuous service of reserve* In the words of the commissioners, 'gold and silver flew about the country with the celerity of magic; its sound was heard In the depths of the forest, yet, like the wind, one knew not whence it came or whither it was going*' In one Instance It was found that the alleged box of specie showed a stratum of gold and silver but all beneath was nails and glass*3 Rg.aa.om fog EaKl.Y Emphasis on SatfiS. The early history of banking in the United States centered on notes and emphasized the Idea that banking was synonymous with the issue privilege.

Prior to the panic of

1857 only one state— Louisiana— had passed a law providing for the maintenance of reserves against deposits* The reasons for this are not hard to discern*

De­

posit banking preceded the issuance of banknotes, chronologi­ cally.

But banking in general only became important with the

development of the banknote*

People would deposit coin and

bullion with a banker more readily when they got in exchange a receipt, in the form of a note Issued by the banker, which could be passed from hand to hand*

Only after the banknote

had obtained wide acceptability as a medium of exchange was the public persuaded to leave large sums on deposit*

Moreover,

3* D. R* Dewey, Financial History of. th& Sniisd. StflfcfiS (Long­ mans, Green and Co., New York, 1936), l&fch edo,pp*260,2ol*

43

bankers were able to lend larger sums on the basis of specie held In their vaults If they were permitted to pay out notes In the event that their depositors wanted cash.

Hence the

most rapid strides In banking were made In those countries which permitted the widespread use of bank currency.^ Until about the middle of the last century the most Important form of bank credit or debt In the United States was the bank note.

Indeed, the note Issue function was the char­

acteristic function used to Identify the banking business.

A

century ago hand-to-hand currency was almost the sole medium of exchange and deposits were only rarely used for this purpose. Loans were taken out In bank notes rather than In the form of deposits against which checks could be drawn.

As Dunbar points

out, "comparative sparseness of population and the Imperfect development of the banking habit in a new and more slowly advancing country, and In a less advanced age than the present, created an early preference for currency which passes from hand to hand and discouraged a use of that which Implies a resort to the bank."5 Hence it was In connection with the issuance of notes that the earliest problems arose.

The first duty of a

bank was to keep Its notes redeemable In specie.

Banking

legislation during the early and middle nineteenth century focused attention on the protection of the holders of baric notes 4. Cf. V. C. Smith, Xbg. Rationale of Central Ban&Ilg (P. S. King & Son, Ltd., London, 1936), pp. 6 , 121. 5. C. P. Dunbar, Economic Essays, ed. by O.M.W.Sprague (The Macmillan Company, New York, 1904), p. 174.

44

and little attention was given to deposit protection.

It was

not until the latter part of the nineteenth century that bank checks drawn on deposits became the most Important medium of exchange and that deposits received much attention In the consideration of reserve policy. As H. £• Miller points out In his history of early banking theory, practically all the earlier discussion of re­ serves referred to their relation to circulation only.^

It

was recognized that banks create money In the form of notes, but little was said about the creation of money In the form of deposits.

Deposits were thought of, not as media of pay­

ment, but as funds left with the bank by depositors for safe­ keeping. bank.

Notes were regarded as based on the deposits of the

The failure to distinguish In bank statements between

deposits originating In the process of discounting and those arising from the actual lodging of cash In the bank led the great majority of writers to conceive of all such liabilities as of the latter type.

Only a handful of writers on monetary

and banking problems saw the similarity between deposits and notes and recognized that the banker, In discounting bills of exchange and promissory notes, creates deposit liabilities which serve as money.^ The preoccupation with notes reflected to a certain

6.1 P. E. Miller, Banking Theories in £fce United States Before i860 (Harvard University Press, Cambridge, 1927)# P« 155* 7. The views of the early American writers on this subject are discussed in Miller, clt.. pp. 109-120, and in M. G. Myers, The New York Money Market (Columbia University Press, New York, 1931)# pp. 87-94.

45

extent the Influence of the English Currency School, which tended to over-emphasize the role of currency*

In 1855, for

example, Samuel Hooper argued that the best way to prevent over-expansion of bank credit would be to deprive them of the right to Issue notes*

Commercial crises, he maintained, are

caused by the over“Issuance of notes, causing specie reserves to be depleted*

Then credit Is violently contracted, preO cipltating a crisis *0 As late as 1891 we find Francis A*

Walker talking about the over-issuance of notes and the in­ adequacy of specie reserves* but deposits are not*

In Walker's view notes are money,

Deposits "do not perform the functions

of money," but merely “save the use of money," and therefore do not have the same effect on p r i c e s . O n this view, the danger of excessive credit expansion lies in the possibility of an over-issuance of notes, rather than in the creation of deposits*

Hence the Justification for dealing with the note

8 * SamuelHooper, Currency or Money; Its Mature and Uses, and tkSL Effects of. ih s . Qlra.Ulfl.tlQn o£ Sank fipfes for Currency (Little, Brown and Company, Boston, 1855), pp* 08-91 and passim* In a later work, entitled All Examination of the Ifegpry and. Effest. s L L a m RggPlatlnK the. Appypt of specie in Banks (Little, Brown and Company, Boston, i860), Hooper expressed different views* He recognized that banks extend credit in the form of deposits as well as notes, that de­ posits constitute an important part of the money supply, and that banks should hold specie reserves of at least onethird of their notes and deposits. 9* F* A* Walker, Money (Henry Holt and Company, New York, 1891), p* 405* An excellent exposition of the contrary views of the so-called Banking School will be found in H* D. Macleod. The Theory of Credit (Longmans, Green and Co., London, 1894), 2nd ed*, Vol. 2, Chaps* lo and 17* Macleod argues that deposits "are only so many Bank Notes in disguise" and attributes booms and crises to the over-creation of bank credit in the form of deposits*

46

issue as a special problem.

But as Dunbar pointed out ,10

bank credit can be extended in the form of either notes or deposits, and the particular form that is chosen depends upon the preference of the borrower*

From the standpoint of credit

control, there is as much reason to compel the maintenance of reserves against one as against the other* It seems likely, then, concludes Professor Reed, that "the real explanation of the emphasis upon note Issues lies in the i115)roper understanding of the extent to which deposits were derived from loans*

The general conception was

that deposits were the equivalent of specie*

To employ m o d e m

terminology, deposits were thought to be of the 'primary,1 rather than of the 'derivative' type*

The larger its deposits,

the more adequately provided with specie a bank would be assumed to be ."11 The early American writers on banking had little to say about deposits*

Gouge, for example, while pointing out

that bankers are prone to transcend "the line of safety" as respects the keeping of reserves against their note issues, has nothing at all to say about the necessity of holding reserves against deposits *12

Vethake, after remarking that banks should

keep enough specie to enable them to "meet their engagements," 10* C. F. Dunbar, The Theory and History q£_ Banking, rev. by 0*M*W.Sprague (G* P. Putnam's Sons, Hew York, 1929 ) 5th ed., pp. 6l-63* 11. H. L. Reed, Money. Currency and Banking (McGraw-Hill Book Company, Inc*, New York, 1942), 1st ed., pp. 230-231* 12. W. M. Gouge, A. Short History qL E&££2L~ft°Q£X S&Qfclng. in the United States (B. & S. Collin, New York, 1835), pp* 21-22.

47

proceeds to discuss the reserve problem solely In terms of reserves against notes*13

He advocates laws providing for

the forfeiture of bank charters In the event that they do not redeem their notes In specie, and discusses the advisa­ bility of establishing a government monopoly of the note issue* Raguet says that banks lend their credit by exchanging their notes for the promises of others and comments on the tendency of banks to overissue their notes*

While his main concern

Is with notes, he does, however, talk about the convertibility of "bank notes and credits," and advocates a penalty tax on "notes and deposltes not paid In coin."1** Other Explanations s £ . the. Baphanin fin. Notes Various other reasons have-been offered at differ­ ent stages in the development of currency and credit doctrine as to why deposit banking came into another category than that of the Issue of notes*

Some writers argued that the pub­

lic had less choice in accepting notes than in accepting checks*

Commenting on this theory, Miller writest

It was frequently pointed out that bank notes circulate among Individuals who accept them without being In the position to use much discretion in the matter; whereas the holders of bank deposits become such voluntarily and with the opportunity of Informing themselves about the bank Involved. Accordingly, such safeguards as legal reserve minima, and regulation of the proportion of cap­ ital to liabilities, were usually proposed for bank notes only* Now, It Is true that protection of noteholders 13* Henry Vet hake, The. Principles fi£ Political Economy (P.H. Nicklin A T * Johnson, Philadelphia, 1838), pp* 156-159 and Chaps* 11, 17 and 19* 14. Condy Raguet, A. Treatise fin Currency ami Banking (Qrlgg & Elliot, Philadelphia, 1839), Chap. 7.

48

(whether by safety fund, prior lien, bond security, or what not), while depositors receive no such protection, has an entirely valid justification. It is, however, with respect to particular banks only that there is force in the arguments that bank notes meet the test of presenta­ tion for payment less frequently, and their acceptance is far less voluntary. There is no reason for distinguish­ ing between notes and deposits when machinery is being set up for the control of expansion on the part of the banking community as a whole. In urging that it is with reference to note issue only that charters should be re­ quired of banks, or minimum ratios of reserves and capital to demand liabilities to be insisted upon, the. part that deposits play in causing fluctuations in the volume of media of payment was overlooked. And in general this was because of the failure to understand that deposits are created by the banks themselves in the process of making loans.^-5 The argument was also advanced that the creation of deposits is more subject than that of bank-notes to the re­ demption check via inter-bank clearings.

Notes are not pr e ­

sented promptly for redemption and they circulate over a wider geographical area.

Once set afloat, their return to the bank

which issued them is uncertain.

In the case of checkB, on the

other hand, there is systematic and early presentation of d e ­ mands.

A check la normally outstanding only a short time and

is presented for payment over the counter or through the clearing house within a few days of its issuance.

Dunbar argues

from this that the privilege of Issuing notes is more liable to abuse, so that special precaution is needed to ensure redeemability .16 "It is also sometimes averred," says R. I. Robinson, "that a distinction between currency and deposits arose because currency was the money of the poor and deposits the money of 15* Miller, o&. sl£.*» P* 116. 16. Xbg. Theory &qjL History

PP» 69-74.

the rich, and that the humanitarian public Interest required greater protection of the poor."1^ A more convincing Justification for the special con­ sideration accorded to notes rested on the fundamental require ment that there shall be no difference in the quality of the various constituents of the circulating medium.1®

Perhaps the

legal tender characteristics of currency also led to preferen­ tial treatment.

Moreover, as Robinson points out, there is an

"institutional difference" between deposit creation and cur­ rency issue. Currency is generally a liability of the Government and deposits are the liabilities of private institutions. Lawmakers are more likely to erect more stringent require ments to guarantee public debt than private liabilities. Moreover, banks as private institutions were frequently permitted to keep their reserves in any form of legal tender money, which frequently included the currency issued by Government. In other words, the currency of Government which was protected by varying kinds of frac­ tional or partial gold reserves was either circulated directly or held as bank reserves. Thus bank deposits.•• were separated from ultimate gold reserves by an inter­ vening step.1^ Professor Reed suggests that another reason for the little consideration given to deposits before 1857 may have been "that the legislative bodies were aware of the greater relative volume of deposits in city than in country banks, but were convinced that city banks required less statutory regulation .1^ 0 17. R. I. Robinson, "The Reserve Position of the Federal R e ­ serve Banks," Federal Reserve Bulletin (March, 1945), Vol. 31, N o . .3, p. 21 8 . 18. This argument is advanced in Dunbar, The Theory and History pp. 64-65. 19* Robinson, flE> cit.. p. 21 8. 20. Reed, pp.. clt*, p. 230.

50

Sarly Stats. Iteglgiatl