Regional President Speech

1 The Tradition against Rediscounting. "It is a generally recognized principle that reserve bank credit should not be used for profit, and tha ^ continu­ ous indebtedness at the reserve banks, except under unusual circumstances, is an abuse of reserve bonk facilities. In cases where individual banks have been guilty of such abuse, the Federal reserve authorities have taken up the natter -.vith officers of the offending banks and have made clear to them that their reserve position should be adjusted by liquidating a part of their loan or investment account rather than through borrowing. Abuses of the privileges of the Federal reserve systen, how­ ever, have not been general among member banks. The tradition against continuous borrowing is well established, and it is the 1. policy of the Federal reserve banks to maintain!it." In these words the Federal Reserve Board described the tradition against rediscounting. The tradition against rediscounting is a new n^me for an old practice of commercial banks. Long before the establishment of the reserve system, commercial bankers, striving to accomplish their two-fold objective of liquidity and profits, developed certain principles and rules of thumb. Among these the most familiar probably is that certain ratios should be maintained between various assets on the one hand and deposit liabilities on the other. Another old rule which many bankers follow is that their institutions should not normally be in debt to other banks on loan account. With the establishment of the Federal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 2 reserve system, o&nks simply extended this practice and strive nor;;&iiy to be ’’even” witn the reserve banks, that is to have neither excess reserves at nor indebtedness t-: the reserve oanks. Most writers agree that the tradition is an extension 3. of pre-federal reserve practice. Periodically, as during, roughly, the decs-; e of the 20’s, reserve authorities ha e 4. encouraged member banks to follow the tradition. During the war of 1914-191S and again in the 1930fs, however, the pressure of the reserve authorities on the member banks was all the 5. other way, i.e., encouraging them to borrow. The effects of the tradition are clearly reflected in the money markets. Mr. Riefler has shown that whereas "market rates on acceptances have never varied greatly from the buying rates established by the reserve banks.... other open-market rates...have frequently ruled at levels sufficiently far above discount rates to have permitted a wide margin of profit to member banks if reserve funds had been borrowed for the purpose of lending in these markets, while at other times they have fallen well below discount frates. It is obvious that these rates in the short-term open markets could not have remained so far above discount rates for such long periods, if member banks had borrowed freely from the reserve banks whenever tne 6 . operation v/as profitable." Just because the tradition aids to an understanding of market rates, it does not follow that the reserve banks may rely upon it as an adequate instrument to restrict the volume Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis of reserve tank credit extended to the market. The fallacy of such a conclusion nay be illustrated • ith an analogy fron English banking. English member banks customarily do not borrow from tne Bank of England. Instead, they caLl loans hie); they have extended to the bill brokers. The Bank of England does net rely upon the custom of the English banks of not borrowing to control the voluiie of reserve resources or the volume of credit which it extends to the market, because it knows that the bill brokers follow no such custom. They borrov fro:., the Esnk when borrowing is profitable; and they are discoursed by the Bank through increases in the rate. The basic instruments which the Bank uses to control the volume of reserve resources and the volume of credit which it extends to the market are the rate and open-market operations, not the tradition of the banks. The tradition merely influences who shall borrow, not how much will be borrowed. Yet it is the volume -vhich is of greatest importance. If one examines the reliability of the tradition as an instrument of central banking control rather than as a concept to explain money market rates, he notes a number of important restrictions in it. In the first place it is not uniformly effective against all banks. That it is effective against many banks, no one will deny. 3one bankers, whose institutions are members of the reserve system, take pride in being able to say that theyfhave '.|ieve^ borrowed from the reserve bank and insist that they^will never>do so short of a catastrophe. But this is not true of ail bankers. Evidence Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis RATES PROFIT AND DISCOUNTS DIS- •• COUNTS 100000000 MARKET RATE BANK RATE SYSTEM DISCOUNTS MARKET RATE MINUS --------7^ BANK RATE / V ,'A / ; / ' A A I A / V, NEW YORK V DISCOUNTS 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 4 may be cited to show that some banks violate the tradition - especially when it is profitable to do so. The Federal Reserve Board reported that some member banks borrowed continuously in excess of three times their basic lines of credit for several years 7. after the war of 1914-1918. In other words, some member banks have not always availed themselves of the opportunity to reduce borrow­ ings instead of expanding loans. Sometimes \lfrien the latter . 8 is more profitable than repayment, some banks expand. Tersely stated, some bankers will violate the tradition whan borrowing is sufficiently profitable. The concentration of borrowings even in a few banks, however, is a serious shortcoming of the tradition as an instrument of control over the total volume of credit. The following analysis will make this clear. If Bank A violates the tradition and borrows at the reserve bank to fcxpand, it will presumably suffer adverse clearing balances. The bank or banks to which it loses funds, however, will receive them as new deposits and new reserves in due course. These banks may now expand without reeourse to the reserve bank. 2fee expansion of these banks, in turn, will permit other hanks to expand without recourse to the reserve bank. Thus the violation of the tradition by some trnnfcs makes possible a manifold expansion of loans and deposits throughout the banking system. All the banks save those which violate the tradition and borrow » y say that they never have recourse to the reserve bank; hut their expansion iabased upon reserve bank credit waft the lees because it is l&dlreet* Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Another nore serious practical difficulty is tLi-t it If possible for banks to fellow the letter of the tradition (if one may so speak of it) without abiding by its purpose. Cer­ tain types of short tine borrowing which are not included in the tradition but are of real importance in the control of 9. credit are of this character. To illustrate: If bank A, after being indebted to the Reserve bank for several days, calls loans to repay the Reserve bank anc thus forces bank B to discount; and bank B, in turn, calls loans after the lapse of a few nore days, only to force bank C into the Reserve bank, no single bank will have violated the tradition against continuous borrowing; nevertheless, the total volume of dis­ counting may be continuously large. The same consequences follow if the action is not deliberate. Indeed, it is just such circumstances which constitute a so-called legitimate "emergency" which warrants a bank in rediscounting at the Reserve bank. It has been said that one of the basic occasions for so-called legitimate borrowing at the Reserve bank is the necessity of member bankd to restore inpaired reserves. Exc^t in unusual circumstances a banK whicn borrows to expand its earning assets *111 not remain in good favor at the Reserve bank. Mr. Keynes says "...pressure is put on the member banks to restrain their use of rediscounting facilities with the Federal reserve banks by enticising them, asking them inconvenient questions, and creating a public opinion to the effedt that it is not quite respectable for a member bank Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 or good for its credit, to be using the resources of the 10 . Reserve bank nore than its neighbors.M borrowing to restore a reserve, on the other hand, is acceptable to the officials. Yet the latter pemits member banks a_s a whole to laaintain an extended condition. The tradition against rediscounting does not meet tne problem. It is also true that discounts and open-market purchases do not exhaust the avenues of access to the Reserve banks. Purchased bi„ls constitute another avenue. The funds which the Reserve bank withdraws fron the i.rrket through a sale of securities may be returned to the market by such purchases of bills at the initiative of the member banks. Again, the tradition is not even designed to operate against such transactions. The tradition would seem to be effective against bankers in proportion to their temerity and scrupulousness. V/ithout the use of other instruments (eg. rationing or threats to ration) it would appear ineffective against the boldly unscrupulous. If this be true, however, it tends to penalize those banks which follow it for the benefit of those which do not follow. The followers do not borrow and make less necessajry increases in the rate; but the advantages of the lower rate accrue to the borrowers, who do not follow the tradition. A third Serious limitation to the tradition is that it is not uniformly effective in time. As one analysis reserve policy in the 1920*s it becomes clear that open market opera­ tions, the tradition, and the rate are intimately related, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Indeed, the theory of the tradition was developed to explain the effectiveness of open market operations. At first some people assumed that a sale of securities by the reserve banks would reduce member banks* feserves by a corresponding amount. It was soon discovered, however, that frequently the actual result was a corresponding increase in rediscounts. In effect, the Reserve banks would have to lend the funds which were used to buy the securities. Under these circumstances, how could the policy of contraction be served? Hr. Burgess answers the question as follows: The importance of the purchase or sale of securi­ ties Mlies usually in their effect upon the amount of indebtedness of member banks to the Reserve Banks. By increasing their holdings of government securities the Reserve Banks lighten the indebtedness of the member banks, and by selling securities they increase this indebtedness. The significance of this operation ari^ses from the unwillingness of the member banks to remain continuously in debt at the Reserve Banks. Their lending and investing policy is very closely rela­ ted indeed to the amount of such indebtedness. "The principle of open-market operations m$y be summarized by saying that purchases of securities by Reserve Banks tend to relieve member banks from debt to the Reserve Banks, and lead them to adopt a more liberal lending and investing policy. Money rates become easier; bank deposits increase. Such purchases tend to create a borrowerfs market. Conversely, sales of securities by the Reserve Banks increase neriber bank borrowing and lead the banks to adopt a somewhat less liberal policy. Money rates grow firmer; bank deposits tend to decline. Sales of securities tend to create a lender’s market." (11) If one compares the reserve system’s holdings of govern­ ment securities with the rate of discount, however, he notes that all fc^preciable changes in the system’s holdings Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 8 In other words, when the systen wishes to tighten the narket, it ^supports" the tradition by an increase in the raie. It is also significant that "Reserve credit is uore costly to nenber banks when Reserve banks substitute rediscounts for other 12 earning assets." Diagram 2 relates for the decade 1919-1928 profitableness of discounting and volume of discounting for the systen and for the New York member banks v/here orofitableness is measured by 13. the difference between the market rate as corroiled by Riefler 14. and the Hew York Bank rate. 'General conditions in the market may be described as follows: first, there was a large supply of short term paper in the market in which investments could be made by banks; second there was a cluster of money rates around the bank rate; third, the discount window was active. At that time it amounted to around #500,000,000 plus at least $100,000,000 of reserve bank investment in bills. These facts were related not only to the tradition but also to the rate. Had the rate been higher, the volume of discounting would doubtless have been less; had it been lower, the volume of discounting would doubt­ less have been greater. The general conclusion is clear and significant. In general the volume of discounts vailed with the profitableness of discounting. Attention nay be called to a few strategic periods. Practically throughout both periods (1922 and 1924) when borrowing was unprofitable, the volume of dis­ counts fell appreciably and continuously. The period of greatest increase in discounts (1919-1920) was also the period in which Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis y discounting was most profitable. None of the conditions of the 20*s obtained intthe 30*s. One nay summarise experience with the tradition as an instrument of policy. It appears most effective at the very times that the reserve banks are reducing rates and are other- wisw interested in expanding credit; and it appears to be least effective precisely when the other actions of the Reserve officials indicate they wish it were most effective. This conclusion is warranted from the fact that the volume of dis­ counts, the number of banks borrowing, and the rate roughly paralled each other. Therein lies the most telling criticism against the tradi­ tion. It is not sufficiently effective to curb a persistent demand for credit when profitable investments are available. If rediscounting is sufficiently profitable, some banks will indulge regardless of the tradition. Reliance upon it permits a situation to develop in which it is necessary to adopt 110re vigorous measures to a greater extent than might have been neces­ sary had they been used originally. Mr. Keynes has expressed the matter as follows: "...measures of cajolery and mild discipline might prove inadequate against a widespread movement of expan­ sion ascribable to the sooalled ’legitimate* demands of trade - which are just as inflationary as the so-called fIllegitimate* 15. demands of finance, and may be more so." In periods of depression* on the other hand, when bankers are not anxious for examinations, all the inconvenient questions Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 which the Reserve bankers asked t j discourage borrowing at other tines will be recalled; and the member baiks wi j.1 be less will­ ing than ever to borrow. At such tines, one nay say, perhaps, that the tradition is effective; but thr-t is precisely when the public interest might be served better if the tradition were violated. At such times the Reserve banks reduce their rates, yet such efforts to stimulate borrowing by direct appeal to profits could hardly be expected to be successful - if the tradition is effective. In short, the tradition has a reverse effectiveness. Hr. Burgess seens to recognize this. At any rate, in 1927 he said that the feeling against borrowing was encouraged by the officers of the reserve system (p. 182). In 1936, he added the significant qualifying phrase "at tines" (p. 220). These factors indicate the wisdom of Mr. Harris’s sugges­ tion: "Reserve policy should allow for the inability of the member banks in the larger city, subject to multiplex incomings and outgoings, always to balance their hooks. But when the ban'-cs ¡10 themselves in debt for long per­ iods of time and when the number of banks in debt is ab­ normally large, there is something wrong fundamentally; the difficulty is no longer temporary disequilibrium of the balance of payments. The New York Bank is willing to discuss matters ’.ith the member banks out of line; but when all banks are borrowing excessively, the situa­ tion is to be met not by refusals but by a higher rate."(l6) University of Missouri Karl R. Bopp Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1. Annual Report of the Federal Reserve Board, 1928, p* 8. 2. Although sim ilar in inoortant ways, inter-bank leans are to be sharply distinguished fron inter-baa.: deposits in the present discussion. 3. W. IV. R iefler, Money Rates and Honey Markets in the United States, New York. 1936. PP.""S9-j£; •'/. R. Burgess, The keserve Banks and the Honey Market, New York, 1936, p. 219. Kr. Ilarrod, however, in Economic Journal, Vol. 37, p. 285, attribu tes the origin of the tradition to "an in itia l d istru st of the new system and the desire of member banks not to becone indebted to it ." 4. See the opening quotation of th is section. See also R. Burgess, C£. C it., p. 220; Benjamin Strong in 67th Congress, 1st session, A griculture1 Inquiry, Hearings on Sen. Cone. Res. 4, /ashington, 1921, part 13, pp. 50b-5$7; J. !•:. Keynes, A T reatise on Honey, New York, 1930, Vol. 2, p. 240. 5. Cf. New York Times. August 21, 1937, August 22, 1937(A rticle by E llio tt V. B ell), August 27, 1937. 6. W. W. R iefler, Cp. c it . » pi>. 22-23. 7. Annual Report wf the Federal Reserve ¿oard for 1922« p. 3* 8. W. W# R iefler, 0£. c it .. o. l6 i; S. 15. H arris, C|>. c it . , p .15; 69th Congress, 1 st session , Stab ilizatio n . Hearings on H# R. 7895. Washington, 1927, pp. 66$, 'ir>2-$73. 9. 69th Congress, 1st session , Op. c it ., p. 150, testimony of Professor Sprague* 10. J. M. Keynes, A T reatise on Iloney, New York, 1930, Vol 2, 240. 11. 0j>• c it ., pp. 238-239. 12. S. E. H arris, Twenty Years of Federal &66erve Policy, Cambridge, 1933, p. 65T 13. W. W. R iefler, Money Rates and Money Markets in the United S tate s. New York, 193$, PP* 232-236. 14* This method knowingly ignores the fact that even a single bank may be able to expand it s loans by a greater amount than it s borrowings fron the reserve bank. See C. A. P h illip s, Bank Credi t , New York, 1924, pp. 32-120; J. E. Rogers, Speculation and the Money Market. Columbia, Ho. 1927 15. 1. J. M. Keynes, 0j). c it ., Vol. 2, p. 243. 16. S. E. H arris, 0j>. c it .. pp. 18-19. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Karl R. Bopp (1941, December 31). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19420101_karl_r_bopp

@misc{wtfs_regional_speeche_19420101_karl_r_bopp,
  author = {Karl R. Bopp},
  title = {Regional President Speech},
  year = {1941},
  month = {Dec},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19420101_karl_r_bopp},
  note = {Retrieved via When the Fed Speaks corpus}
}