Regional President Speech

BOBROWHIG FBQM THE FEDERAL RESERVE BAHK SOME BASIC PBIWCTPLBS Before the Annual Convention of the Pennsylvania Bankers Association Wednesday, May 28, 1958 Atlantic City, H. J. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis borrowing from the federal reserve hank —some hasic principles iflSS MgT-£3.|L. ___ 64-th Annual Convention of the Pennsylvania Bankers Association. small business in an age of big business business review Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Additional copies of this issue are available upon request to the Department of Research, Federal Reserve Bank of Philadelphia, Philadelphia 1, Pa. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis BORROWING FROM THE FEDERAL RESERVE B A N K - SOME BASIC PRINCIPLES By Karl R. Bopp, President* I propose to discuss borrowing from the Federal Before I discuss borrowing as such I would Reserve Bank. I have selected this topic for dis­ like to describe briefly some of the economic cussion today precisely because few member developments and bank lending and investing banks have occasion to borrow at this time. The policies that may lead to it. amount of borrowing is low in part because the Federal Reserve System has provided reserves Why some banks borrow liberally and cheaply in other ways as an impor­ The ebb and flow in the demand for loans at tant contribution to economic recovery. commercial banks is a reflection of the ebb and Why, then, talk about such borrowing now? flow in economic activity itself. In periods of There are several reasons: rising business and inflation, the demand for 1. If experience is any guide, this will not be loans increases and the commercial banker won­ a permanent state of affairs. ders where to get the funds to lend, how to keep 2. We all wish to know the basic principles customers content with less money than they wish, on which we operate. 3. We are more apt to establish valid prin­ *An address before the 64th Annual Convention of the Pennsylvania Bankers Association in Atlantic ciples when our immediate profit position City, New Jersey, May 28, 1958. is not affected by the decisions we reach. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis and how to maintain good will while denying adequately that any investor assumes a risk when some applicants altogether. In periods of declin­ he buys the longer bond. It is the possibility that ing business, on the other hand, the banker seeks yields may go higher with a consequent loss of customers who will borrow as well as other ways capital value. Even a relatively small change in to employ idle funds. yield will mean a relatively large change in the These alterations in demand and supply would, market value of a long-term bond. Although an of themselves, produce corresponding alterations investor is more likely to remember this when in interest rates. Action of the monetary authori­ the time for liquidation comes, it is more profit­ ties who are pursuing a flexible policy adjusted able to remember it when the initial investment to current conditions reinforces such changes in decision is made. Some short-term investors delib­ interest rates. erately buy long-term bonds with the expectation When demand for loans is slack a banker pre­ of liquidating just in time to secure a maximum fers to invest his excess funds in short-term return. This approach has possibilities, but it has securities so that the early maturities will provide hazards as well. Sometimes these individuals the funds to meet his needs when loan demand develop a dual standard. They take credit when again picks up. The same is true of bankers gen­ developments follow their expectations, but they erally and of other lenders. As a consequence, blame others when subsequent developments are short-term rates usually move down much more adverse. than long-term rates, and the structure of interest The prices of long-term bonds, bought to se­ rates takes on an upward slope. This slope is con­ cure income in a period of weak loan demand and firmed when the market anticipates that rates will easy money conditions, decline as money tightens. rise. The reason is that anyone who wishes to And, just when money tightens in response to borrow or lend for a long period can do so either economic expansion, the problem of the banker by means of a single contract for the entire term shifts from trying to find profitable outlets for or by means of a series of short-term contracts. excess funds to finding funds with which to meet If the market anticipates a rise in rates, borrowers expanding demands. The risk that was assumed will prefer the long contract to beat the rise and when the long bonds were bought becomes a lenders will prefer the short contracts so as to loss on the books. In seeking funds to meet secure funds from maturities for reinvestment expanding demands it is understandable that the when the rise occurs. In other words, the supply banker might prefer not to sell the bonds because of funds will concentrate in the short market and this would convert the book loss into an actual the demand for funds in the long market, thus loss. confirming the upward slope in rates. At this point hope often enters the picture— That is not the whole story, however. Slack loan hope that the tightness will be only temporary. demand and low rates of interest put pressure on And, of course, experience shows that although bank earnings. There is, therefore, a strong temp­ the decline in prices continues as money tightens, tation to meet the immediate problem of earnings eventually a peak in yields or a trough in bond by reaching out for longer maturities because of prices is reached from which both move in the the relatively higher yields, even though prices opposite directions. are high. At such times it is not always recognized Why not, therefore, tide over this period by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis borrowing? If the cost of borrowing is not too with the maintenance of sound credit condi­ great, this might appear to be a method of eating tions; and, in determining whether to grant one’s cake, the higher yield, and having it too, or refuse advances, rediscounts or other not incurring a capital loss. credit accommodations, the Federal Reserve Bank shall give consideration to such infor­ The discount window is not an automatic mation.” escape route I want to indicate why member banks should not One reason for not relying on the rate exclu­ seek funds for this purpose from the Federal sively is that the appropriate rate would have to Reserve Bank. Suppose we look at the responsi­ be comparatively high. The same rate would have bilities of the Federal Reserve System under the to be charged to all members; yet the primary conditions that have been described. It is the purpose would be to discourage the relatively central bank which must adjust its monetary small number of banks that tend to borrow exces­ policy to economic developments. It tightens sively. This is not to say that the discount rate is credit to restrain inflationary expansion. One evi­ unimportant. On the contrary, it is an indispens­ dence of tighter money is the higher interest rates able tool of monetary policy. Its level and changes that have been mentioned and the higher discount in it influence the tone of the market, including rates that the Reserve Banks themselves would market rates. I do not, however, have time to dis­ charge under the circumstances. Another is a cuss it adequately today. reduced availability of reserves. The discount window of the Federal Reserve The effectiveness of the System’s efforts to Bank is like a safety valve that enables a member restrain would be blunted if reserves were made to secure funds temporarily to meet needs that available freely, if member banks had no hesi­ could not reasonably be anticipated. It should not tancy in borrowing, and the Reserve Banks never be necessary to charge a member that finds itself asked any questions about continuous borrowing. in such a condition the high rates that would be As an economist, I appreciate that the Reserve necessary to discourage the complacent borrower. Banks probably could discourage, even to the The principles and rules that govern loans to point of preventing, such borrowing by charging member banks are published as Regulation A of a high enough rate. But that is not the kind of the Board of Governors. I would like to read from rate policy on which the Federal Reserve Act is the foreword to that Regulation: based. The Act requires each Federal Reserve “Federal Reserve credit is generally Bank to refuse credit accommodations for any extended on a short-term basis to a member purpose inconsistent with the maintenance of bank in order to enable it to adjust its asset sound credit conditions. It provides specifically: position when necessary because of develop­ “Each Federal Reserve Bank shall keep itself ments such as a sudden withdrawal of informed of the general character and deposits or seasonal requirements for credit amount of the loans and investments of its beyond those which can reasonably be met member banks with a view to ascertaining by use of the bank’s own resources. Federal whether undue use is being made of bank Reserve credit is also available for longer credit.. .or for any ... purpose inconsistent periods when necessary in order to assist Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis member banks in meeting unusual situations, to withdraw the reserves when the loan is repaid. such as may result from national, regional I should stress that the System always views the or local difficulties or from exceptional cir­ net result of total borrowing, when deciding cumstances involving only particular mem­ whether to add more to, or subtract from, bank ber banks. Under ordinary conditions, the reserves through open market operations. So the continuous use of Federal Reserve credit by discount window is not an automatic escape route a member bank over a considerable period that nullifies the effects of open market opera­ of time is not regarded as appropriate. tions. On the contrary, these tools function to­ “In considering a request for credit gether, to achieve the degree and the distribution accommodation, each Federal Reserve Bank of pressure throughout the banking system that gives due regard to the purpose of the credit fulfills at any particular time the objectives of and to its probable effects upon the mainte­ monetary policy. nance of sound credit conditions, both as to Misconceptions clarified the individual institution and the economy generally. It keeps informed of and takes I would like now to try to clear up a few misun­ into account the general character and derstandings that I have heard about the admin­ amount of the loans and investments of the istration of our discount policy. One of these is member bank. It considers whether the bank belief and repetition of an occasional rumor that is borrowing principally for the purpose of I have heard phrased in these words: “Boy, the obtaining a tax advantage or profiting from Fed sure is tough.” It is difficult to trace such rate differentials and whether the bank is rumors to their source. On occasion we have extending an undue amount of credit for the found that they begin with a banker whose bor­ speculative carrying of or trading in securi­ rowing record in terms of frequency, amount, and ties, real estate, or commodities, or otherwise duration concerned us sufficiently to warrant a I would like to call to your attention the signifi­ discussion. We do not, in these discussions, tell cant analysis of the functioning of the discount the banker how he should manage his own insti­ mechanism that appears in the latest Annual Re­ tution. We do point out that we have a responsi­ port of the Board of Governors (pp. 7-18). bility to manage the Federal Reserve Bank in Borrowing at the Reserve Bank is significant accordance with the law and that he should take to the member bank and to the Reserve Bank. To into account that frequent or continuous borrow­ the member it is a privilege of obtaining addition­ ing is not appropriate except in unusual circum­ al reserves to meet unexpected needs. Ordinarily stances. I mention this because unfounded rumors such needs would be for short periods though in may have kept some members from applying for exceptional cases they may be more extended. In advances for legitimate purposes. My suggestion any event, borrowing gives the bank time to make is that when you hear such a rumor either ignore orderly adjustments in its assets should that it altogether or investigate it until you have ascer­ become necessary. To the Reserve Bank appro­ tained all relevant facts in the case. When the rele­ priate borrowing has the advantages of supplying vant facts are known, I would leave to your judg­ additional reserves directly to the banks that have ment whether we acted tough and capriciously legitimate need for them and of attaching a string or responsibly. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis There has been some misunderstanding concern­ rowing that calls for correction even in recessions. ing the distinction I have drawn between manag­ Now, every real craftsman in the field knows ing our own Reserve Bank and managing the that credit cannot be administered according to member bank. As a result, we have at times mechanical rules. Among the important factors received unmerited praise and blame. Usually the that are considered in evaluating the position of praise is some variant of the following observa­ a particular bank are the following: tion: “Thanks a lot for forcing me to sell those What is the nature and extent of its loan bonds to repay our debt to you. The bonds have expansion ? since gone down several more points.” The blame Is it confronted with seasonal requirements is some variant of these statements: “Your atti­ for credit beyond those which could reason­ tude cost my bank plenty. Those bonds you made ably be anticipated? me sell have since recovered several points.” Actually, we do not tell a banker how to adjust To what extent has it liquidated other assets his position so that he can repay. That is his prob­ to meet the loan expansion? lem. The nature of that problem will vary among Has it been subjected to unusual withdrawals banks, depending in part on earlier investment of deposits? decisions. The results of action taken will also Has the community in which the bank is vary, depending on subsequent developments that located experienced economic adversity or cannot be foreseen. other unusual developments that require time Another misunderstanding is that the adminis­ for solution or adjustment? tration of discounting varies over time. I can appreciate how this misunderstanding arises. In Officers of the Federal Reserve Bank are gener­ a period of easy money most banks will be seeking ally familiar with the managements and policies ways to employ idle funds, relatively few will be of most of the member banks in the District. borrowing at all, and very few, if any, may be Nevertheless, our discount officers find it desir­ borrowing inappropriately. In a period of tight able from time to time to supplement our knowl­ money, on the other hand, few banks will have edge by means of direct inquiry. Raising questions idle funds, relatively more will be borrowing, and is at times a necessary part of proper administra­ some may be complacent about their borrowing. tion of discounting. It is not the questions but the In other words the discount department of the answers that influence our judgment. You appre­ Reserve Bank will usually be busier in a period ciate that I cannot cite specific cases because these of tight money than in a period of easy money. relationships are confidential, but I know of More banks may approach the continuous bor­ instances in which the facts demonstrated that rower category as sanguine expectations do not even extended borrowing was appropriate. materialize. And so we have to make more tele­ phone calls. This results, however, from mainte­ Commercial banks are different nance of standards by the Reserve Bank and not I move now to the reasoning that leads some from a change in standards or administration. An observers to very different conclusions with indication of uniformity of standards is the fact respect to the investment policies of commercial that occasionally we do find inappropriate bor­ banks, especially in recessions. Since many of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis the ingredients are the same as those I have men­ pressure on banks. I have a hunch, however, that tioned, I can be brief. they are more expert at constructing economic Most analysts of business fluctuations would models than at managing either commercial or agree that lower long-term interest rates contrib­ central banks. ute to economic recovery from recession by stimu­ I do not mean to suggest that commercial banks lating construction of public works, of houses, should confine their investments exclusively to and of plant and equipment. Since a rising securities of very short maturity. I am well aware demand for long-term bonds would tend to pull of the fact that many commercial banks hold down long-term rates, some analysts would substantial amounts of savings deposits and, to encourage all investors, including commercial pay reasonably competitive rates on such deposits, banks, to purchase such bonds. A few observers, they must invest in longer-term obligations, espe­ if I understand their reasoning, would even single cially when short-term rates are low. I also recog­ out commercial banks particularly for such nize the problem of maintaining earnings in encouragement. They reason that such action by periods of slack loan demand and low rates. What the commercial banks would contribute not only I do suggest is that, in expanding its investment to the recovery but also to restraining later pos­ portfolio at such times, a bank should aim for sible inflationary developments. It would help such a maturity distribution as will meet its fore­ restrain inflation because the losses in capital seeable needs, and not sacrifice adequate liquid­ values that accompany inflation would tend to ity for immediate earnings, nor look to the Fed freeze the bonds into the banks. to rescue it from its errors. The logic behind this view has cogency. Never­ Such a policy, generally followed by commer­ theless, I am not convinced that commercial banks cial banks, would not mean that the banks were should be encouraged to ignore their internal not doing their share to promote recovery. By liquidity positions even in recessions. Their essen­ investing their available funds in whatever matur­ tial role differs from the role of those whose essen­ ities were most appropriate for them, they would tial function is long-term investment. The genuine be helping to finance Government expenditures long-term investor can ride out a temporary loss and providing funds for investment by others. in capital values. The commercial banker, on the other hand, is always faced with the possible Concluding remarks demand for deposit withdrawal and with pros­ I have no desire to tell you how to run your insti­ pective demands from his borrowing customers. tutions. That is your responsibility. On the other Particularly these latter demands—and for indi­ hand, I do have a responsibility with respect to vidual banks the former as well, as we have the Federal Reserve Bank. In the nature of the learned in the Third Federal Reserve District— case there is a reciprocal relationship between are apt to come precisely when long-term bond our operations. When you borrow from the prices are depressed. Federal Reserve, the Federal Reserve lends to This does not disturb the analysts I have men­ you. That is why it seemed appropriate to discuss tioned. On the contrary, they see it as a great Federal Reserve Bank lending policy at a time advantage; because it would make a restrictive when loans are few and we can be most objective. monetary policy more effective by putting greater I cannot close without expressing what we all Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis know and feel. We share a common goal of needed in many areas. Nevertheless, appropriate reasonably full use of our resources and a reason­ monetary policy by the Federal Reserve System ably stable level of prices. The banking system and appropriate policies of the commercial banks alone cannot achieve this goal. Much else is are indispensable parts of the common effort. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Karl R. Bopp (1958, May 27). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19580528_karl_r_bopp

@misc{wtfs_regional_speeche_19580528_karl_r_bopp,
  author = {Karl R. Bopp},
  title = {Regional President Speech},
  year = {1958},
  month = {May},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19580528_karl_r_bopp},
  note = {Retrieved via When the Fed Speaks corpus}
}