Volume 1 REAPPRAISAL OF THE FEDERAL RESERVE DISCOUNT MECHANISM

Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis PREFACE First Vice President of the San Francisco Bank. Rep­ The following report sets forth the conclusions and resenting the Board staff were Mr. Howard Hackley, recommendations of a System steering committee ap­ Assistant to the Board, Mr. John Farrell, Director pointed to reappraise and, where necessary, recom­ mend redesign of Federal Reserve lending facilities. of the Division of Bank Operations, and Mr. Frederic This report is the result of a three-year System-wide Solomon, Director of the Division of Bank Examina­ study. The proposals for the redesign of the discount tions. Prior to his retirement, Mr. Ralph A. Young, mechanism are the product of a combination of re­ Senior Adviser to the Board and Director, Division search, experience, and judgment on the part of those of International Finance, also served on the Secretar­ involved in the study. iat. The Steering Committee, made up of members of Mr. Bernard Shull of the Division of Research the Board of Governors and Presidents of Federal and Statistics was a member of this group and also Reserve Banks, was chaired by Governor George W. served as Director of Research Projects with primary Mitchell. Other members included Governors Sher­ responsibility for the implementation and coordina­ man J. Maisel and William W. Sherrill and Presidents tion of research activity in connection with the study. Karl R. Bopp of Philadelphia, Edward A. Wayne of Miss Priscilla Ormsby was Secretary for the Secretar­ Richmond, Charles J. Scanlon of Chicago, and George iat. Others who contributed to the work of the Com­ H. Clay of Kansas City. Governor Charles N. Shep- mittee were: Mr. George Garvy, New York; Mr. Ed­ ardson and President Harry A. Shuford of St. Louis ward A. Aff, Philadelphia; Mr. Kyle K. Fossum, served as earlier members of the Steering Committee Minneapolis; Mr. T. R. Plant, Dallas; Mr. John B. Wil­ until their respective retirements from the System, and liams, San Francisco; and Mr. Brenton C. Leavitt, Mr. James C. Smith, Mr. Robert Forrestal, Mr. Walter William McC. Martin, Jr., Chairman, Board of Gov­ Doyle, Mr. John Kiley, and Mr. Robert Gemmill, all ernors of the Federal Reserve System, served as a of the Board staff. Special note should be made of member of the committee, ex officio. the study of discount mechanisms in other major in­ A staff Secretariat had the responsibility for de­ dustrialized countries, an extensive review of foreign veloping proposals for Steering Committee review, experience under the direction of Mr. George Garvy. and implementing the study outline as determined by Several academic scholars also contributed to the the parent committee. This group was chaired by Committee’s deliberations through conferences and Mr. Robert C. Holland, Secretary of the Board. Serv­ writings. These efforts were organized by Professor ing on the Secretariat were Mr. Harold Bilby, Vice Lester V. Chandler, Chairman, Department of Eco­ President and Senior Adviser of the New York Re­ nomics, Princeton University, and Academic Con­ serve Bank, Mr. David C. Melnicoff, Vice President sultant to the Discount Study. and chief lending officer of the Philadelphia Reserve The Board is indebted to those named above and Bank, Mr. M. H. Strothman, Jr., First Vice President to numerous others who have cooperated in the ac­ of the Minneapolis Bank, Mr. Philip E. Coldwell, now tivities of this important and far-reaching study, President of the Dallas Bank, and Mr. A. B. Merritt, culminating in the preparation of the final report.

PUBLISHED IN AUGUST 1971 Library of Congress Catalogue Card Number 70-609110

Copies of this report may be obtained from Publica­ tions Services, Division of Administrative Services, Board of Governors of the Federal Reserve System, Washington, D.C., 20551. The price is $3.00 per copy; in quantities of 10 or more sent to one address, $2.50 each. Remittances should be made payable to the Board of Governors of the Federal Reserve System in a form collectible at par in U.S. currency. (Stamps and coupons not accepted.)

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REAPPRAISAL OF THE FEDERAL RESERVE DISCOUNT MECHANISM

CONTENTS

REPORT OF A SYSTEM COMMITTEE 1 Steering Committee

REPORT ON RESEARCH UNDERTAKEN IN CONNECTION WITH A SYSTEM STUDY 27 Bernard Shull

TRANSMITTAL MEMORANDA 77

BORROWINGS DATA 113

RATIONALE AND OBJECTIVES OF THE 1955 REVISION OF REGULATION A 117 Bernard Shull

EVOLUTION OF THE ROLE AND THE FUNCTIONING OF THE DISCOUNT MECHANISM 133 Clay J. Anderson

THE DISCOUNT MECHANISM IN LEADING INDUSTRIAL COUNTRIES SINCE WORLD WAR II 165 George Garvy

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Governor George W. Mitchell, Chairman President Edward A. Wayne, Richmond Governor Sherman J. Maisel President Charles J. Scanlon, Chicago Governor William W. Sherrill President George H. Clay, Kansas City President Karl R. Bopp, Philadelphia Chairman William McC. Martin, ex officio

Members until retirement: Governor Charles N. Shepardson; President Harry A. Shuford, St. Louis

Contents

I. Summary of the Proposed Redesign of the Discount Window______3 II. Background of the Proposed Redesign of the Discount Window______4 A. Scope of the study B. Historical summary of the role of the discount window C. Need for an appropriately redesigned discount window III. Short-Term Adjustment Credit______9 A. Basic borrowing privilege B. Other adjustment credit IV. Seasonal Credit Accommodation______15 A. Needs for seasonal credit assistance B. Seasonal borrowing privilege V. Emergency Credit Assistance______18 A. Emergency lending to member banks B. The System as “ lender of last resort” to the economy through nonmember institutions C. Support of distressed markets through the discount window VI. Discount Rate Policy______21 VII. Ancillary Recommendations of the Steering Committee______23 A. Provisions for coordination of discount administration B. Changes in reserve regulations to facilitate end-of-period reserve adjustment C. On-going studies of means of improving the shiftability of bank assets and liabilities

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I. SUMMARY OF THE PROPOSED REDESIGN OF THE DISCOUNT WINDOW

The proposed redesign of the discount ant means of secular reserve provision and mechanism has as its chief objective in­ the leading edge of monetary policy imple­ creased use of the discount window for the mentation. The role of the discount mecha­ purpose of facilitating short-term adjust­ nism, on the other hand, is to cushion the ments in bank reserve positions. A more strains of reserve adjustment for individual liberal and convenient mechanism should member banks and, thereby, for financial enable individual member banks to adjust markets. In this context the discount win­ to changes in fund availability in a more dow can beneficially assume an increased orderly fashion and, in so doing, should part of the burdens of intramonthly and lessen some of the causes of instability in seasonal reserve adjustments which are cur­ financial markets without hampering over­ rently borne by open market operations. all monetary control. This increased use should come about both Central bank lending operations can pro­ as credit is provided more liberally to indi­ vide funds to individual banks on either of vidual banks faced with these adjustment two bases— continuous or intermittent. In needs and as increased numbers of banks are the first case, banks are always in debt to led to regard the window as a useful source the central bank, and the discount rate is of temporary or seasonal funds. varied in accordance with economic condi­ Two major and interrelated changes are tions to affect indirectly bank lending terms included in the general design of the pro­ and prices. But the bulk of monetary influ­ ence is exercised by the imposition on the posed discount window. These are: (1) a lending policies of commercial banks of such move toward more objectively defined terms restrictions as the central bank believes suit­ and conditions for discounting; and (2) the able to the environment. This system, with inclusion of several complementary ar­ variations, is typical of many foreign coun­ rangements for borrowing at the window, tries. each designed to provide credit for a spe­ In the United States, on the other hand, cific type of need. These changes look for­ banks in recent decades have not been, and, ward to a generally higher level of borrow­ in the view of this report, should not be, ing being done by a rotating sample of permitted to remain continuously in debt member banks. However, such a higher level to the Federal Reserve. Given the highly de­ of borrowing would not mean a correspond­ veloped character of the U.S. economy and ing increase in total reserves, since increased its financial structure, open market opera­ borrowing would be expected to be about tions in Government securities by the cen­ offset by correspondingly smaller net System tral bank serve effectively as the preponder­ purchases of securities in the open market.

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The first of these changes will be accom­ while at the same time maintaining the plished by introducing specific quantity and necessary monetary control. frequency limitations on a part of borrow­ The proposed redesign contains varied ing and by increased reliance on the dis­ arrangements for the Federal Reserve to count rate. These moves will permit a provide short-term adjustment credit, sea­ clearer and more unequivocal communica­ sonal credit, and emergency credit. Short­ tion of discounting standards and limita­ term adjustment credit is further divided tions to member banks and will help to into the “basic borrowing privilege”—which insure uniformity of window operation provides credit on an automatic basis, within among districts and among banks. specified limits on amount and duration, to No one of these types of controls can be all member banks meeting the conditions expected to bear the entire burden of regu­ specified in Section III—and other adjust­ lating discount-window use, however. The ment credit. The latter is available, under ad­ rate charged on borrowing, while normally ministrative control, to meet needs larger in expected to have a significant influence on amount or longer in duration than can be a bank’s use of the window, is not a de­ accommodated under the basic borrowing pendable deterrent to excessive borrowing privilege. Seasonal credit will be provided under pressure and, at the extreme, may to accommodate recurring demands over and above a minimum relative amount, for actually become only a minor considera­ such amounts and duration as the applying tion. Limitations on the quantity and fre­ member bank is able to demonstrate a need. quency of borrowing would also prove in­ The redesigned discount window provides adequate alone as methods of controlling that the Federal Reserve will continue to borrowing. It would be impossible to con­ supply liberal help to its member banks in struct a matrix of limitations a priori in general or isolated emergency situations. In such a way that they exactly accommodate, addition, the redesigned window recognizes, no more and no less, the varying and often and provides for, the necessity that—in its unforeseeable needs of member banks for role as lender of last resort to other sectors discount credit. For these reasons, the move of the economy—the Federal Reserve stand toward objectively defined terms and condi­ ready, under extreme conditions, to provide tions for lending at the window, important circumscribed credit assistance to a broader as it is seen to be, cannot be completely spectrum of financial institutions than mem­ sufficient. Only through the application of ber banks. administrative judgment over some part of Each of these various types of credit the borrowing done at the window can the accommodation, as well as the issue of dis­ System adequately accommodate the widely count rate policy, is discussed in some de­ differing needs of individual member banks, tail in later sections of this report.

II. BACKGROUND OF THE PROPOSED REDESIGN OF THE DISCOUNT WINDOW A. Scope of the study the effectiveness of the current discount The Fundamental Reappraisal of the Dis­ mechanism, an appraisal of the extent to count Mechanism was launched in mid- which operating rules might need to be 1965. The study has involved a review of altered in view of the changing economic

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environment, and the formulation of spe­ mechanism as the principal tool of central cific proposals for implementing such bank policy. In fact, the proportion of total changes as were found to be desirable. reserves supplied via discounting never fell The study has been under the over-all below 37 per cent during the 1920’s and direction of a Steering Committee made up reached a peak of more than 80 per cent of three members of the Board of Gover­ in 1921. During the 1920’s, however, open nors and Presidents of four of the Federal market operations gradually but steadily Reserve Banks. Under this Steering Com­ began to displace discounting as a means mittee, a staff Secretariat was responsible of supplying reserves to the banking system. for developing proposals for Steering Com­ This trend was interrupted in the years mittee review and implementing the study 1928-30 and 1932-33, when discounting outline as determined by the parent com­ was relied upon heavily by many member mittee. banks to assist in their adjustments to the Over 20 individual research projects financial pressures that developed in those commissioned by the Committee provided periods. After 1934, borrowing fell to neg­ historical perspective and quantitative and ligible levels as banks became extremely theoretical background for considering liquid, reflecting a number of influences in­ policy alternatives. Most of these projects cluding enhanced wariness of indebtedness were undertaken by members of the re­ in any form, sizable reserve injections from search staffs of the Board of Governors and gold inflows, and the liberal and increas­ the Reserve Banks, although several papers ingly sophisticated use of contracyclical were also prepared by academic economists. open market operations. Throughout the Central bank lending experience was re­ 1940’s the excess reserves accumulated dur­ viewed closely, both in the United States and ing the middle and late 1930’s and Federal in other major industrialized countries of Reserve purchases of U.S. Government se­ the world. The System also had the benefit curities at pegged prices provided ample re­ of a survey by the American Bankers Associ­ serve funds to meet wartime and postwar ation of bank attitudes toward borrowing. needs, and discounting activity was minimal. Drawing upon the results of this research, The Treasury-Federal Reserve accord in as well as ideas and suggestions from Sys­ March of 1951 freed the Government se­ tem personnel, bankers, and academic and curities market from pegged rates, at a time other economists outside the System, the when private demands for credit were staff Secretariat formulated specific pro­ strong. The immediate result was an up­ posals for the redesign of the discount win­ surge in discounting activity—although still dow. These proposals, with amendments only to a monthly peak of $1.6 billion, or and refinements growing out of further about 7 per cent of total reserves, in De­ discussion within the Steering Committee cember of 1952. This increase was attribut­ and among other System personnel, are pre­ able in part to heavy loan demand but sented in this document. perhaps more significantly to the profita­ bility of borrowing under the provisions of B. Historical summary of the role of the the excess profits tax temporarily in effect. discount window In ensuing years credit demands eased, and The Federal Reserve Act in its original the Government securities market con­ form contemplated use of the discount tinued to develop to an extent which per­

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mitted effective implementation of the bulk the window has continued to fill needs which of policy decisions through System purchases can be met in no other way. Distributive and sales of these assets. At the same time, mechanisms among both economic and geo­ most banks held ample supplies of these graphic sectors in the United States are liquid securities; such holdings were an often imperfect and in some cases clearly in­ aftermath of war financing and enabled adequate. This results in problems of re­ banks to make most adjustments in their re­ serve distribution which the Federal Reserve serve positions by selling Government secu­ can compensate for only through a tech­ rities in a generally efficient and flexible nique such as discounting. The window can market. meet the temporary needs of particular Thus, despite the abandonment of the banks directly as they arise, without wait­ open market policy of pegging rates in effect ing for the sometimes sluggish distributive before the accord, the discount window con­ mechanisms to carry credit injected into the tinued to serve only a marginal role as a sup­ central money market to the point of actual plier of reserves. It provided banks with need. assistance over the peaks of temporary, Discounting can also serve as an impor­ emergency, or seasonal needs for funds that tant adjunct to open market operations in exceeded the dimensions that the banks the implementation of monetary policy. It themselves were capable of reasonably meet­ is often difficult to determine in advance ing out of their own resources. To reinforce the exact degree of stringency which a given a policy of limited bank use of the discount level of open market operations will create window, the 1955 revision of Regulation A in the banking system as a whole, and virtu­ was issued, placing chief reliance upon bank ally impossible to predict its impact on any reluctance to borrow, buttressed as and single bank or group of banks. The exist­ where necessary by disciplinary contacts by ence of the discount mechanism, however, discount officers. Given this kind of discount provides a means for individual banks to policy, open market operations could be cushion temporarily the impact of such undertaken with a new degree of vigor and policy moves and therefore enables the precision, secure in the knowledge that only Trading Desk of the Federal Reserve Bank marginal reserve additions would be intro­ of New York to carry out the System’s open duced through the discount window. The market operations more aggressively than chart on page 5 shows the amounts of would otherwise be practicable. In addition, Federal Reserve credit supplied by each of the three possible means—open market TABLE 1 operations, discounting, and float—over SOURCES OF RESERVE BANK CREDIT the years, and Table 1 shows the relative (Percentage of total) proportions supplied by each for selected Open periods. Period market Discount­ Float Total In the ensuing years, the discount win­ operations ing dow has been of less and less day-to-day 1920-27 37 59 4 100 1928-33 65 33 2 100 significance in the operation of the mone­ 1934-44 96 1 3 100 1945-50 97 1 2 100 tary system, as banks have increasingly 1951-53 95 2 3 100 turned elsewhere to meet their short-term 1954-59 95 2 3 100 reserve needs. Even in this marginal role, 1960-66 95 1 4 100

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RESERVE BANK CREDIT

the level and dispersion of borrowing serves large for individual banks and, in the ab­ as a meter of disaggregated market forces sence of readily available and efficient and financial pressures, providing increased means of adjustment, can cause problems certainty in the implementation of mon­ not only for individual bank managements etary policy. but also for the smooth functioning of the Apart from these functions of the dis­ entire financial system. count mechanism largely concerned with Banks’ difficulties in adjusting to such reserve creation, the window provides a fluctuations in their funds are compounded unique vehicle for direct communication be­ by several factors. The U.S. banking system tween Reserve Banks and member banks. is composed of a very large number of indi­ It has the potential to make an invaluable vidual institutions, each of which is subject contribution to bankers’ understanding of to a variety of short-term pressures. In the monetary trends and thus to their apprecia­ net aggregate, these pressures may not nor­ tion of and cooperation with Federal Re­ mally appear severe. However, the gross serve policies and actions. size and distribution of swings in fund flows C. Need for an appropriately redesigned can produce abrupt pressures on individual discount window banks for which they can prepare only at Short-term and seasonal fluctuations in the cost of excessive liquidity and a signifi­ loans and deposits are fundamental facts of cant limitation on the credit resources they commercial banking. They can be relatively make available to their communities. More­

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over, the liquidity instruments used are de­ liabilities. This trend can be seen in the pendent on financial markets and mechan­ rapid growth of the Federal funds market, isms which often do not function with suffi­ the issuance of marketable certificates of de­ cient speed and elasticity to guarantee that posit and debentures, and the increasingly a bank can always effect its desired adjust­ heavy reliance of some money market banks ments through these means. And not all on the Euro-dollar market. All of these latter member banks have adequate access to such devices, by whatever name they are known, markets. are quite likely to be largely outside the orbit In those periods when all banks held of the bank’s service area and thus different sizable volumes of liquid Government se­ from the normal demand and savings de­ curities, they were able to effect their ad­ posits obtained in that area. Some of the justments easily in the highly developed and smaller, more isolated banks do not, and in almost universally accessible secondary mar­ considerable measure cannot, effectively tap ket for these assets, and liquidity problems these sources of funds. Such banks therefore were of little concern. Since World War II, tend to hold a sizable proportion of their however, non-Federal debt has generally assets in liquid form and as a result may be increased far more rapidly than Federal providing less credit to their communities debt, and bank portfolios have reflected this than would be desirable. trend. The supplies of liquid assets available This increased willingness on the part of for reserve adjustment have been further banks to borrow from other sources has not curtailed by the rise in the total of public been accompanied, however, by a parallel deposits which must be collateralized by the increase in borrowing at the discount win­ dow. A considerable reluctance to borrow hypothecation of specified kinds of assets, from the central bank has in fact been main­ most of which are fairly liquid. tained, largely through the application of the As banks in recent years have placed a current Regulation A, which emphasizes much larger share of their resources into that banks should resort to borrowing from municipal obligations and into business, the Federal Reserve only on a short-term consumer, and mortgage loans, their supply basis when other sources of funds fall short of readily salable assets has been less and of their appropriate needs. less of a cushion against unexpected deposit Thus the present window continues to fluctuations. Part of the answer to this prob­ serve well to hold the volume of reserve lem has been found in the sale of such port­ additions introduced through borrowing to folio assets. Secondary markets for these as­ a minimum. However, with short-term sets are decidedly inferior to the Government reserve needs of individual banks persisting securities market, however; they range from and in many cases growing, and the his­ the municipal bond market—fairly well de­ torically important methods of meeting veloped at least for the bonds of larger and these needs declining in usefulness, very better-known municipalities, but subject to low totals of borrowing from the Federal large price fluctuations—to those for con­ Reserve are no longer consistent with opti­ ventional mortgages and agricultural paper mum performance of the banking system. —rudimentary or virtually nonexistent. Complicating these problems arising from More striking has been increasing bank the changing financial environment has been resort to the issuance of short-term liquid the fact that the current administration of

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the discount window has not been well able opportunity for differences in adminis­ understood by many commercial bankers. tration from one district to another and from Failure of the Federal Reserve to commu­ one case to another. Many of the apparent nicate clearly, consistently, and unambigu­ nonuniformities of administration are con­ ously with member banks regarding the sidered justified, since no two borrowing availability of discount-window accommo­ cases are identical and actions must be dation has caused many of these banks to adapted to fit the differing circumstances of view this as an uncertain source of credit. In borrowing banks. However, comments of addition, occasional Federal Reserve coun­ participants in borrowing transactions and sel as to what would be regarded as appro­ such objective evidence as can be brought to priate adjustments for borrowing banks has bear argue that at times such administrative led many banks to regard the window as differences have been greater than could be having too great a potential for interfering explained by differing circumstances of indi­ with bank management decisions. As a re­ vidual banks. sult, many banks having temporary needs What emerges from this review is a pic­ for funds often make adjustments by more costly, less efficient avenues than that af­ ture of a Federal Reserve discount mecha­ forded through the discount window, some­ nism which must be modernized and rede­ times to the detriment of adequate credit signed if it is to play a significant role in the availability for their local communities. changing financial environment. It is be­ Furthermore, the design and language of lieved that the redesign of the discount win­ the current Regulation A, relying as it does dow herein proposed can bring the mecha­ primarily upon bank reluctance to borrow nism into closer touch with the prevailing and, where necessary, administrative actions economic climate and lead to a more effec­ by the Federal Reserve, provides consider­ tively functioning member banking system.

III. SHORT-TERM ADJUSTMENT CREDIT The adjustment action initiated by banks alternatives open to the bank are limited in in financial markets in response to tempo­ number and availability, this liquidity mar­ rary loan and deposit fluctuations can at gin may have to be disproportionately large times contribute to excessive short-run mar­ or costly in terms of foregone yield or poten­ ket instability, particularly since the precise tial capital loss on security sales. timing and amplitude of temporary swings For those reasons, one of the basic func­ are not predictable. In addition, short-run tions of the Federal Reserve System has fluctuations in loans and deposits give rise been to provide temporary additions to to operations that impair to some extent the commercial bank reserves through loans to efficient operation of the financial system. member banks, in order to cushion the The impairment is the result of otherwise process of adjustment within the financial needless transactions which commercial mechanism. Such credit accommodation bank managers must conduct in order to undoubtedly leads to somewhat wider short- maintain a margin of liquidity sufficient to run fluctuations in aggregate reserves; but meet unforeseen swings. If the adjustment such movements, usually quickly reversed,

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are regarded as less destabilizing than the currently make no recourse to the discount fluctuations in pressures on financial mar­ window. kets and institutions that would otherwise The Federal Reserve does not now pro­ result. vide permanent additions to the loanable funds of individual banks through the dis­ A. Basic borrowing privilege count window, and the proposal herein ad­ A key objective of the proposed redesign of vanced does not alter that fundamental prin­ the discount mechanism is to formalize the ciple. Therefore, it is necessary to impose terms of limited and temporary access to some limitation on the frequency and dura­ the window through the establishment of a tion of credit provided to a member bank “basic borrowing privilege” for each mem­ through a basic borrowing privilege. The ber bank unless and until otherwise notified. recommended operational objective is for A basic borrowing privilege is defined as temporary credit accommodation to be ex­ access to Federal Reserve credit by member tended over a long enough period to cushion banks upon request through the discount short-term fluctuations and permit orderly window within the limits of the law and ac­ adjustment to longer-term movements; but cording to precisely stated limits on amounts not for so long as to invite procrastination and frequency. To some extent, these bor­ in the making of needed adjustments by rowing privileges represent a formalization individual borrowing banks or to delay un­ of the existing practice of providing tem­ duly the response of the banking system to porary credit over a period of time when­ a change in general monetary policy. ever requested by member banks, but under On the basis of extensive review of past existing practices neither the amount nor the bank balance sheet fluctuations and borrow­ duration of such limits is specified in the ing patterns, the Steering Committee has Regulation. concluded that the above objective is appro­ Through a basic-borrowing-privilege ar­ priately served by the following limitation: rangement, however, the Federal Reserve a bank shall not be empowered to draw on would make unambiguously clear to mem­ its basic borrowing privilege if such borrow­ ber banks the terms of their access to this ing would cause it to be indebted to its type of temporary credit. With clearly de­ Federal Reserve Bank (within or in excess fined, precisely stated limits, a high degree of its basic borrowing privilege, but ex­ of uniformity of administration of the basic cluding any use of its seasonal borrowing borrowing privilege should be assured to all privilege as provided on pages 14-16) in member banks. more than—(6-13) out of the last —(13— The explicit nature of the borrowing priv­ 26) reserve periods.1 The—(13-26) period ilege arrangement will enable member banks interval is conceived of as a moving span; to use the Federal Reserve discount window hence, eligibility for temporary adjustment more readily when they need funds for short­ term adjustment purposes and find no more lrThe ranges indicated here and below extend from those limitations felt to provide the minimum mean­ convenient alternatives at hand at compara­ ingful assistance to member banks to the maximums ble cost. This facet of the redesigned mecha­ believed compatible with the aims of monetary man­ agement. Final choices of limitations within these nism should be particularly attractive to the ranges will be made on the basis of experience and great majority of small member banks that further deliberations.

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credit under the basic borrowing privi­ repay indebtedness. Furthermore, it is a rela­ lege in the current reserve period is based tively stable item, and changes therein are upon adjustment borrowing frequency (both promptly reported to the Reserve Banks in within a bank’s basic borrowing privilege connection with the required purchases of and in excess of that amount) during the Federal Reserve stock. Moreover, use of immediately preceding— (12-25) periods. capital stock and surplus as a base discrimi­ The total amount of credit available to nates least against newly organized banks in member banks—through the temporary ad­ their access to the basic borrowing privilege. justment credit program as well as through The distribution of basic-borrowing-privi- other types of borrowing at the discount win­ lege access among member banks might, at dow—must also be controllable if over-all first glance, seem to be most equitably ac­ objectives of monetary policy are to be complished by according the same percent­ achieved. In determining the maximum age of capital stock and surplus to all; how­ credit exposure which could be tolerated, ever, the practicalities of a manageable swing consideration must be given not only to the in aggregate credits and of vast differences in absolute amount of credit provided but also bank size argue for higher percentage limits to the potential fluctuations in borrowing on the basic borrowing privilege of small from reserve period to reserve period. The banks than on that of large banks. A constant recommended operational objective is for percentage constraint applied to all banks basic borrowing privileges to be large enough which would result in a tolerable total individually to be significant to each mem­ credit exposure would provide so little credit ber bank, and large enough in the aggregate to small banks that the program would be to cushion a significant part of the swings of relatively little use to them. If the per­ in market factors affecting reserves, but not so large in total as to exceed the capacity of centage limit were increased uniformly so open market operations to offset any ex­ as to provide a reasonable amount of credit cessive reserve creation or destruction re­ to most banks, the aggregate basic borrow­ sulting from the total of coincident bank ing privilege would be excessive and could drawing on or repayment of their basic jeopardize the ability of the Federal Re­ borrowing privileges. serve System to meet its monetary policy From the point of view of equity and objectives. efficient administration, the distribution Analytical evidence also supports such of the sum total of borrowing privileges a distinction. Studies have confirmed that, among banks needs to be simple and fairly while the largest banks often experience stable, based on a formula that is easily veri­ wide deposit fiuctutaions on a very short- fied and related in some reasonable way to time basis, small banks tend to face rela­ the needs and creditworthiness of the bor­ tively larger fluctuations over periods of rowing bank. All things considered, the several weeks or longer than do large banks. most practical method of establishing the This results in the main from their more basic borrowing privilege is deemed to be limited opportunities for geographic and as a fixed percentage of each bank’s capital functional diversification of depositors. stock and surplus. The combined total of a Though the empirical work done on the asset bank’s capital stock and surplus is a conven­ side is thus far less extensive, these same tional measure of its ability to service and considerations would almost certainly apply

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to loan totals. An inverse relationship be­ basic borrowing privilege would almost cer­ tween loan and deposit changes may be tainly be significantly less than this figure. traced to the fact that both bank borrowers Because of the diversity of fund flows among and depositors are influenced by common or banks and the restriction on frequency of related factors. use discussed above, not all banks should be On the other hand, large banks needing expected to be making full use of their basic to borrow funds to meet temporary out­ borrowing privileges in the same reserve flows have more ready access to money period. market sources here and even abroad. They The initial quantitative limitations sug­ generally have more and cheaper alterna­ gested above may well need to be adjusted tives because of their proximity to corpo­ from time to time as experience with the use rate, institutional, and governmental lenders of the basic borrowing privilege develops. of funds, the continuous information flow It is not intended, however, that such limi­ between themselves and these lenders, the tations should be changed so frequently as ability and initiative of many of their spe­ to disturb orderly bank planning for the cialized money managers, and finally their utilization of such privileges in the course ability to tailor liability offerings to the of reserve adjustment operations. size and maturity preferences of a wide While temporary adjustment credit under range of customers. the basic-borrowing-privilege program is to These considerations indicate that large be generally available upon request, it is banks have, on the whole, less relative need necessary to impose two specific qualifying for and greater access to external sources conditions in addition to those general con­ of credit and therefore have less relative ditions arising from statute. First a bank, to need for assured short-term credit accom­ be entitled to use of its basic borrowing priv­ modation from the Federal Reserve. ilege, must be in satisfactory internal condi­ Given all these considerations, and after tion. Otherwise access to discount window review of the historical borrowing expe­ credit will be subject to administrative re­ rience of various classes of banks, the Steer­ view. In such cases the Reserve Bank will de­ ing Committee recommends granting to termine the over-all condition of the bank, each qualified member bank a basic borrow­ taking into consideration capital adequacy, ing privilege, measured by reserve period soundness of loans, liquidity, and quality of averages, equal to the following proportions management. If the Reserve Bank, after tak­ of the bank’s total capital stock and ing into account all these factors, judges surplus:—(20-40) per cent on the first $1 that the bank’s over-all condition is too poor million; —(10-20) per cent on amounts be­ to warrant access to discount credit without tween $1 million and $10 million; and administrative review, that bank’s basic bor­ —(10) per cent on amounts in excess of rowing privilege will be withdrawn until suf­ $10 million. ficient improvement is shown in its condi­ Although the maximum credit extension tion. During that interval, any adjustment which could currently result under this plan, borrowing which the bank undertakes at the again a reserve-period-average basis, is esti­ discount window would be immediately sub­ mated as approximately— ($2.5-$3.8) bil­ ject to administrative review. Notification of lion, the credit actually extended under the such withdrawal would be given in timely

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fashion, and in the absence of such direct ready access to at least a measure of tem­ notification, a bank would be able to rely on porary adjustment credit for both large and assured access to discount credit so long as it small member banks. stayed within the previously defined limits on amount and frequency. B. Other adjustment credit The second qualifying condition is an ad­ The basic borrowing privilege described ministrative rule that a bank borrowing in the previous section would be the normal under its basic borrowing privilege refrain method of extending short-term credit to from simultaneously providing net new member banks, but it is not conceived as funds to the money market—specifically, adequate to encompass all of the varying aside from possible infrequent transactions credit needs of banks which justify the use that result from miscalculations or large, of temporary adjustment credit. Experience unforeseen movements in the bank’s posi­ has shown that circumstances will arise when tion, it should not be a net seller of Federal adjustment credit is required in larger funds in the same reserve period in which it amounts or for longer duration than can be is borrowing from a Reserve Bank. This re­ accommodated under the limits of the basic striction, a continuation of a policy already borrowing privilege. Such supplemental in force, is retained to preclude a large day- credit should also be available on as unam­ to-day retailing operation in Federal Re­ biguous terms as possible. This credit, it serve credit obtained through the discount should be emphasized, is in addition to and window. It is recognized that banks could not in substitution for the other types of undertake to accomplish much the same pur­ credit described in this paper—namely, the pose by resort to more indirect means, but basic borrowing privilege, the seasonal bor­ currently the funds market is the only ve­ rowing privilege, and emergency credit. hicle that can handle extensions of credit Borrowing beyond the privilege limits among banks on very short notice near the would be subject to administrative proce­ ends of reserve periods, when banks would dures broadly similar to those which have probably be most interested in doing so. If been progressively developed in recent years obvious practices of circuitous transfers of under existing discount arrangements. These credit in evasion of this provision should de­ procedures can be thought of as a sequence velop, consideration will be given to broad­ of administrative actions ranging from re­ ening and strengthening the scope of the view, which would include informational provision commensurately. concern as to the nature of the borrowing The basic-borrowing-privilege program bank’s portfolio policies and the sources of is both desirable and practical. Its adoption its lendable funds, through conferences, dur­ would serve as a clear communication to ing which Reserve Bank officials would con­ member banks that the discount window is sult with the management of the borrowing changed. The program promises to con­ bank as it endeavors to develop a solution to tribute to more effective relations between its problems, to actual discipline, when the member banks and Federal Reserve Banks bank would be asked to begin paying off its while it improves the efficiency of the fi­ loan. nancial system in general by providing a In any case where a member bank, dur­

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ing a consecutive — (12-26)-week period, undertake administrative actions and, if it has received short-term adjustment credit in were called for, might request an early ad­ any amount in more than — (6-13) weeks justment by the bank. In all cases, the scope (that is, when the frequency limitation on and thrust of the adjustment required would the basic borrowing privilege is exceeded), be related, as it currently is, to all aspects of the Reserve Bank will appraise the situation, the bank’s position and historical borrowing perhaps in consultation with the bank, and record and to the desirability of achieving make a determination as to the appropriate­ an orderly program of realignment of bank ness of continued credit extension to that assets and liabilities, with the choice among bank. This determination will be made in alternative adjustment procedures continu­ light of any specific indications that a time­ ing to rest with the bank’s own manage­ ly forthcoming paydown of Federal Re­ ment. serve indebtedness will occur by reason of As this implies, the fact that a bank ex­ expected inflows of funds or some other ceeds the amount or frequency limitation of orderly program of balance sheet adjust­ its basic borrowing privilege does not mean ment. Even if an extension is deemed justi­ that it is immediately contacted and asked to fied by the surrounding circumstances, con­ reduce its borrowing but only that it loses tinuous review will be maintained through­ its immunity to such contact and administra­ out the course of the borrowing. Should the tive review. In contrast to the arrangements initial or any subsequent analysis indicate in some foreign countries, where a line of the absence of circumstances warranting a credit (similar in principle and design to the continued provision of supplemental credit, basic borrowing privilege) is designed to the Reserve Bank will initiate action with a control total use of the discount window, the view toward obtaining an appropriate ad­ proposed redesign includes the borrowing justment. The precise timing and nature of privilege only as a limited source of reserves, such administrative action will, as now, re­ with supplemental borrowing taking place main at the discretion of the Reserve Bank, from time to time as a normal occurrence, taking into account the circumstances in the especially on the part of larger banks. There­ individual case. fore, member banks can expect to receive In actual fact, the basic-borrowing-priv- such discount credit as they have a justifiable ilege limitation on amount may be exceeded need for, in excess of the specific limits on more often than the limitation on frequency. the basic borrowing privilege. The former event, like the latter, will call for An adjustment program compatible with an internal review of the case. Such borrow­ the bank’s situation will be expected of ev­ ing above base will probably occur from ery borrower of supplemental credit, al­ time to time as a result of bank efforts to though in the case of clearly short-term and cushion sharp temporary drains, and there­ self-reversing fund flows this may require fore, as now, could usually be expected to be little or no overt action on the part of the quickly repaid without any need for Reserve borrowing bank. Supplemental adjustment Bank intervention. However, if the balance credit should be thought of as temporary, sheet of the bank suggested that factors other and increasingly extended use will result in than such temporary drains were responsible an increasing probability that the bank will for the borrowing, the Reserve Bank could be asked to work off its debt to the Federal

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Reserve. Discount officials should be con­ To articulate any more specific rules or tinuously informed and should undertake ad­ guidelines in this document is neither prac­ ministrative discipline promptly in any situa­ tical nor desirable, however. In the light tion where it becomes apparent that a bank of case-by-case decisions that would be is following the practice of using supple­ made under the proposed procedures and mental adjustment credit to finance a short­ subject to the underlying principle of equal term position in money market assets. treatment for banks in equal circumstances, The guidelines herein set down for the standard operating procedures should de­ administrative control of supplemental ad­ velop in all discount offices. The final section justment credit have been general and may of this report recommends arrangements to appear to leave too great latitude for the foster effective coordination of these pro­ exercise of discretion by discount officers. cedures among all Federal Reserve offices.

IV. SEASONAL CREDIT ACCOMMODATION

A. Needs for seasonal credit assistance of the communities. Because of size, struc­ Seasonal fluctuations in loans and/or de­ ture, and location, banks in small towns are posits create asset-and-liability-management often at a relative disadvantage in obtaining problems which many smaller banks seem credit from other external sources, such as unable to accommodate without impairing the issuance of large-denomination certifi­ in one way or another the quality and ade­ cates of deposit or participation in the Euro­ quacy of banking service they offer to their dollar or Federal funds markets. communities. Such recurring pressures, sim­ Regulation A currently provides that dis­ ilar in nature and origin and probably to count credit may be extended on a short­ some extent overlapping the short-term fluc­ term basis to enable a member bank to ad­ tuations already discussed, tend to be the just its asset position in cases of seasonal re­ greatest in smaller communities where the quirements for credit “beyond those which economy is frequently dominated by agri­ can reasonably be met by use of the bank’s culture or by a single industry of relatively own resources.” This policy, articulated in small units. The consequence of such spe­ the revision of Regulation A in 1955, was cialization is that the economic base in the adopted against the background of the communities is not sufficiently diversified to heavily liquid positions of almost all banks provide a supply of bank funds with ade­ during the earlier postwar years and their quate flexibility to meet marked seasonal consequent ability to meet most seasonal changes in loan requirements and deposit drains effectively by selling assets. positions. While the correspondent banking With the passage of time, however, the system provides a measure of credit to some liquidity positions of banks in many of the of these communities, most often in the form smaller communities described have been of overline arrangements for loans exceeding markedly reduced by expanding seasonal the lending limit of the local banks, available and secular demands for credit on the one evidence clearly indicates the need for more hand and lagging community net income and in some cases differently structured and deposit growth on the other. Particu­ credit to meet adequately the seasonal needs larly in agricultural areas, where credit

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needs have been rising very rapidly, such which is expected to continue for a period trends seem likely to continue, progres­ of more than 4 weeks and is of sufficient sively narrowing the ability of the local size to be of significance in the asset and banks to meet the short-term credit de­ liability management of the bank. Loan mands in their communities. Despite these and deposit fluctuations which are relatively trends, the discount window has continued small or which do not continue for as long to provide only short-range and varying as 4 weeks should be accommodated by in­ credit assistance to member banks experi­ ternal bank policies or by recourse to ad­ encing seasonal fluctuations. justment credit assistance from the discount Under these circumstances, it has be­ window and are not deemed to qualify a come appropriate to modify present season­ bank for special seasonal credit accommo­ al lending practices at the discount window dation, despite frequency of occurrence. to provide increased assistance to member The size of a bank’s seasonal need for banks in accommodating seasonal demands funds within any 12 months is to be upon them. The discount window can per­ measured by comparing the net intrayear form this function better than any other changes in levels of deposits and loans to monetary tool, since only through it can the customers in the bank’s market area. Since Federal Reserve make credit available di­ the minimum time period is fixed at four rectly where and when it is needed. consecutive weeks, banks might have the op­ tion of using calendar months or, on a more B. Seasonal borrowing privilege refined basis, a 4-week moving average on It is proposed that each Federal Reserve which to base the estimate of their seasonal Bank be authorized to establish a “seasonal need. Seasonal estimates would be estab­ borrowing privilege,” renewable from one lished essentially by projecting past years’ year to the next upon submission of ap­ propriate evidence, for any of its member experience, adjusted as appropriate to ex­ banks experiencing a seasonal need for clude nonrecurring movements. funds of the kind and dimensions outlined In order for the bank to qualify for a sea­ below. The intent of the arrangement is to sonal borrowing privilege, its projected sea­ provide reasonably assured credit access to sonal need for funds must exceed —(5-10) banks with definable and relatively substan­ per cent of its average deposits subject to re­ tial seasonal pressures for the approximate serve requirements during the preceding cal­ duration of such pressures, normally ex­ endar year. Any part of that need in excess pected to be several months, but possibly of this limit is eligible for financing through ranging up to as much as 9 months in excep­ the discount window subject to the other tional cases. conditions described in this section. Use of The seasonal borrowing privilege at the such a “deductible” principle is designed discount window is limited to cases in which to encourage individual bank maintenance the applicant member bank can demon­ of some minimum level of liquidity for pur­ strate a probable recurring increase in its poses of flexibility and also to limit the ag­ need for funds, arising from expanding de­ gregate total of seasonal borrowing priv­ mand for regular customer loans or shrink­ ileges to an amount consistent with the aims ing deposits, or some combination thereof, of over-all monetary management.

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Figures in Table 2 suggest the nature of nificant seasonal need, what amounts of the calculation of a seasonal credit need. credit it expects to need, and the expected In this illustration the total swing in net profile and duration of such needs. In many fund availability is $1.0 million, measured cases the bulk of this evidence will already from the peak of $3.0 million in January, be on file with the Reserve Bank. However, February, and March to the trough of $2.0 member banks should submit with their ap­ million in July, August, and September. As­ plication any supplemental evidence they suming an average level of deposits subject have at hand, especially with regard to to reserve requirements of $5.0 million in altered seasonal demands which they have the preceding calendar year, the swing reason to expect. Such information is needed, clearly exceeds the minimum level of — (5— preferably somewhat in advance of the ac­ 10) per cent of such deposits and therefore tual takedown of credit, not only for sched­ qualifies the bank for a seasonal borrowing uling and maintaining internal review over privilege. The amount of the seasonal bor­ the seasonal borrowing but also to enable rowing privilege at its maximum would be the System to conduct open market opera­ —($750,000-$500,000). Credit actually tions with some foreknowledge of the ap­ outstanding under the seasonal borrowing proximate volume and timing of seasonal in­ privilege would be expected to follow the jections of reserves which are expected to pattern of gradual increase to a peak, fol­ occur at the discount window. This knowl­ lowed by tapering off, as suggested in the edge will help to minimize the degree of un­ table. expected fluctuation in borrowing which In the negotiation of a seasonal borrow­ could make the achievement of monetary ing privilege, the Reserve Bank must have policy objectives more difficult. in its possession evidence demonstrating Given a demonstrated seasonal need on that the applying member bank has a sig- the part of a member bank, the Reserve Bank will arrange to extend credit in the amount and for the duration needed (with­ TABLE 2 in the limits previously defined). Under cur­ CALCULATION OF A SEASONAL CREDIT NEED rent law, firm arrangements are limited to 90 days duration (except in the case of dis­ Seasonal count of eligible agricultural paper, for Month Total Net fund swing in Total customer avail­ from which the maximum duration is 9 months). base year deposits loans ability peak However, in the event that a member bank’s 1 5.3 2.3 3.01 seasonal needs persist beyond the 90-day 2 5.2 2.2 3.0^ Peak period, the Reserve Bank will consider 3 5.2 2.2 3.0j 4 5.0 2.5 2.5 - .5 sympathetically requests for further exten­ 5 4.8 2.6 2.2 - .8 sions of credit in accordance with the initial 6 4.8 2.6 2.2 - .8 7 4.6 2.6 2.0] -1 .0 seasonal credit arrangement. In no case, 8 4.7 2.7 2. Of Trough -1 .0 9 4.8 2.8 2.0J -1 .0 however, would the duration of all seasonal 10 5.0 2.5 2.5 - .5 borrowings under such an arrangement be 11 5.4 2.4 12 5.2 2.2 3.'0/Peak permitted to exceed 9 consecutive months. Under normal circumstances, the amount

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of credit requested in the original arrange­ Because blocks of borrowed funds ex­ ment should not be revised in midseason. tended under seasonal credit arrangements The intention is that drawings of the sea­ will not be generating pressure on the bor­ sonal credit, in accordance with projected rowing banks to adjust assets or other lia­ needs, would be relatively firm and not sub­ bilities in order to repay promptly (as do ject to day-to-day or week-to-week fluctua­ more conventional borrowings), they will be tions because of minor unexpected fund supplying reserves but will otherwise be nei­ withdrawals or additions or resort to tem­ ther adding to nor subtracting from the bite porarily cheaper financing elsewhere. How­ of general monetary policy. The reserve sup­ ever, it is recognized that many factors of an ply from takedowns of seasonal borrowing unpredictable nature can accentuate or di­ privileges can be offset to the extent desired minish the seasonal outflows, and the poten­ by open market operations; conversely, tials for change, while probably not great in these blocks of seasonal credit should prove the aggregate, are sufficient in the case of the sufficiently immune to any moderate changes individual bank to make it impractical to bar in national reserve availability—particu­ all readjustments in the credit arrangement. larly if the discount rate is kept reasonably The Reserve Bank will periodically re­ closely in line with market rates—so as not view the performance of the borrowing to offset the latter changes substantially. member bank, and should this review indi­ cate that the seasonal need is not material­ Given the other needs for credit at the izing as contemplated in the arrangement smaller rural banks, for developmental cap­ or that the bank is failing to operate in line ital as well as for day-to-day working cap­ with the arrangement in some other way, ital, the more liberal granting of discount these factors would have a definite bearing credit for seasonal purposes is regarded as on the Reserve Bank’s evaluation of future one of the more important steps the System applications for seasonal credit accommo­ can take in this field. The assurance of ade­ dation on the part of that bank. However, quate seasonal access should help to foster the Reserve Bank would also retain the more definitive asset management by small option to curtail an outstanding seasonal banks and can also be expected to assist credit arrangement which proves to be un­ various larger banks which may qualify for needed. seasonal credit accommodation.

V. EMERGENCY CREDIT ASSISTANCE In its traditional central banking function, action among such institutions, emphasize the Federal Reserve System is the ultimate the importance of the Federal Reserve’s role source of liquidity to the economy. This in emergency situations. role carries with it the responsibility to deal The financial system’s liquidity—excessive with emergency situations as they affect in the late 1940’s, more than ample in the both member banks and the economy gen­ 1950’s, and reasonably adequate at the start erally. Severe pressures encountered by of the 1960’s—has sometimes barely covered banks and other financial institutions with­ requirements in recent years. The asset struc­ in the past few years, involving increasing ture of commercial banks and savings in­ illiquidity and interdependence and inter- stitutions reflects this downward trend, as

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do increasingly aggressive efforts on the liquidity pressures threaten to engulf whole part of bank management to manipulate classes of financial institutions whose struc­ liabilities in pursuit of liquidity. Wide in­ tures are sound and whose operational im­ terest rate fluctuations in recent years at­ pairment would be seriously disruptive to test to these factors. the economy. Under present conditions, sophisticated open market operations enable the System A. Emergency lending to member banks to head off general liquidity crises, but such The Federal Reserve System has a clear operations are less appropriate when the responsibility to lend to member banks in System is confronted with serious financial both isolated and widespread emergency strains among individual firms or special­ situations. It is expected that such assist­ ized groups of institutions. At times such ance would often have beneficial effects for pressures may be inherent in the nature of the economy as a whole, but in such cases monetary restraint, in the sense that mon­ the immediate responsibility of the System etary policy actions, no matter how imper­ is directly to the member bank. This is one sonally applied, often have, in fact, exces­ of the benefits of Federal Reserve member­ sively harsh impacts on particular sectors ship—paid for in a sense by the mainte­ of the economy. At other times underlying nance of nonearning assets in satisfaction of economic conditions may change in unfore­ reserve requirements—and a basic source of seen ways, to the detriment of a particular confidence in the banking system. financial substructure. And, of course, the Therefore, the Federal Reserve will be possibility of local calamities or manage­ prepared to give prompt and sympathetic ment failure affecting individual institutions consideration to providing the needed credit or small groups of institutions is ever-pres­ assistance to a troubled member bank, after ent. It is in connection with these limited having obtained the assurance of the charter­ crises that the discount window can play ing authority that the bank is solvent and an effective role as “lender of last resort.” that steps are being taken to find a solution This responsibility is not construed as to its problems. Emergency credit assistance placing the Federal Reserve in the position through the discount window should be pro­ of maintaining the financial structure in vided to member banks under essentially the statu quo. The System should not act to same procedures as those employed in the prevent losses and impairment of capital of case of short-term adjustment credit (in ex­ particular financial institutions. If pres­ cess of the basic borrowing privilege). How­ sures develop against and impair the profit­ ever, ad hoc exceptions or alterations in ability of institutions whose operations have these arrangements—within statutory limi­ become unstable, inappropriate to changing tations—will at times be required to deal economic conditions, or competitively dis­ effectively with emergency situations. advantaged in the marketplace, it is not the Any member bank borrowing in an emer­ Federal Reserve’s responsibility to use its gency situation will be under extensive ad­ broad monetary powers in a bail-out opera­ ministrative review. This review will include tion. Except in the case of member banks, a program of coordination with the rele­ where its responsibilities are somewhat more vant supervisory and chartering authorities direct, the System should intervene in its and will ordinarily take the form of coun­ capacity as “lender of last resort” only when seling and such other direction as is needed

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to work out of the situation. Administrative ance, since it authorizes direct advances to discipline may have to be applied in the case “any individual, partnership, or corpora­ of an emergency caused by mismanage­ tion”; but in fact, rather stringent limita­ ment or dishonesty (at least until the of­ tions are imposed by the requirement that fending management is removed), but Fed­ these advances be secured by “direct obli­ eral Reserve efforts in an emergency situ­ gations of the United States.” 3 In effect this ation would normally be geared to less dras­ means that, in an emergency, credit in any tic means of helping the member bank to significant amount could probably be ex­ reestablish a viable position. This will, in tended to nonmember, at least nonbank, most cases, require credit for longer than institutions only by using a member bank would be permissible under the ordinary as a conduit. That is, the Federal Reserve administration of temporary credit provi­ would lend funds to cooperating member sion, but this will be expected and regarded banks that would in turn make loans to as appropriate. nonmember institutions. The relevant Fed­ eral agency can also sometimes serve in B. The System as ‘‘lender of last resort” to the role of a conduit, so long as that agency the economy through nonmember institutions has lending authority and assets eligible for The role of the Federal Reserve as the Federal Reserve acquisition. Thus the cur­ “lender of last resort” to other financial sec­ rent law is not prohibitive of indirect lend­ tors of the economy may, under justifiable ing to nonbank institutions, although it does circumstances, require loans to institutions involve additional arrangements and costs other than member banks. The apparent over those that would be involved in direct general approval of recent instances of lend­ loans. ing and offering to lend to nonmember in­ Decisions as to what types of institutions stitutions has strengthened the belief that the will be regarded, under justifiable circum­ System’s ability to carry out this function stances, as eligible for emergency credit are should be readily available for use when best made in the light of the surrounding cir­ needed. In contrast to the case of member cumstances and relative severity of particu­ banks, however, justification for Federal lar situations. Therefore, no inclusive or ex­ Reserve assistance to nonmember institu­ clusive list of the types of institutions to tions must be in terms of the probable im­ which emergency credit may be extended pact of failure on the economy’s financial should be established in advance of antici­ structure. It would be most unusual for the pated possible developments. Federal Re­ failure of a single institution or small group serve credit would be advanced to nonmem­ of institutions to have such significant re­ ber institutions only after other avenues of percussions as to justify Federal Reserve ac­ relief have been exhausted. Depositary insti­ tion.2 tutions, the suppliers and holders of the na­ The Federal Reserve Act places no ex­ plicit limitations on the types of institutions 3 In unusual and exigent circumstances the Board of Governors, by the affirmative vote of at least five eligible for direct emergency credit assist- members, may authorize any Federal Reserve Bank to discount eligible paper for any individual, partner­ 2 An exception might be made in a case where the ship, or corporation which is unable to obtain ade­ Federal Deposit Insurance Corporation requested quate credit accommodation from other banking Federal Reserve assistance for a nonmember com­ institutions. However, in practice this provision is of mercial bank while the FDIC carried out a program little use, since nonmember institutions typically have to remedy the situation. only very limited holdings of eligible paper.

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tion’s liquidity, are the most likely to en­ cost of maintaining reserves with the System counter situations where this is necessary, which is continuously borne by member and for this reason emergency credit would banks. be accorded, in all but the most extraordi­ nary circumstances, only to those institutions. C. Support of distressed markets through Supervised nonmember financial institu­ the discount window tions would be required to obtain the sup­ It is possible that, in periods of severe mon­ port and assent of the relevant supervisory etary stringency, markets for certain finan­ agency to receive Federal Reserve emer­ cial instruments, such as Federal, State, and gency credit. On the other hand, the Fed­ local government securities, corporate se­ eral Reserve should not be obligated to lend curities, and mortgages, may become so dis­ to nonmembers merely on the request of tressed by disappearance of buyer interest, their supervisor. While institutions can be necessitous selling or “dumping” of issues, declared insolvent only by the chartering or other influences that a crisis develops authority or the courts (and such a declara­ which threatens the entire financial fabric tion would effectively preclude Federal Re­ of the nation. Under such circumstances, serve lending), the System should retain the the Federal Reserve will be prepared to take option to reject requests for assistance even action in a variety of ways to forestall the when the other agency considers the institu­ developing crisis. tions solvent. Action through the Open Market Ac­ When lending to nonmembers, the Sys­ count, where possible, is the appropriate tem will require, in cooperation with the means for dealing with such a widespread relevant supervisory agency, that the institu­ problem. However, in a situation of extreme tions develop and pursue a workable pro­ emergency, consideration would be given gram for alleviating their difficulties and will to making the discount window available to follow the progress of the agreed-upon pro­ member banks (and, more remotely, to gram closely. Credit will be provided only at nonmember financial institutions) in order a significant penalty rate vis-a-vis that to reduce necessitous sales of these assets charged member banks. This penalty rate and thus to alleviate crisis pressures in the can be thought of as offsetting, in part, the market.

VI. DISCOUNT RATE POLICY

The proposed redesign of the discount win­ limitations regulating the basic borrowing dow contemplates an increase in the num­ privilege. But the discount rate also has a bers of banks regarding the window as a significant role to play in this operation if useful source of funds. One of the major the mechanism is to result in an improved obstacles acknowledged to exist currently adjustment process. in this area is the confusion on the part Achieving maximum effectiveness calls of member banks as to the terms and for maintenance of the discount rate con­ conditions for discounting. The redesign sistently at a level reasonably close to rates should substantially reduce banker uncer­ on alternative instruments of reserve adjust­ tainty by the specific quantity-and-frequency ment. The exact relationship to market rates

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at any time will depend largely on current Because of the Federal Reserve’s role as monetary conditions and policy objectives, the lender of last resort, the demand curve but it would be expected that related market which it faces may be somewhat different rates would move higher relative to the dis­ from that applying to other lenders. Ordi­ count rate in periods of restraint and lower narily, this difference should not be very sig­ relative to the discount rate during periods nificant, but during periods of stringency the of ease. demand for accommodations from the Sys­ The closer linkage of the discount rate to tem could conceivably become highly inelas­ market rates will probably call for more tic, particularly in the very short run when frequent changes in the discount rate than banks may face liquidity or credit demands have been made in recent years. It is be­ (including those from long-valued custom­ lieved that such changes can be achieved by ers) without having immediate access to more active communication within the Sys­ adequate alternative sources of funds. In tem and will become easier as the pattern such instances, the exclusive use of price as of more frequent discount rate adjustments the allocator of funds at the discount window tends to reduce the unpredictable announce­ could be severely damaging to the long-run ment effects which often attach to a given stability of financial institutions. rate change. As banks come to regard the There may also be occasions when re­ window as a more liberal and useful source lationships between U.S. rates and those of funds, with no risk of administrative pres­ abroad, or between bank and market rates sures within the confines of the basic borrow­ or those being paid at other financial institu­ ing privilege and a clearer understanding of tions, are so delicately poised that Federal the limitations attaching to other borrowing, Reserve discount rate changes may have to price will naturally become a more meaning­ be withheld in order to avoid triggering ful factor in their decisions. Thus rates on highly disadvantageous flows of funds. At alternative means of adjustment will tend to cluster somewhat more closely around the such times, the overriding importance of discount rate. Because a measure of adminis­ other relevant national interests involved trative review will continue to attach to some may compel the discount mechanism to op­ discounting, however, market rates are likely erate with greater reliance upon its quantita­ to be somewhat above the discount rate so tive and administrative controls and less long as reserves are in scarce supply and rate upon the impersonal criterion of rate. relationships are allowed to seek their own These limitations should not, however, be levels. thought to deprecate the role which the dis­ There are several limitations on using count rate can play under normal circum­ rate as the sole or even major instrument stances; usually rate can serve as a pervasive, for control of borrowing. Complete rate flex­ sensitive, clearly uniform, and flexible con­ ibility is neither practical nor desirable. Un­ trol mechanism. But the limitations men­ der certain circumstances, too frequent or tioned demonstrate the impracticality of ex­ poorly timed changes could contribute to clusive reliance on rate. Other controls instability in the structure of market rates. —quantity and frequency limitations and, This could be particularly true in a period of when necessary, administrative actions— tightness when increasing reserve cost could must be not only available but also in use if rapidly escalate market rates. the System is to be sure that discounting

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operations do not subvert monetary control Reserve Banks, subject to review and deter­ generally. mination by the Board of Governors. This Under the present Regulation A, with the method of rate-setting carries with it the great bulk of Federal Reserve loans carrying possibility of short-term inter-district differ­ maturities of 15 days or less, few problems ences in the discount rate. Such short-term arise with regard to outstanding loans when differences are not viewed as a problem, and the discount rate is changed. The circum­ the proposed redesign contains no special stances would become somewhat different, provisions to prevent them, mainly be­ however, if a seasonal loan were to be out­ cause the machinery for achieving uniform­ standing for as long as 9 months. As an in­ ity, through use of the requirement of ap­ tegral part of the proposal for redesign, proval by the Board of Governors, is avail­ therefore, it is recommended that all dis­ able in the event that it is needed. In any count rate changes be made immediately case, it is probably somewhat unrealistic to applicable to all outstanding loans. The sug­ contemplate the maintenance of wide inter­ gested provision would eliminate the tend­ district rate differentials over any period of ency for banks to overestimate their sea­ time in the highly interdependent economy sonal needs in order to “lock in” credit in of the Nation. anticipation of an expected rate increase. As noted in Section V, emergency credit The automatic rate adjustment would also to the economy through nonmember institu­ be helpful in achieving the objectives of mon­ etary policy, since it would avoid allowing tions should be provided only at a significant relatively long-term loans to remain out­ penalty relative to the discount rate. While standing at the earlier rate, thereby increas­ the responsibility of the Federal Reserve to ing the lag in the impact of a policy-mo- provide lender-of-last-resort credit to the tivated rate change. Lastly, without this type economy through these institutions is gen­ of built-in adjustment, banks whose borrow­ erally recognized, it remains true that the ing begins shortly before a rate decrease benefits of membership in the System must would be unfairly penalized or would be be maintained and member banks should forced to go through the administratively therefore receive some measure of prefer­ burdensome procedure of repaying their ential treatment. This penalty rate might be loans and reborrowing at the lower rate. thought of as offsetting in part the cost of Discount rates will continue to be es­ maintaining reserves with the System, which tablished by the Boards of Directors of the is continuously borne by member banks.

VII. ANCILLARY RECOMMENDATIONS OF THE STEERING COMMITTEE

A. Provisions for coordination of of discounting standards and limitations to discount administration member banks and will thereby help to pro­ The increased reliance on the discount rate mote uniformity of window operation among and on quantity and frequency limitations to districts and among banks. However, the re­ regulate borrowing behavior, which consti­ tention of a measure of administrative con­ tutes an essential part of the redesign of the trol is seen as necessary if the System is to discount mechanism, will permit a clear and accommodate adequately the widely differ­ unequivocal communication of these facets ing needs of individual member banks while

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at the same time maintaining the necessary of Governors as an amendment to Regu­ monetary control. It is intended that such lation D. Under this plan, which will become administrative control be applied in the most effective September 12, 1968, all member uniform and consistent manner possible in banks have a 1-week reserve accounting line with the principle of equal treatment for period with required reserves based upon banks in equal circumstances. Regulation deposits 2 weeks earlier. Vault cash to be and machinery to help insure this objective counted as reserves is also lagged 2 weeks. are therefore regarded as appropriate. Banks are permitted to carry forward to the One effective move in this direction will next reserve period excess reserves or reserve be the formalization of a practice already deficiencies of up to 2 per cent of required in existence. Recent years have seen a sig­ reserves. This plan, including a number nificant increase in the level and frequency of other less significant changes, should ease of communication among the discount offi­ adjustment problems at the end of reserve cers of the 12 Reserve Banks. These offi­ periods and is a move complementary to cials now hold an annual conference and the redesign of the discount mechanism fos­ monthly telephone conference calls in addi­ tering a smoother and more effectively func­ tion to the more informal contacts among tioning member banking system. individual districts. These discussions are devoted in large C. On-going studies of means of improving part to the exchange of information on the the shiftability of bank assets and liabilities ways in which individual borrowing cases A possible type of credit accommodation are being handled. Out of this exchange not provided for in the redesigned window administrative guidelines have been develop­ is long-term credit to meet the needs of ing which can be referred to by discount banks servicing perennial credit-deficit areas officers faced with a new or unusual situa­ or sectors. It was concluded that the solution tion. This development is seen as an evolu­ tionary process, with the character of the to this problem does not properly lie within guidelines expected to change somewhat the scope of discount-window operations. To over time in line with experience and undertake to provide credit for such a pur­ changes in the surrounding economic cli­ pose would enmesh the System in socio­ mate. However, the need for machinery for economic and political problems beyond its fostering the development of such guidelines proper scope and could distort the balance and maintaining them (that is, currently sheet structure of commercial banking in existing and perhaps stepped-up contacts some communities by financing the expan­ among all discount officers) is recognized, sion of loan portfolios far beyond the limits and such further arrangements as are felt of deposits. More direct and fundamental necessary will be implemented as part of the answers to the credit-deficit problem are be­ redesigned discount window. lieved to lie in the improvement of secondary markets for bank assets and liabilities. B. Changes in reserve regulations to The Steering Committee therefore recom­ facilitate end-of-period reserve adjustment mends that ad hoc task forces be established The Steering Committee endorsed the lagged within the Federal Reserve System—possibly reserve proposal adopted by the Board also drawing on the talents of other agencies

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and groups—to pursue detailed studies of the Federal Reserve System in periods of the feasibility of providing long-term credit extreme monetary stringency. As banks are assistance through some types of market- led to concentrate an increasing portion of perfecting actions. It is recognized that ex­ their adjustment efforts in these markets, the tensive work has already been done in this possibilities will increase that conditions in area, with only limited success, but the Steer­ one or more of them could become so dis­ ing Committee nonetheless regards improve­ rupted that it would become necessary to ment of secondary markets as the most take action to forestall the developing crisis. promising solution to the credit-deficit prob­ Such action could include making the dis­ lem and feels that further investigation can count window available to banks to reduce be fruitful. necessitous sales of these assets, thus alleviat­ These studies will have to recognize and ing crisis pressures in such markets. Further evaluate the possibility that the develop­ consideration of this possibility is contained ment and expansion of such markets may in Section V, “Emergency Credit Assist­ in itself impose further responsibilities on ance.”

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Contents

I. Introduction______31 II. Evolution of the Current Discount Mechanism______33 A. Reluctance to borrow as a rationale for rationing credit B. Development of concept of appropriate borrowing C. Activity at the discount window in the 1920’s D. The “ failures” of the 1920's III. The Current Discount Mechanism______38 A. The 1955 revision of Regulation A B. Reliance on the tradition against borrowing C. Operations since 1955 D. Comparison with foreign experience IV. Relevant Characteristics of the Financial Environment------49 A. Bank motivation B. The bank adjustment problem V. Activity at the Discount Window since 1955______65 VI. Related System Policies and Alternative Formulations of the Discount Mechanism______69 A. The discount mechanism and bank supervision B. Discount mechanism problems and monetary control C. Discount study research and well-known proposals for change in the discount mechanism VII. Concluding Remarks______73 Appendix A. Federal Reserve System Manuscripts and Documents Cited------75

Tables 1. Member banks borrowing continuously for a year or more from Reserve Banks------34 2. Member banks borrowing at Federal Reserve Banks, 1915-35______38 3. Borrowers and “ counseled” borrowers in five Federal Re­ serve districts, 1965 and 1966______43

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4. Frequency of large relative outflows: Percentage of banks with fund outflows of 10 per cent or more of net deposits, by size of bank______57 5. Origin of fund flows: Distribution of member banks and their net fund flows, by change in IPC deposits and in loans______57 6. Total gross fund outflow, by relative outflow at bank____ 58 7. Ratio of bank holdings of U.S. Government securities to net deposits: Percentage change, June 1961-June 1965 59 8. Member bank borrowing on eligible paper______59 9. Types of credit available from correspondent banks, 1963 60 10. Use of correspondent credit by insured commercial banks, 1963______61 11. Member bank participation in the Federal funds market, 1966: Banks with less than $10 million in deposits______63 12. Influence of trend and other factors on ratio of borrowing to required reserves------67 13. Ratio of member bank borrowing to required reserves: Federal Reserve Banks compared with all sources______67 14. Percentage change in proportion of country bank borrow­ ing from the Federal Reserve and from all sources, se­ lected periods______68

Charts 1. Discounts and Advances Relative to Total Federal Reserve Credit and Required Reserves______36 2. Member Bank Borrowing at Federal Reserve: Ratio of number of borrowers to all member banks______47 3. Country Bank Borrowing: Proportion borrowing from Fed­ eral Reserve and others______.47 4. Member Bank Borrowing at the Discount Window______66

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I. INTRODUCTION

The research effort of the discount study got changing problems of banks in different under way in the late summer of 1965. The geographic areas and an analysis of foreign Steering Committee, under whose guidance experience, with a view toward recommend­ the research program was developed, stated ing fundamental changes in current philos­ two related objectives at its first meeting on ophy and practices. August 10 of that year. The first was “to The two objectives were initially kept review operational shortcomings of the separate and, in fact, certain minor recom­ discount function,” with a view to develop­ mendations for revision pursuant to the first ing “potential reforms within the scope of objective were made early in the course of contemporary discount philosophy as to rate the study.1 However, the research under­ and administrative control.” To this end taken for both purposes has, in practice, the discount study Secretariat was instructed blended into a reasonably unified program to develop a plan aimed at throwing “addi­ aimed at providing information on the tional light on the economic, attitudinal and operations of the mechanism by which credit other factors influencing differing use of is provided to member banks through ad­ the discount window among districts and by vances and discounts (hereafter referred to banks” and to survey “Reserve Bank dis­ as the discount mechanism) and on pro­ count experience.” The second objective was posals for change. The research program, to reappraise the “discount function as an which was developed in the last half of instrument of System policy” and to evaluate 1965, came to fruition in a series of papers “alternative formulations.” This second ob­ and reports submitted for the most part in jective was considered to require an ex­ late 1966 and in 1967.2 These papers were tended study, including investigation of the i In particular, recommendations were made with respect to changes in the maturity and negotiability N o t e .— The author wishes to acknowledge the requirements of Regulation A. A questionnaire was helpful comments of Robert C. Holland, Robert sent to the Reserve Banks regarding their discount Lawrence, Emanuel Melichar, and James Pierce of the operations to meet the Committee’s first objective, but Board of Governors, George Garvy of the Federal as described below, it proved to be of substantial value Reserve Bank of New York, Lester V. Chandler of in meeting the second. Princeton University, and Ralph A. Young, formerly 2 Citation of these papers (some unpublished) is by Senior Adviser to the Board. He has benefited substan­ author, title, and the general reference: “(Discount tially from continuing discussion, over a period of sev­ Study).” References are to the documents and manu­ eral years, with numerous Reserve Bank officials asso­ scripts that were available when this Report was pre­ ciated with discount operations, and wishes to note, in pared. Some have undergone substantial editorial re­ particular, the extended colloquy with Harold Bilby vision, including changes in authorship and title. of the Federal Reserve Bank of New York and David Results of other staff studies are also presented in the Melnicoff of the Federal Reserve Bank of Phila­ text, and staff members responsible are indicated in delphia. It should not be inferred that any or all of footnotes. Complete citation of published material is those mentioned fully agree with all the views ex­ provided in footnotes. A bibliography of discount pressed. This report is republished here as it was ini­ study papers cited in the text and of related unpub­ tially prepared for the Steering Committee and pub­ lished Federal Reserve System documents is provided lished in August 1968. in Appendix A.

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prepared, for the most part, by the staffs of made throughout to specific papers and the Reserve Banks and the Board, but sev­ other staff studies. In addition, reference is eral were undertaken by academic econo­ made from time to time to the other pub­ mists.3 lished and unpublished literature on the Over-all, the reappraisal has concentrated issues raised by the study. Several investi­ on the current rationale of the discount gations made by the author, not incor­ mechanism, its operations since the last re­ porated into specific papers, are also dis­ vision of Regulation A in 1955, and its cussed where relevant. It will be observed effectiveness in serving several types of pur­ that, in a number of cases, gaps in informa­ poses. These include not only purposes re­ tion preclude definitive answers, and results lating to monetary policy but also those are presented as suggestive rather than con­ relating to bank supervision and the pro­ clusive. vision of credit to individual banks for In reviewing the research, certain limita­ adjustment to short-term fluctuations in tions in scope should be noted. First, there reserves. Considerable time and attention has not been a full evaluation of the relative has been given to the development and roles of open market operations and the evaluation of proposals that could meet de­ discount mechanism as “tools of monetary ficiencies uncovered. In addition, there has policy.” It became clear early in the study been a reconsideration and clarification of that there would be no pressing need for this. the function of the discount mechanism in While some aspects of open market opera­ providing credit to member banks and other tions have been considered, and some de­ financial institutions under certain specified ficiencies in supplying reserves through open conditions, for example, in emergencies. market operations are noted below, there The aim of this report is to provide, in did not seem to be any persuasive reason to light of the issues of concern, a review and contemplate a drastic change in relative roles an evaluation of the research undertaken in such as took place in the 1930’s and there­ connection with the Federal Reserve Sys­ after.4 tem’s reappraisal of its discount mechanism, Secondly, a systematic evaluation of and, in particular, to indicate the findings monetary policy, in its theoretical approach that have important implications for change and practical implementation, was not at­ in the mechanism. The nature of the report tempted. It was considered important, of is such that a considerable amount of “sift­ course, to review aggregate borrowing and ing and winnowing” of the available research the free-reserve variant as measures of mone­ papers has been necessary. Reference is tary restraint and as targets for policy, par­ ticularly in light of some of the findings reported below. However, for the most part, 3 In addition, Professor Lester V. Chandler, of the discount mechanism was evaluated Princeton University, was employed as an academic consultant; he helped maintain a liaison with scholarly within the framework of monetary policy effort, which included the holding of a seminar at­ tended by a number of prominent contributors to as it currently exists. Recommendations for academic discussion on monetary policy and the dis­ count mechanism. See Priscilla Ormsby, “Summary of Issues Raised at the Academic Seminar on Changes 4 In addition, a joint Treasury-Federal Reserve Sys­ in the Discount Window” (Discount Study); and re­ tem study of the U.S. Government securities market plies from economists to letter from Lester V. Chan­ began in early 1966. See Board of Governors of the dler, Spring 1966, “The Federal Reserve Discount Federal Reserve System, Fifty-second Annual Report: Mechanism and Discount Policies” (Discount Study). Covering operations for the year 1965, p. 217.

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change were clearly seen as having impor­ developed by the principal committees on tant implications for monetary policy; and specific aspects of the discount mechanism. these implications have been under continu­ Full evaluation of current policies, judg­ ing study. ments as to prospective conditions, and Finally, it should be noted that no effort broader socioeconomic considerations, as is made in this paper to review in detail the well as the research findings underlying such relationships between the research findings recommendations, are developed in the and the recommendations that have been separate reports of the committees.

II. EVOLUTION OF THE CURRENT DISCOUNT MECHANISM

The current formulation of the discount bank policy to a coordinate, though seem­ mechanism developed out of a study by the ingly unimportant, tool is a matter of con­ Federal Reserve System in 1953-54.1 The tinuing historical interest.4 This transfor­ principal proposals of the System Commit­ mation has been closely associated with the tee on the Discount and Discount Rate concept of “reluctance to borrow” as a ra­ Mechanism were adopted and implemented tionale for restricting credit flows at the dis­ in 1955 by a revision of Regulation A.2 count window. However, the rationale of the 1955 revision, Development of coordinated open market as well as the administrative techniques operations in the early 1920’s, and recog­ adopted, developed out of some of the ear­ nition that the “real bills” doctrine was not liest System experiences. So, for example, a realistic standard for extending credit, ne­ it was noted soon after the revision of 1955 cessitated a reconsideration of the basis for that “the central bank turned back to old Reserve Bank credit extension. With com­ ways of doing things.” 3 In form, this was mercial banks engaged in a wide variety of true; but in substance, as will be discussed lending functions, eligibility and associated below, the statement requires modification. statutory requirements were inadequate.5 The following review and analysis of the Rationing credit by means of differential early development of the discount mech­ discount rates was evidently viewed as a anism is meant to provide some perspective potentially effective device in the early in considering its more recent changes and 1920’s. But short-lived and misconceived functioning. experiments with rate control and credit lines quickly disabused the Reserve Banks A. Reluctance to borrow as a rationale for 4 See, for example, A. James Meigs, Free Reserves rationing credit and the Money Supply (University of Chicago Press, 1962), chapter II; Milton Friedman and Anna Transformation of the discount mechanism Jacobson Schwartz, A Monetary History of the United from the principal instrument of central States, 1867-1960 (Princeton University Press, 1963), chapters 5, 6; and Karl Brunner and Allan H. Melt- zer, The Federal Reserve’s Attachment to the Free System Committee on the Discount and Discount Reserve Concept, Committee on Banking and Cur­ Rate Mechanism, “Report on the Discount Mecha­ rency (U.S. Government Printing Office, May 7, nism,” Mar. 12, 1954 (hereinafter referred to as “Re­ 1964), pp. 2-17. port on Discount Mechanism, 1954”). 5 As distinct from eligibility requirements, there 2 Federal Reserve Bulletin, January 1955, pp. 8, 9. were attempts in the 1920’s to limit discount credit by 3 Edward C. Simmons, “A Note on the Revival of requiring additions to collateral. Clay J. Anderson, Federal Reserve Discount Policy,” The Journal of “Evolution of the Role and the Functioning of the Dis­ Finance, December 1956, p. 415. count Mechanism” (Discount Study).

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that attempted to use them and, it would cial bank operations and effective central seem, the System in general. Hardships bank policy. Because the desired objective worked by progressive rate formulas on was a consensus or agreement on these mat­ banks with persistent outflows of funds ters, the approach taken may conveniently proved to be long-remembered experiences.6 be called “the reluctance convention.” 11 A reluctance to be in debt continuously Supporting bank reluctance to borrow had evidently been a periodic characteristic was consistent with both monetary manage­ of the commercial banking system during ment and supervisory objectives. As well the preceding decades.7 A System policy was as facilitating the adoption of the “reserve developed that built upon this characteristic position” approach to the implementation by maintaining that it was also not tradi­ of monetary policy,12 “(i)t established rela­ tional for the central bank to lend continu­ tions between member banks and Reserve ously.8 Restricting Reserve Bank credit in Banks that facilitated attempts at qualita­ this way was, to some degree, successful in tive control, for example, over the stock the 1920’s and “helped to make open market market in 1929”.13 More generally, it pro­ operations rather than rediscounting the vided a heuristic standard for bank super­ main instrument for quantitative control.” 0 vision.14 Emphasis on reluctance may be looked The significance of this standard for bank at as a substitute for rationing and distrib­ supervision was clarified in a series of events uting credit by means of the discount rate or by requirements related to eligible col­ TABLE 1 lateral.10 It involved an attempt at persua­ MEMBER BANKS BORROWING CONTINUOUSLY sion by the Federal Reserve as to the degree FOR A YEAR OR MORE FROM RESERVE BANKS of credit restraint at the discount window As of— Number that is desirable in light of “sound” commer­ 1925-August 31...... 593 c Three of the four Reserve Banks that established December 31...... 517 progressive rates based them on credit lines tied to 1926-December 31...... 457 the amount of reserves deposited by each bank at the Reserve Bank. As reserve balances fell, the credit line 1927-December 31...... 303 contracted and the rate on borrowing could increase to very high levels. A highly publicized case involved S ource.—Board of Governors, Federal Reserve System, internal a rate of 87.5 per cent. Ibid. memoranda on banks that borrowed continuously from Reserve 7 Riefler has noted that “long before the establish­ Banks in 1925, 1926, and 1927. ment of the reserve system, it was one of the funda­ mental traditions of sound banking practice in this country, that a bank’s operations should be confined 11 See J. M. Keynes, A Treatise on Money, (Mac­ to the resources which it derived from its stockholders Millan and Co., London, 1930), vol. 2, p. 239. and depositors, and interbank borrowing was at all Keynes wrote “(t)he history of the Federal Reserve times limited. When it did occur, it was viewed with System since the war has been, first of all, a great such distrust as an evidence of weakness, or at the abuse of the latitude thus accorded to the Member least of unsound practice, that various subterfuges Banks . . . and subsequently a series of efforts by the were developed by banks to conceal borrowing in Reserve authorities to invent gadgets and conventions their published statements.” Winfield Riefler, M oney which shall give them a power, more nearly similar to Rates and Money Markets in the United States (Har­ that which the Bank of England has, without any overt per and Bros., 1930), pp. 29, 30. However, such re­ alteration of the law.” luctance as did exist appears to have weakened con­ 12 Tenth Annual Report of Federal Reserve Board: siderably from time to time, for example, after World Covering operations for the year 1923, pp. 13-16; War I. See Friedman and Schwartz, op. cit., p. 268. Meigs, loc. cit. 8 See Thirteenth Annual Report of the Federal Re­ 13 Friedman and Schwartz, op. cit., p. 269. serve Board: Covering operations for the year 1926; 14 A discussion of such standards may be found in Riefler, op. cit., p. 29. Kalman J. Cohen and Frederick S. Hammer, “Linear 9 Friedman and Schwartz, op. cit., p. 269. Programming and Optimal Bank Asset Management 10 A fuller analysis of “reluctance to borrow,” Decisions,” The Journal of Finance, May 1967, pp. viewed in this way, is presented below in Section III. 153-54.

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beginning in 1925. In that year data were position with regard to the additional assets collected by the Board on the number of of the bank, because those rediscounts are member banks indebted continuously for at not of as high a quality as the paper which least a year.15 It was found that as of Aug­ the bank hypothecates.” 10 Consequently, the ust 31, 1925, 588 member banks had been Reserve Bank should carefully investigate borrowing for a year or more from Federal the conditions and behavior of the borrow­ Reserve Banks.10 Of the 588 continuous bor­ ing bank in order to protect its depositors.20 rowers, 239 had been borrowing since 1920; In subsequent years, additional surveys and 122 had begun borrowing before that. of a similar nature were made. In each, the It was also found that about 150 of the con­ number of continuous borrowers in an “ex­ tinuous borrowers were then in an “over­ tended or unsafe condition” and the number extended” position.17 “likely to liquidate borrowing” during the In a review of these data, it was noted coming year were indicated. In addition, that 259 national member banks had failed data were gathered on the number of con­ since 1920, and a guess was made that at tinuously borrowing banks reported in the least 80 per cent had been habitual bor­ previous survey that had since gone out of rowers prior to their failure.18 In what was existence.21 to become an accepted position within the Emphasis on reluctance also reflected a System, it was stated that . . in borrowing, concern about an “equitable” distribution . . . the bank uses the best assets it has and of reserves provided by the System. Exces­ puts him, the depositor, in a less satisfactory sive borrowing by some member banks was viewed as unfair to other member banks in 1C The data were requested in a letter from Walter that the total pool of reserves was, at the L. Eddy, Secretary to the Federal Reserve Board, to all Federal Reserve Agents, dated Sept. 15, 1925. time, considered limited.22 10 See Table 1. The figure of 593, shown in Table 1, is a subsequent revision. 17 Overextended banks were defined as “those re­ B. Development of concept of appropriate ported in statement accompanying request for author­ borrowing ity to close books of Federal Reserve banks on De­ cember 31, 1925, as having been in an over-extended The movement away from rationing credit condition on November 1.” The data were attached to a memorandum from Mr. Smead to Mr. Eddy en­ by eligibility requirements to rationing by titled “Banks borrowing from the Federal Reserve Banks continuously for the year ending August 31, the “reluctance convention” was accom­ 1925,” Jan. 22, 1926. panied by the development of a set of rules 18 Statement of O. M. W. Sprague, Minutes of Joint Conference of the Federal Reserve Board with the for administering the discount window.23 A Governors and Chairman and Federal Reserve Agents of the Federal Reserve Banks, Nov. 4-5, 1925, pp. basis for the “surveillance” of borrowing 75ff. The minutes report that Professor Sprague, banks had been established in the early who was serving as a consultant to the Board, indi­ cated 888 member banks borrowing continuously, but 1920’s. The Board’s Annual Report for in light of the original reports in the records this must be an error. Sprague severely criticized “ha­ bitual” borrowing, noting that neither eligibility nor 19 Sprague, Minutes of Joint Conference, op. cit., p. discount rates were “effective agencies for preventing 77. banks from becoming over extended. . . .” See also the 20 Ibid. letter written by John Perrin to the Federal Reserve -l For example, it was reported that of the 457 Board on “Destructive Effect of Over-Lending to Mem­ continuous borrowers in 1926, 41 had suspended oper­ ber Banks,” Feb. 26, 1926. It is well to note, how­ ations during 1927, while 24 more had liquidated ever, that the causal relationship between “overbor­ voluntarily or merged. Memorandum from Mr. Smead rowing” and banks getting into difficulty cannot be to Federal Reserve Board, “Member banks borrowing viewed as one way. Clearly a bank may borrow large from Federal Reserve Banks continuously during amounts for long periods because it is in difficulty for 1927,” May 10, 1928. independent reasons, for example, because it has made “ Anderson, op. cit. bad loans. 2:! Ibid.

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1923 had reaffirmed that credit should not and, moreover, “(i)t may also impair the be used for investment or speculative pur­ ability of the borrowing bank in case of in­ poses, in accordance with the real-bills doc­ solvency to meet its obligations to depos­ trine.24 While it noted that “(c)redit for itors.” short-term operations in agriculture, indus­ The earlier emphasis on short-term paper try, and trade . . . is a productive use of under the real-bill standard was altered to credit,” it also stated that “(t)here are no emphasize short-term borrowing: automatic devices ... for determining, when . . . the funds of the Federal reserve banks are pri­ credit is granted by a Federal reserve bank marily intended to be used in meeting the seasonal . . . whether the . . . extension of credit by and temporary requirements of members . . ,28 the member bank (is) for non-productive And finally, the principle that borrowing use.” 25 The same report stated that “(pro­ should normally be confined to unusual or tection of their credit against speculative adverse circumstances was stated: uses requires that the Federal reserve banks In using their influence to discourage member should be acquainted with the loan policies banks from making continuous use of the lending and credit extensions of their member facilities of the reserve banks, the operating offi­ banks___ ” 26 cials of the reserve banks are not only protecting the resources of the Federal reserve system as a Secondly, a restriction on continuous bor­ whole, but are also helping individual member rowing was developed. The Board’s Annual banks to conserve their capacity to borrow at the Report for 1926, no doubt with the 1925 reserve bank at times when adverse economic con­ ditions in their localities and among their cus­ study of continuous borrowing in the back­ tomers may make additional dependence upon the ground, stated: resources of the reserve system not only justifiable but necessary.29 Even where the paper is unexceptionable in every respect, the reserve bank must be fully assured in The restriction on “borrowing to prof­ addition that further credit may be granted to this member not only “safely and reasonably,” but also it,” 30 with a provision for long-term credit “with due regard for the claims and demands of 28 Ib id . other member banks.” This question arises not in­ 29 Ib id ., p. 5. frequently in cases where a member bank remains 80 That the issue of “borrowing-to-profit” had not continuously in debt to a reserve bank for a con­ been resolved by the mid-1920’s is indicated by the siderable length of time. In such cases, inquiry may fairly be made as to whether the member 11 DISCOUNTS and ADVANCES... bank’s use of reserve bank credit does not in effect amount to increasing its own capital out of reserve PER CENT bank funds.27 The Report goes on to note that because the Federal Reserve System represents a “co­ operative pooling of . .. funds” this is unfair

24 Annual Report, Federal Reserve Board , 1 9 2 3 , p. 33. 25 Ib id ., p. 34, 35. 26 Ib id ., p. 35; Reserve Bank surveillance actually began in the period of “direct pressure” following World War I. In the spring of 1920, the Board asked “Reserve Banks to submit a written report of methods used to keep informed on how member banks were using Reserve Bank credit.” See Anderson, o p . cit. 27 Thirteenth Annual Report of Federal Reserve Board: Covering operations for the year 1926, p. 4.

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in “unusual circumstances,” was indicated by the Federal Reserve in the 1920’s were in the Board’s Annual Report for 1928: provided through borrowing by member It is a generally recognized principle that reserve banks. Discounts and advances as a propor­ bank credit should not be used for profit, and that tion of Federal Reserve credit reached a continuous indebtedness at the reserve banks, ex­ peak of about 82 per cent in 1921 and never cept under unusual circumstances, is an abuse of fell below 37 per cent during the period reserve bank facilities.31 (Chart 1). In addition, the proportion of Absent the explicit limitation on seasonal member banks borrowing from the Reserve borrowing to amounts beyond those “which Banks generally ranged around 60 per cent can reasonably be met by use of the bank’s during the 1920’s (Table 2). It was not own resources,” all the principles of current uncommon, evidently, for hundreds of banks discount administration can be found by to be continuously borrowing amounts in this date. excess of their capital and surplus.32 For the decade as a whole, the proportion C. Activity at the discount window in the of Federal Reserve credit supplied through 1920’s the discount window fluctuated considerably A major proportion of the reserves supplied but showed a clear decline after 1921. The proportion of member banks borrow­ fact that in 1925, John Perrin, Chairman of the Board at the Federal Reserve Bank of San Francisco, felt it ing also reached a peak in 1921. This peak necessary to inquire of the Federal Reserve Board was not reached again until the crisis year about the “propriety” of a member bank borrowing to purchase Government securities. Perrin noted that of 1933, by which time the number of he did not think this was in any way wrong. In fact, member banks had declined substantially he said, “(t)he advance in prices (of governments) has demonstrated the bank’s soundness in Judgment (Table 2). Reports on continuous borrow­ (sic) in thus adding to profits at a time of relatively small earnings.” He indicated, however, that a ques­ ers in 1925 and thereafter, reviewed above, tion had been raised by one of the directors of the were consistent with an active Board policy to Reserve. Bank who was a “competing banker.” [Tele­ grams from John Perrin to Federal Reserve Board, April 18, 1925, and April 21, 1925] The Board did 32 Annual Report, Federal Reserve Board, 1926, p. 5. not answer the questions directly but requested further Interest in this figure stemmed from the fact that prior information on the bank in question. to the establishment of the Federal Reserve System, 31 Fifteenth Annual Report of Federal Reserve national banks were not generally permitted to borrow Board: Covering operations for the year 1928, p. 8. in excess of their capital and surplus. . relative to Federal Reserve credit and required reserves

PER CENT

15

10

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TABLE 2 D. The “failures” of the 1920’s MEMBER BANKS BORROWING AT FEDERAL RE­ The generally acknowledged successful SERVE BANKS, 1915-35 conversion from a discount mechanism Member banks based on the “real bills” doctrine to a dis­ Year Proportion count mechanism based on “reluctance to Number Total borrowing discounting number 2 borrow” in the 1920’s was accompanied by paper i generally acknowledged unsuccessful at­ 1915...... 1,920 7,615 25.2 1916...... 1,788 7,606 23.5 tempts to use the discount mechanism in 1917...... 3,127 7,653 40.9 1918...... 5,493 8,213 66.9 certain ways to achieve certain purposes. 1919...... 5,993 8,822 67.9 As mentioned, these “failures” include the 1920...... 6,941 9,399 73.8 1921...... 7,415 9,745 76.1 attempt to use the discount rate, credit lines, 1922...... 6,956 9,892 70.3 1923...... 6,333 9,856 64.3 1924...... 6,060 9,650 62.8 and collateral requirements to control the ex­ 1925...... 5,183 9,538 54.3 tension of credit and also attempts to use 1926...... 5,343 9,375 57.0 1927...... 4,869 9,099 53.5 preferential or penalty rates and “direct pres­ 1928...... 4,718 8,929 52.8 1929...... 5,113 8,707 58.7 sure” to influence the final use of credit.35 1930...... 4,991 8,315 60.0 Such experiences are hardly conclusive in 1931...... 5,260 7,782 67.6 1932...... 5,017 6,980 71.9 1933...... 4,270 5,606 76.2 themselves in precluding certain objectives 1934...... 1,393 6,375 21.8 or the use of certain techniques today. But 1935...... 692 6,410 10.8 they are of much interest—for example, in 1 Represents number borrowing one or more times during year; suggesting the difficulties that would be in­ figures are from annual reports of the Federal Reserve. 2 From Banking and Monetary Statistics, Board of Governors of volved in using the discount mechanism for the Federal Reserve System, Washington, D.C., 1943. purposes of selective credit controls.30

discourage continuous borrowing.” The num­ 1925 there existed a policy of mild monetary restraint induced by the flow of bank credit to the stock market, ber of member banks borrowing continu­ while in December 1927 there existed a policy of mild ously for a year or more was cut in half ease, induced by both international and domestic con­ siderations. See Elmus R. Wicker, Federal Reserve between August 1925 and the end of 1927 Monetary Policy, 1917-1933 (Random House, 1966), pp. 95-116; and Lester V. Chandler, Benjamin Strong, (Table l).34 Central Banker (The Brookings Institution, 1958), pp. 435-47. The decline in numbers of continuous bor­ 33 The files for 1926-29 include a number of letters rowers might be attributed in part to the change in reflecting the efforts of the Board and the Reserve monetary policy as well as to the change in discount Banks to eliminate continuous borrowing for such policy. purposes as carrying Government securities and 35 Anderson, op. cit. operating in the call loan market. !0 See Lester V. Chandler, “Selective Credit Control” 34 It should be noted, however, that in August of (Discount Study).

III. THE CURRENT DISCOUNT MECHANISM

The banking crisis in the early 1930’s led World War IT, and the early postwar period to liberalization of collateral requirements —borrowing activity at Reserve Banks re­ for borrowing from Reserve Banks. Em­ mained at very low levels. Discounts and phasis was further shifted during this period advances averaged only $11.8 million be­ from the technical requirements of eligibility tween 1934 and 1943, and $253 million to the requirement that collateral be “satis­ between 1944 and 1951. Little interest was factory.” However, for almost two decades expressed in the intellectual and operating after 1933—during economic depression, characteristics of the discount mechanism.

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With the revival of flexible monetary short-run adjustments resulting from mone­ policy after the “accord” in 1951 there was tary restraint; that is, it would serve as a also a revival of concern about the possible safety valve. More generally, short-term “over-extension” of credit through the dis­ credit would be available to permit adjust­ count window. Partly as the result of a profit, ment to unexpected declines in deposit flows incentive to borrowing introduced by the and increases in loan demand; and longer- excess profits tax,1 discounts and advances term credit, to help ameliorate emergency increased to more than $1.6 billion in mid- situations. In addition, it was believed that 1952 and remained over $1 billion during this “modernized philosophy” would serve the first 4 months of 1953.2 “These develop­ to eliminate “incompatible interdistrict ments in particular” according to the System differences in discount methods” among the Committee on the Discount and Discount Reserve Banks.4 This conception of the dis­ Rate Mechanism established in 1953, count mechanism was essentially adopted in “brought under discussion within the Sys­ the 1955 revision of Regulation A. It is most tem the whole question of the philosophy clearly stated in the “General Principles” of and effectiveness of its existing discount the Foreword to the Regulation. mechanism.” 3 While the terminology of the “General Principles” is almost identical to that used A. The 1955 revision of Regulation A in the 1920’s, the 1955 revision reflected a The System Committee that had been estab­ difference in at least one important respect/’ lished to study the question recommended Concern about excessive borrowing in 1952 that Regulation A be formulated so as to and 1953 arose when borrowing increased to place reliance on and give support to the over $1 billion. This was not a low dollar fig­ “tradition against borrowing.” It was ar­ ure by 1920 standards. But in 1952-53, it gued that, by doing so, the discount represented only about 4 per cent of required mechanism would serve both monetary reserves and 3 per cent of Federal Reserve policy and supervisory purposes. As a re­ credit. The revision of Regulation A in this sult, discounting could not be used to re­ situation reflected a choice to restrict activity lieve for long or indefinite periods the at the discount window well below even the pressure of monetary restraint upon the lowest relative levels reached in the 1920’s banking system and its customers. In addi­ and to provide almost all reserves by open tion, support given to the “tradition against 4The report states: “(l)ack of a modernized dis­ borrowing” would contribute to the finan­ count philosophy . . . is a factor fostering undesirable regional differences in discount practices. . . . While cial soundness of individual banks and the some incompatible interdistrict differences in discount banking system. At the same time, it was methods may now exist, the Committee is persuaded that differences not supported by variations in regional argued, the discount window could serve to conditions and needs would be largely eliminated by a meet the “needs” of individual member Regulation A reoriented along the lines suggested.” “Report on Discount Mechanism, 1954,” pp. 23, 34. banks for credit accommodation to facilitate 5 In addition to the restriction on continuous bor­ rowing the “General Principles” cite three “appro­ 'Under a ruling by the Bureau of Internal Revenue priate” purposes for borrowing (to meet “sudden” in 1951, borrowing by banks could be included in their deposit withdrawals, seasonal requirements beyond capital base for the purpose of calculating excess those that can “reasonably” be met, and emergency profits tax liabilities. needs resulting from “unusual situations” or “excep­ 8 See Bernard Shull, “The Rationale and Objectives tional circumstance”) and three “inappropriate” pur­ of the 1955 Revision of Regulation A” (Discount poses (“principally” to profit from rate differentials, Study). to obtain a tax advantage, or to extend an “undue” ’ “Report on Discount Mechanism, 1954,” p. 22. amount of credit for speculative purposes).

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market operations. In qualitative terms, the If the member banks generally meet their normal 1955 revision was essentially a revival and operating responsibilities, use of the System dis­ count facility would ordinarily be limited and codification of the rationale and administra­ would increase appreciably at times only in re­ tive guidelines that had evolved in the sponse to System operations directed at credit 1920’s. In the post-World-War-II environ­ restraint.9 ment, with commercial banks holding large The Committee felt this was both desirable amounts of liquid Government securities, and practical. It noted that any attempt to it was intended to be far more restrictive meet the seasonal “needs” of individual than what had been achieved earlier. The banks could result in a redundancy of credit, intervening years in which banks had not since increases in demand by some banks are made very much use of the window, in effect, typically accompanied by decreases in de­ permitted a major quantitative change, albeit mand by others. Reserve Bank credit made a relative one, in operations. available to individual banks for seasonal The increased degree of restriction was purposes would inevitably have an effect on most clearly expressed in reference to the general credit conditions through the loan issue of credit for seasonal purposes. It was and investment process. “An oversupply of indicated that the Federal Reserve had re­ reserve funds through the discount window sponsibility for responding to the seasonal to meet seasonal needs of individual banks swings in reserves that affect the banking may thus render more difficult the conduct of system as a whole, but that member banks general credit and monetary policy.” 10 The should generally meet foreseeable seasonal System would rely on open market opera­ swings out of their own resources.6 Since tions to compensate for seasonal (and other seasonals are, by definition, largely foresee­ undesired) drains from the banking system able, it is reasonable to believe that credit as a whole and would rely on existing insti­ for such purposes was intended to be re­ tutions and markets to distribute reserves to stricted to the exceptional case.7 The em­ the individual banks experiencing declines phasis on temporary borrowing, as indicated in deposits or increases in loans. The princi­ symbolically by a 15-day maximum maturity pal market on which the distribution of in normal circumstances, was intended to reserves was seen to depend was the Govern­ further support the general exclusion of bor­ ment securities market. rowing for seasonal purposes.8 By maintaining an adequate portfolio of short­ It was argued that this restriction was nec­ term Government securities and other money mar­ essary to make a monetary policy of re­ ket paper which can be sold as needed, individual straint effective. The report stated: member banks in providing for ordinary seasonal requirements may assure themselves of a satisfac­ 6 See “Report on Discount Mechanism, 1954,” pp. tory access to funds available in the credit mar­ 26, 27, and Appendix B. ket. . . . Nearly all banks hold a considerable 7 “It appears to the Committee that a limitation of amount of Government securities not only at Reserve Bank credit extensions for seasonal require­ ments to those ‘which cannot reasonably be anticipated periods of seasonal ease but also on a continuing and met by the use of the member bank’s own re­ basis.11 sources’ is a desirable safeguard. . . . there will be extraordinary seasonal cases, most likely smaller bank 9 Ib id .y p. 26. situations, which will require discount acceptance on 10 Ib id ., Appendix B, p. 1. the basis of a reasonable evaluation by Reserve Bank 11 Ib id .f Appendix B, pp. 10, 11 [italics added]. The officials of the special considerations giving rise to the report also noted that “undue seasonal reliance of borrowing need.” Ib id ., pp. 26, 27. some member banks on discounts goes back more to 8 Ib id . Compare Section 202.2, note 1, of Regulation inadequate holdings of cash assets and short-term A. 12 CFR 201, as revised effective Feb. 15, 1955, with Government securities than to the pressure of strong Section 2, note 6, of the previous revision in 1937. seasonal movements in deposits and loans,” p. 12.

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In addition, the Committee stated that the Reserve Banks in lending and member problem, even for the highly seasonal bank, banks in Reserve Bank borrowing.” is generally not unmanageable; “the propor- It is reasonable to believe that the “Prin­ portion of resources that is stable is sub­ ciples,” which are now found in the Fore­ stantial. . . 12 Finally, it was suggested that word to Regulation A,15 were not intended correspondent banking relationships amelio­ to be applied independently of one another rate the seasonal problem, at least for city as limits on the supply of borrowed funds. banks. Rather, they represent a set of terms that Seasonal movements in interbank loans are not roughly describe the kind of borrowing be­ consistent, and in any event the magnitude of such havior expected of a bank “reluctant to bor­ loans is small. Interbank deposits (however), are considerably larger and show considerably larger row.” 14 fluctuations in dollar amounts over the year. . . . In combination, they were intended to fa­ Thus, city banks actually gain funds at the period of their peak seasonal need. . . .13 cilitate the rationing process, that is, to help discount officers and committees make a dis­ B. Reliance on the tradition against tinction between sufficiently reluctant (ap­ borrowing propriate) and insufficiently reluctant (in­ As noted, the conception of the discount appropriate) borrowing. It is suggested in mechanism as a strategic instrument of Fed­ the Committee’s report that the duration of eral Reserve policy was to be implemented borrowing was to be used to establish a re­ through reliance on the tradition against buttable presumption that borrowing was borrowing. for an inappropriate purpose.17 The purposes A major lesson brought out by the bank credit that were viewed as inappropriate, such as liquidation (in the early 1920’s) . . . was that it borrowing to profit from rate differentials, was unsound for any member bank to use con­ were those that implied reliance on borrowed tinuous indebtedness to its Reserve Bank as a re­ source for conducting regular banking operations. funds in the “normal” course of business.18 . . . In the severe banking crisis and liquidation in Nevertheless, it was not expected that dif­ the early Thirties, adjustment problems of the ag­ ficult rationing decisions would have to be gressive, continuous borrowing banks made evi­ dent the hazards to safety of depositor funds. . . . made very often, or in the case of very many Because of this costly lesson, it was possible by 15 Ib id ., p. 23. The “General Principles” suggested the mid-Thirties to speak of an established tradi­ by the “Report on Discount Mechanism, 1954” and the tion against member bank reliance on the discount “General Principles” as finally embodied in the Fore­ facility as a supplement to its resources. . . . F u ­ word to Regulation A as revised in 1955 are essen­ ture discount policy . . . should build on the tradi­ tially identical. 18 Shull, o p . cit. tion as a keystone .14 17 It was expected that an “initial” request for credit by a member bank would normally be granted, and The tradition against borrowing was to the question of continuous borrowing “. . . would arise first at the time of the first renewal.” “Report on be supported through the statement of a set Discount Mechanism, 1954,” Appendix C, p. 7. Cer­ of “General Principles” in Regulation A. tain “objective procedures . . . would facilitate ad­ ministration where findings indicated that developments These principles were designed “. . . to guide other than those stated were responsible.” Ib id ., p. 34. With each successive period in which borrowing oc­ 12 Ib id ., Appendix B, p. 11. curs, the report noted, “the probability that the bor­ 13 Ib id ., Appendix B, pp. 6, 7 [parenthetical material rowing stems from inadvertent causes obviously de­ added]. Presumably, the country bank problem would creases.” Ib id ., Appendix C, p. 10. be ameliorated by the drawing down of excess cash de­ 18 Much of the analysis in the report relates to posited with correspondents during periods of seasonal changes affecting individual banks under conditions of tightness. uncertainty. The definition of what, for example, con­ 14 Ib id ., pp. 10-13 [parenthetical material and italics stitutes an “unforeseeable seasonal decline in deposits” added]. was not rigorously developed.

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banks. The Committee’s report suggested It would appear that “initial” requests that most banks were sufficiently reluctant for credit are invariably accommodated in their borrowing behavior to satisfy the promptly, with little if any discussion and requirements of monetary policy and bank with little inconvenience to the borrower.24 supervision and that only a few aggressive In most circumstances no real effort is made banks borrowed excessively. It was expected to ascertain the purpose of borrowing initi­ that the revised Regulation, by indicating ally.2" Beyond this initial accommodation, the System’s position, would support the the administrative process can, for purposes many adhering to the tradition against bor­ of analysis, be broken down into three con­ rowing, while the work of discount officers secutive stages: (1) surveillance of the bor­ and Reserve Banks would influence the be­ rowing bank; (2) a decision with respect to havior of the aggressive few.1" the “appropriateness” of the borrowing; and In summary, the administrative procedure (3) in cases where an “inappropriate” suggested—involving Reserve Bank surveil­ decision is reached, the undertaking of “ad­ lance and frequent contact with continuous ministrative counseling” or “discipline” borrowers—was intended to influence bank aimed at securing repayment and “educat­ attitudes by promoting the tradition against ing” the borrower in the appropriate use of borrowing and, thereby, reducing the de­ the discount window. mand for credit. Where necessary, admini- These three stages may be viewed as ele­ tration provided a device for rationing the ments in the process of nonprice rationing supply of credit.2" and “moral suasion” at the discount window. It is useful to discuss briefly the substance C. Operations since 1955 of the approach taken, and then to consider Information on the manner in which the certain related problems that have come to “General Principles” of Regulation A have light. been and are administered was obtained through a general questionnaire sent to each 1. Nonprice rationing. The administrative Reserve Bank,21 an additional questionnaire procedures adopted by the Reserve Banks sent to the discount departments of five are essentially identical to the procedures Reserve Banks.22 and a variety of other envisioned in the 1954 Report on the Dis­ sources.23 A reasonably complete picture of count Mechanism. Surveillance takes place discount-window administration has been through observation and analysis of data on obtained. the operations of borrowing banks and through direct inquiries. An initial de­ 1‘* “Report on the Discount Mechanism, 1954.” pp. cision that borrowing which has continued 36-40. * l b i d . over some time is “inappropriate” may be 21 “Questionnaire to Federal Reserve Banks Regard­ viewed as tentative. It is dependent on a ing Discount Operations,” Oct. 1, 1965 (herein­ after referred to as “Questionnaire, 1965”). variety of factors. These include some that ~ This questionnaire was part of a review of mem­ ber bank borrowing cases conducted by Kyle E. are “given” when credit is extended (the Fossum, Federal Reserve Bank of Minneapolis. amount borrowed, the previous borrowing 23 These include descriptive presentations by several discount departments of their administrative pro­ record of the bank, the stated purpose); cedures, quarterly borrowing reports by each Reserve Bank to the Board of Governors on problem borrow­ 34 By “initial” is meant the first request of a bank ing cases, and periodic conference calls among the that is not currently subject to surveillance for reason discount officers of all Reserve Banks and staff mem­ of previous borrowing. bers of the Board of Governors. 25 Shull, o p . cit.

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some that vary while the credit is outstand­ was suggested in an analysis of replies to ing (the borrowing bank’s asset and liability the questionnaire sent to the discount de­ management); and, of course, “time” itself, partments of five Reserve Banks. The ques­ since duration is taken as evidence of “re­ tionnaire requested information on cases in luctance.” These factors may be thought of 1965 and 1966 in which the borrowers were as interacting in influencing the initial “ap- “counseled.” propriate-inappropriate” decision.20 A fairly substantial proportion of bor­ Once the appropriateness of an outstand­ rowing banks were contacted for admin­ ing debt has been seriously questioned, “ad­ istrative purposes during 1965 and 1966. ministrative counseling” or “discipline” is In both years, over one-quarter of the re­ undertaken. This procedure has been de­ serve city bank borrowers were “coun­ scribed by a Reserve Bank discount officer seled” (Table 3). In 1965 only 8 per cent as follows: TABLE 3 . . . a Reserve Bank official will promptly write, phone or arrange a conference with the member BORROWERS AND “COUNSELED" BORROWERS IN banker whose bank borrowings from the Fed. be­ FIVE FEDERAL RESERVE DISTRICTS, 1965 AND 1966 come frequent or extensive. Whatever form of communication is used, the Reserve banker’s pur­ 1965 1966 Item pose is the same: to solicit from the borrowing Reserve Reserve member additional information about the circum­ city Country city | Country stances that are causing his bank to borrow heavily banks banks banks banks or frequently; and depending on the nature of Number of member banks. . . 67 2,145 67 2,101 these circumstances, to counsel with the member Borrowing at least once: bank about whether his bank’s continued use of Number...... 57 384 62 551 the discount window appears appropriate and con­ Percentage borrowing...... 85 18 93 26 sistent with principles established by the Board of Borrowers counseled: Number...... 16 32 17 129 Governors and set forth in its Regulation A. Percentage of total bor- 28 8 27 23 If the “inappropriate” presumption is main­ tained while borrowing continues, “coun­ seling” is “escalated” by meetings between of the country bank borrowers were “coun­ Reserve Bank and borrowing bank officials seled,” but the figure rose to 23 per cent at successively higher levels to “explain” during the period of increased monetary re­ the standards established by Regulation A, straint in 1966. For 13 of the 48 reported to request the presentation of a repayment banks “counseled” in 1965 (the only year program, and as a final measure to indicate for which data are available), the Reserve that the bank’s request for renewal of credit Banks decided conclusively that continued will not be honored. This procedure for re­ borrowing would be inappropriate, and they stricting the duration and amount of credit requested full or partial repayment. is consistent with the view that the objec­ The rise in the number of country banks tive is to reach, if possible, a mutual under­ counseled in 1966 is indicative of the in­ standing and agreement on the standards of creased burden imposed on discount ad­ Regulation A.27 ministration during periods of monetary re­ A reasonable idea of the extent and quali­ straint. In part, pressure may be attrib­ tative significance of nonprice rationing uted to restricting the growth of bank re­ serves to a rate below that at which loan x ibid. “ ib id . demand was growing. In part, it may be at­

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tributed to an increasing differential between to the borrowing bank the frequency or dur­ market rates and the discount rate, which ation over which borrowing will be consid­ made borrowing at the discount window a ered appropriate.30 Uncertainty surrounding relatively profitable source of reserves.28 In the terms and conditions on which credit is periods of restraint, the differential between available and, in addition, the subjective market rates and the discount rate generally aversion of banks to being “counseled” increases, and in 1966, of course, the dif­ would also influence the relative attractive­ ferential widened substantially. ness of discount-window accommodation In qualitative terms the effect on discount and of borrowing from other sources. administration was described as follows by The “costs” imposed on borrowing banks a Reserve Bank discount officer: by administrative contacts under current . . . there was some tendency for 1966 cases to be procedures are, in general, indeterminable. a little stickier than those in 1965. The borrowing They are difficult, if not impossible, to con­ periods involved were somewhat longer than aver­ trol—depending as they do on subjective as age; frequently more calls or letters were needed to accomplish the desired results; and bankers well as objective factors. They are, conse­ were generally slower in accepting suggestions in­ quently, susceptible to nonuniformities volving alternate ways of adjusting their positions. among member banks and over time. From the member bank’s point of view, 2. Administrative differences. In recent limitations on future borrowing capacity and years, questions have arisen about the uni­ inconvenience involved in negotiations with formity of discount-window administration Reserve Banks would tend to raise the ac­ among districts.31 Replies to the question­ tual “cost” of credit once a judgment were naire sent to each Reserve Bank in 1965 reached that the borrowing is inappropri­ provided substantial evidence that under­ ate.29 Moreover, a considerable degree of standing as to the significance of the re­ uncertainty must attach to the use of the strictive terms of the “General Principles” discount mechanism. There would be un­ m Ib id . certainty about (1) the duration over which 31 For example, the report of the Commission on an initial request for credit will be con­ Money and Credit stated: “Clearly the intent of the Federal Reserve Board is to have discount adminis­ sidered appropriate; (2) the rate at which tration relatively homogeneous among the twelve Federal Reserve banks, and the commission urges the real cost of credit will rise, in terms of the continued efforts to assure uniform standards of dis­ inconvenience of being “counseled” and counting practice. Uniform standards, of course, mean that like circumstances result in like treatment, at the the implicit reduction in future borrowing same time permitting differences in practice where capacity; and specifically (3) the effect of regional differences in economic conditions or needs require.” Money and Credit: The Report of the Com­ the past borrowing record on (1) and (2). mission on Money and Credit (Prentice-Hall, 1961), p. 66. When credit is initially extended, the Reserve More recently a study was undertaken by the American Bankers Association which has included a Bank is generally not in a position to indicate survey of commercial banks on questions relating to the use of the discount window. The survey question­ 28 See Donald R. Hodgman, “Member Bank Borrow­ naire has included a question asking the bank’s im­ ing: A Comment,” Journal of Finance, March 1961, pression as to whether administration of the discount pp. 90-93, for a discussion of both causes. Empirical function varies from one Federal Reserve district to findings on the responsiveness of the demand for credit another. About one-third of those responding felt that to market and discount rates are discussed below. there were differences. See The Discount Function, 29 Since the amount of a loan (relative to bank The American Bankers Association, New York, 1968, size) is taken as one indication of “purpose,” the cost p. 50. See also David T. Lapkin and Ralph W. Pfouts. of borrowing over any extended period of time would “The Administration of the Discount Function,” T h e be positively related to the amount, ceteris paribus. National Banking Review, December 1965, pp. 179— Shull, op . cit. 86.

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differs in important ways. In consequence, to the extension of credit; an upper group; the Regulation is or could be administered in and a broad middle range. While these dis­ substantially different ways among districts. tinctions are essentially qualitative in nature, Differences of importance among Reserve the standards and the interpretations expres­ Banks were identified with respect to bor­ sed appeared to be more homogeneous with­ rowing for seasonal purposes, borrowing “to in the groupings, particularly the upper and profit from interest rate differentials,” and lower, than between them.32 “continuous” borrowing. With respect to It is worth noting that there has been no “continuous” borrowing, differences report­ attempt to translate the “General Principles” ed involved the duration of “continuous” in into explicit operational standards and cri­ the administrative “rules of thumb” reported, teria. The individual “Principles” were not whether or not one or more groups of banks intended to be specified in this way. To de­ (for example, country banks, small rural fine them more precisely would change the banks) were excluded from the general Regulation from being principally an in­ “rules” and whether or not such “rules” were tended influence on demand to principally in terms of “days” as well as reserve periods a device for rationing supply; and the basis in debt. Information on discount-window ad­ for rationing would change from one where ministration in borrowing cases that involved borrowing, if done reluctantly, were appro­ conditions not specifically referred to in the priate to one as yet undefined.33 Foreword to Regulation A (such as borrow­ 3. Relations between Reserve Bank and mem­ ing while lending to correspondents) was ber bank. Responses to the 1965 question­ also obtained from the survey. This informa­ naire also produced evidence to suggest that tion also indicated considerable differences the borrower-lender relationship established among Reserve Banks and, for the most under Regulation A contains elements of part, was consistent with the differences in friction not normally found in commercial interpretation of the three major “Prin­ borrower-lender relationships. These ap­ ciples” indicated above. parently stem from both the highly restricted The nonuniformities reported in the re­ nature of the accommodation and the diffi­ sponses to the questionnaire should be clearly distinguished from differences in cir­ :J2The middle group included districts that were, in cumstances that are, in fact, sanctioned by fact, in the “middle range” in their administration and also districts about which there was insufficient infor­ the Regulation. The regulatory design leaves mation to make a judgment. The classification varia­ bles are used in a regression analysis focusing on the considerable discretion to the Reserve Banks influence of trend, the results of which are provided in in deciding, on the basis of all the infor­ Table 12. 33 In a study of the determinants of borrowing in six mation available, whether a particular bor­ districts for which weekly reporting data for individual banks were available, it was found that in districts rower is sufficiently reluctant in his borrow­ where relatively large amounts were borrowed from ing behavior. The differences reported, the Federal Reserve, relatively large amounts were also borrowed from other sources. (Leslie Alperstein, however, derive from differences in the def­ “A Reevaluation of the Determinants of Member Bank inition and interpretation of the “General Borrowing from the Federal Reserve,” unpublished doctoral dissertation, University of Pittsburgh, 1967.) Principles.” The six districts included five that, on the basis of the questionnaire responses, had been classified in the Reserve Bank responses to the question­ “middle range.” This finding, while suggesting the im­ portance of demand as a determinant of borrowing, naire tended to fall into three categories: a remains consistent with the existence of administrative lower, or below average, group with respect differences.

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culties in communicating the basis on which significant degree of misunderstanding and/ credit is extended and restricted. or dissatisfaction by member banks, they Most of the Reserve Banks expressed tend to confirm the other reports mentioned. varying degrees of concern about the ade­ Even during the period of severe monetary quacy of the discount mechanism in meeting restraint in 1966 many large banks chose the kinds of demands for credit arising at not to borrow at the discount window, but member banks. Several indicated that mem­ rather to pay considerably higher rates else­ ber banks were not obtaining sufficient funds where.30 This policy on the part of potential from the discount window to meet what were borrowers reaffirmed earlier choices that believed to be reasonable demands.34 had resulted in a rise in the Federal funds Some Reserve Banks also reported diffi­ rate above the discount rate after many culties in communicating in a satisfactory years in which the latter rate had represented way to member banks the basis of appropri­ an upper limit. The aversion of large banks ate borrowing at the discount window. These to borrowing at the discount window has also and others reported serious difficulties in de­ been reported by discount officers as an termining, in accordance with the “General indication of misunderstanding or dissatis­ Principles,” the purposes for which funds are faction with administration.37 borrowed.85 At least one Reserve Bank sug­ The effects of discount-window adminis­ gested that rationing under Regulation A tration on large banks is one aspect of cur­ generates resentment among borrowers. rent relationships that requires considera­ It was noted above that replies to the tion. Regardless of the friction, however, most questionnaire on borrowing cases in which reserve city banks do borrow from Reserve “counseling” was undertaken indicated that Banks at least occasionally during any year. in 1965 there were 13 such cases at five The proportion of country banks that nor­ Reserve Banks in which it was decided that mally do not borrow even once a year is, on borrowing was inappropriate. In four of the other hand, relatively large—running in these cases the borrowing bank indicated recent years around 75 to 80 per cent (Chart that it felt unfairly or inadequately treated. 2). Many nonborrowers in the country bank While it is difficult to know how representa­ classification never borrow from any source tive such a figure is, the direction of the bias and therefore may be presumed not to have seems clear. One discount officer noted: and/or not to recognize profitable opportu­ I think it is unrealistic to think that you are going nities for borrowing. However, the estimated to get any fair appraisal of attitude by asking proportion borrowing from all credit sources member banks whether they agree with Reserve Banks; I mean it’s like the traffic cop asking has been consistently larger than the propor­ whether you agree with him when you go through tion borrowing at the discount window a red light . . . I mean, four banks were honest (Chart 3). In 1966 about 25 per cent of enough to indicate some difference of opinion. country member banks borrowed from the To the extent that the responses suggest a :!6 See Dolores P. Lynn, “Reserve Adjustments of the M “Questionnaire, 1965.” Eight Major New York City Banks During 1966” 85 It also seems clear that a number of Reserve (Discount Study). Banks have adopted more or less arbitrary rules on *7 The attitude of some large banks was complicated amount and frequency of borrowing as proxies for in 1966 by the introduction of a special lending pro­ actual purpose. It is noteworthy that such rules are, gram at the discount window under the so-called in effect, proxies for a proxy since the purpose restric­ “September 1 letter.” An inquiry into the impact of tions were intended to throw light on “reluctance.” this program was also undertaken.

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Member Bank Borrowing at Federal Reserve dustrial countries abroad, it was found that Ratio of number of borrowers to all member banks “(o)nly a few of the central banks surveyed

PER CENT base the administration of the discount win­ dow on the assumption that commercial banks are reluctant to borrow (and to stay in debt) . ..” 58 In a number of the countries surveyed “discounting is considered a nor­ mal source of a considerable part of the banking system’s cash reserves rather than merely a safety valve, available normally only for a very short period, pending adjust­ ment of bank assets and liabilities.” 311 ’62 ’64 Since the conditions that make open mar­ ket operations the monetary instrument of choice in the United States do not exist in System, while 41 per cent were estimated to most other industrial countries, the discount have borrowed from all sources. Given the window has continued to be a principal relatively attractive rates on one-day or one- tool of monetary policy. “Against the background of foreign experience, our dis­ Country Bank Borrowing count mechanism, no less than our entire Proportion borrowing from Federal Reserve and others monetary and banking system, appears as a PER CENT unique case. ...”40 In recent years, many foreign central banks have been confronted with the prob­ lem of excess liquidity in the banking sys­ ;6o tem resulting from foreign exchange sur­ pluses and, to some degree, Government ALL SOURCES 40 deficits. In these countries, efforts have been made to restrict the growth of the reserve 120 base, in part by restricting the extension of FEDERAL RESERVE credit at the discount window and in part ______J__ ’60 ’62 ’64 by developing other means of control. Some techniques, long used in the United States, period money at the discount window, and have been introduced abroad—for example, the absence of any absolute restriction on open market operations, reserve require­ borrowing for short periods, it is reasonable ments, and the use of moral suasion. In addi­ to believe that many nonborrowers also mis­ tion, relatively unfamiliar devices have been understand and/or are dissatisfied with the used. These include (1) controls aimed at discount facility. limiting the expansion of bank credit direct­ :58 George Garvy, “The Discount Mechanism in D. Comparison with foreign experience Leading Industrial Countries Since World War II” (Discount Study), Part I [over-all review], Part II In comparing the Federal Reserve’s discount [country studies]. Parenthetical material added. 39 Ibid. mechanism with discount mechanisms in in­ 40 Ibid.

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ly, for example by means of limits on loans disruptive to financial markets. In countries or permissible rates of increase during speci­ where international capital flows are an im­ fied time periods; and (2) controls aimed portant source of bank reserves, there has at limiting the expansion of credit indirectly been concern about the offsetting effect of through quantitative restrictions on borrow­ rate increases that would induce inflows of ing at the discount window and through use funds from abroad.43 In countries where the of various types of penalty rates. use of rate means frequent variation in the Indirect controls have traditionally in­ “official” discount rate, there has been con­ cluded the use of the discount rate as a de­ cern about “announcement effects.” In Can­ vice to restrict the extension of credit. In ada the problem of announcing increases in some countries the discount rate has de­ the discount rate was met, between 1956 and veloped into a structure of rates related to 1962, by tying the discount rate to the Treas­ the size and duration of borrowing, borrow­ ury bill rate.44 ing within or above some specified quota, There appears to have been no effort in and/or borrowing in order to extend credit foreign countries to maintain nonrate ration­ for some preferred or nonpreferred purpose ing constant in changing economic circum­ or type of loan. stances, as is the case in the United States. All the countries surveyed have a multiple (This difference may perhaps be attributed rate structure. But most have not been able to the fact that the controls over credit exten­ to place exclusive reliance on rate.41 For ex­ sion elsewhere are aimed principally at serv­ ample, in recent years even the United King­ ing the objectives of monetary management dom, which has traditionally relied heavily and not, as in the United States, the purposes on rate, has also found it necessary to rely to of bank supervision as well. If there is no a significant degree on moral suasion.42 need to select a standard of “reluctance” Exclusive reliance on rate has not proved acceptable to the conditions of bank “sound­ practicable for a variety of reasons; but it ness,” which by its nature cannot be varied should be noted that not all of these reasons easily, there is no apparent reason to main­ are relevant in the economic and institu­ tain an inflexible degree of nonprice ration­ tional environment of the United States. ing.) In addition, it was found that foreign Attempts to ration credit by rate in coun­ central banks do not uniformly frown upon, tries where there are automatic linkages or penalize relending at a profit.4!i between the discount rate and bank lending or deposit rates, and in countries where “ Ib id ., Part I. 44 Ib id ., Part II, “Canada.” discount credit accounts for a substantial Ib id ., Part I. In contrast to the discount mecha­ nisms of foreign central banks, which are principally proportion of bank reserves, will quickly if not exclusively tools of monetary policy, the ad­ result in relatively large interest rate move­ vance mechanism of the Federal Home Loan Bank System in the United States is principally if not exclu­ ments throughout credit markets. There has sively a tool for facilitating the adjustment and growth of locally oriented savings and loan associations. The been considerable concern in the countries availability of credit in all maturity ranges, on a large surveyed that such rate fluctuations would be scale, to relatively small institutions has been accom­ panied, in recent years, by restrictions of a supervisory nature. The Federal Home Loan Bank Board has im­ 41 Among other controls should be noted the use of posed restrictions aimed at curtailing credit to associa­ mandatory liquidity ratios to immobilize assets that tions engaged in “unsound” practices as evidenced by could otherwise be used to borrow at the central bank. the growth of “slow assets” (Staff review of Home Loan Ib id ., Part II, “France.” Bank System by Lynn Styles, Federal Reserve Bank of 12 Ib id ., Part I and Part II, “United Kingdom.” Chicago, and Robert King, Board of Governors.)

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IV. RELEVANT CHARACTERISTICS OF THE FINANCIAL ENVIRONMENT The discount mechanism as it was formally borrow out of “need” or for “profit” appear designed in 1955 is built on a number of largely resolvable.1 “Need” may be identified hypotheses about the economic environment with a reluctance to borrow, which may be in which it was intended to operate. There interpreted as meaning that bankers attach was a perceived ecology on whose approxi­ a negative utility to incurring debt. There is mate existence the usefulness of the mecha­ no theoretical difficulty in incorporating a nism was considered to be dependent. The disutility attributable to debt into a function, hypothesized “outside” conditions may be including profit from borrowing, which contrasted with the “inside” workings of the bankers are assumed to maximize.2 As a re­ mechanism itself discussed above. sult of doing so, however, empirical issues are Some important issues that arise in evalu­ raised. In general these relate to the respon­ ating the discount mechanism relate to the siveness of borrowing to interest rates, that current validity of the environment hypothe­ is, in the interest elasticity of demand for bor­ sized in 1955. The hypotheses themselves rowing;8 and to the effect of past borrowing range from views about bank motivation and behavior (that is, outstanding debt) on cur­ behavior to the functioning of financial mar­ rent borrowing. kets. In this section these hypotheses will be 2. The “tradition against borrowing” in System elaborated and also evaluated in the contem­ thought. The “tradition against borrowing” porary environment. and related concepts, that is, “reluctance to borrow” and “reluctance to borrow con­ A. Bank motivation tinuously,” have, as indicated, dominated The relative importance of the several values System thinking about the discount mecha­ motivating bankers in their borrowing deci­ nism since the mid-1920’s. They have, by sions has been and is a critical issue in and large, dictated the role ascribed to the evaluating the current discount mechanism. discount rate and the strategy of the System As discussed above, if banks are “reluctant” toward member bank asset and liability to borrow and/or remain in debt to an im­ management. It is worth noting, however, portant degree, then debt can be viewed as that the issue was never simply whether having a uniquely restrictive impact on bank banks were, at a given time, reluctant to behavior. Presumably banks would not be borrow, but also whether the “reluctance particularly sensitive to differentials between

market rates and the discount rate. If, on the 1 Anderson, op . c it.; David M. Jones, “A Review of other hand, banks are not particularly re­ Recent Academic Literature on the Discount Mech­ anism” (Discount Study). luctant to borrow, then the restraint im­ 2 See Murray E. Polakoff, “Reluctance Elastictity, posed by an increase in the aggregate debt Least Cost, and Member Bank Borrowing: A Sug­ gested Integration,” Journal of Finance, March 1960, of the banking system is not automatic, and pp. 1-18; Polakoff, “Federal Reserve Discount Policy and Its Critics,” Banking and M onetary Studies, edited emphasis must shift to the restriction im­ by Dean Carson (Richard D. Irwin, Homewood, Illi­ posed by nonprice rationing at the several nois, 1963), pp. 190-212; Donald R. Hodgman, lo c. cit.; Stephen M. Goldfeld and Edward J. Kane, “The discount windows. Determinants of Member Bank Borrowing; An Eco­ l. Need versus profit. The theoretical issues nometric Study,” Journal of Finance, September 1966, pp. 499-514. involved in the debate over whether banks 3 Goldfeld and Kane, o p . c it., pp. 502-03.

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convention,” as supported by System policy, would vary from bank to bank, as preference was viable over the long run.4 systems would vary. However, the belief It is reasonable to believe that the current implicit in the 1955 revision was that, for reconciliation of “need” versus “profit,” the banking system as a whole, demand is described above, is not alien to the theoreti­ not very high or elastic,7 and/or could be so cal views underlying the current discount influenced. mechanism. Reluctance has generally been Finally, it appears to have been well un­ presumed to influence the demand for credit derstood that the preference systems of by reducing bank responsiveness to differen­ banks could, and in fact do, change radically tials between market rates and the discount from time to time. The large amounts of rate. Reluctance to borrow may then be in­ borrowing during the expansion of 1920-21, terpreted as an attitude possessing some and the surveys of continuous borrowing in value in a system of values that includes 1925 and thereafter, clearly indicated that profit; '■ the position and slope of the demand an acceptable degree of reluctance was schedule can theoretically be obtained from neither an automatic nor inevitable condi­ the relevant costs and returns on borrowed tion. funds and the preferences of bankers. In the early 1950’s, many in the Sys­ The so-called “reluctance to borrow con­ tem no doubt believed that the experience tinuously” suggests that banks will aim at of the 1930’s had supported the attitude of zero amounts of long-term borrowing in reluctance in a substantial way. But, at the managing their assets. Such reluctance would same time, the concern that led to a revision also tend to reduce the amount borrowed. of Regulation A reflected a belief that re­ Borrowing would be negatively related to luctance was waning. In consequence, it may existing debt or, perhaps more generally, be inferred that the relationships among associated with the pattern of borrowing in borrowing, interest rates, and bankers’ pref­ the recent past. It has been argued that, erences were viewed as changing with the during periods of restraint, reluctance takes business climate. hold when banks begin to be continuous In this context, terms such as “tradition borrowers, as indicated by the fact that against borrowing” and “borrowing out of aggregate borrowing at the discount window need” may be taken as oversimplifications. had reached a relatively high level.® Reluctance to borrow has been viewed as It was clearly recognized, in at least some “traditional” principally in the sense that System documents, that the slope and posi­ economic circumstances encouraging re­ tion of demand schedules for borrowing luctance are viewed as traditionally recur­ ring phenomena. The expectations, and 4 The revision of the discount mechanism in 1955 on therefore the attitudes, of bankers toward the basis of “reluctance” was not, however, accepted uncritically throughout the System; this is indicated in borrowing have been seen as both deter­ papers and memoranda prepared during the 1953-54 mining and being determined by the current study. See in particular, Karl R. Bopp, “Role of the Discount Rate,” in Statements of Associate Econo­ and past states of the economy. Finally, mists of the Federal Open Market Committee before “borrowing out of need,” with its real-biUs the Conference of Presidents, June 21, 1954, and, in reply, Winfield Riefler, “Volume of Borrowing vs. overtones, is a misleading term in that it Profitability of Borrowing,” Memorandum to Dis­ count Rate Committee, Aug. 19, 1954. 5 Jones, o p . cit. 7 See Riefler, “Volume of Borrowing vs. Profitabil­ 6 Bopp, o p . cit. ity of Borrowing,” o p . cit.

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suggests a bank motivation that is not, in borrowing from the Federal Reserve is reality, independent of borrowing aimed at a responsive to relationships between market better earnings position. rates and the discount rate, and also to in­ 3. Interest elasticity of demand for borrowed ternal portfolio considerations. The fuller funds. Empirical studies testing the relation­ explanation of borrowing from non-Federal ship between market rates and borrowing Reserve sources is consistent with the exist­ have for the most part had available only ence of a more complicated and restrictive highly aggregated data. On the basis of such constraint on the supply of funds at the data, there have been findings that borrow­ Federal Reserve; this constraint was not ing is positively related to profitability (for specified in the model." both reserve city and country banks) and Because it has not been possible to specify that elasticities are sufficiently large to reject precisely the supply function for borrowing the hypothesis that banks are insensitive to from the Reserve Banks, studies up to now rate spreads.8 have not been able to distinguish effectively One study of borrowing by weekly re­ between the reluctance of banks to borrow porting member banks in six Federal and what might be thought of as the willing­ Reserve districts, mentioned above, found ness, in different circumstances, of Reserve that borrowing activity at the discount win­ Banks to lend. A failure of banks to respond dow was related to a number of factors, in­ to rate differentials might be due to either. cluding a measure of bank liquidity, bank To the extent it is due to the latter, no light size, the difference between the bill rate and is thrown on the issue of bank reluctance, the discount rate, and the district in which though it is evident that borrowing can be member banks are located. The measures controlled by the Reserve Banks. of borrowing activity included the propor­ Beyond this conceptual issue, it should be tion of banks borrowing in each district, the noted that there is relatively little empirical frequency with which the banks borrowed, evidence on the relationship between the and the proportion of deposits borrowed. previous pattern of borrowing and current A variety of tests were made which tended borrowing.10 Nevertheless, among the large to support the findings that holdings of liquid assets are negatively related to borrow­ * Alperstein, op c it See also Stephen Goldfeld. Commercial Bank Behavior and Economic Activity: A ing, that bank size is positively related to Structural Study of Monetary Policy in the Postwar borrowing, and that the difference between United States (Amsterdam: North Holland Publish­ ing Co., 1966), pp. 43-50; Goldfeld and Kane, op. cit., the bill rate and discount rate is positively pp. 503-06; Murray E. Polakoff and William L. Silber, “Reluctance and Member Bank Borrowing: Additional related to borrowing. In addition, it was Evidence," The Journal of Finance, March 1967. pp. found that borrowing activity varied signifi­ 88-92. cantly among districts. Finally, it appeared 10 However, see Frank de Leeuw, “A Model of Financial Behavior,” in The Brookings Quarterly Eco­ that the same determinants explained bor­ nometric M odel of the United States , edited by James S. Duesenberry (Rand McNally & Co., 1965), p. 513. rowing from other sources more fully than According to de Leeuw, “the negative influence of they did borrowing from the Federal Re­ lagged borrowing—banks’ ‘reluctance to borrow’— is greater when funds are flowing in than when banks serve. are short of funds.” Also see Goldfeld and Kane, o p . cit., pp. 505, 506, 511, 512. Goldfeld and Kane These findings are generally in accord state: “current borrowings will vary positively with with expectations. They tend to confirm that the level of borrowing in previous weeks, with the influence of past borrowings falling off (and perhaps, because of surveillance costs, even becoming negative) * Jones, o p . c i t as they recede into the more and more distant past”

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money market banks at least, there is sub­ cern of most depositors with matters such as stantial evidence from their asset and lia­ the collateral hypothecated by the manage­ bility management that reluctance to borrow ment of their banks, which apparently ex­ is not an important attitude in restraining isted prior to the introduction of Federal policies. The large New York banks, for ex­ deposit insurance and modem monetary and ample, show continuous basic reserve de­ fiscal policies; and (3) high rates of bank ficiencies of substantial amounts, even failure (in the 1920’s and early 1930’s) as­ though relatively little borrowing is done at sociated with different economic circum­ the discount window.11 As to smaller banks, stances and earlier views of economic policy. it would be difficult to generalize about their Little can be said with certainty about attitudes toward borrowing. But there seems the Federal Reserve’s current influence on to have been, in recent years, a growing bank attitudes toward borrowing. The most acceptance of participation in credit markets direct influence would likely be on attitudes such as the Federal funds market.12 toward borrowing at the discount window. 4. Federal Reserve influence on bank atti­ However, to the extent the discount window tudes. As indicated above, System views on represents a little used source of funds by bank borrowing imply a belief that there is relatively few banks, it seems doubtful that an element of reluctance in bank attitudes the window can be used effectively to in­ toward debt that can be emphasized and fluence attitudes that are continually being supported by System efforts. The issue shaped in a growing variety of credit mar­ raised by this view cannot be completely kets. Particularly in view of the existence of resolved by economic analysis. other sources of credit and the interbank It should be noted that the financial condi­ markets for excess funds, the attempt to in­ tions that have historically tended strongly to fluence attitudes is more likely to affect the support a reluctance of banks to borrow real cost of credit at the discount window have now largely disappeared. These in­ than the preference systems of banks with clude: (1) the close financial interdepend­ respect to borrowing in general. ency among banks that existed before the de­ velopment of modem monetary policies and B. The bank adjustment problem that tended to make banks cautious about interbank borrowing; (2) the intimate con- The discount mechanism provides a method by which banks can meet reserve re­ (p. 506). However, the existence of multicollinearity quirements when, for one reason or another, in the borrowing variables for previous periods made it difficult to distinguish the effects of successively reserve deficiencies develop toward the end earlier debt positions (p. 512). In addition, it has been argued that as the rate spread widens the rate- of reserve periods, and also when large and effect on borrowing will, after some point, become more sustained outflows of funds develop negative. Polakoff, “Reluctance Elasticity, Least Cost and Methber Bank Borrowing—A Suggested Inte­ during particular seasons of the year or in gration,” op . cit. In such an event, the rate spread, periods of financial emergency. It has been which appears to be reflection of an accumulated indebtedness, would operate in the restrictive manner observed that small, unit banks are generally envisioned by current monetary policy. However, this point is still moot and a subject of current contro­ less well equipped to handle seasonal and versy in the literature. Goldfeld and Kane, o p . cit., other adjustment problems through financial pp. 512-14; Polakoff and Silber, o p . cit. 11 Lynn, o p . cit. markets than are large branch banks.13 It “ See Parker Willis, “A Study of the Market for Federal Funds” (Discount Study). 13 This note appears on opposite page.

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should also be noted that adjustments by sub-issues that bear on the general question large banks through financial markets can­ raised; and a number of research papers not always be managed without substantial have developed information on these. impacts on financial conditions generally, and without raising serious problems for the 1. The nature of structural disadvantage. banking system and for monetary policy.14 Relatively large fluctuations in deposits and/­ In periods of financial difficulties, open or loans experienced by small, rural, unit market operations constitute an effective banks apparently derive from their lack of technique for relieving market pressures. But diversification. It is a well-known proposi­ since reserve drains fall on individual banks, tion that variability of a bank’s deposits de­ and because smaller and more remote banks pends, among other things, upon the extent are not the immediate or certain recipients of geographic and functional diversification of funds provided, the discount facility con­ of depositors. Variability, then, would be stitutes a more selective device. related to bank size and also to the geo­ graphic extent of branching organization.15 The 1955 revision of Regulation A in­ Unusually large seasonal variations may dicated that Reserve Bank credit would be also exist because of an inverse relationship available to facilitate bank adjustment. But between loan and deposit changes traceable it also indicated that only minimal amounts to bank borrowers and depositors who are would be available in the absence of exigent influenced by common or related factors.16 circumstances. This orientation was based It can be shown that changes in locally on the belief that the nonemergency adjust­ generated demands for bank loans and ment problems could be substantially ameli­ deposits will be in opposite directions to the orated in the then-existing financial environ­ extent that both changes derive from fluctua­ ment, through timely open market purchases tions in the expected yield on nonfinancial and the market-determined distribution of investment.17 Since the expected yields on reserves thus supplied. A principal issue raised in the course of 16 For evidence on the relationship between size and variability see for example, Lyle E. Gramley, “Deposit the discount study has been whether this Instability at Individual Banks,” Essays on Commer­ orientation is reasonable and equitable, par­ cial Banking , Federal Reserve Bank of Kansas City, 1962, pp. 43-53; and C. Rangarajan, “Deposit Varia­ ticularly with respect to small unit banks. bility in Individual Banks,” The National Banking Re­ v ie w , September 1966, pp. 61-71. (Beyond this, of course, is the question of Data on intrayear fluctuations in loans and deposits whether it is practicable to do anything other for all insured banks are presented below. Further study of seasonal fund flows, using daily deposit and than what was done in 1955.) semimonthly loan data for a selected group of mem­ ber banks, has more recently been undertaken. It is possible to break out some economic “ Robert J. Lawrence, “The Regional Distribution of Bank Loans” (Discount Study). 17 Lawrence postulates that D — D (rSi r 0, Y ) and 33 See Robert V. Roosa, “Credit Policy at the Dis­ L = L ( n , E , F), where D is the demand for bank de­ count Window: Comment,” Quarterly Journal of Eco­ posits in real terms, r s is the interest rate on Government n o m ics, May 1959, p. 335; Edward C. Simmons, o p . securities, r Q is the expected yield on real property, Y is cit., p. 416; Simmons, “Federal Reserve Discount-Rate real income, L is the demand for bank loans in real terms, Policy and Member-Bank Borrowing, 1944-50,” T h e n is the interest rate on loans, and E is the set of expected Journal of Business, January 1952, pp. 20 and 21. returns from the use of loan proceeds. The interest rate 14 The use of the discount mechanism as a “safety on deposits may be assumed to be zero or constant valve” during periods of monetary restraint is dis­ throughout. The demand for both loans and deposits is cussed in Section VI. For a description of the way in directly related to income. The demand for loans is which large New York City banks adjusted during inversely related to r t and directly related to E; the the period of financial restraint in 1966, see Lynn, demand for deposits is inversely related to r s and r g. op. cit. The expected yield on real property and the expected

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nonfinancial investment will vary seasonally In borrowing, on the other hand, the dis­ in many agricultural areas (as well as advantages of a unit banking structure secularly among regions experiencing differ­ could become more readily apparent. ential economic change), the regional dis­ Smaller banks generally appear to have fewer tributions of loan demand and bank de­ alternative creditors and also to suffer from posits, at any point in time, may be quite the high cost of reliable information about different.13 So, for example, a bank located them. The small size of these banks may in an area with a highly seasonal economy preclude systematic participation in some that is growing very rapidly may well find markets (for example, Federal funds). Ties a dearth of locally generated deposits, par­ to specific correspondents for a variety of ticularly at its seasonal peak in loan demand. services may discourage, if not preclude, Banks requiring additional reserves may effective searching for and use of alternative obtain them by selling assets or by borrow­ sources of credit. Lack of information or ing. If all banks have liquid assets such as lack of ability on the part of managers of Government securities to sell, then each can these banks would tend to reduce the number obtain additional reserves at approximately of alternative credit sources also. Finally, sys­ the same market cost, that is, the yield tematic reliance on time deposits may prove foregone on the securities.19 If banks do not impossible due to maximum rates permitted have Governments to sell, however, they under Regulation Q. (If large, well-known must sell other assets or borrow. In selling banks are paying the maximum, smaller other assets, such as municipals, mortgages, and lesser-known banks cannot hope to rely farm loans, etc., secondary market struc­ on the time deposit market.) In addition, tures assume particular importance. These lack of readily available information about markets range in quality from excellent to smaller banks would, in general, tend to primitive.20 It would appear, however, that make them higher-risk investments to poten­ differences in the quality of such markets do tial lenders. In particular, their lack of di­ not necessarily constitute a unique problem versification would increase the likelihood of for small, unit, rural banks.21 problems as seen by lenders, without any off­ set that might be warranted by more detailed returns on loan proceeds vary directly; however, the but costly investigation. Both a lesser num­ demand for loans is directly related to the expected return on loan proceeds, whereas the demand for de­ ber of alternative credit sources and the posits is inversely related to the expected yield on property. higher risks involved in lending would, in 18 Lawrence, o p . cit. themselves, tend to result in a relatively high " I b id . 20 Staff study of secondary markets in municipals, cost and lower volume of borrowed re­ mortgages, and farm loans was undertaken, respec­ serves.22 tively, by William Staats, Federal Reserve Bank of Philadelphia, and J. A. Cacy and Raymond Doll, Fed­ The structural disadvantage of smaller eral Reserve Bank of Kansas City. See Raymond J. Doll, “An Investigation of the Credit Requirements banks was not disregarded by the System and Availability of Credit in Agricultural Areas” (Dis­ Committee in 1955, but no special provi- count Study), and William F. Staats, “The Secondary Market for State and Local Government Bonds” (Dis­ count Study). kets adjust to monetary restraint. See Hyman Minsky, 21 Improvements in secondary markets for assets “Financial Instability Revisited: The Economics of held by large numbers of commercial banks could im­ Disaster” (Discount Study). prove the availability and reduce the cost of obtaining 28 In effect, the demand for funds confronting a po­ reserves in the absence of Government security hold­ tential lender would appear less elastic, and the ings. Better secondary markets might have desirable volume of funds such a lender would make available effects, as well, on the ease with which financial mar- at various rates would be lower.

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sions at the discount window were believed ondly, while some customers would benefit to be necessary because the vast majority of from such competition, others—particularly banks held large amounts of Government small and locally limited customers—would securities.23 The implicit assumption was that probably not and could suffer as a result. reserves, whether newly injected or already Whether or not extra-local competition de­ existing, would be available, and at a reason­ velops, the problems associated with small able cost, to banks for any short-run pur­ size would tend to result in an undesirable pose.24 In effect, it was argued that “sound” allocation of bank credit. banking requires the holding of Government Finally, the responsibility assumed by the securities, and that the holdings of Govern­ System in providing reserves through open ment securities give all banks access to re­ market operations in response to seasonal serves, whenever the banks demand them, at and other fluctuations to facilitate bank ad­ a market price more or less determined by justment is made more difficult in a bank­ the Federal Reserve. ing system that relies on credit markets. The Regardless of the volume of Governments difficulties faced by small banks, among held by commercial banks, the disadvantage other things, create conditions such that the of structure to the customers of small, unit, reserves provided through open market pur­ rural banks would exist. There are costs as­ chases will not necessarily be distributed sociated with operating under these con­ among banks in proportion to losses in re­ ditions, and these costs presumably are serves they are intended to replace.25 passed on to local customers. To the extent 2. Magnitude of the problem. An evaluation of that disadvantaged banks compete directly current discount policy with respect to the with more favored banks, the latter would provison of credit for bank adjustment pur­ tend to grow larger and the former smaller. poses was approached by considering the However, if local customers of smaller banks magnitudes of intrayear fluctuations faced can only obtain credit elsewhere from higher by banks in different size groups and eco­ rate financial institutions or at higher rates nomic situations, and by examining the ways that include a risk premium associated with in which adjustments currently may be their distance and the high cost of infor­ handled. In considering alternative methods mation about them, they too would incur the of adjustment, recent developments in bank disadvantage. holdings of Government securities were re­ There are, consequently, several general viewed, as was evidence on credit flows implications that also warrant consideration. through the correspondent system and the First, geographic extension of competition markets for Federal funds and certificates of for bank customers will tend to injure deposit. smaller and more specialized banks. Sec- a. Intrayear Fluctuations. As noted above, deposit variability at the individual bank “ It should be added that unit banks in rural areas level is related to the economic diversifica­ have also had an advantage in obtaining funds in their local areas. Limited numbers of competitors and high tion of bank customers. Loan demand varia­ regulatory barriers to entry have permitted these bility would seem to be directly related to banks, at least until very recently, to obtain deposits at rates well below those paid in major metropolitan the economic diversification of borrowers. areas. “ The emphasis on short- or possibly intermediate- term adjustment stems from the restriction on con­ 25 On the reserve distribution problem, see Gold­ tinuous borrowing reviewed above. feld, o p . c it., p. 153.

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Such variability in deposits and loan demand in which pressure on reserves is met by sales may tend to be reinforcing rather than off­ of liquid assets. setting in producing variability in the de­ Results of the analysis based on these mand for reserves, at least over some periods data are generally consistent, however, with of time. expectations and may be viewed as provid­ A rough attempt was made to determine ing some notion of the quantitative signifi­ the magnitudes of intrayear fluctuations at cance of the fluctuations experienced. Data individual banks by looking at their quar­ for all member and all insured banks sug­ terly and semiannual outflows (or inflows) gest that the likelihood of a bank experi­ defined as the change in the deposits of encing a “large” intrayear outflow (defined individuals, partnerships, and corporations as 10 per cent or more of deposits) is in­ (IPC) minus the change in nonfinancial versely related to size (Table 4). Thus, in loans, after both were “adjusted for trend.”26 the first half of 1966, for example, 27 per The only comprehensive data available for cent of member banks with deposits of under banks of all sizes were from condition re­ $2.5 million had “large” fund outflows, com­ ports. Semiannual and quarterly changes pared with 6 per cent of banks with deposits were computed for the period July 1962- of $25 million to $100 million. Substantially June 1963, and semiannual changes for the identical results were obtained for the first period July 1965-June 1966, these being half of 1963. Quarterly data for 1962-63 the only periods for which data were avail­ and data for all insured banks also are con­ able. The analysis was based on data for all sistent with the conclusion.27 insured commercial banks. For a number of banks, fund outflows re­ The inflows and outflows of funds, as cal­ sulted from a combination of deposit de­ culated, include both random and seasonal clines and loan increases during the same movements. In addition, there is little like­ period. For example, during the second lihood that the maximum variation in either quarter of 1963, 42 per cent of member type of movement (or the net of the two) banks had simultaneous increases in loans has been accurately calculated, since the and declines in deposits. These combined dates upon which the calculations are based to cause an outflow of $2.75 billion at these are not necessarily analytically meaningful. banks.28 During the first half of 1966, 46 (However, the half-year periods July-De- per cent had increases in loans and declines cember may approximate the period of max­ in deposits, with a resulting outflow of $5.5 imum fund outflow in many agricultural billion (Table 5). areas.) It should also be noted that the cal­ The dollar amounts involved in intrayear culation makes no distinction between loans fund outflows of banks with “large” outflows and deposits as claims on bank resources. were, as might be expected, a relatively small Thus in the case of pressure on a bank’s re­ portion of total outflows. For example, in serve position, where loans are liquidated to the first quarter of 1963, the aggregate out­ meet deposit losses, the calculated outflow of flow for all member banks experiencing out­ funds would be reduced; and the outflow fig­ flows was $5.7 billion. Of this amount, the ure would not be comparable with the case aggregate outflow for banks with an outflow 26 An exact definition of the fund flow calculated may be found in Emanuel Melichar, “Intra-year Fund 27 Ibid. Flows at Commercial Banks” (Discount Study). 23 Ibid.

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TABLE 4 FREQUENCY OF LARGE RELATIVE OUTFLOWS Percentage of Banks with Fund Outflows of 10 Per Cent or More of Net Deposits, by Size of Bank

Net deposits (millions of dollars) Net deposits (millions of dollars)

Period Total 2.5 5.0 10.0 15.0 25.0 100.0 Total 2.5 5.0 10.0 15.0 25.0 100.0 Under to to to to to and Under to to to to to and 2.5 4.9 9.9 14.9 24.9 99.9 over 2.5 4.9 9.9 14.9 24.9 99.9 over

Member banks Member and insured nonmember banks

July-Dee. 1965. 1 1 3 2 2 2 July-Dee. 1962. 1 0) 2 3 2 2 Jan.-June 1966. 14 27 18 15 9 7 18 31 19 16 10 Jan.-June 1963. 16 27 20 15 9 8 20 30 21 14 9 July-Sept. 1962. 2 1 2 2 1 2 Oct.-Dec. 1962. 10 1 5 10 5 3 Jan.-Mar. 1963. 14 10 3 4 3 10 16 10 6 3 Apr.-June 1963. 15 8 3 2 (0 9 15 10 6 0)

1 Less than one-half of 1 per cent. S ource.—Emanuel Melichar, “Intra-Year Flows of Funds” (Dis­ count Study).

TABLE 5 ORIGIN OF FUND FLOWS Distribution of Member Banks and Their Net Fund Flows, by Change in IPC Deposits and in Loans 1

Deposits down Deposits up Deposits down Deposits up Period Total Total Loans Loans Loans Loans Loans Loans Loans Loans down up down up down up down up

Percentage distribution of banks Net fund outflow, (—); 1or inflow, (+ ) (in millions of dollars)

July-Dee. 1965...... 100 11 8 46 35 +8,237 -143 -324 +5,525 +3,180 July-Dee. 1962...... 100 13 8 50 29 +7,108 -38 -285 +4,844 +2,583 Jan.-June 1966...... 100 35 46 8 11 -8,237 -3,180 -5,525 +324 +143 Jan.-June 1963...... 100 29 50 8 13 -7,108 -2,583 -4,844 +285 +38 July-Sept. 1962...... 100 23 13 42 22 +520 -488 -1,293 +1,811 +490 Oct.-Dec. 1962...... 100 15 16 35 35 +6,588 -106 -444 +4,370 +2,769 Jan.-Mar. 1963...... 100 47 27 15 10 -4,648 -3,295 -2,100 +690 +58 Apr.-June 1963...... 100 18 42 9 31 -2,461 -561 -2,747 +742 +103

1 IPC deposits are those of individuals, partnerships, and corpora­ S ource.—Emanuel Melichar, “Intra-Year Flows of Funds.” (Dis­ tions. Loans exclude those to financial institutions and those for count Study). purchasing or carrying securities. of over 5 per cent of deposits was $2.9 bil­ peared to be related to the magnitude of the lion; for banks with an outflow of over 10 outflow. And as also expected, the adjust­ per cent, it was only $700 million. Similar ment in these assets made by nonmember results were obtained for the 1965-66 pe­ banks in response to a given magnitude of riod29 (Table 6). outflow was larger than for member banks.30 Finally, as expected, changes in holdings b. Bank Adjustment in Agricultural Areas. of U.S. Government securities and in bal­ Because of State branching laws and re­ ances held with other domestic banks ap- gional economic conditions, small, unit,

29 Ib id .

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TABLE 6 TOTAL GROSS FUND OUTFLOW, BY RELATIVE OUTFLOW AT BANK (In billions of dollars)

Fund outflow as percentage of net deposits Fund outflow as percentage of net deposits

Period Total Total Under 5.0 10.0 15.0 I 20.0 25.0 j Under | 5.0 10.0 15.0 ! 20.0 25.0 to to to ' to and 5.0 to to to J to and 5.0 9.9 14.9 19.9 24.9 over 9.9 14.9 19.9 24.9 over

Member banks Member and insured nonmember banks

July-Dee. 1965. .9 .6 .2 .1 0) 0) 0) 1.3 .7 .3 .1 0) .1 July-Dee. 1962. .6 .4 .1 0) 0) 0) 0) .9 .5 .2 . ! .1 (l) Jan.-June 1966. 9.1 3.8 3.9 .9 .2 .1 .2 11.6 4.4 4.8 1.4 .5 .2 .3 Jan.-June 1963. 7.7 2.6 3.6 1.1 .2 .2 .1 9.7 3.0 4.2 1.4 .4 .3 .3 July-Sept. 1962...... 2.1 1.5 .5 .1 0) 0) 2.5 1.7 .6 .1 0) O) 0) Oct.-Dec. 1962...... 9 .5 .2 .1 C1) 0) 0) 1.4 .6 .4 .2 .1 0) 0) Jan.-Mar. 1963...... 5.7 2.8 2.2 .6 .1 0) 0) 7.0 3.2 2.7 .7 .2 .1 .1 Apr.-June 1963...... 4.1 2.4 1.3 .3 .1 O) C1) 5.3 1.8 .4 .2 O) C1)

i Less than $50 million. So u r c e .—Emanuel Melichar, “Intra-Year Flows of Funds.” (Dis- count Study).

rural banks tend to be concentrated in the serve district (Kansas City), for example, southern and middle western portions of the total loans at rural banks increased about United States, that is, in the sixth, seventh, 180 per cent between 1950 and 1965. eighth, ninth, tenth, and eleventh Federal Income and deposits in rural areas have Reserve districts. Close to 4,000 member increased much more slowly. Deposits at banks, about 65 per cent of all members, are country banks in 20 farm States increased located in these six districts. About 6,000 about 29 per cent in the 1946-56 period of the 7,300 nonmember banks are also in and 66 per cent in the 1956-66 period.33 these districts. The secular growth of credit demands Over the last 15-20 years there have been and the slower growth of income and depos­ persistent increases in demands for credit its in rural areas would presumably tend to in many such areas derived from an expan­ aggravate the traditional short-term adjust­ sion of the optimum-size farm and a sub­ ment problems for rural banks. Other things stitution of capital for labor in farming.31 being equal, intrayear outflows of funds Total farm debt to banks and other credit would become larger in both dollar and rela­ institutions has increased substantially. The tive terms. Historical data, however, are not increase at banks was 213 per cent in the available to investigate this hypothesis, and 1946-56 period and 126 per cent in the it should be noted that this tendency might 1956-66 period.32 In the tenth Federal Re­ well be offset by diversification among cus­ tomers of rural banks. To the extent that 81 Staff study of credit demands in agricultural areas was undertaken by a task force headed by farmers diversify and reduce their own sea­ Raymond J. Doll, Federal Reserve Bank of Kansas City. See Doll, op. cit. sonal movements in income and credit de­ ^Emanuel Melichar, “Bank Financing of Agri­ mands, rural banks would similarly obtain culture/’ Federal Reserve Bulletin, June 1967, p. 928. Farm credit provided by other institutions, such as the benefits of diversification. Farmers Home Administration, Federal intermediate credit banks, production credit associations, and Fed­ eral land banks, has also increased substantially. 38 Ibid.

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TABLE 7 RATIO OF BANK HOLDINGS OF U. S. GOVERNMENT SECURITIES TO NET DEPOSITS Percentage Change, June 1961-June 1965

Qass of bank, San and deposit size Boston New Phila­ Cleve­ Rich­ Atlanta Chicago St. Minne­ Kansas Dallas Fran­ (millions of dollars) York delphia land mond Louis apolis City cisco

Member: Reserve city: 25 and under...... -21.0 -43.4 -60.2 -12.2 -52.1 25-100...... -29.6 -21.1 -41.5 -62.0 -31.3 -3 8 .9 -6 3 .2 -1 8 .3 Over 100...... -52.5 -54.7 -35.3 -49.0 -3 2 .0 -3 3 .9 -3 8 .4 -4 7 .2 -2 8 .8 -3 5 .3 -3 4 .4 -4 4 .9 Country: 25 and under.. -27.0 -17.3 -17.7 -16.1 -20.1 -21.0 -16.1 -17.8 -16.1 -18.5 -25.7 -1 8 .5 25-100...... -36.0 -31.6 -2 7 .5 -2 9 .0 -2 7 .5 -31.1 -2 2 .5 -3 5 .2 -2 7 .6 -3 5 .2 Over 100...... -47.7 -38.7 -26.7 -25.2 -4 2 .7 -21.7 -30.8 -33.5 -3 1 .5 -3 6 .9 Nonmember insured: 25 and under... . -21.5 -21.1 -14.7 -11.9 -16.1 -1 5 .6 -7.4 -14.7 -8.7 -13.1 -2 3 .8 -2 3 .3 25-100...... -31.7 -22.3 -23.5 -32.3 -2 9 .0 -1 0 .3 -2 4 .7 -3 1 .8 -1 4 .0 -30.1 Over 100...... -43.0 -17.3 -48.4 -31.7 —31.0 +11.0 -3 8 .3

So u rc e.—Board of Governors of the Federal Reserve System.

C. Holdings of Government Securities. In the and at country banks about 42 per cent. By last two decades rapidly rising demands for the end of 1967, the proportion held in Gov­ credit in the private and non-Federal Gov­ ernments had declined for all members to ernment sectors have substantially raised the about 16 per cent, with reserve city banks returns on bank assets such as loans, and holding 13 per cent and country banks 20 thereby the cost of holding Government per cent. Data for the period 1961-65 sug­ securities. In consequence, there have been gest that declines in holdings of U.S. Gov­ substantial reductions in the proportion of ernment securities have been consistent assets and deposits held by banks in Govern­ across different geographic areas. On the ment securities. average, small, medium-sized, and large re­ At the end of 1954, about 40 per cent serve city, country, and nonmember insured of net deposits of member banks were held banks in each district have experienced sub­ in U.S. Government securities. At reserve stantial declines (Table 7).31 city banks the proportion was 39 per cent In rural areas some banks’ holdings of Government securities were still found to be TABLE 8 quite high. For example, in the Kansas City MEMBER BANK BORROWING ON ELIGIBLE PAPER District it was reported that a number of rural banks have more funds invested in Face value of paper presented and analyzed (millions of dollars) 34 At the discount window, in the last several years, Year Number this trend has been reflected in the substantial in­ borrowing All member crease in borrowing collateralized by eligible paper in All member except reserve banks city banks in contrast to Government securities. The face amount N.Y. district of eligible paper presented and analyzed at Federal Reserve Banks increased from about $150 million in 1959...... 13 153 143 1959 to over $20 billion in 1966 (Table 8). In some banks, the Government securities that are held are 1960...... 21 673 673 1961...... 5 5 5 pledged largely as collateral for public deposits. It is 1962...... 7 71 71 estimated that around half of the more than $50 bil­ 1963...... 8 134 134 lion in U.S. Government securities held by banks are 1964...... 20 249 120 pledged. See Charles F. Haywood, The Pledging of 1965...... 40 7,186 602 Bank Assets, A Study Prepared for the Trustees of 1966...... 82 20,085 3,691 the Banking Research Fund, Association of Reserve City Bankers, p. 5.

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Government securities than in loans. Staff these data suggests that the correspondent study found that banks maintaining rela­ system does generate a substantial amount tively high ratios of Government securities of credit.38 In the fall of 1963, the estimated were not infrequently found in communities volume for all commercial banks aggregated where other banks had reduced their hold­ roughly $5.5 billion. Of this total, a rela­ ings of Governments substantially. The find­ tively small amount, about $500 million, ing suggests that profitable opportunities in was in the form of direct borrowing under acquiring alternative assets may well exist credit lines or similar arrangements, or even where banks maintain large volumes of through asset sales. The preponderance was Government securities.33 in the form of loan participations (Table d. Credit Flows Through the Correspondent 9). Banking System. There is evidence that corre­ spondent relationships result “. . . in a sub­ TABLE 9 stantial net flow of funds from smaller local­ TYPES OF CREDIT AVAILABLE FROM CORRE­ ities, where credit availability is relatively SPONDENT BANKS, 1963 low and interest rates are high, to larger (In millions of dollars) localities where availability is high and rates All insured Banks with are low.” 36 However, many different kinds Type of credit commercial deposits less banks than $100 million of services are obtained by small banks from Participation loans—amount held large correspondents and are paid for prin­ by correspondent: 1 Commercial and industrial...... 2,845 878 cipally with deposit balances. In conse­ Non-real-estate farm...... 218 150 quence, the implications of this “perverse” Other...... 1,990 367 deposit flow for credit availability from Total participation credit___ 5,054 1,395 Borrowing under lines of credit 2.. 330 228 large correspondents are not completely Sales of assets to correspondents 3 136 48 clear. Total...... 5,521 1,672

The best data currently available on credit 1 Outstanding as of survey date. 2 Largest amount reported to have been borrowed within 12 months flows through the correspondent banking previous to survey. system were obtained in a 1963 survey for 3 Mortgages, State and local government securities, and consumer loans sold in 12 months previous to survey. the Committee on Banking and Currency of Source.—Estimates based on data from 1963 survey of the Banking the House of Representatives.37 Analysis of and Currency Committee of the U.S. House of Representatives. However, much of the volume represented 35 To some undetermined degree, the decline in hold­ ings of Government securities by banks has probably an exchange of credit among relatively large been restrained by Federal Reserve System policies. banks; $3.8 billion was obtained by banks For example, the Federal Reserve Bank of New York developed an examinations procedure designed to eval­ with deposits over $100 million. Only some uate the operations of banks by the standards of current Regulation A. The procedure is directed par­ portion of the remainder can be thought ticularly at finding out whether or not banks are of as credit that might conceivably be avail­ maintaining sufficient liquidity to meet seasonal pres­ sures. Benjamin Stackhouse, “Discount Policy and able to small banks for adjustment pur­ Bank Supervision” (Discount Study). poses.39 39 Jack M. Guttentag and Edward S. Herman, Banking Structure and Performance , Institute of Fi­ nance, New York University, February 1967, pp. 38 Staff study of correspondent banking was under­ 132-33. taken by a task force headed by Ernest Baughman 37 See Ira Scott, Jr., A Report on the Correspondent and Dorothy Nichols, Federal Reserve Bank of Banking System , Subcommittee on Domestic Finance Chicago. of the Committee on Banking and Currency of the S9As can be seen in Table 9, of the $1.7 billion U.S. House of Representatives, Washington, 1964. that can be identified as going to banks with less than $100 million in deposits, $1.4 billion was in the form

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About two-thirds of all insured banks with in deposits used correspondent credit in ex­ deposits of less than $100 million reported cess of 10 per cent of their loans. some sort of credit arrangement with cor­ There is evidence that the amount of credit respondents in 1963. However, the propor­ provided by correspondents to rural banks, tion of banks reporting actual credit trans­ though still modest in dollar totals, has in­ actions in that year was considerably less. creased substantially over the last decade. This was particularly true for small banks— Data for 1956 and 1966 indicate that farm banks with deposits of less than $5 million participation loans increased 618 per cent, (Table 10). or at an average annual rate of 22 per cent. A check on this “long-term” trend with data TABLE 10 for 1963 indicated that roughly the same USE OF CORRESPONDENT CREDIT BY INSURED annual rate of increase had occurred in re­ COMMERCIAL BANKS, 1963 cent years.41 (Pei* cent of all insured banks) It would appear then that correspondent Size of insured bank (total credit, at least in some moderate amounts, deposits, in millions of dollars) has been and is available to relatively small Type of credit reported Under Under banks. This does not mean, however, that 100, 50-99 5 total the credit generally available is suited to

Any credit arrangements with meeting the problems of bank adjustment. correspondents...... 63.1 86.5 62.3 Measurable credit on date of The preponderant type of accommodation survey...... 40.7 69.2 35.3 Participation loans on date of is the participation loan, and a substantial survey...... 41.7 68.5 35.9 Borrowing under lines of credit. 5.8 7.7 6.8 proportion of the participations are appar­ Sales of assets...... 1.7 3.8 1.0 ently overlines, that is, loans that exceed the Number of banks—total...... 12,782 260 7,000 lending limit of the smaller bank. The over­ line participation loan, at least, represents a N o te .—In some cases the correspondent’s share of a participation loan was retired prior to the survey date. In consequence, the pro­ portion reporting measurable credit is slightly lower in some instances relatively inflexible type of credit. than the proportion reporting participation loans. Perhaps even more importantly, there is S o u r c e .—Estimates based on data from 1963 survey of Banking and Currency Committee of the U.S. House of Representatives. reason to believe that the cost of participa­ tion and overline credit is quite high, even Among member unit banks with under though the maintenance of a balance by $25 million in deposits, outstanding corre­ smaller banks and the package of services spondent credit in late 1963 amounted to offered by the large correspondents in re­ about $313 million, that is, about $204,000 turn effectively preclude accurate cost es­ per bank. The average was about $ 160,000 timates. The availability of credit generally for banks with less than $5 million in de­ depends on the profitability of the long-run posits.40 Relatively few commercial banks balance supplied by the borrowing bank. (about 6 per cent) with under $100 million When credit is extended in the form of a par­ of loan participations. It should be noted that these ticipation, the borrowing bank is also fre­ figures are not comparable with figures on credit made available at the discount window, since the latter are quently asked to increase its balance at least typically on a daily-average basis. The estimate of aggregate volume passing through the correspondent 40 Among nonmember unit banks, the per-bank systems includes participations outstanding as of the average was $178,000 for banks with under $25 mil­ survey date, the largest amount borrowed under lines lion in deposits and $87,000 for banks with less than of credit in the previous 12 months, and sales of $5 million. mortgages, municipals, and consumer loans in the n Emanuel Melichar, “Bank Financing of Agricul­ previous 12 months. ture,” op . cit., p. 937.

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by as much as that which the customer ability and the lower “cost” of additional would be expected to maintain if he had reserves to an office that is part of a single obtained the loan directly from the corre­ banking organization with many branches. spondent. Finally, the participating bank The branch office would benefit in obtaining receives the interest paid by the customer “credit” not only from a less severe liquidity on the share of the loan taken. constraint but also from the financial market A relatively high cost for participation position of its larger organization, the geo­ credit should not be unexpected. Funds are graphic diversification of other offices in the made available without a long-term rela­ system, and, most probably, a better in­ tionship with the ultimate customer; conse­ formed management. quently the loan would normally be viewed e. Credit Flows Through the Federal Funds as a relatively undesirable use of funds by Market. Since the early 1960’s, there have the lending bank. From the point of view of been highly important changes in the nature the borrowing bank, credit is solicited, par­ of the Federal funds market. These include ticularly in case of overlines, in order to a rapid expansion in the number of small keep a long-term relationship with a cus­ banks participating, either as sellers or buy­ tomer who might otherwise be immediately ers, or both. In 1961 about 400 country and irrevocably lost, and often with some banks, generally larger than $75 million in feeling that the solicitation of overline credit deposits, traded in Federal funds; their par­ from a larger bank is dangerous because the ticipation was probably infrequent. The customer may be ultimately lost in the proc­ standard unit of trading at that time was $1 ess anyway. Both supply and demand factors million; and this was a larger amount than would, therefore, tend to result in high would be efficient for banks of much less “prices”; and the expansion of correspondent than $100 million in deposit size. In con­ credit in recent years may simply reflect the trast, in 1966 it was estimated that over still higher cost of alternative methods of ad­ 2,000 country banks traded, at least occa­ justment.42 sionally. These included banks with less than A comparison between fund flows in a $10 million in deposits; the standard unit of unit-correspondent banking system and in a trading had declined to $200,000, with con­ branch banking system is useful. There is siderably smaller amounts being traded from considerable evidence to the effect that the time to time.44 There has been a rapid de­ potential and actual fund flows in a branch velopment of participation by small and geo­ banking system are substantially greater.43 graphically dispersed banks. The proportion This must reflect both the greater avail­ of banks with less than $10 million in de­ posits that traded Federal funds was about 42 It should be noted that variability in interbank 22 per cent in 1966. In the Boston District, deposit balances is not a reasonable measure of the correspondent banking contribution to meeting ad­ the proportion was 72 per cent but in all justment problems, at least for small, unit banks. As in the case of Government securities, such balances others was considerably lower (Table 11). have declined substantially in recent years as a per­ The growth of small bank participation in centage of deposits, from about 9 per cent to 5.5 per cent. the Federal funds market is traceable in large 43 Staff study of fund flows within branch banking systems was undertaken by Verle Johnson, Federal part to the efforts of large, money market Reserve Bank of San Francisco; Harmon Haymes. Federal Reserve Bank of Richmond; and Margaret 41 Parker Willis, “A Study of the Market for Fed­ Beekel, Federal Reserve Bank of Cleveland. eral Funds,” o p . c it.

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TABLE 11 still in flux, though there is doubt that large MEMBER BANK PARTICIPATION IN THE FEDERAL numbers of additional small banks will be FUNDS MARKET, 1966 incorporated into it in the near future.40 The Banks with Less Than $10 Million in Deposits principal impact of the change has been to Banks in district reduce the volume of excess reserves carried District Percentage by smaller banks and to weaken reliance on Total Number trading number i trading* the discount window by larger banks, if not

Boston...... 139 100 72 smaller ones. New York...... 185 44 24 Philadelphia...... 237 50 21 The initial objective of the correspondent- Cleveland...... 285 63 22 Richmond...... 251 57 23 accommodating system was, as noted, to fa­ Atlanta...... 280 56 20 Chicago...... 600 150 25 cilitate reserve adjustment for larger banks, 346 69 20 Minneapolis...... 360 54 15 not smaller ones. Nevertheless, the system Kansas City...... 650 90 14 Dallas...... 491 98 20 has developed competitively to serve addi­ San Francisco...... 117 39 33 tional purposes. Indeed, “(m)any smaller Total...... 3,941 870 22 country banks indicate that trading in Fed­ 1 Based on numbers of banks shown in annual member bank oper­ ating ratio reports or monthly reviews of the Federal Reserve Banks. eral funds has reduced their reliance on pur­ 2 Figures for traders in the Boston, Philadelphia, New York, Richmond, Chicago, Minneapolis, and Kansas City Districts were chases or sales of Treasury and other money derived from surveys. Data for other districts are estimated. market instruments as a means of reserve So u r c e .—Parker Willis, “A Study of the Market for Federal Funds” (Discount Study). adjustment.” 4T Most of the smaller banks involved are, banks, particularly in New York City. The however, typically sellers, not purchasers. In objective has been to secure a dependable 1966, the smaller banks supplied from source of continuous credit to support larger $800 million to $1 billion net on average portfolios than would otherwise be possible. The provision of an investment service by each day. Their average daily purchases these large banks to small banks in outlying probably did not exceed $300 million.48 areas for short-term money has evidently Moreover, there is considerable doubt as to put competitive pressure on large regional whether heavy buying by smaller banks is banks to provide a similar service. It is esti­ feasible. It was found that at least some mated that by 1966 there were 70 accommo­ smaller banks fear that turning to the corre­ dating correspondent banks, that is, banks spondent will lead to a demand for addi­ that trade for themselves and other banks, tional balances.4” But the extent to which with mutually exclusive networks ranging smaller banks can “buy” probably varies from 5 or 6 to several hundred smaller from group to group,50 and as noted above, banks.45 On an average day, $3.5 billion to about three-quarters of the banks with less $4 billion has been traded in the market; than $10 million in deposits still do not par­ and considerably more on some days. In con­ ticipate. Finally, the credit involved is still, trast, borrowing at the discount window essentially, “1-day” money, though some rarely exceeds $1.5 billion to $2 billion on any day, and normally is well below that. M Ibid. Ibid. The Federal funds market is probably 48 Ibid. This includes the purchases of all banks in the country bank classification. 49 Ibid. 45 Ibid. 50 Ibid.

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longer-term arrangements are made from prime CD’s when issued and traded require time to time.51 a higher rate than CD’s of prime name In sum, smaller, unit banks probably can­ banks in New York.52 “In this sense,” it was not view the Federal funds market, even in reported, “buyers discriminate against certifi­ its current high state of development, as a cates of smaller, less well-known banks.” 53 dependable substitute for holdings of Gov­ The prime (and “lesser-prime”) banks cur­ ernment securities or excess reserves for ad­ rently constitute less than 100 in number, justment purposes. They may well view it however, and include only very large institu­ as an outlet for excess reserves and an occa­ tions, with deposits of $500 million or sional source of credit to meet unexpected more.54 The “off-prime” banks whose certifi­ and very short-run reserve losses. The larger cates trade in the secondary market still in­ banks that have initiated its development, clude only large institutions by comparison on the other hand, evidently do view it as with the vast majority of banks. While a source of reserves for both intermediate- and longer-term adjustment. smaller banks can frequently sell certificates One additional implication of these changes at favorable rates in local or regional mar­ in the Federal funds market should be noted. kets, these do not normally trade at all.55 The behavior of neither the large banks nor The designations of “prime” and “off- the small banks is consistent with the ra­ prime” reflect relative marketability. Mar­ tionale of Regulation A as originally con­ ketability depends on the degree to which a ceived. Continued reliance on borrowed bank is “known.” 56 An inability on the part funds by the larger banks indicates an in­ of smaller banks to sell CD’s outside local sufficiently reluctant behavior that requires market areas or to have their CD’s traded some degree of “administrative discipline” cannot moreover be completely attributed to when and if they borrow at the discount differences in the actual risk involved in window. The frequent sale of Federal funds lending to them or, for that matter, even to by smaller banks would seem also to reflect the cost of gathering information about an “undue” sensitivity to market rates of in­ them. Many small banks are no doubt ex­ terest under current discount standards. tremely safe institutions. And while informa­ Such sales to large money market banks can tion on their operations is typically collected become particularly important during peri­ by supervisory authorities, it is not normally ods of monetary restraint when the objective disclosed to potential lenders. Policies asso­ of Federal Reserve policy is to force asset ciated with releasing information, not the adjustments. cost of gathering it, have established a level f. The Markets for Certificates of Deposit. of risk that is not necessarily an accurate The extent to which small banks in rural reflection of what exists. areas are at a disadvantage in purchasing re­ 3. Conclusions. The available information serves outside their local market areas is only supports the view that small rural banks, indirectly suggested by differential rates on concentrated in the sixth through the elev- prime and off-prime CD’s of commercial °3 Parker Willis, “The Secondary Market for Ne­ banks. While the differential varies with eco­ gotiable Certificates of Deposit” (Discount Study). nomic conditions, it was noted that off- 53 Ibid. “ Ibid. 55 Ibid. 151 Ibid. “ Ibid.

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enth Federal Reserve districts, have serious pay relatively high rates when such credit disadvantages relating to their organizational is available. structure. In many cases the prohibition of The volume of credit available to small branching precludes growth to large size. banks via the correspondent banking system This restriction on growth and geographic is still relatively small. However, the amount expansion frequently results in a high de­ of credit passing through the correspondent gree of deposit and asset specialization that banking system in recent years, in partici­ promotes variability in deposits and loans. pations and Federal funds, has apparently Such variability may be accommodated by been growing. Competition among large cor­ holding relatively large volumes of liquid as­ respondents shows some signs of providing sets or by borrowing. If liquid assets are increased benefits to small banks. Never­ relied on, substantial portions of bank assets theless, the “correspondent market” in which may be unavailable for local loans and the cost of lending will be correspondingly small banks attempt to obtain credit is still higher. highly imperfect. It is characterized by In recent years, the opportunity costs of large bank-small bank bargaining relation­ holding liquid assets have risen considerably ships, traditional and multiservice arrange­ and many banks have increasingly relied on ments that probably tie small banks rather credit for adjustment purposes. When at­ firmly to particular large banks, and a dearth tempting to obtain credit, smaller banks are of information on the real costs of the in­ apparently at a disadvantage and probably dividual services being provided. V. ACTIVITY AT THE DISCOUNT W DOW SINCE 1955 As noted above, the implicit change in the As would be expected under the current formulation of the discount mechanism in discount mechanism, there have been cycli­ 1955 was a more restrictive interpretation cal changes in borrowing activity. There ap­ of “appropriate” borrowing than in the pears also to have been a downward trend 1920’s. In large measure the broad aim of which, while widely appreciated within the restricting the provision of Reserve Bank Federal Reserve System, is not obvious from credit through the discount window has been aggregate borrowing figures alone. In Table met over the last 13 years. As can be seen 12, the results of a multiple regression analy­ in Chart 1, in comparison with the 1920’s sis are presented, relating a trend variable, a very small proportion of Federal Reserve among others, to ratios of borrowing to re­ credit has been provided at the discount quired reserves. Holding constant the bill window since 1955. On a quarterly basis, rate, discount rate, required-to-total re­ the ratio of borrowing to required reserves serves, offices-to-banks, and indicated ad­ has ranged from less than 1 per cent to a ministrative standards among groups of dis­ little over 5 per cent; the proportion of mem­ ber banks borrowing from the Federal Re­ tricts, a linear trend variable was significant serve has ranged between 9 and 22 per cent. and explained a considerable proportion of (Chart 4).1 quarterly and on an annual basis are not comparable. To the extent different banks borrow in each quarter, 1 It should be noted that the proportions of mem­ the proportion borrowing on an annual basis would ber banks borrowing from the Federal Reserve on a be higher.

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Member Bank Borrowing The reduction in activity has been ac­ at the Discount Window companied by an expansion in estimated

PER CENT borrowing from other sources and in no way should be taken as evidence of a strong reluctance to borrow as the term has been defined above. While the proportion of re­ quired reserves borrowed by member banks from the Federal Reserve declined by 30 per cent between 1959 and 1966, the esti­ mated proportion of required reserves bor­ rowed from all suppliers or sources of credit increased by 124 per cent (Table 13).3 Since 1959, the proportion of reserve city banks borrowing from Federal Reserve Banks has changed very little, but the pro­ portion of reserves they have borrowed from the Reserve Banks has declined. In contrast, the proportion of reserves borrowed from all sources has increased substantially. The borrowing behavior of country banks since 1959 is equally, if not more, indica­ tive of the movement from borrowing at Reserve Banks to borrowing from other sources. Table 14 shows by Reserve District Quarterly data. the percentage changes in country bank bor­ the variation in borrowing over time.2 This rowing at the discount window and borrow­ was true of reserve city and country banks. ing from all sources for the recent period These results suggest a decline of close to (with alternative initial and terminal dates: 1 percentage point per year in the ratio of 1959-66; 1959-65; 1960-66). In each borrowing to required reserves for reserve comparison of the proportion of reserves city banks; and a decline of V2 percentage borrowed from the Federal Reserve and point per year for country banks. Given bor­ from all sources, the contrasting directions rowing ratios that range between 1 and 5 per of change are generally evident. For ex­ cent, the importance of such a decline is evi­ ample, between 1959 and 1966 the propor­ dent. The equations suggest that the borrow­ tion of banks borrowing from the Federal ing ratios have, in fact, been maintained be­ Reserve declined in 8 out of 12 dis­ cause of increases in required-to-total re­ tricts; the proportion borrowing from all serves and, for city banks, by the rise in sources increased in 11 out of 12 districts. market rates relative to the discount rate. 3 The 1959-66 period is one for which detailed 2 The variable, bank offices-to-banks in each district, borrowing data are available and, in comparing per­ is based on the hypothesis that branch banking affords centage changes, is advantageous in that both 1959 greater stability of deposits and loans and, therefore, and 1966 were years of monetary restraint. Alteration the extent of branching is, other things equal, inversely in initial and terminal dates, so that the period runs related to supply and demand for credit at the discount from 1960 to 1966 or from 1959 to 1965, does not window. alter the conclusions.

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TABLE 12 INFLUENCE OF TREND AND OTHER FACTORS ON RATIO OF BORROWING TO REQUIRED RESERVES Regression Coefficients for 1955-65

Independent variable

District classification1 Coefficient Class of bank Percent­ Ratio of of multiple age of offices Bill Discount required Trend determina­ rate rate to total to tion R 2 reserves banks Upper Middle

Reserve city: Including “central reserve city” .. 3.1* - .0 8 1.46* -.3 3 * -.9 1 * 4.30* .08 .61 30.5 (.9) 0 .12) (.49) (. 12) (.10) (.68) (.50) Excluding “central reserve city” .. 3.1* - .1 2 1.67* -.3 5 * -.9 4 * 4.29* .11 .60 29.4 (.9) (1.13) (.52) (.01) (. 10) (.69) (.52) Country...... 24 1.36* .17* -.22* -.5 0 * .37 - .2 6 .53 22.5 (.40) (.50) (.05) (.06) (.05) (.25) (. 21)

* Significant at the 5 per cent level. annual aggregates for each district. The statistical procedures involved 1 For discussion of classification, see p. 15. a pooled cross section (by district), time-series analysis for yearly data- N o te .—Ratios for borrowing to required reserves are based on Standard errors in parentheses. The actual changes themselves, even when District, the decline was about 40 per cent; in the same direction, generally suggest a in St. Louis about 65 per cent; and in At­ differential influence at work. So, for ex­ lanta about 22 per cent. Declines in the ample, the proportion of country banks bor­ proportions borrowing from all sources were, rowing from the Federal Reserve in the respectively, — .2 per cent, — .9 per cent, Philadelphia District declined 41 per cent — 4.8 per cent, and — 6.8 per cent. Similar between 1959 and 1965; in the Richmond examples can be found by examining the table. TABLE 13 There are, no doubt, a number of related RATIO OF MEMBER BANK BORROWING TO RE­ QUIRED RESERVES reasons for a downward trend in borrow­ Federal Reserve Banks Compared with All Sources ing at the discount window. These would in­ clude the general prohibition of credit for Federal Reserve Banks All sources normal operating purposes, the gradual im­ Year All Reserve All Reserve plementation of the revision of Regulation member city Country member city Country banks banks banks banks banks banks A after 1955, and development of other markets for credit. 1959...... 4.0 4.6 3.8 12.0 17.8 6.5 1960...... 2.2 2.4 2.5 13.4 19.7 6.1 In the kind of financial environment that 1961...... 4 .3 .5 6.6 8.8 2.2 1962...... 5 .5 .5 10.8 14.8 2.9 has been developing, a related reason 1963...... 1.2 1.5 .9 15.6 21.4 4.5 1964...... 1.3 1.6 1.0 17.4 23.2 6.6 may also be considered. To potential bor­ 1965...... 2.2 2.7 1.4 21.6 29.3 7.6 rowers who do not conform to the rough 1966...... 2.8 2.8 2.8 26.9 36.8 9.5 regulatory image of a “sufficiently reluctant” Percentage change, borrower, described in the General Prin­ 1959-66.... -30.0 -39.1 -26.3 + 124.2 +106.7 +46.2 ciples of Regulation A, the discount mecha­

N o te.—Figures for “all sources” are estimates of borrowing from nism represents an uncertain source of funds. all suppliers of credit obtained by capitalizing the interest paid on borrowed funds, shown in earnings and dividends reports, at the There would be, for such borrowers, sub­ discount rate through 1965, and at the average effective Federal funds rate in 1966. stantial nonmonetary costs associated with

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TABLE 14 PERCENTAGE CHANGE IN PROPORTION OF COUNTRY BANK BORROWING FROM THE FEDERAL RESERVE AND FROM ALL SOURCES, SELECTED PERIODS

District

Source San Boston New Phila­ Cleve­ Rich­ Atlanta Chicago St. Minne­ Kansas Dallas Fran­ York delphia land mond Louis apolis City cisco

Change from 1959 to 1966

Proportion borrowing from: Federal Reserve...... - 6 .5 - 8 .0 -22.4 -45.7 -20.2 +21.7 +15.2 -15.3 - 1 .9 + 3.0 + 7 .6 -2 3 .9 All sources...... +10.1 + 1.7 +22.1 - 7 .3 +10.8 + 9.2 +44.4 +30.6 +36.3 +18.4 +78.8 +75.0 Proportion of required re­ serves borrowed from: Federal Reserve...... -33.3 +11.9 -48.6 -66.7 -55.8 +281.8 ...... -4 6 .2 -56.1 -48.4 -26.1 -53.8 All sources...... - 8 .9 +90.2 +64.7 +71.4 +19.4 +10.2 +88.4 +31.6 +42.9 + 8.6 +136.4 +184.6

Change from 1959 to 1965

Proportion borrowing from: Federal Reserve...... -30.7 -32.6 -40.7 -69.8 -39.6 -22.4 -30.9 -65.3 -30.7 -27.9 -53.3 -72.5 All sources...... + 10.6 - 11.8 - . 2 -19.6 -.9 -6.8 +6.2 -4.8 +8.0 -5.1 +38.0 +65.8 Proportion of required re­ serves borrowed from: Federal Reserve...... -73.7 -47.6 -68.6 -87.5 -78.8 +27.3 -65.5 -73.1 -65.9 -59.4 -60.9 -53.8 All sources...... -19.6 +47.6 +29.4 +34.3 -24.2 -1.0 +16.3 +2.6 +16.3 +14.3 +69.7 +171.8

Change from 1960 to 1965

Proportion borrowing from: Federal Reserve...... -36.9 -29.6 -37.6 -65.3 -63.9 -47.7 -40.5 -66.9 -28.4 -24.5 -62.3 -73.6 All sources...... + 2.3 - 6 .7 - . 8 -1 4 .9 + 2.2 - 11.0 - 7 .4 -1 4 .9 + 4.5 - 2 .8 +16.7 +21.7 Proportion of required re­ serves borrowed from: Federal Reserve...... 50.0 +29.4 -66.7 -78.6 -69.4 +75.0 -50.0 -61.1 -51.7 -43.5 -69.0 -60.0 All sources...... 28.0 +95.2 +20.0 +38.2 -2 1 .7 + 9.0 +11.1 - 9 .3 +11.8 +33.3 +24.4 +68.3

uncertainty and administrative inconveni­ discount window would tend to decline—by ence. If the estimates of interest elasticity administrative control over supply or by the developed in recent econometric studies and behavior of banks who feel that the cost is the developments in the Federal funds mar­ likely to be too high. ket described above provide an even close- At an extreme (for example in 1966), to-accurate indication of the state of mind of abstention from borrowing at the discount increasingly large numbers of member window because of high or rising nonmone­ banks, then it seems likely that growing tary costs is not a completely convincing ex­ numbers would not normally conform to planation. During 1966 the rate differential the acceptable regulatory image. In conse­ was highly favorable to such borrowing, and quence, growing numbers of banks would either approach the discount window in full it is reasonable to believe that it would have awareness of the restrictive surveillance to been clear to potential borrowers that non­ which they would be subjecting therr.selves, monetary costs for at least some borrowing or not approach the window at all. In either would not be prohibitive. Nevertheless, bor­ case, the amount of credit extended at the rowing from Reserve Banks remained at very

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low levels. In this case, noneconomic ex­ would occur warrants careful consideration planations should probably be considered. but will not be discussed in detail here.5 One possible explanation is that the discount 5 Legitimacy may be viewed as functionally related to window was rejected by potential borrowers a number of qualitative nonlinear “variables” that ex­ hibit discontinuities. Boulding, op. cit. While a “legiti­ as a “legitimate” source of credit.4 Why- this macy cliff” may have developed in 1966, movement toward the cliff may be traceable to much earlier de­ 4 On the concept of “legitimacy,” see Kenneth velopments. This possibility is supported by the Re­ Boulding, “The Legitimacy of Central Banks” (Dis­ serve Bank reports on dissatisfaction and/or resent­ count Study). ment on the part of borrowers. VI. RELATED SYSTEM POLICIES AND ALTERNATIVE FORMULATIONS OF THE DISCOUNT MECHANISM The existing discount mechanism reflects, in mechanism. Those proposals are principally large measure, constraints derived from aimed at changes in the techniques and/or other Federal Reserve System responsibil­ targets of monetary policy. Such proposals ities, particularly those of over-all monetary have, for the most part, been viewed as be­ control and bank supervision. Its operations yond the scope of the present study. How­ were intended to be integrated with policies ever, their relationship to the focus of the designed to meet these other responsibilities. present study is also reviewed briefly below. In recognition of these relationships, the current study has focused on the extent to A. The discount mechanism and which other policies provide “elbow room” bank supervision for changes in discount operations designed With respect to bank supervision, the cur­ to overcome shortcomings in rationale, ob­ rent rationale of the discount mechanism jectives, administration, and borrowing be­ and its implementation is, in the existing havior that have come to light. It has become financial environment, clearly an oversim­ reasonably clear that there is some range of plification. With the advent of deposit in­ practicable alternatives to the existing for­ surance, the vast majority of depositors are mulation within the current framework of no longer concerned with the quality of monetary policy and bank supervision.1 paper banks hypothecate in borrowing. It has also been noted that the problems The relationship between borrowing and the uncovered in the course of the study have likelihood of failure is by no means simple importance not only for the effective opera­ and, to the extent that the “reluctance con­ tions of the discount mechanism, per se, but vention” implies opposition to borrowing in also for related policies. Implications of the the normal course of business, it may impede findings for bank supervision and within the banks from making a full contribution to current framework of monetary control are their communities, and thereby simply en­ reviewed below. courage the establishment of competitive Problems of monetary control have been financial institutions. Current discount stand­ widely discussed, and there are certain well- ards, therefore, would not appear to be an known proposals for fundamental change accurate reflection of modem objectives in that involve alteration in the discount bank supervision.

'On monetary policy, see Paul Meek, “Discount B. Discount mechanism problems and Policy and Open Market Operations” (Discount monetary control Study). On bank supervision, see Examinations De­ partment, Federal Reserve Bank of New York, op.cit. Within the current framework of monetary

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policy, the discount mechanism provides one the aggregate level of borrowing from the of a number of operational guides to the de­ Federal Reserve tends not to be a compara­ gree of monetary restraint in financial mar­ ble measure of monetary pressure over time. kets, that guide being the aggregate level It was clear in 1966, for example, that the of member bank borrowing. Reserve Bank relatively low level of borrowing from the credit is also intended to provide a “safety Federal Reserve did not adequately reflect valve” against the build-up of undesirable the high level of pressure in financial mar­ levels of pressure at individual institutions kets, and it was not comparable in this re­ and in financial markets. Finally, changes in spect to relatively low levels of borrowing in the cost of Reserve Bank credit, that is, the previous periods. discount rate, are, from time to time, in­ Variability in administrative pressure at tended to signal changes in central bank Reserve Banks also makes interpretation of policy. These monetary policy aspects of the borrowing figures difficult. It has long been discount mechanism are, of course, comple­ recognized that the impact of any level of mented by operational aspects of open mar­ aggregate borrowing would depend on its ket policies, whereby reserves are provided distribution among banks, at least partly or withdrawn to meet secular, seasonal, and because “reluctance” among different groups shorter-term variations in demand. of banks might differ and partly because the As noted, the view that the aggregate level impact on financial markets would depend of member bank borrowing (or the free re­ on the extent to which such borrowing were serve variant) is a reliable, though provi­ concentrated in banks in differing condi­ sional, measure of monetary restraint is tions. Findings on nonuniformity of admin­ based in part on the belief that banks are istration suggest an additional reason why reluctant to borrow. If banks are reluctant, the impact of any given level of aggregate and open market operations force them into borrowing would depend on how such bor­ debt, they would presumably make asset rowing were distributed. adjustments (in order to repay borrowing) The decline in reluctance (and, in the of the sort desired. However, as also noted current financial environment, little likeli­ above, the largest banks do not appear re­ hood that it could be revived), the develop­ ment of new markets for short-term credit, luctant to borrow; smaller banks appear to and changes in attitudes toward borrowing be growing less reluctant to borrow. While at the discount window, for whatever reason, pressure toward asset adjustment may still all make the monetary policy interpretation be imposed by administration at the dis­ of borrowings data difficult. These same de­ count window, the availablity of credit from velopments likewise lead to a conclusion that other sources, particularly for large banks, the discount mechanism has not functioned permits relief from such pressure. Total as intended as a “safety valve.” 2 During pe­ bank reserves may thus be controlled within the desired range, but interest rates in short­ 2 Whether the growth of aggregate borrowing dur­ ing a period of restraint is viewed as an “escape term credit markets can, as a result, fluctuate hatch” or a “safety valve” seems to some degree a matter of semantics. If the money supply is the only sharply. target of significance to the monetary authority, then One consequence of recent developments an increase in borrowing may be viewed as an “escape hatch.” However, if one or more additional targets in credit markets and bank behavior is that are considered, including interest rate targets, it is not

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riods of monetary restraint, the growth of rate on market expectations as to future in­ borrowing generally permits values and rates terest rates, and therefore on the level and in financial markets to change more slowly structure of current rates, has been discussed than they otherwise would. Tobin has in detail both within and outside the Federal stated: Reserve System. It has long been recognized . . . suppose there is a boom which increases de­ that changes in the discount rate may have mands for bank loans. Under the present system a significance that is independent of the the availability of loans at a fixed discount rate at measureable change in the cost of borrowing the Fed permits the banks to meet some of these demands, and limits the rise in interest rates. . . . at the Federal Reserve.5 It has also been (T)he safety valve of discounting is probably generally recognized that such effects, to the good. It gives the Fed time to react to events, extent they exist, are not easily predicted whether the events are its own policies or external shocks.3 or controlled. In the 1954 Report on the Discount And Samuelson has said: Mechanism it was indicated that periodic Now in particular, when you are squeezing the revisions in the discount rate would have to market tight there is an adversary procedure going on between you and the . . . banks. This is where be made in order to adjust the cost of bor­ the discretionary versus nondiscretionary use of the rowing to changes in market rates.6 It was mechanism comes in. I suppose you are actually also recognized that changes in the discount making a discretionary use of it and exercising a rate could “serve as an objective indication certain degree of rationing. Then, if you have over­ done it just a bit, they come in with blood in their to the business and financial community of eyes and very self-righteously protesting, causing System credit policy.” 7 you to ease up and change the degree of rationing. Nevertheless, it has proved difficult in But then gradually you do later pull in on the rope and bring them to heel.4 practice to separate “announcement effect” changes in the discount rate from “technical When there is little borrowing from the adjustments.” The result has been to support Federal Reserve, adjustments during a the tendency for a widening discount rate- period of restraint, such as in 1966, are market rate differential during periods of re­ more precipitous and involve more rapidly straint, such as in 1966. As a result, a rising interest rates than otherwise would be serious burden is placed on nonprice ration­ the case. If, to paraphrase Samuelson, bank­ ing at the discount window. As discussed ers do not come in with blood in their eyes, above, there is clearly no danger that reserve but stay away with blood in their eyes, the creation might become excessive. But the discount window will not, of course, func­ standards of the Regulation are not well tion as a safety valve. Borrowing from non- suited to extensive nonprice rationing. Federal Reserve sources cannot, of course, provide a substitute, in this respect, for credit C. Discount study research and well-known extended at the discount window. proposals for change in the discount mechanism The effects of a change in the discount There have been numerous proposals for

necessary to interpret the growth of borrowing during 5 The idea of an “announcement effect” was con­ a period of restraint as such. sidered in Annual Report, Federal Reserve Board, 3 See replies from economists [Tobin] to letter from 1 9 2 3 , p. 11. See also Jones, o p . cit., for a summary Lester V. Chandler, o p . cit. of recent literature on the subject. 4 Statement of Paul Samuelson at Academic Semi­ 6 “Report on the Discount Mechanism, 1954,” op . nar on Changes in the Discount Window, May 11, cit., p. 43. 1966. 7 Ib id .

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change in the discount mechanism. Many linkages among open market operations, the are not fully motivated, or may not neces­ money supply, and interest rates, by stabiliz­ sarily be motivated at all, by the considera­ ing aggregate borrowing from the Federal tions reviewed in this report. Some have Reserve over the cycle. emanated from the Federal Reserve System Even if success in accomplishing these and some from non-System sources.8 ends were unquestioned, the desirability of The research effort of the discount study the result would not be completely clear. The has not had as one of its principal objectives stabilization of borrowing, either at zero by the full evaluation of each responsible pro­ abolishing the discount window, or at some posal on its own merits. Rather, an attempt positive figure, would change the current has been made to consider proposals likely monetary mechanism which incorporates a to meet the problems uncovered. Neverthe­ safety valve independent of open market less, it is useful to relate certain well-known operations. Experience in 1966 has suggest­ proposals to this frame of reference. ed that market rates of interest for short­ Neither the proposal to pay interest on term funds can rise very rapidly and to excess reserves at the discount rate, and to very high levels during periods of economic reinstitute explicit interest on demand de­ expansion if borrowings are not permitted to posits9 nor the proposal to abolish the dis­ increase. Tying the discount rate to a market count mechanism10 were given the attention rate might not establish tighter linkages with­ they might warrant in a fuller reappraisal out causing unacceptable swings in interest of the entire monetary mechanism. However, rates.12 Moreover, tying the discount rate and proposals to tie the discount rate to some opening the window would break the one market rate and permit banks free access at existing direct link for communications be­ the discount window received more con­ tween the Federal Reserve, in its monetary sideration. Such proposals were suggested policy function, and individual member and viewed as a technique that might elimi­ banks. While current relationships through nate the problems associated with nonprice this channel may be less than satisfactory, rationing at the discount window, the differ­ there is no inherent reason why they have to ential costs of reserve acquisition attributable be. Finally, it also seems reasonable to be to structural conditions, and the announce- cautious about giving up instruments that ment-effect barrier to raising the discount are at least potentially useful, such as the rate during the periods of monetary re­ discretionary setting of the discount rate. straint.11 It was also recognized that a tied The proposal to tie the discount rate to a rate could, at the same time, tighten the market rate also raised questions about what market rate should be used, the premium to be maintained, and the possibility of having 8 See replies from economists to letter from Lester V. Chandler, op. cit.; Jones, op. cit.; and Doll, op. cit. a schedule of rates related to the amount “James Tobin, “Toward Improving the Efficiency of the Monetary Mechanism,” Review of Economics borrowed by each bank, or possibly the and Statistics, August 1960, pp. 276-79. volume of borrowing in aggregate. While at 10 Milton Friedman, A Program for Monetary Stability, Fordham University Press, 1960, p. 38. first these seemed merely practical issues, as "However, it should be noted that the withdrawal matters turned out they raised important of Canada from a tied-rate system removes the ex­ ample that evidently initially suggested this kind of 12 See replies from economists [Tobin] to letter proposal. See Garvy, op. cit., Part II, Canada. from Lester V. Chandler, op. cit.

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technical and conceptual considerations.13 bank attitudes toward borrowing, the “Gen­ The importance of the unanswered ques­ eral Principles” of Regulation A have, of tions about proposals to tie the discount rate necessity, assumed substantial importance as to a market rate by no means implies that a standard for rationing credit at the dis­ the discount rate cannot be used more ef­ count window. This circumstance, well over fectively to ration credit than is currently a decade after the 1955 revision of Regula­ the case. But such questions as have been tion A, must be considered contrary to the raised clearly suggest the need for further intent of the revision and to the expectations study.14 expressed at the time it was implemented. The “General Principles” of Regulation A VII. CONCLUDING REMARKS are not well suited as a standard for ration­ This paper has attempted to provide a re­ ing credit. The credit-restrictive terms are view and evaluation of a major portion of not easily understood or unambiguously ap­ the research undertaken in connection with plied. Problems in interpretation and admin­ the Federal Reserve’s reappraisal of the dis­ istration appear to have contributed substan­ count mechanism. As noted in the Introduc­ tially to an undue degree of difference in ad­ tion, materials have been covered with par­ ministration among districts and to a high ticular reference to specific issues raised by degree of friction between member bank the Steering Committee and the Secretariat. borrowers and Reserve Banks. Looking at (The principal recommendations for change the matter another way, nonprice rationing in the discount mechanism have also been at the discount window may be viewed as under study, but this aspect of the research imposing both objective and subjective non­ has not been systematically reviewed here.) A number of findings have been made on monetary costs on the banks that borrow; the issues discussed. These may be sum­ but the “costs” imposed cannot be readily marized briefly: controlled by the lender nor clearly com­ It seems doubtful that the Federal Re­ municated to the borrower. serve’s support of the “tradition against bor­ Lower levels of borrowing were a clearly rowing,” through the discount mechanism, intended result of the 1955 revision of Regu­ has much influence currently on the aggre­ lation A, but it appears that there has been gate demand for credit by banks. Commer­ an even more restrictive effect than intended. cial bank behavior in credit markets appears It is likely that the use of the “General Prin­ increasingly to reflect only moderate if not ciples” as a standard for rationing credit has minimal degrees of reluctance toward bor­ contributed to this downward trend in bor­ rowing. rowing activity at the window. This is pos­ As a result of recent developments in sible because, as mentioned, the nonmone­ interbank borrowing and in other credit tary costs imposed at the discount window markets, along with relatively permissive are not subject to sufficiently precise control. Since 1955 there have been substantial 11 For a review of discussion on these matters at declines in the relative importance of Gov­ the academic seminar on discounting in 1966, see Ormsby, op. cit. ernment securities in bank portfolios. Re­ 14 In this connection see the recent paper by Franco duced holdings by large money market Modigliani, “Some Proposals for Reform of the Dis­ count Mechanism” (Discount Study). banks, coupled with greater activity in pri­

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vate credit markets, resulted in asset and distribution of bank reserves and bank cred­ liability adjustments during the period of it, as envisioned in the 1955 revision of restraint in 1966 that involved rapidly rising Regulation A, seems unlikely. rates of interest and a tendency toward dis­ These findings suggest that the current ruption in some financial markets. The dis­ discount mechanism has been defective in count mechanism, at least recently, has not achieving the objectives for which it was in­ functioned in the way contemplated as a tended. In large measure and in perspective, safety valve. these findings may simply reflect the fact Many small rural banks have traditionally that the underlying rationale of the current difficult adjustment problems. In some rural mechanism developed out of an era far areas there have been rapid increases in de­ different from that which exists today—a mand for credit associated with the changing period of relatively free entry in banking, nature of agricultural production; holdings of large numbers of very small banks, of of Government securities by smaller banks distress in agricultural areas, of widespread have also declined. To some degree credit is available through correspondent relation­ bank failure, particularly in agricultural ships and in the Federal funds market for areas, and prior to Federal deposit insurance many banks. However, small banks are at and modern economic policy. Given the far- a disadvantage relative to larger urban banks reaching economic and financial changes in obtaining credit; such credit as is avail­ since the 1920’s, and even since 1955, such able is probably at a relatively high price. problems as have been discussed should not Under these circumstances, the geographic be considered extraordinary.

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APPENDIX A

FEDERAL RESERVE SYSTEM MANUSCRIPTS AND DOCUMENTS CITED

Documents Prepared for the Discount Study, 1965-68 Anderson, Clay J., “Evolution of the Role and Staats, William F., “The Secondary Market for the Functioning of the Discount Mechanism.” State and Local Government Bonds.” Bank Examinations Department, Federal Re­ Shull, Bernard, “The Rationale and Objectives serve Bank of New York, “Discount Policy of the 1955 Revision of Regulation A.” and Bank Supervision.” Willis, Parker, “The Secondary Market for Ne­ Boulding, Kenneth, “The Legitimacy of Central gotiable Certificates of Deposit.” Banks.” Willis, Parker, “A Study of the Market for Fed­ Chandler, Lester V., “Selective Credit Control.” eral Funds.” Doll, Raymond J., “An Investigation of the Credit Requirements and Availability of Other Documents (Unpublished) Credit in Agricultural Areas.” Garvy, George, “The Discount Mechanism in Federal Reserve Board memoranda, “Banks Leading Industrial Countries Since World Borrowing ‘Continuously’ from the Federal War II.” Reserve Banks,” 1925, 1926, and 1927. Jones, David M., “A Review of Recent Aca­ Federal Reserve Board and Reserve Bank re­ demic Literature on the Discount Mecha­ search personnel, “The Discount and Dis­ nism.” count Rate Mechanism,” group of special Lawrence, Robert, “The Regional Distribu­ studies. tion of Bank Loans.” Hackley, Howard H., “A History of the Lend­ Lynn, Dolores P., “Reserve Adjustments of the ing Functions of the Federal Reserve Banks.” Eight Major New York City Banks During Letter from Walter L. Eddy to all Federal Re­ 1966” serve Agents, September 15, 1925. Melichar, Emanuel, “Intra-Year Fund Flows at Letter from John Perrin to the Federal Reserve Commercial Banks.” Board, “Destructive Effects of Over-Lending Meek, Paul, “Discount Policy and Open Mar­ to Member Banks,” February 26, 1926. ket Operations.” Minutes of Joint Conference of the Federal Re­ Minsky, Hyman, “Financial Instability Revis­ serve Board with Governors and Chairmen ited: The Economics of Disaster.” and Federal Reserve Agents of the Federal Modigliani, Franco, “Some Proposals for a Re­ Reserve Banks, November 4-5, 1925. form of the Discount Mechanism.” Riefler, Winfield, “Volume of Borrowing vs. Ormsby, Priscilla, “Summary of Issues Raised Profitability of Borrowing,” memorandum to at the Academic Seminar on Discounting.” Discount Rate Committee, August 19, 1954. Questionnaire to Federal Reserve Banks Re­ “Statements on the Discount and Discount Rate garding Discount Operations (mailed under Mechanism of Associate Economists of the letter from Governor George W. Mitchell to Federal Open Market Committee before the Presidents of Federal Reserve Banks, dated Conference of Presidents,” June 21, 1954. October 1, 1965). System Committee on the Discount and Dis­ Replies from economists to letter from Lester count Rate Mechanism, “Report on the Dis­ V. Chandler “The Federal Reserve Discount count Mechanism,” March 12, 1954. Mechanism and Discount Policies,” Spring Telegrams from John Perrin to the Federal 1966. Reserve Board, April 18 and April 21, 1925.

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Contents

Evolution of the role and the functioning of the discount mechanism 81 Clay J. Anderson A review of recent academic literature on the discount mechanism 84 David M. Jones Summary of issues raised at the academic seminar on discounting 84 Priscilla Ormsby Financial instability revisited: The economics of disaster 87 Hyman P. Minsky The secondary mortgage market 89 J. A. Cacy The discount mechanism in leading industrial countries since World War II 91 George Garvy Capital and credit requirements of agriculture, and proposals to increase availability of bank credit 93 Emanuel Melichar and Raymond J. Doll A study of the market for Federal funds 95 Parker Willis The secondary market for State and local government bonds 96 William F. Staats Discount policy and bank supervision 97 Benjamin Stackhouse The secondary market for negotiable certificates of deposit 99 Parker Willis Overseas branch balances in the reserve management practices of large money market banks 101 Fred H. Klopstock An evaluation of some determinants of member bank borrowing 102 Leslie M. Alperstein Discount policy and open market operations 103 Paul Meek The legitimacy of central banks 105 Kenneth E. Boulding Intrayear fund flows at commercial banks 106 Emanuel Melichar Some proposals for a reform of the discount window 110 Franco Modigliani

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To assist the Steering Committee in its Fun­ mechanism. Some memoranda are included damental Reappraisal of the Discount for papers that, for a variety of reasons, Mechanism, a number of research papers were not carried through to the publication were commissioned. Transmittal memo­ stage. On the other hand, some papers were randa, which are reproduced on the follow­ written later in the course of the study and ing pages, were prepared by the Secretariat sent to the Steering Committee without to accompany the papers as they were sub­ transmittal memoranda. Even when both mitted to the Steering Committee. In most the paper and its memorandum are being cases the memoranda contain a very brief published, the paper has undergone edi­ summary of the paper, but their major torial, and perhaps substantive, revisions function was to point out the significance of since it served as the basis for the memo­ the paper for the redesign of the discount randum; as a result there may be inconsis­ mechanism and, in some instances, suggest tencies in content. conflicting Secretariat views on issues. The memoranda are presented in the The memoranda were written as Com­ chronological order in which they were sent mittee documents and reflect the collective to the Steering Committee. Thus the reader judgment of the individuals of the Secretar­ has some sense of the development of a iat. However, they do not necessarily reflect proposed redesign of the discount mecha­ the views of any single member of the nism in the collective mind of the Secretar­ group, of the higher-level Steering Commit­ iat. While the memoranda do not report di­ tee, or of the staffs of the Board of Gover­ rectly on that development, they contain nors of the Federal Reserve System or of the almost without exception comments on the Federal Reserve Banks. stage of development that prevailed on the The papers for which memoranda were indicated date. Therefore, the memoranda written do not coincide with the papers reflect to a limited extent the development published in the series on the discount of the proposed redesign.

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MARCH 1, 1967 EVOLUTION OF THE ROLE AND THE FUNCTIONING OF THE DISCOUNT MECHANISM Clay J. Anderson Federal Reserve Bank of Philadelphia

The paper, “Evolution of the Role and the in fact constitute a positive handicap in the Functioning of the Discount Mechanism,” operation of the discount window. This idea attempts to describe the continuous fusion was of course actually accepted with the of ideas and conditions that resulted in the rejection of the real bills doctrine, but the original formulation of the discount mecha­ eligibility requirements have persisted, and nism and its subsequent evolution as Mr. Anderson’s findings add support to the shaped by experience, discovery, and ad­ eligible paper bill presently before Con­ justment to changing economic and finan­ gress. cial conditions. The judgments expressed in the paper focus on the decade of the 1920’s 2. Direct pressure and do not generally reflect the important The paper also makes clear that direct pres­ and different post-1955 experiences. These sure, as practiced in the 1920’s, was not a earlier experiences can and should offer feasible method of control. Even then a guidance for the current reformulation of moderate proportion of all banks were bor­ the discount mechanism, but it is worth­ rowing from the Federal Reserve at any while noting that care must be exercised in one time, and even among those that were generalizing from the results of actions borrowing it was difficult to tell if a bank taken in circumstances that were in many were lending too much in one area until it ways very different from those existing had built up a fairly substantial portfolio. today. In the remainder of this memoran­ Direct pressure can, of course, have some dum, the nine main points that the Secre­ initial impact on all banks, though only tariat believes to be important are briefly through moral suasion on nonborrowers. summarized, and the current judgment of However, this impact usually is progres­ the Secretariat as to the key implications sively eroded as nonbank institutions move for the design of the future discount mecha­ into the relevant loans and moral suasion nism is expressed. loses its bite. For direct pressure to retain some effectiveness over time, the area sub­ 1. Narrow purpose and eligibility ject to it must constantly be broadened. constraints Direct pressure can be applied either for Mr. Anderson’s paper gives further support its monetary effects or for its sound bank­ to the idea that the type of narrow “dollar ing effects. However, in the thinking of the tracing” purpose control of discounting as­ 1920’s, these two objectives were tied: if sociated with the real bills doctrine has not through direct pressure the Federal Reserve proved to be practical. It also strengthens could limit reserve credit to productive the view that eligibility requirements not uses, the proper quantity of reserves could only are impractical, but are illogical and then be supplied with little effort.

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The issue of direct pressure is one to in the Reserve Bank. The fourth Bank tied which the above warning about generaliza­ it to the member bank’s capital plus sur­ tion is especially pertinent. During the plus. This supposedly gave each bank its 1920’s the discount window was the pri­ “fair share,” as its rate schedule was related mary source of reserves. Thus the Federal to its contribution to the earning capacity Reserve could not demand that the banking of the Reserve Bank. This was illogical in system repay all or even a large part of its view of the Reserve Bank’s function as a discount credit, regardless of the use it creator of reserves and bore little or no re­ might be making of this credit. To do so lation to a member bank’s reserve need. In would have left the banks with patently in­ fact, when a bank suffered a deposit out­ adequate reserve balances. In addition, the flow and presumably needed more help classification of loans was not well specified than usual from the discount window, its in the 1920’s, making it difficult to single reserve balance, and thus its basic line, de­ out proper and improper uses of reserve clined. The second and a related weakness credit. For instance, it was almost impossi­ was that no ceiling was established beyond ble to differentiate between a loan for spec­ which rates would not be allowed to rise. ulative dealings in securities and a perfectly Such a ceiling would have prevented cases legitimate loan for the purchase of securi­ such as the one when a bank paid 87.5 per ties to support industry. Last, one of the cent for its marginal borrowing. most frequent problems, at least in the mid­ The third weakness was that only four dle and late 1920’s, was stock market Reserve Banks instituted the progressive credit. However, to treat such loans too rate system. Thus member banks could cir­ harshly would probably have hastened the cumvent the higher rates by borrowing collapse of the market. There was also the from correspondents outside the affected consideration here that stock market loans districts. This weakness might have been were not bad per se; it was rather the in­ avoided if all districts adopted the progres­ flated condition of the market that was bad. sive rate schedules, although the possibility Thus the Federal Reserve was faced with a would still exist of borrowing from a corre­ number of circumstances in the 1920’s spondent that had not used up its basic that are not currently pertinent, and the line. These weaknesses provide lessons in use of direct pressure as applied in the themselves, and the experience of the 1920’s must be evaluated with an aware­ 1920’s should be examined in light of them. ness of these circumstances. It might be noted that progressive rate sys­ tems employed by several foreign central 3. Progressive discount rate banks have avoided these weaknesses and The well-documented failure of progressive have achieved a more rational and success­ discount rates as a control mechanism in ful operation, although of course almost all the early 1920’s must also be examined of them have their own weaknesses of vary­ with close attention to the environment in ing degrees of seriousness that should be which it occurred. There were at least three recognized. obvious weaknesses in the arrangements used. First, in the case of three of the four 4. Effect on customer rates Reserve Banks employing the arrange­ Mr. Anderson’s work indicates that, at least ments, the rate schedule was hinged to a in the 1920’s, changes in the discount rate member bank’s reserve balance plus capital were generally not carried forward directly

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into customer rates. Rather, a change in the the discount window on the day previous so discount rate signaled a change in the avail­ that they can show an average or lower ability of credit and thus influenced over-all level of borrowing on their statement. monetary conditions. This is probably The paper suggests that, while all three equally true today (except possibly on types of reluctance to borrow might be be­ some loans and credits to borrowers with coming progressively less viable as an auto­ easy access to the money market) and matic and self-enforcing control of borrow­ might always be true in the absence of the ing, the first and third types—reluctance to tied arrangements in effect in some foreign borrow from any source and to show bor­ systems. rowing—would be very difficult to eradi­ 5. Rates related to collateral cate quickly or fully. In fact, to eradicate this reluctance as it applies to substantial The paper also indicates that preferential borrowing, in contrast to incidental, would discount rates of the type used, based on not be desirable because of the adverse ef­ collateral, were shown during the condi­ fects this might have on bank liquidity posi­ tions prevailing in the 1920’s to be imprac­ tions. Convincing banks to use the discount tical as a control device. So long as it was window more freely (that is, to increase the available, banks would naturally offer the share of their borrowing done at the Fed­ collateral with the lower rate, and the pref­ eral Reserve) is quite possible, but that erential rate would thus become the effec­ would take time. However, so long as either tive rate. the first or the second form of reluctance to 6. Reluctance to borrow borrow—from any source or specifically Mr. Anderson’s paper provides support for from the central bank—persists to an im­ the idea that there are at least two kinds of portant degree, it will be impracticable to reluctance to borrow that should be distin­ achieve large contracyclical changes in the guished. One is a basic reluctance of a volume of borrowed reserves, and thereby bank to pile up debt to anyone; if carried in the total quantity of reserves. However, too far its solvency might be endangered. the Federal Reserve has other tools, notably The second is a reluctance to be in debt to open market operations, which can exercise the central bank in view of its limiting rules this contracyclical influence on reserve to­ and the kind of administrative discipline to tals, and it seems likely it will have to con­ which a borrowing bank might be subject. tinue to rely on them in the foreseeable fu­ This is at least partly an artificial reluctance ture. stemming from the rules, statements, and actions of the Federal Reserve. 7. Value of administrative discretion The Secretariat believes that there is per­ The paper also points up the real value of a haps a subcategory of the first type of re­ certain amount of administrative discretion. luctance worth citing as a third category. Many of the problems of the past could This is a reluctance to show borrowings be­ have been dealt with more successfully if cause of presumed customer and investor the Federal Reserve had had some ability attitudes. Such reluctance is, as indicated, to vary mechanical rules quickly and flexi­ akin to the first type, but it has a somewhat bly. This is particularly true when these different rationale and accounts for situa­ rules prove to be inappropriate to meet the tions such as often occur around statement varying circumstances within the banking dates, when banks borrow very heavily at system.

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8. Attempts to influence uses of credit 9. Changing objectives of discount policy The history related in the paper demon­ Last, the paper indicates that over the years strates that, in the past, the specification of the objectives of discount policy have a qualitative use of credit to be encouraged evolved and been adapted or modified as or discouraged by the discount window has the implementing rules have proved un­ always given way to direct action in which workable in changing circumstances. In the window became a threat. This history the past, experience with the discount should at least be recognized in designing policy has been to a large extent a learning any future use of the window. process.

MARCH 27, 1967 A REVIEW OF RECENT ACADEMIC LITERATURE ON THE DISCOUNT MECHANISM David M. Jones Federal Reserve Bank of New York

and SUMMARY OF ISSUES RAISED AT THE ACADEMIC SEMINAR ON DISCOUNTING Priscilla Ormsby Board of Governors, Federal Reserve System

The paper, “A Review of Recent Academic fore academic reaction to 1966 is reflected Literature on the Discount Mechanism,” to any great extent in published literature. examines academic literature of the decade This being the case, this paper is valuable following the 1951 Treasury-Federal Re­ in reflecting most of the relevant and fairly serve accord and presents the major argu­ recent academic thinking available. ments that pertain to discounting in that The paper, “Summary of Issues Raised at literature. It concentrates on literature that the Academic Seminar on Discounting,” bears directly on the implications of dis­ was prepared in connection with the semi­ counting for monetary control. nar held at the Board on May 11, 1966. It The literature examined was all pub­ reflects the expression of the more recent lished prior to the experiences of 1966, and thinking of a number of influential aca­ therefore some of the arguments presented demic economists and may therefore be may be at least partially overcome by thought of as modifying to a certain extent events. However, it is the opinion of the some of the ideas presented in Mr. Jones’ Secretariat that few academics will undergo paper. However, even this paper was based any substantial changes in attitude as they on discussion held prior to many of the im­ look at 1966. Rightly or wrongly, they will portant developments of 1966 and there­ probably view those events as strengthening fore suffers from the same handicap. the opinions they have held in the past. In The paper, “Financial Instability Revis­ any event, it will probably be some time be­ ited: The Economics of Disaster,” prepared

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for the discount study by Professor Hyman perfect in practice. The fall of 1966 offered P. Minsky and submitted to the Steering striking evidence that borrowing can be ex­ Committee separately, does represent one tremely inelastic vis-a-vis interest rates and academic economist’s reaction to the events at times the efforts of the Trading Desk to of 1966. However, it seems most unlikely achieve a given level of borrowing can be that many academics will emerge from an largely frustrated by the nonmonetary costs examination of these events with Minsky’s that banks attach to borrowing. conclusions. However, the Federal Reserve retains at In the remainder of this memorandum, least a general control over aggregate bor­ the five main points in the Jones and Orm- rowing levels, and, what is perhaps more sby papers that the Secretariat believes to important, has the ability to make fairly ac­ be important are briefly summarized, and curate predictions of those levels, even the current judgment of the Secretariat as when it might not choose them. The Secre­ to the key implications for the design of the tariat in its deliberations has given and con­ future discount mechanism is expressed. tinues to give close attention to the proba­ ble effects of various changes on the 1. General dissatisfaction with the discount predictability of borrowing. It has also rec­ mechanism ognized that the likely response of the Most of the academic economists consulted banking system to a given level of borrow­ seem to regard the discount mechanism, as ing is not invariant, but may depend on currently constructed, as being antagonistic such things as where in their borrowing to the Federal Reserve’s primary task of spans the indebted banks may be (that is, monetary management. They point out that how close they are to the threshold of ad­ the initiative for borrowing rests with the ministrative discipline). Thus, the Secretar­ member banks, that borrowing adds to total iat considers the predictability of this re­ reserves, and that the level of borrowing sponse even more meaningful than the varies procyclically. predictability of borrowing levels. These contentions are answered by some The arguments that borrowing adds to academics and by others with the now- total reserves and that the level of borrow­ familiar arguments outlined below. The ing varies procyclically cannot be refuted Secretariat generally supports the following in and of themselves. However, the signifi­ arguments, with the caveats noted in the cance of these arguments can be questioned. discussion. Borrowed reserves have long been argued While the borrowing of an individual as having less expansive implications than member bank is at its own initiative, the unborrowed reserves because of the bank aggregate level of borrowing can be con­ adjustment efforts they make necessary. It trolled by the Federal Reserve. One of a is also true that the existence of the dis­ variety of operational targets employed in count window to serve as a safety valve open market operations is the level of free makes possible more vigorous open market reserves, and since excess reserves generally operations than could otherwise take place. remain fairly stable in toto (although there may be wide fluctuations in the distribution 2. Determinants of borrowing of those excess reserves) the effective target Mr. Jones’s paper sketches the still partially is often aggregate borrowings. This control unresolved debate over whether banks bor­ is obtainable in principle, but it is less than row out of need or to obtain a profit. It

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notes that empirical evidence on this ques­ of the window, which they almost unani­ tion remains small and inconclusive. How­ mously equate with interest rate control. ever, it suggests at least one reconciliation The most frequent proposal is for a tied of the profit motive and the reluctance to rate system, where the discount rate would borrow. This is that banks are, on the be set above and would vary with some whole, reluctant to borrow, but that, given market rate. This proposal generally leaves a reserve deficiency—and therefore a need unspecified the questions of the appropriate to borrow, whether they come to the dis­ market rate to be used as the peg—a diffi­ count window or turn to some other short­ cult one for a diverse and fragmented bank­ term source of funds will depend on rela­ ing system employing a variety of reserve tive cost considerations. adjustment procedures—and of the rate The academic literature still does not spread. seem to have produced a satisfactory recon­ Largely ignored by the academic litera­ ciliation between reluctance to borrow and ture is the interest rate instability that a tied the administrative discipline exercised by discount rate might introduce into the finan­ discount officers. The Secretariat notes, cial structure. This problem was probably however, that this question was dealt with an important factor in Canada’s abandon­ in its memorandum of March 1, 1967, ac­ ing the system in 1962. companying the paper, “Evolution of the It also might be noted that, even with a Role and the Functioning of the Discount tied discount rate, the Federal Reserve Mechanism.” At that time it suggested that would probably find it necessary to admin­ there are two basic sorts of reluctance to ister the rate spread at times, as well as to borrow—one an innate reluctance to be in influence the level of market rates, to bring debt based largely on a concern for the liq­ about desired responses. A completely auto­ uidity and solvency of the institution, and matic control over discounting at all times the other an acquired reluctance to be in does not seem to be compatible with discre­ debt to the central bank growing out of the tionary monetary policy. actions, regulations, and statements of that A system of control based on rate alone, central bank. The Secretariat also notes the with an administratively determined rate, widespread and in some respects impressive would also pose serious problems. It would breakdown in recent years of at least the result in a loss of control over reserve crea­ first type of reluctance to borrow. The in­ tion in the short run, and would make the creased willingness of banks to issue short­ setting of the discount rate probably the term, liquid liabilities is apparent in the most important decision made by the cen­ Federal funds market, the CD market, and tral bank. A mistake in that decision could the Euro-dollar market. have very serious implications for monetary conditions. Therefore, the Secretariat sees a 3. Nondiscretionary control need, in the future as in the past, for some Most of the academic economists consulted kind of other, nonprice constraints on dis­ are strongly opposed to the use of adminis­ count window use. trative discipline by discount officials, which has been the major factor in creating 4. Announcement effects the second type of reluctance to borrow dis­ Academic economists are almost unani­ cussed above. They would propose com­ mous in considering the announcement ef­ plete reliance upon nondiscretionary control fects of changes in the discount rate to be

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unclear, unnecessary, and often perverse. cance should justify, those closest to the is­ The Secretariat also has reservations, but is sues may be attributing to them more not convinced that the announcement ef­ power than they actually possess. fects cannot serve a constructive purpose both domestically and internationally. Sev­ 5. Reserve redistribution eral academics recognize the value of an­ An important, although probably second­ nouncement effects, given the attention ac­ ary, topic in the academic literature is that corded discount rate changes in interna­ of reserve redistribution. On this issue, the tional financial markets. academics seem rather satisfied with the Academic economists suggest eliminating status quo. They prefer to see this realloca­ the announcement effects through a tied tion done by other agencies with the Fed­ rate system or minimizing it by instituting a eral Reserve role limited to that of lender frequent and regular schedule of smaller of last resort. discount rate changes. Possibly the second alternative merits further consideration. Conclusion It seems possible that much of the dis­ In sum, the Secretariat often finds itself cussion by academics and by others gives considerably at variance with academic atti­ undue importance to the announcement ef­ tudes on discounting. Nonetheless, it feels fects. These rate changes are only one of a that indexing these attitudes is worthwhile variety of factors influencing the decisions and has noted a number of areas in the of borrowers and lenders. While they do foregoing discussion where academic econo­ have some real significance and perhaps ex­ mists offer constructive criticism and sug­ ercise more influence than this real signifi- gestions.

MARCH 27, 1967 FINANCIAL INSTABILITY REVISITED: THE ECONOMICS OF DISASTER Hyman P. Minsky Washington University

The paper, “Financial Instability Revisited: the 14 main points that the Secretariat be­ The Economics of Disaster,” is unusual and lieves to be important are briefly summa­ out of the main stream of academic thought rized. in that it deals basically with the role of the Federal Reserve as a lender of last resort 1. The “banking theory” for all units and less with its function on monetary man­ Firms and households can be thought of as agement. It also deals with the dynamics of balancing their expected cash inflows and domestic financial flows, in contrast to the outflows, holding portfolio assets to bridge static approach adopted by most academic any prospective cash shortfalls with suffi­ economists. cient provision of liquidity to guard against The paper draws much of its evidence uncertainty. from the experiences of 1966 and might be regarded as a lesson in economic brink­ 2. Initial effects of euphoria manship. When continuing economic prosperity gen­ In the remainder of this memorandum, erates euphoric attitudes, expectations as to

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future income and asset values are esca­ shortfalls in cash flows from their euphoric lated, and expected cash needs to guard expectations, and are led (a) to try to bor­ against shortfalls and uncertainty are scaled row or otherwise raise cash to cover their down; as a result, firms and households are shortfalls, and (b) to adopt a more con­ led to become more illiquid—and the servative portfolio and cash flow posture. greater the euphoria, the greater this shift toward illiquidity. 7. Role of the central bank Consequently, the central bank, as the only 3. The discounting of protection ultimate source of liquidity, needs to be This change in attitudes can lead to liquida­ prepared to perform as a liberal lender of tion pressures and higher interest rates on last resort to ameliorate the deflationary the safest and most liquid assets, as increas­ swing back toward a greater desire for li­ ing confidence causes holders to shift to­ quidity. ward higher-yielding even though riskier assets. 8. Scope of central bank actions Central bank provision of liquidity at such 4. The impact on financial institutions times should extend to all financial institu­ Such holder adjustments affect particularly tions and secondary markets for major banks and other financial intermediaries types of liquid and/or safe assets on which that had earlier benefited from the public’s pressures are likely to concentrate. This cautious attitudes by issuing liquid liabili­ raises the broad policy issue as to whether ties and holding less liquid assets—and, of such central bank action would not be course, the greater this disparity and the more effective if the central bank had regu­ more that adjustments are constrained by lar contact with and participation in the regulatory limitations for a particular group markets in question, particularly in the of institutions, the tighter the pinch. form of financing assistance for dealers in these markets. However, the Secretariat 5. Public policy to counteract euphoria feels that this should not go so far as to in­ Counterinflationary public policy—what­ volve the Federal Reserve in a commitment ever the mix between monetary and fiscal to these markets. policy—has to endeavor to moderate the euphoric expectations that cumulative ex­ 9. Early public policy actions pansion generates, but in so doing it risks Because the risk of financial crisis seems the kind of financial squeeze outlined higher the greater and more prolonged the above, which can assume crisis proportions preceding euphoria, the paper implicitly if the deflation of euphoria is abrupt, as it places some premium on early public policy can easily be if the preceding euphoria had actions to curtail the development of eu­ been strong and widely held. phoric attitudes. This points up the need for coordination among the various supervisory 6. Failures to meet euphoric expectations authorities. This pinch on financial intermediaries and on markets for safe assets can l6. Limits on monetary restraint pounded by a second kind of liq premium is also placed on a careful and sure, as firms and households expt v owledgeable weighing by the central

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bank of how far it can go with counterin- 13. Discretion on the part of the flationary monetary restraint before needing Federal Reserve to step in with lender-of-last-resort-type To respond effectively to the changing finan­ ameliorative actions. cial conditions, the central bank must main­ tain a substantial amount of discretion and 11. Cash flow analysis flexibility in choosing the policy tools to be Both for this purpose and for more effective used and in the application of these tools. bank supervision for other purposes, exami­ The adequacy of tools now available should nations should introduce cash flow analysis be re-examined from the point of view of of the position of each financing institution, the above analysis. based upon empirically validated (or simu­ lated) probable consequences of various al­ 14. Direct relevance for the ternative economic environments that could discount study conceivably develop. The Secretariat regards these views as inter­ 12. Regional pressures esting and worthy of further consideration. The authorities will also need to stay aware They seem to argue for more liberal and of potential regional concentration of finan­ flexible use of the discount window at all cial crisis pressures (for example, Califor­ times, both to forestall crises and to facili­ nia, or other areas of heavy capital im­ tate handling of those crises that may de­ ports). velop.

JULY 5, 1967 THE SECONDARY MORTGAGE MARKET J. A. Cacy Federal Reserve Bank of Kansas City

The main points in the paper, “The Sec­ are “open market” price quotations avail­ ondary Mortgage Market,” that the able on a continuous basis. Secretariat believes to be important are 2. A number of serious obstacles have briefly summarized as follows: impeded the development of secondary mar­ 1. A secondary market for mortgages is ket facilities. all but nonexistent. First, the cost of providing the kind of The Federal National Mortgage Associa­ information necessary to secondary market tion buys and sells only Government-under­ operations is prohibitive. Mortgage loans written home mortgages. Moreover, its op­ are small in size and heterogeneous in na­ erations on the buy side are best ture, and under present arrangements it is characterized as primary market transac­ necessary to have detailed knowledge of the tions. Most of its purchases are from origi- property and borrower characteristics of nator-servicers, who, in effect, are mortgage underwriters. each loan. No private organizations exist that make Second, the mortgage market tends to be a market for seasoned mortgages by acting fragmented into a number of submarkets, a continuously as brokers and/or dealers; nor fact which discourages market making. The

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tendency for principal lenders to specialize tional inadequacies in the mortgage market. in particular sectors of the market is en­ Rather the System should encourage desira­ couraged by the heterogeneous nature of ble changes in both the primary and the mortgage loans and by various legal ar­ secondary markets. rangements such as geographic lending re­ The Secretariat believes a number of the strictions, restrictions on asset composition, recommendations contained in the Cacy and policies affecting competition for sav­ paper for improvements in the secondary ings. market to be worthy of further considera­ Finally, for various reasons, including tion. These include: (1) removing barriers the existence of customer relationships and that limit the speed or extent to which the absence of secondary markets, mortgage mortgage rates are able to fluctuate with lenders have adopted the attitude that mort­ market rates; (2) restructuring FNMA to gages, once acquired, are not to be sold. perform a full-fledged dealer operation in Hence there is no attempt, when originating Government-underwritten mortgages, main­ mortgages, to tailor them to the require­ taining its portfolio within narrow limits by ments of a larger market. adjusting its buying and selling prices; (3) 3. The development of a secondary taking steps to reduce the heterogeneity of market would be desirable. conventional loans by encouraging uniform­ For one thing, such a market would en­ ity in origination procedures, lending prac­ hance the shiftability of assets and intro­ tices, and State mortgage laws; and (4) re­ duce greater flexibility into the financial moving legal or other obstacles that prevent structure. This greater flexibility, in turn, responsible financial institutions from com­ would tend to encourage flows of funds into peting on an equal footing with other insti­ areas and sectors of greatest need, thereby tutions for conventional mortgage loans on contributing to improved allocation of re­ a nationwide basis. sources. The proposal in the Cacy paper that the System perform a stabilizing role in the sec­ Also, a secondary market should increase ondary mortgage market in time of stress the sensitivity of mortgage rates to general by undertaking open market operations in monetary conditions. To the extent that completely insured mortgages is not looked flows of funds into the mortgages are influ­ upon with favor by the Secretariat. enced by differential rates of return be­ The Secretariat recognizes that promo­ tween mortgages and bonds, this should en­ tion of a secondary mortgage market and courage stability in the housing industry encouragement of appropriate changes in and should reduce the differential impact of the institutional structure of the primary monetary policy on residential construction. market are not direct System responsibil­ In the Secretariat’s view the Cacy paper ities. Nevertheless, the Secretariat believes has the following implications for the rede­ that a useful purpose might be served if the sign of the discount mechanism: System were to cooperate and work closely 1. It would not be wise or feasible to at­ with the various agencies associated with tempt to divert flows of funds into the the mortgage markets, perhaps through a mortgage market via the discount mecha­ mortgage subcommittee of a System task nism. force charged with the general responsibil­ 2. The discount mechanism should not ity of looking into market-perfecting de­ be redesigned so as to paper over institu­ vices.

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3. An effective secondary mortgage mar­ secondary market for mortgages. Conceiva­ ket would provide banks with another bly, there could be widespread unloading alternative to the discount window in mak­ during periods of monetary restraint, in ing reserve adjustments. What the interrela­ which case it might be necessary for the tionships would be would obviously depend System to provide credit in some fashion to on the kind of window that is ultimately central lenders in order to prevent disor­ adopted and on the nature of the new sec­ derly conditions. On the other hand, freer ondary market. This points up the need for and better secondary markets, while not continuing adaptation of the discount dealing with the fundamental problems en­ mechanism as the financial system changes. countered in 1966, might moderate some of It would be unrealistic to hope that the win­ the adjustment difficulties faced then. More dow can be redesigned once and for all. sensitive mortgage rates and improved com­ 4. It might be necessary for the Federal petitive relationships among financial insti­ Reserve to exercise a lender-of-last-resort tutions would tend to prevent sudden shift­ function in connection with an improved ing of funds out of the mortgage market.

JULY 5, 1967 THE DISCOUNT MECHANISM IN LEADING INDUSTRIAL COUNTRIES SINCE WORLD WAR II George Garvy Federal Reserve Bank of New York

The paper, “The Discount Mechanism in problems and strikingly different conditions, Leading Industrial Countries since World this paper focuses on the policy environ­ War II,” represents a general survey of dis­ ment and institutional factors that have count policies in these countries and does shaped the discount mechanism in the indi­ not attempt to evaluate the policies or vidual countries studied. apply them to the specific proposal for a The paper clearly shows that there is no redesigned discount window being devel­ uniform “foreign experience” that can be oped by the Secretariat. This study was ini­ compared with ours, but, rather, there is a tiated with the thought that central bank variety of examples of adapting the oldest experience in the advanced industrial coun­ tool of monetary policy to specific but tries would: (a) offer significant insights changing conditions in each given country. into the relationship of the discount mecha­ Indeed, the paper did not aim at a compre­ nism to other tools of monetary policy; (b) hensive comparative study of the discount show the way in which various policy tools mechanism of the countries covered, or at interact; and (c) suggest problems and ad­ assessing its effectiveness in each individual vantages associated with specific techniques country. that might be considered in redesigning the In the remainder of this memorandum, discount window in the United States. the main points in the research report that In order to bring out the various possibil­ the Secretariat believes to be important are ities and limitations that should be consid­ briefly summarized. ered in relating foreign experience to our 1. Discounting remains a principal tool

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of monetary management in most of the ad­ count window have been introduced to vanced industrial countries. One reason for cope with excess liquidity, mostly generated the continuing importance of the discount by balance of payments surpluses and/or mechanism has been the survival of com­ Government deficits. Controls at the win­ mercial bills as a main instrument of bank dow may be direct or indirect, by immobi­ lending in most of these countries. Another lizing (through liquidity ratios) specified factor is the lack of alternative means for quantities of discountable assets in bank controlling bank liquidity in the short run. portfolios. In several countries this reflects the unde­ c. Moral suasion has been introduced veloped state of the money market and, in to reinforce general monetary controls in a particular, of the market for Government number of countries. The form of moral securities. suasion varies: it may consist of formal 2. In contrast to the United States, in expression of the central bank’s wishes most foreign countries foreign exchange (as in the case of Governor’s Letters in the surpluses have provided the banking system United Kingdom), gentlemen’s agreements with adequate (or more than adequate) li­ with regard to the rate of bank credit ex­ quidity, and as a result the need for using pansion (as in the Netherlands), or de­ the discount window has diminished con­ tailed tutelage (as under the “window guid­ siderably in recent years. In these countries, ance” system in Japan). the main problem of monetary management Quantitative regulation imposes on the has been to adjust discount policies to ef­ monetary authorities responsibility for de­ fects on reserves of fluctuations in the bal­ termining the appropriate rate of increase ance of payments (and in some cases, of in bank credit (or related monetary magni­ Treasury operations) over which the central tudes)—a responsibility that, in fact, we bank has no direct control—in particular, have recognized ourselves in recent years. in the short run. 4. The discount rate has gradually 3. Foreign experience shows that for a evolved into a structure of rates. This oc­ variety of reasons exclusive reliance on rate curred in part to ration central bank credit for controlling domestic credit conditions as by imposing a higher cost for successive well as for maintaining international equi­ tranches of borrowing, or for borrowing ex­ librium is impractical. As a result, opera­ ceeding stipulated periods, and in small tions of the discount window have been part because the discount mechanism has supplemented by other means of monetary been used as a means of selective credit management: control. Also, the link between the princi­ pal official rate and subsidiary rates has a. In several countries, open market gradually become more flexible. operations and various techniques to con­ 5. In several of the countries surveyed, trol the effect of fluctuations of exchange discounting provides at least a part of the holdings on bank reserves have been devel­ permanent additions to the reserve base. oped to supplement the discount mecha­ While for a generation the Federal Reserve nism. Reserve requirements have been in­ System has been using open market opera­ troduced in several countries. tions in U.S. Government securities for this b. By and large, however, quantitative purpose, foreign experience suggests the controls to limit permissible expansion of possibility that in the future some part of bank credit or to regulate access to the dis­ the growth in the reserve base could possi­

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bly be supported through the discount quotas, and other means; and (b) for re­ mechanism. stricting extension of credit for purposes, or 6. Operations at the discount window to areas, of low priority. It offers, however, have been simplified and made more flexi­ only scant guidance for possible aggressive ble in several countries by shifting the em­ use of the discount window in deflationary phasis to advances and to repurchase agree­ situations. ments. Depending on the country, advances Some of the techniques discussed in the are either a normal substitute for discounts paper were tried in the United States in the (substantially identical rate and terms 1920’s; others are novel to American expe­ applying to both operations) or a means of rience. In many cases, such techniques were obtaining additional central bank accom­ shaped by the particular characteristics of modation under more stringent conditions, each national financial system. for short periods but at a higher cost. 8. While the underlying conditions in 7. Foreign experience offers numerous the United States are considerably different examples of window use for (a) encourag­ in several respects from those existing in ing specific activities (or by designated sec­ the countries covered by this paper, a few tors) through preferential rates, special of the techniques developed abroad recom­ credit lines, access to the window outside of mend themselves for further study.

JULY 5, 1967 CAPITAL AND CREDIT REQUIREMENTS OF AGRICULTURE, AND PROPOSALS TO INCREASE AVAILABILITY OF BANK CREDIT Emanuel Melichar and Raymond J. Doll Board of Governors and Federal Reserve Bank of Kansas City

The paper, “Capital and Credit Require­ ment of the Secretariat as to the key impli­ ments of Agriculture, and Proposals to In­ cations for the design of the future discount crease Availability of Bank Credit,” mechanism is expressed. investigates: (1) potential credit require­ ments of the agricultural industry; (2) 1. Credit needs of agricultural areas and availability of credit in rural areas; (3) the role of commercial banks mobility of credit flows between rural The paper concludes that, up to the present and other sectors of the economy; (4) time, agriculture has been able to meet its unique problems confronting rural banks; rapidly growing credit needs; the bulk of and (5) proposals for altering prevailing production credit has come from commer­ mechanisms or for providing supplementary cial banks, but other institutions such as the mechanisms that will help alleviate difficul­ Federal intermediate credit banks have as­ ties that may occur. sumed increasing importance. The credit The main points in this paper that the needs of agriculture are expected to con­ Secretariat believes to be important are tinue to increase at a rapid pace, however, briefly summarized, and the current judg­ and it is questionable whether commercial

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banks will be able to maintain their com­ and an increasing supply of locally gener­ petitive position in this area. Since deposit ated funds. growth in these banks is closely related to income growth and credit needs grow 3. Ultimate solution— market perfection largely out of a changing capitalization Despite the limited contributions that the ratio rather than an expanding industry, the redesign of the discount window may make local banks will probably find it more and to the filling of agricultural needs, the Sec­ more difficult to mobilize sufficient funds to retariat feels that the only long-run solution make these loans. The trend is aggravated lies in the perfection of secondary markets by declines in country bank holdings of liq­ for bank assets and liabilities. What might uid assets and by their very limited access appear to be a preferred position presently to the central money market. occupied by the large banks results essen­ The Secretariat would not suggest that a tially from their ready ability to sell their deliberate attempt be made to perpetuate instruments—both earning assets and liabili­ the banks in their current share of the mar­ ties—in the market place. Small rural banks ket. But it would support the principle that will be able to compete for funds on an the Federal Reserve should attempt to in­ equal footing only to the extent that they sure that banks have an equal opportunity have a similar ability to market their instru­ to compete for agricultural business and are ments. not handicapped by imperfections in the flows of funds. 4. Ad hoc System committee The issue of market perfection lies largely 2. Role of the discount window outside the scope of the discount study, and The Secretariat is opposed to the provision the Secretariat therefore recommends estab­ of long-term credit through the discount lishment of an ad hoc System committee to window, including that to banks in agricul­ investigate and develop suitable means of tural areas. It feels that such credit would perfecting market performance and improv­ probably enmesh the System in socioeco­ ing credit flows. Since this study would be nomic and political problems beyond its independent of the discount study and scope and competence, and that it could re­ would probably continue for some time sult in a pyramiding of debt on the part of past its conclusion, the Secretariat will not individual banks that could become danger­ try to outline specifically the areas of con­ ous from the supervisory point of view. cern or actions of this group. It does sug­ However, a contribution to the credit gest, however, that such a committee study needs of agricultural areas can be made encompass the whole broad panoply of sec­ through more liberal provision of seasonal ondary markets, and that it establish special credit. In addition to meeting certain agri­ subcommittees to concentrate in those mar­ cultural credit needs directly, this and any kets that seem to have the greatest difficul­ other liberalization of the discount window ties and/or hold out the greatest hope for should result in the freeing of a limited improvement (for example, the mortgage amount of funds, currently held in highly market and the market for agricultural liquid forms as secondary reserves, for paper). The newly created committee longer-term lending. This liberalization should also determine the extent of its in­ might even go further than its direct effects volvement with other interested Federal and act as a catalyst, spurring local growth agencies.

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JULY 5, 1967 A STUDY OF THE MARKET FOR FEDERAL FUNDS Parker Willis Federal Reserve Bank of Boston

The paper, “A Study of the Market for be particularly true in periods of tight Federal Funds,” describes and analyzes the money, when the large banks are keenly in­ growth and development of the Federal terested in retaining funds to finance their funds market, emphasizing those changes own lending activities. that have occurred in the postwar period. 2. The adoption of the lagged reserves The paper notes that the market has be­ and reserve carry-forward proposals will come broader, deeper, and more efficient in probably tend to reduce the need of smaller recent years. As a result, the linkages have banks for 1-day money and may also tend been strengthened within the various divi­ to reduce small-bank participation on the sions of the money market and also be­ selling side of the funds market. This fol­ tween the money market and longer-term lows from the likelihood that banks under credit markets. the new plan will be able to carry over Improved brokerage facilities and in­ small misses into the next reserve period. creased services provided by accommodat­ 3. It is questionable whether or not ing banks have given the market an increas­ small banks should be encouraged to use ingly national character. While a handful of the Federal funds market to support addi­ banks account for most of the dollar tions to portfolios, since considerable skill volume of trading, the market has ex­ is required in the use of this day-to-day panded to include a relatively large number market as a dependable source of reserves. of smaller banks. Many of these indicate There is also some question as to the desir­ that trading in funds has reduced their reli­ ability of larger banks using the market for ance on transactions in Treasury bills and this purpose to the extent they have. This is other money market instruments as a means an additional reason for believing that the of reserve adjustment. Most small partici­ development of new and improved liquidity pating banks, however, use the market pri­ standards for banks should be given high marily as a means of disposing of excess priority. reserves. 4. On the whole, the Federal funds mar­ The Secretariat believes that the follow­ ket has worked very well in recent years ing points should be kept in mind in re­ and has demonstrated its ability to respond designing the discount mechanism. quickly and appropriately to changing 1. The Federal funds market is working needs and conditions. The adaptability of quite efficiently for large and medium-sized this market, the implementation of the banks. For small banks, however, the mar­ lagged-reserve proposal, and the possibility ket is not now, nor does it seem likely to of a discount window redesigned in such a become, a dependable source of funds, in way as to permit more ready access by part because many large institutions are ap­ smaller banks argue against adoption of parently reluctant to sell funds, at least on such drastic proposals as a Federal funds a relatively sizable or extended basis, to auction or even the milder proposal that the their smaller correspondents. This seems to Federal Reserve act as a clearinghouse for

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funds transactions of smaller banks. The The Federal Reserve might, however, Secretariat has a strong preference for consider changing its rules so as to permit avoiding any action that would tend to dis­ wire transfers in uneven amounts without courage the development or improvement penalty. This should provide a minor stimu­ of private market facilities that have a rea­ lus to further broadening of the market sonable chance of developing adequately on since it would permit interest on Federal their own. funds to be included in the return wire.

JULY 19, 1967 THE SECONDARY MARKET FOR STATE AND LOCAL GOVERNMENT BONDS William F. Staats Federal Reserve Bank of Philadelphia

The paper, “The Secondary Market for located in major financial centers who State and Local Government Bonds,” eval­ make a market in the issues of large, well- uates the municipal bond market on the ba­ known governmental units. There is some sis of its performance during 1966 against evidence that investors trading with smaller three widely recognized criteria of a good dealers in the local or regional sectors of securities market. the market may pay higher costs than neces­ It concludes that the market passes the sary, but additional research would be first test—that there should be free interplay needed to prove this point. between the largest possible number of buy­ Under normal conditions the market ers and sellers who have available to them passes the third test of being able to adjust a maximum amount of information perti­ readily to temporary disturbances in sup­ nent to the market—moderately well but ply/demand relationships, thereby main­ there remains room for improvement. The taining price continuity. During the peak of breadth of the market is reduced to some the cyclical pressures in 1966, however, the extent by the tax-exempt feature, which performance of the market deteriorated tends to limit the market to those institu­ sharply, largely because of the abrupt shift tions and individuals able to benefit from of commercial banks from the buy side to the special tax advantage. Also, bonds that the sell side of the market. Only a handful carry exemption of State and local taxes of dealers continued to make markets in tend to be restricted in their market to municipals and some of these bid very low fairly small geographic areas. Perhaps the so as to minimize the likelihood of taking most critical shortcoming is the existence of on additional bonds. Under these circum­ a huge number of heterogeneous bonds, stances, wide differences occurred in the making it difficult and costly for market prices of two consecutive trades in the same participants to secure sufficient information bond on the same day. to make an optimal decision. The Secretariat recognizes the following The second test, that buyers and sellers implications of the paper for the redesign of be brought together at minimum cost the window: through an efficient institutional structure, 1. Considering the extreme nature of the is passed with a high score by those dealers pressure placed on the municipals market in

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1966, this paper can be accepted as docu­ secondary market for municipal securities mentary evidence that the secondary mar­ could become an increasingly important al­ ket performs very well under normal cir­ ternative to discount accommodation. cumstances and can survive even the most 3. The Secretariat has a strong prefer­ trying circumstances. This does not rule out ence for giving private market facilities free the possibility of improvement, and the Sec­ rein to develop and adapt to changing con­ retariat recommends that the performance ditions, if they seem to have the capacity. of this market be reviewed from time to The rapid development and the generally time by System study groups in order to good performance of the secondary market stay abreast of its developing characteristics in municipals make unnecessary the adop­ and to be able to recommend changes that tion at this time of any of the more drastic would moderate the disproportionate im­ possibilities listed in the paper. No need is pact of monetary restraint on small, rela­ seen at present to use open market opera­ tively unknown governmental units and tions to stabilize prices of muncipals or to would enable the market to operate better have a Government agency act as broker. It during periods of unusual stress. could be necessary, however, for the Fed­ 2. The growing importance of municipal eral Reserve to exercise a lender-of-last- securities in the portfolios of commercial resort function in connection with the mu­ banks and the increased willingness, espe­ nicipals market in periods of unusual stress. cially of large banks, to sell these securities The Secretariat looks forward to municipal in the market have added a new dimension securities being made eligible for discount to the reserve adjustment mechanism. The on passage of proposed legislation.

JULY 19, 1967 DISCOUNT POLICY AND BANK SUPERVISION Benjamin Stackhouse Federal Reserve Bank of New York

The paper, “Discount Policy and Bank Su­ The remainder of this memorandum pervision,” sets forth the various examina­ summarizes the main points of the paper tion approaches to liquidity under the pres­ and sets forth its implications for the rede­ ent framework for borrowing specified in sign of the discount window, as the Secre­ Regulation A. It recognizes that recent tariat sees them. banking changes have altered the tradi­ tional concept of bank liquidity and that a 1. Postwar changes in liquidity and in the substantive change in the rules governing meaning of liquidity standards discounting could alter that concept still Bank liquidity, defined as the ability of a further and necessitate a revised approach bank to meet known and foreseeable de­ to liquidity measurement. While the paper mands for money that may be made upon does not attempt to spell out any such new it, has become a subject of increasing con­ approach, it is nonetheless valuable as a cern in recent years. Not only has liquidity summary of approaches in use under the declined to quite low levels according to the present rules of the game. traditional liquidity measures, but the use­

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fulness of these measures has been impaired and soundness of longer-term assets, on the to some extent by the growing tendency for adequacy of capital, on the adequacy of banks to adjust positions by manipulating earnings to cover the costs of borrowing, their liabilities. Borrowing from various and on flow of funds analysis. sources—in the Federal funds market, through sales of securities under repurchase 3. Cooperation between bank examination agreements, and more recently through the and discount administration Euro-dollar market—and what might be The redesign of the discount window will termed “quasi-borrowing” through issuing require some readjustment in the approach negotiable certificates of deposit have all to liquidity employed by bank examiners. provided funds to meet other deposit with­ Within reasonable limits, this can be ac­ drawals and credit demands. Borrowed complished without affecting the quality of funds, however, cannot be regarded as un­ their supervision. conditional sources of liquidity, since short­ The window redesign will probably also term borrowing itself establishes a need for result in increased attention to a bank’s liquid funds in the very near future for pur­ over-all liquidity position on the part of dis­ poses of refinancing or repayment. The counting authorities. This will make it all foregoing changes that have occurred in the more desirable for administrators of the banking practices in recent years make nec­ window and bank examiners to utilize the essary the formulation of new and im­ same methods for analyzing that liquidity proved liquidity standards. Contemplated position. While bank examination should changes in the discount mechanism add a continue to have primary responsibility for new note of urgency to this endeavor. enforcing liquidity standards, the Secretar­ iat recognizes the need for complementary 2. Liquidity standards under the new discipline in connection with discount ad­ window ministration. The precise nature of the role Bank liquidity standards will not be less im­ assigned to each function will depend, of portant if the discount window is opened course, on the kind of discount mechanism wider and made a more certain source of that is ultimately adopted. But in any case, funds. They will, however, need to be there should be a free and regular flow of somewhat different. Assurance of being information and a close coordination of ac­ able to meet a larger portion of seasonal tions between the two functions. Presuma­ and random needs through discount accom­ bly, the examination department would con­ modation, for example, would reduce the duct an intensive analysis of a bank’s need for banks to hold as large a volume of liquidity position at the time of each exami­ short-term, highly liquid assets as secondary nation, while the discount department reserves. Precise liquidity standards cannot would make repeated but less detailed re­ be developed before the details of the new views of current positions in connection window are known, but assuming a some­ with occasional discount accommodation what more liberal window, examiners during the course of the year. Both func­ would probably tend to regard a relatively tions may also need to be supported by a lower level of bank liquidity (as currently more regular and frequent flow of pertinent defined) as adequate, while placing corre­ data from each member bank than is re­ spondingly greater emphasis on the quality ported under existing arrangements.

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AUGUST 1, 1967 THE SECONDARY MARKET FOR NEGOTIABLE CERTIFICATES OF DEPOSIT Parker Willis Federal Reserve Bank of Boston

The paper, “The Secondary Market for Ne­ ther with the establishment of uniform rates gotiable Certificates of Deposit,” describes on all maturities of CD’s in December 1965 and analyzes the growth and development and the rapid escalation of market rates in of the secondary CD market, emphasizing 1966. With the flattening of the yield curve, those changes that occurred in the period an important source of profit was elimi­ from 1961 through 1966. Because second­ nated. Furthermore, dealer positions be­ ary market trading takes place almost exclu­ came exposed to undercutting from primary sively in large-denomination CD’s of fairly issuers who extended the maximum rates to well-known banks, which are issued primar­ shorter and shorter maturities. As a result ily to nationally known concerns, the paper, dealers reduced their inventories sharply of necessity, focuses on the kind of CD that and trading activity declined to very low has implications for large banking institu­ levels. tions. Despite the gyrations of the secondary The secondary market during this CD market during the period under review, 1961-66 period experienced ups and downs participants seemed pleased with the mar­ in activity, primarily in response to differ­ ket’s performance. In rating the various ing relationships between money market short-term markets, they described the mar­ rates and Regulation Q ceilings. Secondary ket for Treasury bills as excellent and ac­ market activity tended to expand as long as corded a “good” rating to the market for banks were forbidden to pay more than 1 bankers’ acceptances and CD’s. This is a per cent for 30- to 89-day money. This quite remarkable tribute to the speedy evo­ forced a downward-sloping yield curve on lution of the-CD market in view of the fact the market and permitted both dealers and that the acceptance market is an old estab­ investors to profit from riding the curve. lished market in which the Federal Reserve Under such circumstances dealers were has participated as a buyer and seller for willing to hold fairly large inventories. Dur­ many years. While the secondary CD mar­ ing the period from 1961 through 1964, ket still has limited “depth, breadth, and re­ the market grew steadily, dealer inventories siliency,” in view of its rapid development rose, and the volume of trading expanded and its performance during trying times, significantly. The increased liquidity of the continued improvement can be expected CD instrument provided further incentive with the passage of time. for growth in the volume of CD’s outstand­ The paper catalogues a number of pro­ ing. posals designed to improve the marketabil­ Activity in the secondary market de­ ity of certificates. Implementation of some clined following a change in Regulation Q of the proposals could presumably be left in November 1964 that permitted issuers to entirely to the market and would require no pay as much as 4 per cent on maturities of action on the part of any governmental less than 3 months. Activity declined fur­ unit. These proposals include: (1) the issu­

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ance of certificates on a discount basis, (2) 1. To some extent the secondary market dealer endorsement of certificates for a fee provides an alternative means of reserve ad­ as in the case of acceptances, and (3) the justment. Banks hold some CD’s issued by marketing of certificates of smaller banks other banks that can be sold in the market. through a firm that would be recognized by Also, dealers have been known to acquire a consortium of banks as the leading dealer CD’s directly from issuing banks. More im­ in their certificates in the secondary market. portantly, the existence of the secondary None of these apparently show much prom­ market imparts a fairly high degree of li­ ise. The practice of issuing certificates on a quidity to the CD instrument, thereby en­ yield-to-maturity basis is now firmly estab­ couraging the growth of the primary mar­ lished, dealers do not want to assume the ket. This, in turn, makes it possible for obligation of certifying the credits of issuing banks, under normal circumstances, to at­ banks, and an attempt by a large commer­ tract funds by creating new instruments, a cial paper house in early 1966 to market fact that has implications for a discount CD’s for a consortium of regional banks window designed to accommodate seasonal met with an unenthusiastic reception. needs. For a significant number of banks, Several other proposals for improving issuance of CD’s may be a reasonable alter­ marketability of certificates would require native to reliance on a seasonal discount action on the part of one or more Federal window. agencies. These suggestions include: (1) 2. There does not seem to be a pressing enhancing the homogeneity of the CD in­ need for the Federal Reserve to encour­ strument by granting complete FDIC insur­ age further development of the market for ance coverage; (2) permitting the Federal large-bank CD’s. This market arose in the Reserve to purchase certificates for the Sys­ first instance in response to particular needs tem Open Market Account and/or enter of an important group of large banks, and into repurchase agreements with certificate in the main, the market can be relied upon dealers; (3) allowing Federal Reserve to adapt itself to the changing needs of Banks to act as brokers in smaller-bank these banks. Because it believes that the CD CD’s, arranging contacts between banks market as presently constituted is primarily needing funds and wishing to issue CD’s suited to the needs of big banks, the Secre­ and other banks with surplus funds that tariat is unwilling to endorse any specific might be interested in buying CD’s; and recommendations designed to expand the (4) permitting greater market freedom market to include a larger number of with respect to CD rates. The author seems smaller institutions. The Secretariat holds to have very little enthusiasm for any of this view because of the hazards to which these proposals except the last. relatively small and undiversified institu­ The Secretariat sees the following impli­ tions with managements unskilled in money cations of the secondary negotiable CD market matters could expose themselves by market for the redesign of the discount win­ aggressive CD sales to other than their reg­ dow. ular customers.

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AUGUST 23, 1967 OVERSEAS BRANCH BALANCES IN THE RESERVE MANAGEMENT PRACTICES OF LARGE MONEY MARKET BANKS Fred H. Klopstock Federal Reserve Bank of New York

The Secretariat recognizes the following im­ market banks. Therefore, the existence of a plications of the paper, “Overseas Branch growing volume of Euro-dollar borrowing Balances in the Reserve Management Prac­ through the foreign branches does not mean tices of Large Money Market Banks,” for that the money market banks as a group the redesign of the discount window: might not need to use the discount window 1. Borrowings from foreign branches as an important adjunct to money market can, under certain circumstances, be an im­ borrowing when making reserve adjust­ portant alternative to borrowings in the ments. U.S. market or from the discount window 3. But the ability to borrow through for the small group of large banks that have their foreign branches does give those branches abroad. Although only a dozen money market banks with branches abroad banks are presently involved, they account a competitive edge over the other money for as much as 47 per cent of the business market banks. Banks with foreign branches loans made by weekly reporting member may have a better opportunity to develop banks, and their share in deposits and total customer relationships with foreign busi­ assets of the same group of banks is about nesses and investors than do banks that op­ one-third. erate only in the United States or through 2. Money market banks as a group do correspondent banks abroad. Moreover, not obtain corresponding additions to their banks with branches are able to bid for de­ reserve balances as a result of borrowing of posits without the actual or potential con­ Euro-dollars through foreign branches, as— straints impused by the existence of Regula­ for example— they do whenever they borrow tion Q ceilings. Federal funds net from nonmoney market The advantages of borrowing through banks. This is because borrowings by U.S. branches are probably least where the U.S. banks of foreign-owned funds through for­ head office is seeking funds for day-to-day eign branches reduce the supplies of these adjustments; this is because time-zone dif­ funds invested directly by foreigners in the ferences, incomplete information, and vari­ U.S. money market, either through deposits ations in market practice make it difficult in U.S. banks or through purchases of for U.S. banks to make last-minute adjust­ money market instruments.1 Shifts out of ments by having their branches bid for these latter assets would typically have a funds abroad. considerably adverse impact on the money The added measure of flexibility that the banks with foreign branches obtain ap­ 1 This is the case even when a foreign investor pears, in the first instance, to be only at the moves from a foreign-currency investment to a dollar expense of other money market banks. But investment, since the foreign central bank that loses how the effects of an increase in borrowing reserves in the process will have to reduce its invest­ ments in U.S. money market assets. from branches are ultimately distributed

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will depend on the extent to which the to the branches (usually, but not neces­ banks that lose foreign deposits turn to sarily always with repurchase agreements) other market sources of funds or to the — argues against reliance on any narrow or discount window. pat definition of liabilities for purposes of 4. In any event, the wide variety of ways either bank supervision or discount window in which large banks have proved able to administration. The extensive range of al­ supplement their liquidity positions— in­ ternative sources of funds available to such cluding, in those cases where foreign banks requires a close analysis and evalua­ branches exist, not only increased liabilities tion in any appraisal of the liquidity of to those branches, but also the sale of assets these institutions.

SEPTEMBER 6, 1967 AN EVALUATION OF SOME DETERMINANTS OF MEMBER BANK BORROWING Leslie M. Alperstein Board of Governors, Federal Reserve System

The paper, “An Evaluation of Some Deter­ from sources other than the Federal Re­ minants of Member Bank Borrowing,” is a serve, is a positive function of the size of the statistical study of factors affecting the like­ bank. lihood, volume, and frequency of member Because of limitations of data and tech­ bank borrowing from the Federal Reserve nique, however, the conclusions of the and from other sources. Most previous paper should be regarded as highly tenta­ studies of this nature have used aggregative tive. Individual bank borrowing data were information, a fact that has limited their not available for the most recent period of usefulness. One important contribution restraint and the analysis is therefore lim­ made by this paper is the basing of analysis ited to 1959-61. This time span is an edi­ on data relating to 143 individual banks in fying one, but it should be noted that, in six Federal Reserve districts. contrast to the 1966 period, the Federal The paper relates borrowing, defined in funds rate remained below the discount various ways, to five independent variables rate. It is difficult to predict how much this — a liquidity ratio, bank size, Federal Re­ change in rate structures might have influ­ serve district, reserve classification, and the enced the results. differential between the discount rate and The meaningfulness of the results is also the 3-month Treasury bill rate. limited by the choice of districts used. Five The paper provides confirming evidence of the six districts included fall in the mid­ of some of the relationships which one dle group when all districts are classified would have expected a priori and which are into three groups by the degree of restric­ fairly obvious. It concludes, for example, tiveness of their discount administration. that borrowing is inversely related to bank On the basis of such a sample, it is not sur­ liquidity; that banks, if they have to bor­ prising that the study failed to uncover any row, tend to borrow from the least expen­ evidence of significant interdistrict differ­ sive source; and that borrowing, especially ences.

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Within the bounds imposed by these lim­ bank borrowing. This suggests that careful itations, the finding most relevant to the attention should be accorded the possibili­ redesign of the discount window is the evi­ ties for more active use of the discount rate dence that interest rate differentials are im­ as a device for controlling the volume of portant determinants of sources of member member bank borrowing.

FEBRUARY 23y 1968 DISCOUNT POLICY AND OPEN MARKET OPERATIONS Paul Meek Federal Reserve Bank of New York

The paper, “Discount Policy and Open value for this purpose stems from its two Market Operations,” undertakes to review key functions: (a) it is where otherwise un- the current operating relationships between provided-for changes in the economy’s re­ discounting and open market operations, as serve demands show up for accommoda­ seen from the vantage point of the Trading tion; and (b) in due course it imposes Desk, and to outline the considerations that certain pressures upon borrowing banks to should be taken into account in making any readjust their assets and liabilities, thereby changes in the discount mechanism in order exercising an influence over the growth and to maintain the effective functioning of relative availability of bank credit and the open market operations. behavior of interest rates. On the basis of its study and discussion 4. Thus, a move toward more restrictive of this document, the Secretariat regards open market operations— or an expansion the following points as the main implica­ of credit demands— generally results in tions of open market policy considerations greater bank borrowing at the discount win­ for the redesign of the discount mechanism. dow. This is followed by some tightening of 1. Open market operations and the dis­ credit market conditions and moderation of count window need to function together bank credit availability as borrowing banks harmoniously to achieve a climate of re­ endeavor to liquidate assets or borrow serve availability that serves the current funds elsewhere in order to retire their in­ objectives of monetary policy. debtedness to Reserve Banks in accord with 2. For a variety of reasons, open market current discounting practices. Conversely, a operations have become, and should, for move toward more liberal open market op­ the foreseeable future, continue to be, the erations— or a slackening of credit de­ predominant means of affecting the supply mands— generally produces a reduction in of reserves to the banking system. Reserves bank borrowing at the discount window, required for seasonal purposes may, over followed by some easing of credit market time, come to be furnished increasingly conditions and enhancement of bank credit through the discount window, however. availability as erstwhile borrowing banks 3. Under current procedures, the aggre­ are freed of the pressure to contract their gate level of member bank borrowing earning assets or borrow funds elsewhere in serves as one of the practical operational order to conform to the current rules with targets for open market operations. Its respect to the use of the discount window.

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5. The present discount mechanism en­ 8. There is scope for liberalization in the deavors to limit the volume and timing of amount of member bank borrowing to be reserves provided through the window by permitted without serious detriment (and confining appropriate borrowing essentially perhaps even with some benefit) to the to marginal and temporary purposes; this efficacy of open market operations, pro­ is accomplished by both fostering bank re­ vided that the volume of reserves borrowed luctance to borrow and applying active ad­ under any new rules is not so large, and ministrative discipline. does not change with such rapidity and un­ 6. The present discount mechanism en­ predictability, as to exceed the capacity of deavors to achieve a reasonable degree of the Trading Desk to offset it with open predictability in the response of a borrowing market operations whenever and to what­ bank to its discipline (in terms of the bal­ ever extent they result in over-all reserve ance sheet and interest rate changes in­ availability incompatible with current mon­ duced) by holding the conditions of discount etary policy. accommodation—apart from the discount 9. The ability of the Federal Open Mar­ rate, which is varied contracyclically—as ket Committee and the Trading Desk to uniform as practicable (a) over time and perceive and make use of borrowing (b) as among banks in similar circum­ changes and consequent bank responses stances. should be enhanced to the extent that bank 7. However, no form of discount mecha­ borrowing practices can be made more uni­ nism that is designed to provide funds at form and bank responses to borrowing can the initiative of member banks can comply be regularized. Changes that would make ideally with the objectives cited in para­ bank borrowing and its consequences more graphs 5 and 6. The present mechanism falls predictable should enable open market op­ short by the extent to which variations in erations to generate desired money and credit demands or reserve flows produce credit market conditions with a higher sharp and uneven concentrations of mem­ order of reliability. ber bank borrowings. It also falls short in 10. Any changes made in the discount the degree to which differing bank adjust­ mechanism to achieve these purposes ments result from any given aggregate level should be reasonably long-lived. Frequent or change in borrowing, depending upon changes in the “rules of the game” could keep the patterns of borrowing and their ef­ differences among borrowing banks in (a) fects in continuous flux, and thereby make their reluctance to borrow, whether inher­ it difficult for open market operations to be ent or induced; (b) their closeness to the conducted with any assurance of the need thresholds of administrative disciplinary ac­ for or effects of such actions. tions; (c) the kinds of administrative pres­ 11. From an operational point of view, sure received from their Reserve Banks; the most convenient time to introduce any and (d) their sensitivity to administrative major changes in the discount mechanism discipline when encountered; and also de­ would be in a period of monetary ease, pending upon the variations in all these fac­ when borrowing would be minimal and tors over time, because of changes in bank both banks and System authorities could management, administrative rules, and the grow gradually accustomed to the new surrounding economic and financial envi­ framework within which reserves would be ronment. supplied. It is possible, however, that the

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shortcomings in the current system could rant a prompt introduction of some reme­ become so troublesome under the stresses dial changes in discounting rules, even at of a period of monetary restraint as to war- the cost of transitional operating difficulties.

FEBRUARY 27, 1968 THE LEGITIMACY OF CENTRAL BANKS Kenneth E. Boulding University of Colorado

The paper, “The Legitimacy of Central tion, in its exchanges with other elements of Banks,” looks at the Federal Reserve from society, to yield “payoffs” that are greater a lofty vantage point. In a highly abstract, than the social costs of its operation—as multidisciplinary view, the details of day- though it had a heavy positive balance in a to-day operations and tactics are obscured, comprehensive cost-benefit analysis. and the System is revealed as one of many Good “payoffs” are often not sufficient, interrelated nodes of activity in a large and however. They are best accompanied by complex social system. Boulding is inter­ some combination of the five other legiti­ ested in the factors which give “legitimacy” macy factors, which he labels “Sacrifice,” to the central bank and its role. He has not “Age,” “Mystery,” “Ritual,” and “Alli­ commented specifically—and was not asked ances.” In describing these, Boulding seems to comment—on the discount mechanism. at first glance to be dealing, half-seriously, Any lessons for the window in his paper with trivialities. The terminology is strange must be inferred. in this context, but Boulding is using it By “legitimacy” Boulding means to quite seriously; and, as one becomes accus­ imply a degree of acceptance and approval tomed to his mode of expression, it is ap­ sufficient to induce other social role-occu- parent that he is attempting to take into pants to serve the institution with “inputs.” consideration some very powerful social He sees legitimacy as a part of the social forces that the mechanics of formal eco­ cement that holds the elements of society nomic or political analysis often overlook. together and makes possible a continuity of “Sacrifice” he defines as a one-way trans­ operations. Without “legitimacy,” Boulding fer from one decision unit to another, by has said elsewhere, relations among individ­ contrast with exchange, which is a two-way uals and institutions would become “one- transfer. His second social force is “Age,” shot jobs, single acts of violence or even of the simple act of surviving over time. exchange, without any continuing pattern.” Third, he refers to “Mystery,” something For a particular institution, a loss of legiti­ that is not understood but is dimly macy will lead to an erosion of its viability perceived by the public as something grand and to its ultimate demise. The letter of the or deeply significant. “Ritual,” the fourth law and the police power of the State may social force, he describes as artificial order, not be sufficient to counter such a loss. stemming from regularly repeated rituals, Six sources of legitimacy are delineated liturgies, and human law. Last, Boulding by Boulding. The first is familiar and, in a discusses “Alliances,” the identification of a sense, obvious. It is the ability of an institu- new and nonlegitimate institution with

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other institutions that already possess a What this paper contributes to a study great deal of legitimacy. These are the five of the discount mechanism is highly infer­ classifications into which Boulding fits real ential. It emphasizes that the most de­ events and processes in order to describe pendable basis for an institution’s viability their impact on institutions and to evaluate is its real payoffs to society. This places a their contribution to a social equilibrium high premium on recognition of social that is constantly upset and re-established as priorities and a lower value on doctrine. It intentions and consequences collide. suggests that it is better to keep the finan­ This interpretation attributes a function­ cial mechanism running smoothly and alist view of society to Boulding, which effectively than it is to keep its traditional may be unjustified. His paper, after all, is principles inviolate. The consequent pain of not intended to state more than a fragment inflation may qualify as Sacrifice. It is bet­ of a theory, and one should not extrapolate ter to look at the real consequences of a from it. It provides sufficient grounds, how­ particular configuration of the discount ever, for Boulding to find the Federal Re­ mechanism than to be preoccupied with the serve System “for its time, an optimum so­ logic of its construction. Boulding would lution for the maximization of legitimacy,” admit, however, that in the performance of which faces no major threats. His reasons central banking functions, a little Mystery are somewhat different from those found in is a good thing. And the Ritual of the dis­ the standard texts. They include elements of count rate change in itself has a value. Sacrifice (on the part of member banks), Boulding does not imply that the Federal Age, Mystery, and Ritual (including move­ Reserve System should be run by a public ments of the discount rate). At the mo­ opinion poll. He is a pragmatist, not a con­ ment, the System’s necessary alliance with formist. In his view of human endeavor, the Government enhances the former’s legiti­ System should lead as well as follow, but macy, although he believes that at some fu­ preferably in directions that subsequent ture time that relationship could be re­ public evaluation will regard as socially versed. beneficial.

MAY 13, 1968 INTRAYEAR FUND FLOWS AT COMMERCIAL BANKS Emanuel Melichar Board of Governors, Federal Reserve System

The study, “Intrayear Fund Flows at Com­ large groups of banks. The magnitude and mercial Banks,” was undertaken to help ex­ duration of individual flows, as well as their plore the feasibility of permitting individual distribution among different types and sizes member banks to meet a larger portion of of banks, could affect the advisability of their seasonal needs through discounting. A liberalizing borrowing for seasonal pur­ basic need for such a study was to obtain poses. A primary objective of the study was data on seasonal flows of funds at indi­ to provide appropriate data of that kind. vidual banks, as opposed to the generally The data in the study were obtained available data on aggregate net flows at from the periodic reports of condition re­

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quired from all insured banks. Two 12- mind that any empirical measures of cur­ month time frames—June 1962-June 1963 rent seasonal movements of loans and de­ and June 1965-June 1966—were exam­ posits cannot take into account those cases ined; detailed call report data were avail­ where banks have curtailed loans because able approximately quarterly for the first of deposit outflows and lack of ready of these, but only semiannual data were sources of seasonal credit assistance. Thus available in computer language for the true seasonal pressures, which it is expected second. Fund flows were defined as the net would be the appropriate measure of the changes in deposits and nonfinancial loans need for increased discount window assist­ of individuals, partnerships, and corpora­ ance, are undoubtedly somewhat larger tions. Because of the short duration of the than indicated by these data. periods being examined, the normal statisti­ The net effect of these considerations is cal method of extracting changes due to almost certainly a downward bias of the secular and cyclical influences could not be data. In recognition of the statistical short­ applied. However, allowance for “trend” in comings of call report data, the Secretariat each item was achieved by calculating the undertook several projects to develop some June-to-June change and then subtracting independent indication of seasonal credit one-fourth of this value from each observed needs in individual districts. These projects quarterly change and one-half of the value encountered even greater difficulties in de­ from each observed semiannual change. fining and measuring these needs and in no The calculation of fund flows in each pe­ case did they produce clear and unambig­ riod was performed separately for each in­ uous or even usable results. However, the sured bank; aggregate fund flows for groups over-all impression gained from the pilot of banks were then computed by summing studies is a confirmation of the expected the flows at the individual banks. Gross downward bias in the call report data. outflows or gross inflows were computed by Despite these drawbacks in data, the summing individual flows only at banks study carried out by Mr. Melichar repre­ with outflow or with inflow, respectively. sents the only comprehensive treatment of The aggregate net fund flow for a group of the probable demands that would be made banks was obtained by summing their in­ on a liberalized discount window for sea­ dividual fund flows irrespective of direction. sonal credit and makes a useful contribu­ The use of call report data is recognized tion to the examination of this possibility. as having obvious drawbacks. It is unlikely The remainder of this memorandum sum­ that these specific dates coincide precisely marizes and comments on some of the with the peaks and troughs of seasonal paper’s more important findings for the re­ credit swings, and so results are probably design of the discount window. biased downward somewhat. In addition, the data contain a random element which 1. Fund flows at large and small banks results in a bias of indeterminate direction. compared Last, using call report data makes it likely According to Mr. Melichar’s results, the that the balance sheets on which the data fund flow at a large and primarily urban were based had undergone some window bank arises mainly through seasonal dressing; the specific data used are not, changes in deposits, with less trend-adjusted however, normally subject to significant change in loan volume on a half-year basis. window dressing. It should also be kept in At some small rural banks, on the other

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hand, loan volume undergoes a substantial the year, one-half of all member banks ei­ intrayear change because of the very high ther experienced fund inflow or had outflow dependence of the bank and the community of less than $250,000. In each period, how­ on a single industry with a marked seasonal ever, large individual outflows accounted movement in its funds needs. For the same for the bulk of the total outflow. The 18 reason, such smaller banks also exhibit per cent of member banks with outflows of greater relative intrayear change in depos­ $1 million or more in the first half, for in­ its. stance, had 86 per cent of the total gross Relative to its deposits, the large bank outflow of that period. generally finds small changes in U.S. Gov­ As a general rule for the period exam­ ernment securities and in balances with ined, the proportion of banks with outflows other banks to be sufficient to cope with its did not vary greatly by size of bank, and fund flow. In contrast, some smaller banks the direction of total net fund flow in a often have to make relatively large changes given period was the same for different size in these items to meet their loan and de­ groups. As expected, large banks accounted posit flows. On a relative basis, their portfo­ for much of the total outflows in most peri­ lio adjustment problems loom much larger ods. than those of the larger bank. During part In each period studied, outflows at most of the year, relatively large amounts of banks were limited to less than 10 per cent funds have to be kept idle or invested in of deposits. In fact, during each semiannual securities that can be readily liquidated to period, about one-half of the banks with meet the coming seasonal fund outflow. outflows experienced outflows amounting to These results support the view that a less than 5 per cent of their net deposits, substantial need exists among some small and during each quarter over three-fifths of banks, although not necessarily among the banks with outflow were within this large banks, for increased assistance in figure. The bulk of the total outflow oc­ meeting the seasonal demands upon them if curred at these banks with small or moder­ they are to serve effectively the over-all ate individual outflows. But in each period credit needs of their communities. some banks had relatively large outflows, 2. Aggregate fund outflows and the percentage of banks in this situa­ tion differed considerably among the peri­ On the basis of semiannual call report data, ods examined. 22 per cent of member banks had outflows of funds during the second half of 1965, to­ 4. Potential seasonal borrowing by banks taling $0.9 billion or 1.7 per cent of net de­ with large relative outflow Only a minor part of total fund outflow posits at these banks. In the first half of in most periods occurred at small banks, 1966, 78 per cent of member banks had a minor part of each period’s outflow oc­ outflows, which totaled $9.1 billion and curred at banks with large relative outflows, amounted to 4.7 per cent of net deposits at and, as these facts would imply, large such banks. Both semiannual and quarterly relative outflows occurred much more fre­ data for 1962-63 exhibited approximately quently among smaller banks than among the same relationships. larger institutions. 3. Fund outflows at individual banks These findings have several implications Only a minority of banks had large out­ for design of a program that permits more flows during any period studied; even in the seasonal borrowing by member banks. They period of greatest outflow, the first half of are as follows:

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a. “If the program were limited to banks ified percentage of deposits at each bank with the larger relative outflows, which now can be regarded as an estimate of potential have to make large portfolio adjustments, borrowing from the Federal Reserve under the total amount of funds likely to be sup­ a regulation permitting banks to borrow to plied under such discounting would consti­ meet only those fund outflows that exceed tute a very small proportion of total re­ the specified relative level. Under a 5 per serves in the banking system, which would cent “deductible” provision, potential first- be consistent with the System’s general de­ half borrowings are estimated at $2 billion, sire to continue to supply the bulk of mem­ with just over one-half of the sum going to ber bank reserves through open market op­ banks with deposits of $100 million and erations.” over. Potential first-half borrowings under b. “The small banks that constitute the the 10 per cent deductible plan are esti­ majority of banks eligible for the program mated at $400 million, with perhaps two- are likely to be operating at a disadvantage fifths of the total being borrowed by the in present financial markets commonly em­ large banks. ployed for portfolio adjustment purposes. These figures emphasize the substantial The discount route for seasonal funds differences in potential borrowing under should therefore be a relatively attractive different percentage deductible levels. Mr. one for such banks.” Melichar suggests that, on the basis of these c. “Many of the small banks with large data, the 10 per cent level appears to be relative seasonal flows are probably heavily rather restrictive unless it should prove that involved in financing agriculture, a sector many banks have in fact been forced to that in recent decades has been generating limit seasonal lending significantly in recent credit demands in excess of its contribution years. On the other hand, he suggests that to the growth of country banking resources. the 5 per cent deductible, under which The seasonal discount program would pro­ two-fifths of member banks were estimated vide a net addition to the lending resources to be eligible for first-half borrowing, might of such banks that currently find it difficult be considered to violate the goal of limiting to meet total local farm credit demands.” the program to banks with relative outflows While again emphasizing its serious re­ significantly above average. He therefore servations about basing any decisions on has undertaken the same calculations for these data alone, the Secretariat would gen­ intervening percentages and determined erally endorse these implications. that approximately half the credit exposure 5. Outflows exceeding specified relative is eliminated in the move from 5 to 7 per levels cent with progressively smaller decreases as In each period studied, the proportion of one approaches 10 per cent. banks with the large relative outflows was This study provides the most useful greater among the smaller banks. During available data on fund flows, which have periods in which some large banks did have been helpful to the Secretariat and should large relative outflow, however, such banks continue to exert an influence on the ulti­ accounted for a substantial share of the mate design and specification of the sea­ total outflow. Also, because of the size of sonal borrowing privilege. However, the these banks, the total outflow was much Secretariat does not feel justified in making larger during these periods than at other a definitive recommendation for the per­ times. centage deductible plan to be adopted on The amount of outflow exceeding a spec­ this basis.

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NOVEMBER 13, 1968 SOME PROPOSALS FOR A REFORM OF THE DISCOUNT WINDOW Franco Modigliani Massachusetts Institute of Technology

The paper, “Some Proposals for a Reform questioned access to the discount window of the Discount Window,” represents an ex­ up to a predetermined and stated amount. perimental effort by a leading academic The rate charged on this credit would be scholar to design a system whereby the vol­ tied to, and significantly in excess of, a ume of member bank borrowing can be short-term market rate. Professor Modigli­ controlled by the discount rate alone, an ani recognizes the problems inherent in the innovation long recommended, although choice of such a rate, but after this recogni­ usually in more general terms, by many ac­ tion largely sets them aside and uses the ademics. Treasury bill rate as a peg for the purposes Professor Modigliani identifies as one of of exposition. Borrowing at this “regular” the major goals of his proposals a reduction discount window would be on a 1 -day basis, of the slippage between nonborrowed re­ but would be automatically renewable at the serves and the supply of demand deposits option of the borrower. and a consequent improvement in the con­ By setting the discount rate significantly trol that the Federal Reserve exercises over higher than the base market rate, Professor the money supply. He cites free reserves as Modigliani proposes to minimize the level the main source of the slippage and seeks of borrowing at the window while still to minimize variations in the level of free maintaining the Federal Reserve’s function reserves by minimizing fluctuations in the as a lender of last resort. Based on this volume of borrowing at the discount win­ design and certain other assumptions as to dow. linkages in financial markets,1 the paper Other major goals set include the follow­ proceeds to show analytically that, follow­ ing: to eliminate or reduce the discretion ing any disturbance in financial equilib­ and, at times, caprice that the author pres­ rium, free reserves would, in his model, ently sees in discount window operation; to tend to return to their initial levels unless give smaller banks more equitable access to the Federal Reserve took specific action to funds vis-a-vis large banks; and to improve counteract this tendency. the spatial allocation of funds. In addition, Professor Modigliani also explains why, Professor Modigliani foresees two desirable in his model, the choice of the differential side effects that would result from his pro­ between the discount rate and the base rate posal. These are the elimination of an­ would be of major consequence only in de­ nouncement effects of discount rate changes termining the character of the short-run, and increased attractiveness of membership semi-autonomous response of the banking in the Federal Reserve System, further im­ system to a persistent disturbance while the proving the System’s monetary control. Federal Reserve made a decision as to Under the proposal put forth in the paper, all banks meeting prescribed stand­ 1 Professor Modigliani cites the various articles on the Federal Reserve-MIT econometric model for fur­ ards of creditworthiness would have un­ ther elaboration of these assumptions.

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whether and in what way it should act in reserves and additional reforms in reserve response to that disturbance. The greater accounting procedures—chiefly the intro­ the differential the more heavily the initial duction of staggered settlement periods. response will be concentrated in variations In a further proposal, which he sees as in short-term interest rates as opposed to largely independent of the two described variations in the money supply. While not above, Modigliani suggests a third discount advocating any specific appropriate size of window, which he calls the “term” window. the differential, Professor Modigliani sug­ This would provide credit of intermediate gests the possibility of a variable differential but fixed maturity (for example, 3 months) between the discount rate and the base to any bank willing to pay the price, again market rate that would increase with the up to some limit determined by a credit­ volume of aggregate borrowing above a worthiness standard. The rate charged specified amount. Such a system would pre­ would be reset at frequent intervals and serve the usefulness of the window as a would be tied to a short-term market rate cushion for day-to-day bank needs, but with a flexible differential, again increasing would avoid an excessive injection of re­ with the aggregate volume of borrowing. serves in response to a major disturbance The design of this window would not be before the Federal Reserve could make a such as to minimize borrowing, since it determination as to its appropriate counter­ would be viewed as a substitute for an in­ action, if any. terbank loan market or, alternatively, as a In addition to the “regular” discount device to extend to smaller banks facilities window described above, Professor Modigli­ analogous to those provided by the market ani proposes a “special” discount window for certificates of deposit. aimed specifically at the smaller banks lack­ The Secretariat views exclusive reliance ing adequate access to the Federal funds on the discount rate to control the volume market. This window could be open only to of borrowing at the discount window as un­ banks of a given size or could be limited to workable in the U.S. economy for a variety loans up to a given absolute amount. The of reasons. It therefore does not endorse rate charged would be tied to but somewhat Professor Modigliani’s proposal. However, in excess of the Federal funds rate. The same general considerations regarding the one cannot help but be impressed by the interaction of the window with market striking similarities that appear between this forces would apply to this “special” window proposal and that actually being recom­ as were outlined for the “regular” window, mended by the discount study, once allow­ although the equilibrium level of borrowing ance is made for the idealized and simpli­ would be expected to be higher, relative to fied world deliberately assumed in the the aggregate size of eligible banks or Modigliani model in contrast to the practi­ loans, since the “special” window would cal constraints recognized in the Steering serve as a day-to-day substitute for the Fed­ Committee report. There are, of course, also eral funds market for some banks. significant differences in basic approach Professor Modigliani makes a number of and operational detail, but the fact remains other suggestions to improve the stability of that two proposals emanating from people free reserves within his model. These in­ with different backgrounds and experience clude the payment of interest on excess have much in common.

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Contents

Table 1— Member Banks: Number, and Number Borrowing, 1959-68, by Class 114 Table 2— Borrowings and Required Reserves of Member Banks, 1959-68, by Class 114 Table 3— Collateral for Member Bank Borrowing at Federal Reserve Banks 115

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BORROWINGS DATA

TABLE 1 MEMBER BANKS: NUMBER, AND NUMBER BORROWING, 1959-68, BY CLASS

Number (at year-end) Number borrowing (during year)

At least once from Year Federal Reserve From all sources All Reserve member city Country All Reserve All Reserve member city Country member city Country

1959...... 6,233 293 5,940 1,911 238 1,673 2,341 256 2,085 1960...... 6,171 240 5,931 1,903 207 1,696 2,360 223 2,137 1961...... 6,113 225 5,888 1,268 161 1,107 1,821 207 1,614 1962...... 6,049 220 5,829 1,102 150 952 1,759 198 1,561 1963...... 6,116 215 5,901 1,222 168 1,054 1,897 196 1,701 1964...... 6,221 208 6,013 1,232 158 1,074 2,226 189 2,037 1965...... 6,217 194 6,023 1,157 161 996 2,251 189 2,062 1966...... 6,145 192 5,953 1,651 172 1,479 2,626 183 2,443 1967...... 6,068 185 5,883 1,105 129 976 2,489 176 2,313 1968...... 5,977 182 5,795 1,296 147 1,149 2,586 178 2,408

TABLE 2 BORROWINGS AND REQUIRED RESERVES OF MEMBER BANKS, 1959-68, BY CLASS Averages of daily figures, in millions of dollars

Borrowing from— Required reserves

Federal Reserve Banks All sources Year All Reserve Country All Reserve All Reserve member city member city Country member city Country

1959...... 731.4 543.4 187.9 2,187.6 1,851.8 335.8 18,201.2 12,745.1 5,456.2 1960...... 398.6 271.6 127.0 2,401.0 2,061.8 339.3 17,969.1 12,367.9 5,601.2 1961...... 75.3 44.6 30.6 1,227.7 1,091.7 136.0 18,696.9 12,525.0 6,171.9 1962...... 101.0 68.2 32.8 2,085.6 1,898.9 186.7 19,357.9 12,853.6 6,504.3 1963...... 239.8 185.3 54.5 2,996.3 2,701.5 294.8 19,254.2 12,640.7 6,613.4 1964...... 270.5 208.1 62.5 3 ,50§.0 3,047.4 460.6 20,130.1 13,136.8 6,993.3 1965...... 467.2 366.9 100.3 4,604.5 4,027.7 576.8 21,346.5 13,771.2 7,575.3 1966...... 633.9 406.2 227.7 6,084.3 5,311.4 772.9 22,580.6 14,450.3 8,130.3 1967...... 171.5 116.5 55.0 5,561.5 4,961.9 599.6 23,667.3 15,357.4 8,309.9 1968...... 553.0 344.8 208.2 7,276.5 6,387.9 888.6 25,934.5 16,686.1 9,248.4

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TABLE 3 COLLATERAL FOR MEMBER BANK BORROWING AT FEDERAL RESERVE BANKS A. Under Sections 13 and 13a

Number of banks borrowing Collateral

Number of pieces Face amount (in millions of dollars) Year All Reserve Country member city All Reserve All Reserve member city Country member city Country

1959...... 13 8 5 527 355 172 153.0 82.3 70.7 1960...... 21 9 12 1,006 448 558 673.0 241.3 431.7 1961...... 5 1 4 123 5 118 5.4 4.2 1.2 1962...... 7 3 4 397 131 266 71.3 56.9 14.4 1963...... 8 5 3 277 223 54 133.7 133.4 .3 1964...... 20 8 12 833 271 570 248.6 239.3 9.2 1965...... 40 21 19 18,343 11,934 6,409 7,186.4 7,064.9 121.5 1966...... 87 46 41 23,255 15,617 7,708 19,683.2 19,238.1 445.1 1967...... 43 27 16 6,712 5,286 1,426 6,180.9 6,152.7 28.2 1968...... 61 41 20 10,409 10,062 347 10,256.5 10,055.6 200.9

TABLE 3 (Cont.) COLLATERAL FOR MEMBER BANK BORROWING AT FEDERAL RESERVE BANKS B. Under Section 10b

Number of banks Type of collateral (face amount, in millions of dollars) borrowing

Total Mortgages Municipal bonds Other Year All Re­ mem­ serve Coun­ All Re­ All Re­ All Re­ All Re­ ber city try mem­ serve Coun­ mem­ serve Coun­ mem­ serve Coun­ mem­ serve Coun­ ber city try ber city try ber city try ber city try

1959 12 4 8 6.3 3.3 3.0 0 0 0 6.2 3.3 2.9 .1 0 .1 1960 16 4 12 22.8 14.3 8.5 2.2 0 2.2 17.3 14.3 3.0 3.3 0 3.3 1961 8 0 8 3.5 0 3.5 0 0 0 3.5 0 3.5 0 0 0 1962 4 0 4 2.8 0 2.8 0 0 0 2.8 0 2.8 0 0 0 1963 10 0 10 4.7 0 4.7 0 0 0 4.5 0 4.5 .2 0 .2 1964 24 3 21 32.9 3.7 30.3 0 0 0 6.7 .8 5.9 26.2 2.9 24.4 1965 31 1 30 4,211.0 .7 4,210.3 .9 0 .9 12.7 0 12.7 4,197.4 .7 4,196.7 1966 43 3 40 113.1 73.3 39.8 .4 0 .4 32.9 5.5 27.4 79.8 67.8 12.0 1967 12 0 12 4.7 0 4.7 0 0 0 3.3 0 3.3 1.4 0 1.4 1968 22 5 17 144.5 39.1 105.4 18.6 12.0 6.6 113.9 17.3 96.6 12.0 9.8 2.2

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Contents

I. Introduction______119 II. The Current Regulation: Objectives and Techniques 119 A. Objectives in revising Regulation A B. General Principles C. Contemplated administration of Regulation A ill. Administration of Regulation A______125 IV. Restrictive Impact of Regulation A______126 A. General Principles and demand for credit B. General Principles and the discount rate C. General Principles and the supply of credit D. Demand and supply relationships V. Summary and Conclusions______130

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I. INTRODUCTION The 1955 revision of the Federal Reserve re-established after the Treasury-Federal System’s Regulation A governing discounts Reserve accord in 1951. and advances developed out of a study by a This paper reviews and evaluates the ra­ System Committee in 1953 and 1954. The tionale and objectives of the 1955 revision principal change recommended in the re­ of Regulation A—in particular as they re­ port issued by the Committee was adopted, late to the mechanisms for rationing credit that is, a set of General Principles to guide established by the General Principles. The borrowing and lending at the discount win­ analysis is based principally on the 1954 dow.1 The report’s recommendations were System Committee report on the discount deeply rooted in the development of the dis­ mechanism and is supplemented by re­ count mechanism during the 1920’s, and sponses to a questionnaire on discount op­ also in the System decision to rely princi­ erations sent to each Reserve Bank in 1965. pally on open market operations in the con­ The historical development of the discount duct of monetary policy once flexibility was mechanism in the 1920’s and the principal changes represented by the 1955 revision 1 System Committee on the Discount and Discount are discussed elsewhere.2 Rate Mechanism, “Report on the Discount Mecha­ nism,” Mar. 12, 1954, unpublished document (herein­ after referred to as “Report on the Discount Mecha­ 2 See Bernard Shull, “Report on Research Under­ nism,” 1954). taken in Connection with a System Study,” pp. 31-75.

II. THE CURRENT REGULATION: OBJECTIVES AND TECHNIQUES

The 1953-54 study of discounting was in­ rowed from the discount window developed stituted as a result of concern about the after almost 20 years of low levels of activ­ possible “overextension” of Federal Reserve ity. Between 1934 and 1943, discounts and credit through the discount window. In advances averaged $11.8 million per year; mid-1952 discounts and advances had in­ between 1944 and 1951 they averaged creased to over $1.6 billion; after that they $253 million. Only in the early post- had declined somewhat but throughout the World-War-I period (1918-21) and in the first half of 1953, they still exceeded $1 late 1920’s (1928 and 1929) did discounts billion.3 and advances approximate in dollar amount This upsurge in the volume of funds bor- the levels in 1952 and early 1953.4 3 This note appears on p. 120. 4 This note appears on p. 120.

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A. Objectives in revising Regulation A (2) Individual banks should not be permitted to depend on the discount window as a normal In developing and recommending a reformu­ source of funds for investments and loans. Such lation of Regulation A, the System Com­ dependence on borrowing unduly raises the risk of mittee emphasized several objectives. These their insolvency and/or illiquidity.6 Furthermore, increases in the risk of insolvency and illiquidity may be summarized as follows: for individual banks, aside from being undesirable (1) The discount mechanism should not serve per se, endanger the stability of the financial sys­ to relieve for long or indefinite periods the pres­ tem and militate against the effective operations of sure of monetary restraint upon the banking sys­ monetary policy.7 tem and its customers.5 (3) That member banks are generally reluctant to borrow is, for the reasons stated above, in the public interest. In order to prevent a weakening 3 According to the “Report on the Discount Mech­ anism,” 1954, p. 22: “In part the rapid rise in bor­ of this attitude, it is necessary that Regulation rowing during 1952 was a direct effect of restrictive A be formulated so as to give support to the credit influence exerted by the System. But it also extant “tradition against borrowing.” 8 represented borrowing by some member banks to avoid excess profit taxes, by others to profit from safety valve, easing temporarily the special reserve differentials between prevailing discount rates and pressures on individual banks. At the same time, [the market yields that developed under the tightening facility need not become] a gaping hole through credit market conditions, and by still others to sup­ which are released all the pressures on bank reserves plement operating resources in order to accommodate built up within the banking system as a whole.” “Re­ the active credit demands being generated by infla­ port on the Discount Mechanism,” 1954, pp. 9 and tionary trends. These developments in particular brought under discussion within the System the 1 26 ‘ “A major lesson brought out by the bank credit whole question of the philosophy and effectiveness of liquidation [in the early 1920’s] . . . was that it was its existing discount mechanism.” unsound for any member bank to use continuous in­ The circumstances leading to a revision in Regula­ debtedness to its Reserve Bank as a resource for con­ tion A were also described in the Annual Report of ducting regular banking operations. . . . In the severe the Boatd of Governors of the Federal Reserve Sys­ banking crises and liquidation in the early thirties, temi, 1957, p. 9: “In 1952-53 as credit demands ex­ adjustment problems of the aggressive, continuous panded and Federal Reserve policy limited the borrowing banks made evident the hazards to safety amount of reserves made available through open of depositor funds and the dangers to bank solvency market operations, pressure on bank reserves in­ resulting from the injections between bank capital creased, and member bank borrowing from the Re­ and deposits of borrowed funds having creditor sta­ serve Banks rose rapidly. During this initial revival tus ahead of deposit liabilities.” Ibid., pp. 10, 11. of the discount mechanism after a generation of dis­ 7 “Chronically indebted banks risk depositor pres­ use numerous problems arose, including uncertainty sure in the event that economic conditions turn ad­ among many member banks about what was an ap­ verse and the fact of their difficulties in a closely propriate use of the discount privilege. . . . As one interdependent banking community can make other result of these developments, the System re-examined banks, even those in a strong position, highly sensi­ historical experience, notably in the 1920’s. . . . In tive about their own liquidity needs. This kind of the light of practices shown by experience to be ap­ banking climate can set the stage for a period of ir­ propriate and sound and also in the light of statutory rational bank credit liquidation. As Federal Reserve provisions . . . , the Board of Governors revised its experience in at least one important period illus­ Regulation A.” trates, constructive credit and monetary policy to 4 In the 1918-21 period discounts and advances av­ cushion economic recession and foster revival can be eraged $1,840 million; in 1928 and 1929 they aver­ rendered substantially ineffectual by persistent de­ aged $886 million. However, it should be noted that pendence on the discount facility developed by some in the 1918-21 period discounts and advances aver­ banks in a prior phase of economic boom.” Ibid., pp. aged close to 70 per cent of total Federal Reserve 12 and 13. credit outstanding. In 1928 and 1929 they represented 8 “Because of this costly lesson [during the 1930’s], about 60 per cent of such credit. At the peak of dis­ it was possible by the mid-thirties to speak of an es­ count activity in December 1952, discount credit rep­ tablished tradition against member bank reliance on resented only 6 per cent of Federal Reserve credit the discount facility as a supplement to its resources. outstanding. “Member Bank Reserves and Related In a banking organization made up of thousands of Items,” Supplement to Banking and Monetary Statis­ member banks engaged in widely differing kinds of tics, Section 10, 1962, pp. 14-19. banking business, a well-entrenched tradition against 5“(T)he borrowing facility should not provide a commercial bank reliance on borrowed funds is an channel through which member banks generally or important aid to reserve banking . . . (S)uch a tradi­ an important segment of them may be able to avert tion permits the discount facility to serve as a safety the over-all credit and monetary policies of the Sys­ valve. . . . From the standpoint of strong and re­ tem . . . (T)he discount facility [can] serve as a sponsive banking conditions, the tradition against

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With the achievement of these objectives, signed “. . . to guide Reserve Banks in the Committee believed the discount mech­ lending and member banks in Reserve anism could and should serve to meet the Bank borrowing,” and “. . . to give clear “needs” of individual member banks for and full expression to the discount obliga­ credit accommodation to facilitate short-run tions of the Reserve Banks as they are adjustments in response to changes in the stated in, or implied by, present law.” 12 degree of monetary restraint and to meet The Committee indicated that “(a) key “unexpected” changes in deposit flows or premise underlying the . . . suggested revi­ loan demand and to ameliorate emergency sion of Regulation A is that explicit stand­ situations.9 In this role, discounting would ards for use of the discount facility would complement open market purchases and reinforce the member bank tradition against sales in achieving the desired degree of borrowing by providing a frame of refer­ monetary restraint. ence for evaluating undue reliance on dis­ The Committee also expressed the belief counting by aggressive member banks... .”13 that formulation of Regulation A to meet The majority of banks who were viewed the objectives cited would serve to elimi­ as “reluctant to borrow” would, presuma­ nate “incompatible inter-district differences bly, receive support from the position taken in discount methods” among the Reserve by the Federal Reserve and the observed Banks.10 change in behavior on the part of the “ag­ gressive” few.14 The relatively few “aggres­ B. General Principles sive” borrowers, it was expected, could be To achieve these objectives, the “Report on persuaded to shape their demands for credit the Discount Mechanism” recommended a to the standards of reluctance established by set of General Principles to be incorpo­ the regulation. rated into Regulation A.11 These were de­ The Report noted that “(i)f the discount standards advanced should . . . be applied too inflexibly by Reserve Banks . . . then borrowing in long periods of economic prosperity the regulation could tend increasingly to helps to prevent the more aggressive member banks from building up undue dependence on discount supplant tradition.” 15 The principles ad- credit. . . . The Committee believes that the tradition against continuous member bank dependence on the discount facility is sound in principle. . . . Future 12 Ibid., pp. 23 and 24. discount policy, in its opinion, should build on the 13 Since relatively few banks ever borrowed at all, tradition as a keystone. . . . [Italics added.] [How­ it was inferred that the majority were “reluctant to ever] (t)he tradition against large and continuous borrow.” The System Committee indicated that a pos­ borrowing, being without adequate regulative sup­ sible objection to its suggested revision was that the port, is subject to the risk of weakening in periods of System’s discount mechanism problem was mainly credit tightness. . . .” Ibid., pp. 11-13, 22 and 23. one of relatively few insistent borrowers. Ibid., pp. 36 9 “It is desirable . . . to keep open the privilege of and 37. The Committee stated that: “(t)he majority individual member banks to borrow at the Reserve of member banks are now administering their affairs Banks to meet essential temporary or emergency in line with the philosophy of the suggested revi­ needs.” Ibid., p. 9. sion.” Ibid., p. 40. A more recent expression of the 10 The “lack of a modernized System discount phi­ view is contained in The Federal Reserve and the losophy . . . is a factor fostering undesirable regional Treasury Answers to Questions from the Commission differences in discount practices. . . . While some in­ on Money and Credit, 1953, p. 139. compatible inter-district differences in discount meth­ 14 “The majority of member banks . . . now ad­ ods may now exist, the Committee is persuaded that ministering their affairs in line with the philosophy of the differences not supported by variations in re­ the suggested revision . . . might feel kindly rather gional conditions and needs would be largely elimi­ than antagonistic to a revision of the regulation that nated by a Regulation A re-oriented along the lines would help bring less conservative banks into con­ suggested.” Ibid., pp. 23 and 24. formity.” “Report on the Discount Mechanism,” 1954. 11 Ibid., Appendix D. is Ibid., p. 36.

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vanced, the Committee stated, were . . The credit-restrictive portions of the intended to be general guides and standards General Principles can be divided into three and not precise administrative instructions types: (1) descriptive statements about the inflexibly applicable to all cases.” 16 Never­ “type” of credit available at the discount theless, the principles were not intended to window; (2) statements about the “pur­ vary with cyclical changes in monetary pol­ poses” for which the type of credit de­ icy, though the amount of credit flowing scribed may or may not be appropriately through the discount window would vary.17 extended; and (3) statements reserving the The General Principles as finally em­ right to restrict credit on the basis of bank bodied in a new Foreword to Regulation A supervisory considerations in general. show minor alterations in emphasis and 1. Type of credit available. Credit available at considerable editorial revision; but they the discount window is normally short term, and show relatively little in the way of substan­ maturities are generally limited to 15 days. This tive change.18 The General Principles of “short-term” credit is not to be extended on a “continuous” basis. (Longer-term credit is avail­ the current regulation may be viewed as able, but only in exigent situations; that is, for the device designed to achieve the objec­ certain “purposes.”) tives developed in the System Committee 2. Appropriate and inappropriate purposes. Report. The appropriateness of any given request for

be appropriate. . . . (5) In determining whether to 16 Ibid., pp. 24 and 25. grant or refuse credit . . . Federal Reserve Banks are 17 The Report indicated that “(w)hile the Commit­ required . . . to consider the general character and tee contemplates a System discount activity varying amount of the loans and investments of the member in accordance with general credit policy, it wishes to bank and whether the bank is extending an undue stress particularly that it is not recommending a set amount of credit for speculative purposes. . . . (6) of discount principles that would in themselves flex Federal Reserve credit should not be extended where with such policy by administrative discretion,” Ibid., it appears that the member bank’s principal purpose p. 32. is to profit from rate differentials or to obtain a tax 18 The revision suggested by the System Committee advantage. (7) The law permits only such extensions Report incorporated the suggested General Princi­ . . . as may be ‘reasonably and safely made’; and the ples in Section 1 of the regulation. An introduction acceptance of paper offered for rediscount or as col­ indicated the basic objectives underlying Federal Re­ lateral . . . must be determined in the best judgment serve credit policy, the methods utilized to achieve of the Federal Reserve Bank. . . . (8) The board of these objectives, the effect of borrowing on the sup­ directors of each Federal Reserve Bank is required ply of reserves, and, consequently, the need for by law to administer the affairs of such Bank fairly “guiding principles” in extending credit by discount­ and impartially and without discrimination.” ing. It indicated also that “(a)ccess to the credit fa­ Section 1 of the suggested revision closed with a cilities of the Federal Reserve Banks is a privilege of statement that “(i)n passing upon requests for credit membership . . . which must be considered in the accommodation . . . the Federal Reserve Bank light of these principles.” Eight “Principles” were should give consideration to all of the principles . . . stated. These were, in abbreviated form, as follows: together with any other factors which may be perti­ “(1) Due regard must be given to the effect of any nent.” Ibid., Appendix D, pp. 1-5. extension of credit upon the maintenance of sound With the exceptions of (7) and (8), the Princi­ credit conditions. . . . (2) Federal Reserve credit ples suggested by the System Committee were incor­ should normally be extended for short periods to porated in the Foreword to the Regulation, as meet temporary credit needs of member banks. (For revised in 1955, rather than in Section 1. The actual example . . . in order to enable a member bank to revision did not list the principles by number, and adjust its asset position because of such developments some minor changes in language were made. But as a temporary loss of deposits or to assist a mem­ there seemed to be little in the way of changes in ber bank in meeting requirements for seasonal credit substance. The Principles numbered (7) and (8) in which cannot reasonably be anticipated and met by the System Committee Report were not explicitly use of the member bank’s own resources). (3) In incorporated in the General Principles in their final order to enable member banks to meet unusual and form; but the portion of the Federal Reserve Act exigent situations, Federal Reserve credit should be from which they derive (Section 4, paragraph 8) is extended for as long a period as may be deemed referred to in a footnote. See Howard H. Hackley, necessary. . . . (4) (U)nder ordinary conditions con­ “A History of the Lending Functions of the Federal tinuous use of Federal Reserve credit . . . would not Reserve Banks,” p. 432.

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short-term credit is dependent on the purpose tial” request for credit by a member bank for which the credit is requested. Short-term would normally be granted. The Report credit may be appropriately extended to meet a “sudden withdrawal of deposits or seasonal re­ notes that “. . . promptness of discount ac­ quirements beyond those which can reasonably tion would require reliance in the first in­ be met by use of the bank’s own resources.” stance on a member bank’s own statement A credit request is not appropriate if the funds of purpose”;21 and the question of continu­ are to be used to obtain “a tax advantage,” to ous borrowing “. . . would arise first at the profit “from interest rate differentials,” or for the “undue” extension of credit for speculative time of the first renewal.” 22 In determining purposes. Long-term credit, as mentioned, is the appropriateness of borrowing thereafter, available for certain “purposes.” 19 the restrictions on continuity and purpose 3. General supervisory considerations. A Re­ would, presumably, operate in a coordi­ serve Bank will, in extending credit, give “due regard . . . to its probable effects upon the main­ nated fashion, since all the “principles . . . tenance of sound credit conditions, both as to are closely interrelated.” 23 the individual institution and the economy gen­ The intended relationship between the erally. It keeps informed of and takes into ac­ “purpose” and “continuous borrowing” re­ count the general character and amount of loans and investments of the member banks.” strictions, however, is not obvious; nor for that matter are the relationships among the It is stated in the regulation that “access “purpose” restrictions themselves. The two to the . . . discount facilities . . . is granted major types of restrictions and the intended as a privilege of membership . . . in the relationships require further consideration. light of the . . . general principles.” This statement was interpreted at the time and in 1. Restriction on “continuous” borrowing. the ensuing years as meaning that “Reserve It might seem, at first, that the restriction Banks do not discount eligible paper on “continuous” borrowing was intended to or make advances to member banks be sufficient, in and of itself, to limit the automatically,” 20 as they presumably would supply of credit. While it is possible to in­ if access to the discount window were terpret the restriction in this fashion, there granted as a “right.” is good reason to believe that such was not intended. It seems more likely that the in­ C. Contemplated administration of tent was to use duration—or more exactly, Regulation A frequency of borrowing over some duration —to establish no more than a rebuttable The 1954 “Report on the Discount Mecha­ presumption of “inappropriate purpose.” nism” discussed how Regulation A, if re­ The Report explicitly indicates that the vised as recommended, would be adminis­ continuation of borrowing, with some de­ tered. It also suggested how the restrictions gree of frequency, is to be taken as progres­ on credit (in the General Principles) would sively more persuasive prima-facie evidence operate. that the credit extension is not for an ap­ It was evidently expected that an “ini- propriate purpose. 19 “Federal Reserve credit is also available for “With each successive period in which borrowing longer periods when necessary in order to assist occurs . . . the probability that the borrowing member banks in meeting unusual situations, such as may result from national, regional or local difficulties or from exceptional circumstances involving only par­ ticular member banks.” Regulation A, 12 CFR 201. 21 “Report on the Discount Mechanism,” 1954, p. 20 The Federal Reserve System: Purposes and Func­ 34. tions, Board of Governors, Washington, D.C., 1963, 22 Ibid., Appendix C, p. 7. p. 42. 23 Ibid., p. 24.

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stems from inadvertent causes obviously de­ usual seasonal developments, or for “emer­ creases. . . . Consequently, if a bank borrows at gency” reasons) would not, in principle, be least once in each of a number of consecutive reserve periods, there exists a presumption that limited in duration by the restriction on con­ it is using this means deliberately to avoid more tinuity. Rather, most “appropriate” purposes basic adjustments in its position and hence that would be such as to involve only short-term the borrowing is continuous in the sense indicated here.” 24 borrowing.28 Consistent with this view of the 2. “Purpose” restrictions. The “purpose” restriction, the “Report on the Discount restrictions may, then, be considered the Mechanism” refrains from a specific defini­ basic restrictions on the supply of discount tion of “continuous” borrowing, though the credit. Presumably it would be on the basis Committee went into some detail on the of “purpose,” as perceived by the Reserve issue.25 It noted that it is “. . . necessary Banks, that a determination would be made [to develop] some reasonable empirical as to whether or not an extension of credit standard for judging the number of reserve was “appropriate.” It was contemplated, periods that a bank may borrow succes­ under the revised Regulation A, that the sively before it is to be considered a con­ Reserve Bank would give “. . . more atten­ tinuous borrower.”26 But the Report states, tion to the purpose of member bank bor­ “(t)he specific guideposts for identifying rowing” and that certain “. . . objective such borrowing can be established only on procedures . . . would facilitate administra­ the broad discount experience of individual tion where findings indicated developments Reserve Banks and discussion among the other than those stated [by the member Reserve Banks.” 27 bank] were responsible ...”29 Given that the “continuous borrowing” However, the Report does not provide restriction was intended to represent evi­ specific definitions of the three “appropri­ dence that would help illuminate the “pur­ ate” purposes cited in the General Prin­ pose” of borrowing, it follows that borrow­ ciples (borrowing to meet sudden with­ ing for an “appropriate purpose” (for ex­ drawals, seasonal requirements beyond ample, “the result of chance factors,” or to those that can reasonably be met, and emer­ meet extraordinarily large deviations from gency needs resulting from unusual situa­ tions or exceptional circumstances); nor 21 Ibid., p. 10. It is conceivable that some specific does it provide definitions of the three duration of indebtedness (in terms of number of pe­ “inappropriate” purposes cited (borrowing riods or frequency over a period of time) might have been chosen as establishing a conclusive pre­ principally to profit from rate differentials, sumption that the borrowing is for an “inappropriate to obtain a tax advantage, or to extend an purpose.” Continuous borrowing would then be suffi­ cient to restrict credit, but still only as a proxy for 28 So, for example, the provision of Regulation A “purpose.” However, the author has been informed permitting long-term credit in emergency situations by one reviewer, intimately familiar with the deliber­ could be thought of as establishing not a separate ations during the period, that there was a System- category of “emergency” loans but rather a separate wide consensus that the definition of continuous bor­ “purpose” for which extended credit is “appropriate.” rowing should not be pushed further. 29 “Report on the Discount Mechanism,” 1954, 25 The Report does indicate that both extended- p. 34. The Report also stated that a Reserve Bank repetitive borrowing; that is, cases in which banks are would “. . . engage in analyses of changes in the bal­ in and out of debt “over nearly successive reserve ance sheet items of its member banks and of the sea­ periods,” and extended-uninterrupted borrowing; that sonal changes in their loans and deposits so that it is, borrowing over successive periods, should be in­ would be in a position to make an independent, cluded under the definition of “continuous borrowing.” objective judgment of the factors giving rise to bor­ 26 Ibid., Appendix C, p. 9. rowing. The methods applicable would not present 27 Ibid., p. 11. too difficult technical problems.”

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undue amount of credit for speculative pur­ priate” purposes cited in the regulation poses). In consequence, the purposes cited are, of necessity, qualified. The General did not, on their face, establish mutually Principles can be confusing because, taken exclusive categories of “appropriate” and literally, borrowing could seem to be simul­ “inappropriate” borrowing. taneously for both an “appropriate” and an As will be discussed below it is not be­ “inappropriate” purpose. lieved such mutually exclusive categories Because they are so closely related, the were indeed intended. Moreover, the “pur­ credit-restrictive terms of the General Prin­ pose” terms themselves are closely inter-re­ ciples warrant further analysis. An attempt lated. So, for example, in defining a word will be made below to explain this “related­ such as “reasonably” in the phrase that lim­ ness.” It will be helpful, however, to con­ its the extension of credit for seasonal pur­ sider first some aspects of the way in which poses, the definitions of the three “inappro- the regulation is administered.

III. ADMINISTRATION OF REGULATION A Information on the manner in which the ing repayment and “educating” the bor­ standards incorporated in the General Prin­ rower in the appropriate use of the discount ciples of Regulation A are being adminis­ window. These stages may be viewed as tered was obtained through a questionnaire elements in the process of nonprice ration­ sent to the Reserve Banks.30 It would ap­ ing and moral suasion at the discount win­ pear that “initial” requests for credit are dow. invariably accommodated promptly, with The “counseling” and “discipline” proce­ little if any discussion and with little in­ dures are quite similar at each Reserve convenience to the borrower.31 The infor­ Bank. They typically involve contact with mation requested by the Reserve Banks on the borrowing bank, generally first by tele­ application for credit suggests that in most phone, and inquiries on the “purpose” of circumstances no substantial effort is made borrowing and about the presumed plans of to ascertain the “purpose” of such an initial the bank to “work out of” its debt. If a de­ borrowing. finitive judgment is reached that the borrow­ Beyond this initial accommodation, the ing is inappropriate, the Reserve Bank esca­ administrative process can, for purposes of lates its efforts. Such “escalation” involves analysis, be broken down into at least three contacts between officials of the Reserve stages: (1) surveillance of the borrowing Bank and those of the borrowing bank at bank; (2) a decision on the appropriate­ increasingly higher levels, meetings with ness of the borrowing; and (3) in cases in Bank officials to “explain” the standards which the borrowing is judged “inappro­ established by Regulation A, requests for priate,” the undertaking of “administrative the presentation of a repayment program, counseling” or “discipline” aimed at secur- and, as a final measure, an indication that 3° “Questionnaire to Federal Reserve Banks Re­ the bank’s continued request for credit will garding Discount Operations,” October 1965 (herein­ not be honored. after referred to as “Reserve Bank Questionnaire, 1965”). The procedure described appears to re­ 31 By “initial” is meant the first request of a bank flect an attempt to persuade borrowers that that is not currently subject to surveillance at the discount window for reason of previous borrowing. further borrowing is not in their own best

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interest.32 If a mutual understanding cannot ences in understanding among Reserve dis­ be reached, the Reserve Banks are in a po­ tricts as to the significance of the restrictive sition to deny credit and to curtail the bor­ terms of the General Principles. In conse­ rowing privilege in the future. Replies to quence, it appeared that the regulation the 1965 Questionnaire provided evidence, could be and was administered in substan­ however, that there were important differ- tially different ways.33

32 For further discussion of this point, with refer­ 33 For a statement as to the kinds of differences ence to experience in the 1920’s, see pp. 33-38. found, see pp. 44 and 45.

IV. RESTRICTIVE IMPACT OF REGULATION A The principal intention of the 1955 revision operates to suggest that the principal re­ of Regulation A was to limit the flow of striction on credit was intended to operate credit through the discount window, partic­ through what might be called “moral sua­ ularly during the periods of monetary re­ sion,” on the demand for Reserve Bank straint, and to develop an acceptable ra­ credit. tionale for doing so. However, the When the purpose and continuous bor­ regulation itself does not, of course, spell rowing restrictions of the General Princi­ out in detail under what economic condi­ ples are considered as reflecting an effort tions the credit limitations would be im­ to restrict the demand for Reserve Bank posed. Conceivably, the restrictive effects credit, and not as independent constraints could stem from constraints on the supply on the supply of such credit, the lack of of credit, from persuasive efforts aimed at preciseness in the individual restrictions is limiting the demand for credit, and/or from somewhat clarified. The stated restrictions adjustments of the discount rate relative to on borrowing—for purposes such as profit­ market rates. An evaluation of the current ing from interest rate differentials, accom­ discount mechanism requires consideration modating seasonal demands for commercial of the kind of restrictive impact intended or agricultural credit, and compensating for and of that realized. expected withdrawals of deposits—may be thought of as reflecting a somewhat impres­ A. General Principles and demand sionistic regulatory image of the behavior for credit that could be expected of a bank that, to It may be recalled that the System Commit­ some degree, was “reluctant to borrow.” tee Report in 1954 stressed the fact that the For such a bank, being in debt would entail key to the revision it was suggesting was some nonmonetary “cost.” Consequently, the intent to give regulatory support to the the bank would not borrow simply because “tradition against borrowing.” This explicit borrowing was profitable in money terms. intention implies an effort to limit the flow At equal, and perhaps even at somewhat of credit by influencing bank attitudes to­ higher costs, it would prefer to obtain re­ ward borrowing. There is much in the Re­ serves in other ways. If the “reluctance to port—particularly in the General Princi­ borrow” were very strong, the bank might ples—and in the way the regulation borrow only small amounts “occasionally”

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on a “short-term, noncontinuous” basis. In and do not represent a very efficacious con­ this way the duration of borrowing, in con­ straint on supply because they do not estab­ junction with other information, would rep­ lish mutually exclusive categories of “ap­ resent evidence of the “purpose” of borrow­ propriate” and “inappropriate” borrowing. ing, or, more exactly, the degree of And (3) the administrative procedure asso­ reluctance of the borrower. ciated with the current regulation is con­ In actual operation the restriction on sistent with this interpretation and is diffi­ “extended” borrowing provides the vehicle cult to understand otherwise. A decision to for discussion between the Reserve Bank retire an outstanding debt is generally in­ and the member bank about the purpose of tended to reflect agreement between the Re­ borrowing; that is, whether there really is a serve Bank and the borrowing bank—al­ “reluctance” on the part of the borrower. though the latter may be quite reluctant to “Surveillance” of borrowing banks and pe­ terminate his borrowing. Such an agree­ riodic conversations on the “purpose” of ment, reached after considerable persuasive borrowing presumably provide the Federal discourse, strongly suggests a process de­ Reserve with an opportunity to influence signed to influence bank attitudes and fu­ bank behavior and, by persuasion, bank at­ ture bank behavior. titudes. Such persuasion, of course, is backed by the mutual understanding that B. General Principles and the discount credit can be curtailed and that further bor­ rate rowing capacity at the Federal Reserve can Flexible use of the discount rate, as a be impaired. Presumably these discussions principal device to ration credit, was re­ would, at a minimum, provide an incentive jected by the System Committee in 1954. for member banks to conduct their business However, the Committee did consider as “reluctant borrowers” would. briefly the role of the rate under its pro­ It is not easy to draw an exact line be­ posed revision. Its view tends to confirm the tween the influence of administration on conclusion stated above that the intention bank attitudes, and therefore on the de­ was to restrict borrowing by building on the mand for credit, and nonprice rationing of general “reluctance” of banks to borrow. the supply of credit. It seems clear, how­ The Committee noted: ever, that a principal intent of the regula­ “If member banks generally felt free to borrow tion was to provide a mechanism whereby and remain in debt when borrowing was profit­ member banks would be persuaded to limit able, the discount rate would need to be ad­ —on their own—their demands for Reserve justed frequently to keep it at a level equal to Bank credit. To summarize the evidence or not far below short-term market rates in order to function as a primary deterrent to discounting provided thus far: (1) The 1954 “Report when the demand for credit is higher. If member on the Discount Mechanism” indicated that banks limit their ordinary discounting to meeting one of the principal purposes of revising temporary needs pending other adjustments, how­ ever, the sensitiveness of their borrowing to the Regulation A was to give regulatory sup­ spread between the discount rate and market port to the “tradition against borrowing.” rates would be less marked. The need for fre­ (2) The General Principles can be con­ quent change in the discount rate to keep borrow­ ing from appearing profitable, therefore, would be sidered a reasonable attempt to influence diminished . . ,34 bank attitudes by establishing a model of “appropriate” behavior. The restrictive 34 “Report on the Discount Mechanism,” 1954, terms of the General Principles could not p. 43.

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C. General Principles and the supply of officials. This “surcharge” is not easily credit translated into specific money terms. Consistent with the intention to restrict the Since the threat to future borrowing and demand for Federal Reserve credit by sup­ the “inconvenience” imposed by negotia­ porting the “tradition against borrowing,” tions increase progressively once a judg­ the General Principles of Regulation A ment is reached that the borrowing is for also appear to represent an attempt to facil­ an “inappropriate purpose,” the actual itate the distinction between borrowing that “cost” of credit to the bank would rise over is in accordance with the “tradition” (suffi­ time.36 Since the Federal Reserve has al­ ciently reluctant) and borrowing that is not most complete discretion in making and re­ (insufficiently reluctant). But, as indicated, newing loans, the true “cost” could rise the distinctions that the Reserve Banks very rapidly, and at some point credit could have drawn in practice are not, and cannot be cut off completely. be, clear cut. Typically, an “initial” borrow­ Given the Reserve Bank’s interpretation ing request is assumed to be “appropriate,” of the regulation, the duration over which (that is, sufficiently reluctant) and is ac­ a particular loan (or pattern of borrowing commodated at the going discount rate.35 behavior) would be considered “appropri­ Through “surveillance” that takes place ate” would depend on a variety of factors. over time, a judgment is reached as to These include some that are stated at the whether the borrowing (or the pattern of time credit is extended (such as the amount borrowing that has developed) is, in fact, of the borrowing, the previous borrowing “appropriate.” When a judgment is reached record of the bank and, if available, its that the borrowing is “inappropriate,” coun­ statement of purpose); some that vary seling or disciplinary action is undertaken. while the credit is outstanding (such as the The ultimate step in this “disciplinary” pro­ borrowing bank’s portfolio and liability cedure would be a Reserve Bank indication management); and “time” itself, since the to the borrowing bank that the bank’s note, length of time the credit is outstanding is if presented again, would not be honored. presumed to provide evidence of But some time would pass before such a “purpose.” 37 These factors may be con­ step were taken; and in fact, it appears that 36 Since the amount of a loan (relative to bank final recourse to credit rationing in this size) is taken as one indication of “purpose,” the strict sense seldom occurs. cost of borrowing over an extended period of time would be positively related to its amount ceteris par­ Short of explicitly denying the continued ibus. The System Committee Report stated: “The extension of credit, the “disciplinary” pro­ amount borrowed is one piece of evidence to be taken into account in judging whether the borrowing cedure is perhaps best viewed as imposing is intended or complacent. The larger the amount of an additional “cost” on the borrowing bank borrowing in relation to required reserves and capital above the discount rate. The additional . . . the greater the presumption that borrowing is planned or complacent and not the result of a suc­ “cost” may be thought of as reflecting cession of chance developments.” Ibid., Appendix C, a threat to future borrowing capacity at the p. 11. The amount borrowed currently appears to be treated in this way by the Reserve Banks. Federal Reserve and the “inconvenience” of 37 Even a loan that was initially “appropriate” be­ having to negotiate with Federal Reserve cause it was to meet a sudden deposit withdrawal would not be “appropriate” indefinitely since the 35 No doubt there is some limit on the amount bank is expected to adjust its portfolio within a rea­ that a Reserve Bank would lend to an individual in­ sonably brief period of time if the funds do not re­ stitution. However, there is no explicit limit (either turn. Moreover, a succession of “sudden” deposit in absolute or relative terms) in Regulation A or in withdrawals would not be “sudden” under the terms the Federal Reserve Act. of the regulation over any extended period of time.

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ceived of as interacting in influencing the extreme cases are rare. But the “threat” to “appropriate—inappropriate” decision.38 future borrowing capacity is, of necessity, From the member bank’s point of view, implicit at all stages in the disciplinary pro­ a considerable degree of uncertainty must cedure, not simply the final stage of credit attach to the use of a discount mechanism rationing. operating in this way. There would be un­ Consequently, similar questions arise in certainty about: (1) the duration over all such cases. Specifically, these are: (1) which an initial request for credit for a par­ how soon will a credit request be honored ticular purpose is considered appropriate; after the bank has been disciplined and it (2) the rate at which the cost of credit has repaid its loan; and (2) to what extent rises once it is decided that the borrowing is will the previous borrowing record shorten for an “inappropriate purpose”; and (3) the period over which the loan is “as­ the effect of the past record of borrowing sumed” and/or “judged” appropriate. There and disciplinary conflict, if any, on (1) and is no information available to suggest that (2 ). credit will be denied for any lengthy period At the time the initial credit request (as­ of time after repayment brought about by sumed “appropriate”) is granted, the Re­ “disciplinary action.” However, as is well serve Bank is generally not in a position to understood, the appropriate duration for a indicate to the borrowing bank how often or new loan is influenced by the previous bor­ how long borrowing will be considered ap­ rowing record of the bank.40 propriate. The rise in the “cost” of credit— once a decision as to inappropriateness is D. Demand and supply relationships reached—is, by its nature, a matter of much It has been suggested that the 1955 revision uncertainty also. The effect of “inappro­ of Regulation A was intended to influence priate” borrowing behavior in the past on the demand for Federal Reserve credit by the availability and “cost” of credit cur­ supporting the “tradition against borrow­ rently cannot be indicated except in a very ing.” The intention was to keep demand for general manner. To take an extreme exam­ Federal Reserve credit relatively low and ple: If, after an extended period of borrow­ inelastic with respect to the differentials be­ ing, credit to a bank is denied, how tween market rates and the discount rate. long should the discount privilege be The administrative procedures designed to withheld? 39 As previously mentioned, such facilitate this intention imply, however, a And extended borrowing to meet these withdrawals rising supply schedule for credit. This would presumably not be “appropriate.” would, in and of itself, serve to limit the 38 They may be thought of as independent variables in a joint functional relationship with the “appropri- flow of discount credit. ate-inappropriate” decision. The value of the inde­ A rising supply schedule is implicit in the pendent variable “time,” at the point at which the decision is reached that the loan is not for an appro­ limitations on future borrowing capacity in­ priate purpose, would give the duration over which corporated in disciplinary procedures and, the “cost” of credit would equal the discount rate. to some degree, in the physical inconveni­ 39 One Reserve Bank indicated that after the ulti­ mate step in disciplinary procedure is reached, the ence of negotiations instituted while credit borrowing bank receives reassurance about the avail­ is outstanding. Such conditions impose real ability of credit for initial requests. “In no event would a banker be told that the borrowing privilege 40 At some Reserve Banks, the previous borrowing was being permanently curtailed but only for the rel­ record would include borrowing from other sources atively short run; it would be made plain that truly as well as the Federal Reserve. In either case, the emergency needs of the member bank would always previous record would suggest the degree to which receive appropriate consideration.” the borrowing bank was “reluctant to borrow.”

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costs on the borrowing bank. However, un­ would not normally encounter a situation in certainty surrounding the threat to future which their borrowing behavior became borrowing capacity, together with the trou­ suspect. This argument begs an important blesomeness of negotiations, would also issue in that it assumes that banks for the work, through bank preferences, to limit the most part are sufficiently “reluctant to bor­ demand for Reserve Bank credit. row” that they will generally conform to the It is quite conceivable that many banks rough regulatory image described in the would have a strong preference to avert the purpose restrictions of Regulation A as ad­ risk of incurring “disciplinary action.” The ministered. administrative procedures under Regulation If such is not the case— that is, to the ex­ A would, for such banks, imply an even tent that banks are less reluctant to borrow greater limitation on their demand for Fed­ than deemed appropriate— there would be eral Reserve credit than is suggested by a more certainty of action in the extreme rising supply schedule, or by the intent to than in the normal run of cases. For exam­ support or alter bank attitudes toward bor­ ple, banks that borrow heavily so as to be rowing. able to sell Federal funds at rates above It might be argued that uncertainties the discount rate would be fairly certain of concerning the duration of the time period quick and vigorous “disciplinary action.” over which no questions are asked, the Banks that borrow to avoid or postpone the vigor of “disciplinary action” once ques­ sale of investments (and also to earn a tions are raised, and the effects of “discipli­ profit) would have to determine in each in­ nary action” on subsequent borrowing exist, stance the duration of the time period over for the most part, in those relatively rare which the holding of such investments cases of “extended borrowing” and that would be considered appropriate and the most banks, applying reasonable caution, “costs” incurred in exceeding this duration.

V. SUMMARY AND CONCLUSIONS

The intention of the 1955 revision of Regu­ The General Principles also seem in­ lation A was to limit the amount of credit tended to facilitate a distinction that dis­ available at the discount window, particu­ count officers and committees would, from larly during periods of monetary restraint. time to time, be required to make between Both demand and supply limitations were borrowing behavior that was sufficiently re­ envisioned. The General Principles in the luctant (“appropriate”) and borrowing be­ Foreword to the revised regulation appear havior that was insufficiently reluctant (“in­ to describe roughly the kind of borrowing appropriate”). However, it was not thought behavior expected of a bank that was reluc­ that it would be necessary to make this tant to borrow. They were principally in­ distinction often. In those instances where tended to support the attitudes of the large such nonprice rationing proved necessary, it majority of banks considered to be reluc­ was believed such rationing would have a tant borrowers. In this sense, they repre­ remedial effect. sented a form of moral suasion designed to The current mechanism clearly provides limit the demand for credit. for adequate control over the volume of

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credit available at the discount window. In primarily because the General Principles fact, it appears to create a degree of uncer­ were not designed and are not well suited tainty about the terms and conditions of for large-scale rationing of credit from the credit that would tend to limit borrowing supply side. The distinction between suffi­ more than intended. This is particularly ciently reluctant and insufficiently reluctant true in a financial environment in which borrowing is not easily drawn in practice. large numbers of banks are not reluctant to The restrictions, both individually and borrow in accordance with the regulatory collectively, are not easily understood or image implicit in the General Principles. communicated. Differences in administra­ Nonreluctant attitudes on the part of banks tion among Federal Reserve districts may would tend to place a heavy burden on the be viewed as a reflection of difficulties in administrative machinery of Regulation A, implementing the current regulation.

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Contents

Introduction______135 Summary of Findings______136 Regulating use of bank credit Allocation among banks Appropriate borrowing The discount rate Concluding remarks Evolution of the Discount Function: Episodes of Current Significance______140 Reasons member banks borrow Attempts to regulate final use of bank credit Allocation among banks Appropriate and inappropriate use Disuse and revival Elimination of eligibility requirements Discount rate policy Bibliography______162

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INTRODUCTION

There are two major aspects of the discount the four policy-making groups prior to 1935 function, both of which exercise some influ­ —conferences of the Governors of the ence on the volume of reserves supplied via Federal Reserve Banks; conferences of the the discount window. Chairmen and Federal Reserve Agents of Discount policy (administration of the the Federal Reserve Banks; the joint con­ discount window) influences the total vol­ ferences of these groups with the Federal ume of borrowing. It also affects the alloca­ Reserve Board; and minutes of the Open tion of Reserve Bank credit among member Market Investment Committee. banks and indirectly it may influence the al­ Other unpublished material of the Sys­ location of member bank credit among final tem included special studies, such as the re­ uses. The discount rate affects the cost of port of the ad hoc Committee on the Dis­ member bank borrowing. But discount count Mechanism in 1954, and the policy is not considered an effective means excellent “A History of the Lending Func­ of influencing specific uses of credit. tions of the Federal Reserve Banks,” by A complete history of the evolution of Howard H. Hackley, which includes all the discount function— philosophy, princi­ amendments to the Federal Reserve Act re­ ples, and policies embraced in administra­ lating to the discount function and revisions tion of the discount window and in discount of Regulation A. rate policy— as recorded in the literature 2. Published material, including works within the System and by outside econo­ of the better-known academic economists mists would be a weighty document. Much (prior to World War II); Annual Reports of the material, however, is of historical in­ of the Federal Reserve Board (Board of terest only. This paper is limited to infor­ Governors of the Federal Reserve System mation and experiments that might be help­ since 1934); and congressional hearings, ful in determining what the role of the particularly the “Agricultural Inquiry,” discount function should be.1 Joint Commission of Agricultural Inquiry in The principal sources of material used 1921 and “Operations of the National and were: Federal Reserve Banking System” (U.S. 1. Unpublished material available within Senate) in 1931. the System, especially the Proceedings of It should be noted that the bulk of the 1 It should be noted that academic literature since material to be covered in this study ap­ World War II is included in David M. Jones, “A Re­ peared prior to the Great Depression. The view of Recent Academic Literature on the Discount Mechanism,” vol. 2 of this series. discount function fell into disuse following

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the Great Depression and did not become a cepts and philosophies embraced in discount significant policy instrument again until and discount rate policies and some experi­ after the Treasury-Federal Reserve accord in ments that appear of relevance in determin­ March 1951. Within the System, policy dis­ ing the current role of the discount mecha­ cussions since the accord, except for the nism. Evaluation, other than that made in study in 1953-54 and this one, have dealt the literature covered, is often unnecessary. largely with open market operations. No attempt has been made to cover each The paper is divided into two main parts. amendment affecting the discount function The first is a brief summary of the evolu­ or each revision of Regulation A. Nor are tion of the discount function; the second the V-loan and Section 13b-loan programs deals in more detail with the principal con- included.

SUMMARY OF FINDINGS

Evolution of the discount function during discount rate was regarded as a more effec­ the past half-century reflects the influence tive instrument for regulating the total of economic thought and economic events. quantity of bank credit. The underlying philosophy of the discount provisions of the Federal Reserve Act was Regulating use of bank credit the “real bills” doctrine that bank credit The philosophy embodied in the Federal should be confined to short-term productive Reserve Act contemplated that Reserve uses. This view strongly conditioned the ev­ Bank credit should be extended for a short olution of the discount function in the first term only and that it should be confined to two decades of the System. It even led to financing the production and the distribu­ efforts, at times, to use discount policy to tion of goods from producer to consumer. curb the use of bank credit for certain pur­ It should not be used to finance investments poses. or speculative activity of any kind— securi­ Economic events, however, soon created ties, commodities, or real estate. Confining doubts as to the validity of this doctrine, bank credit to productive purposes, it was both in principle and in practice. Confining believed, would result in an automatic re­ credit to “productive uses” would not nec­ sponse of supply to the expanding and con­ essarily automatically result in the proper tracting needs of commerce, industry, and total quantity of bank credit. During an in­ agriculture. flation boom, total bank credit expansion The implications of this real bills doc­ resulting from lending for so-called “pro­ trine for Federal Reserve policy were two­ ductive uses” could be excessive; hence it fold: (1) use of Federal Reserve credit to was necessary to regulate the total quantity finance unproductive activities should be of bank credit in the interest of sustained prevented, and (2) System officials should over-all stability. pursue a passive policy allowing the supply These two views had significant implica­ of credit to respond to changing demands tions for the discount function. For selec­ of “legitimate” business and agriculture. tive regulation, such as confining bank At first, eligibility requirements were credit to certain uses, discount policy was considered the principal method of confin­ considered a more useful instrument; the ing Reserve Bank credit to productive uses;

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however, experience soon demonstrated an increasing flow of bank credit went into that the kind of paper offered for discount the stock market. With business operating was no indication of the uses made of the below capacity and prices tending down­ bank credit extended on the basis of the ward, the situation called for selective con­ proceeds. trol to curtail credit for speculation without Following World War I, emphasis shifted making credit scarcer or more expensive for to “direct pressure” as a means of confining business and agricultural purposes. Those bank credit to appropriate uses. Even favoring direct pressure instead of an in­ though Reserve Bank officials might not be crease in the discount rate thought the lat­ able to identify the specific uses made of ter would have little effect on speculative the proceeds of a discount, they could and use of bank credit but would work a hard­ should keep informed of the loan and in­ ship on business and agriculture. Others, vestment policies of their member banks. however, thought the policy of direct pres­ Reserve Bank credit should be denied those sure could not be implemented effectively. banks using it for unproductive purposes. Some loans against securities might be for Most System officials were sympathetic speculation but others were for productive with the ultimate goals of direct pressure, purposes. They favored an increase in the but there was growing opposition to the discount rate. policy in the 1920’s. One of the major The Great Depression brought to a close points of opposition was that it was im­ attempts to implement the real bills doc­ practical. It was impossible to confine trine as a means of achieving business sta­ credit to productive uses through adminis­ bility. The quantity of eligible short-term tration of the discount window. A member commercial paper dwindled, and eligibility bank discounts or borrows to replenish a requirements handicapped the Reserve reserve already deficient— a deficiency that Banks in providing adequate assistance to usually results from a number of transac­ some member banks. Then, too, emphasis tions. Moreover, reserves created by loans continued to shift from selective control to to banks making only “productive” loans regulating the total quantity of bank credit might flow to banks extending credit for and the money supply. speculative and nonessential purposes. Sec­ ondly, a substantial number of banks do Allocation among1 banks not borrow from the Federal Reserve Banks Preventing excessive borrowing by individ­ and hence are not subject to direct pres­ ual member banks has always been a prob­ sure. Finally, there was increasing doubt lem, especially in the earlier years of the that confining credit to productive uses Federal Reserve System. System officials would result in the proper total quantity of thought that too much borrowing was un­ credit. The total quantity of credit, even sound banking policy because experience under a productive-use criterion, may ex­ had shown that banks heavily indebted to pand more rapidly than ability to produce the Reserve Banks were among the first to goods and services to match it. Discount fail. Excessive borrowing was also consid­ policy by itself was not considered an effec­ ered inconsistent with the spirit of the Fed­ tive means of regulating the total quantity eral Reserve Act, which authorized Reserve of bank credit. Banks to administer the discount window The controversy over direct pressure in­ so that each member bank would be able to tensified in the latter part of the 1920’s as get its fair share of Reserve Bank credit.

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The problem here involved allocation of discount window. There seemed to be gen­ Reserve Bank credit among member banks eral agreement that borrowing from the instead of allocation of member bank credit Federal Reserve should be short term to among uses. meet temporary needs, that habitual bor­ One of the early experiments in attempt­ rowing was unsound and undesirable, and ing to prevent excessive borrowing by some that banks should not borrow to profit from member banks was the establishment of higher rates. progressive discount rates by four Reserve The discount window was not used much Banks. Progressive rates would penalize ex­ from about the mid-1930’s until 1951 be­ cessive borrowers without making borrow­ cause of the large volume of excess reserves ing more expensive for member banks not generated by gold imports and of the ready abusing the privilege. availability of reserves under the policy of The four Reserve Banks establishing pro­ supporting the prices of U.S. Government gressive rates soon abandoned them. A fun­ securities. With the return to a flexible damental weakness was that the penalty monetary policy, System officials launched was based entirely on quantity of borrowing studies in order to reappraise use of both in excess of a basic line, which in turn was the discount window and open market op­ computed in an illogical manner. The de­ erations in the new environment. vice worked a hardship on banks suffering The studies and the revision of unusually large seasonal or other types of Regulation A in 1955 were concerned pri­ deposit drains, and exceptionally high rates marily with appropriate and inappropriate paid by a few banks aroused widespread types of borrowing from the Reserve Banks. criticism and subjected the System to politi­ The principles adopted were largely a reaf­ cal attack. The consensus of Federal Re­ firmation and refinement of principles that serve officials seemed to be that excessive had evolved, mainly in the 1920’s. borrowing could be better controlled by dis­ Appropriate uses of the discount window cretionary discount policy than by a rigid, were principally twofold: (1) short-term mechanical formula such as progressive dis­ advances to meet temporary reserve drains, count rates. such as from a deposit loss, and seasonal The burden of preventing excessive bor­ requirements that could not reasonably be rowing by individual banks fell mainly on anticipated; and (2) advances for longer administration of the discount window. Re­ periods if necessary to enable member serve Bank officials soon began to keep banks to meet unusual and emergency situ­ closer tab on member banks that were bor­ ations. rowing either unusually large amounts or Inappropriate uses included continuous continuously. In the case of problem banks borrowing to supplement a bank’s own re­ the usual investigation was supplemented by sources, borrowing for speculative purposes, conferences with officers or directors of the and borrowing to profit from interest rate borrowing bank. Reserve Bank officials also differentials or to obtain a tax advantage. used various contacts and methods to try to The philosophy embodied in the revision educate member banks on proper use of the of Regulation A contemplated only a lim­ discount window. ited use of the discount window. Except in emergency situations, advances are to help Appropriate borrowing meet temporary reserve drains that a well- Another aspect of discount policy discussed managed bank ordinarily would not be in a in the 1920’s was appropriate uses of the position to meet out of its own resources.

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Borrowing is to afford time for a more or­ widely accepted principle was that the dis­ derly adjustment of assets and/or lending count rate should be raised when there was policy. evidence that bank credit expansion was be­ coming excessive in relation to the volume The discount rate of business activity, and that the rate The Federal Reserve Act contained little should be lowered in periods of depression guidance for discount rate policy. Section to encourage expansion. 14 stated that rates should be established Studies were also initiated to determine “with a view of accommodating commerce the effects of discount rate action. Surveys, and business.” including questionnaires and calls on mem­ Initially, there was little crystallized ber banks by field men, indicated that thinking among System officials either as to changes in the discount rate had little effect the role of the discount rate or as to criteria on bank loan rates to customers. Excep­ that would be useful in determining the tions were loans that were closely related to timing of rate changes. The penalty-rate market rates, such as call loans, and busi­ concept was widely accepted in principle ness loans of the larger banks in financial but considered impractical in the United centers. States. Even though most member banks indi­ Several factors influenced the role of the cated that changes in the discount rate had discount rate in the 1920’s. Emphasis on little effect on customer loan rates, some the use of discount policy for selective System officials thought that the effect of a credit regulation, and a consensus among change on the cost of borrowed reserves System officials that the discount rate was had a significant influence on the total vol­ ineffective for preventing excessive borrow­ ume of bank credit. ing by an individual member bank, tended Although open market operations have to relegate the discount rate to a secondary been the major policy instrument since role. On the other hand, belief by some of­ 1951, a new proposal regarding the dis­ ficials that “direct pressure” was impracti­ count rate advanced in academic literature cal, and increasing emphasis on the need to is that the discount rate should be tied to regulate the total quantity of credit, favored some relevant market rate. a more important role for the discount rate. Concluding remarks Discovery of the value of open market op­ erations in the early 1920’s gave System The evolution of the discount function, officials two quantitative tools. The discount even though interrupted by a long period of rate and open market operations soon came quiescence in both implementation and to be regarded as the “twin instruments” of thought, has some significant implications Federal Reserve policy. for discount policy. On the basis of past ex­ System officials devoted considerable at­ perience the principal implications, in the tention to guides that might be useful in de­ opinion of the author, are the following: termining the timing of changes in the 1. Administration of the discount win­ discount rate. The dominant view that dow has been neither an equitable nor an emerged was that no simple rule or formula effective instrument for implementing a pol­ would suffice. Instead, decisions should be icy of selective credit control. At best, it made on the basis of a wide range of rele­ has reached only a minority of commercial vant information on current credit and banks (a large number of member banks as business conditions. Perhaps the most well as many nonmember banks do not use

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the discount window) and an even smaller sistent with the maintenance of sound credit fraction of all lenders. Discount officers can conditions. Second, progressive rates hit ordinarily identify “misuse” only after it especially hard member banks that are sub­ shows up in bank condition reports— a fait ject to erratic and pronounced seasonal and accompli. Moreover, banks denied access to other temporary reserve drains. the discount window because of noncompli­ Preferential discount rates, used only ance may have an inflow of reserves from briefly except in war financing, proved to banks that do borrow from the Reserve be discriminatory and ineffective. The pref­ Banks, or they may acquire reserves in the erential rate soon became the effective rate. market. One of the lessons of experience is that 2. The use of mechanical devices in ad­ courageous and well-informed discount ministering discount policy has never been a officers have been more effective in imple­ satisfactory substitute for discretion. menting discount policy than any rule or The experiment with progressive discount mechanical formula yet developed. rates in 1920 was soon abandoned. Some 3. Eligibility requirements have been of the shortcomings were the result of the more of a handicap than a help in imple­ particular type of plan adopted. But even menting policy. They never achieved the more serious weaknesses are inherent in purpose for which they were intended, and progressive rates. First, no logical basis has the philosophy underlying the requirements thus far been proposed for computing a has been inappropriate for the economic basic line. Any basic line, regardless of how environment that has prevailed for many computed, implies that quantity is the pri­ years. This is mainly why the System has mary determinant of validity of borrowing recommended to the Congress their elimina­ from a Reserve Bank. Borrowing in excess tion from the Federal Reserve Act. of some arbitrary basic line is automatically 4. Experience has demonstrated that the penalized regardless of the reasons for the discount function has been useful in rein­ borrowing. This view is the antithesis of the forcing anticyclical monetary policy— forc­ concept (and the spirit of Section 4 of the ing banks to the discount window and rais­ Act) that, in deciding whether to extend ing the discount rate when desirable in credit to a member bank, Reserve Bank implementing a restrictive policy, and low­ officials should take into consideration the ering the discount rate and using open mar­ condition and policies of the applicant bank ket operations to take member banks out of and whether the proposed borrowing is con­ debt in periods of monetary ease.

EVOLUTION OF THE DISCOUNT FUNCTION: EPISODES OF CURRENT SIGNIFICANCE

This section is devoted primarily to issues The principal topics covered are as fol­ and episodes believed to be of some rele­ lows: the reasons member banks borrow; vance in the current reappraisal of the dis­ attempts to regulate the final use of bank count function. It attempts to summarize credit; techniques of allocating Reserve the dominant views expressed within the Bank credit among member banks; appro­ System and in academic literature prior to priate and inappropriate borrowing; and the World War II. discount rate.

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Reasons member banks borrow banks may be compelled to turn to the dis­ Soon after the System began operations, count window. Reserve Bank officials became concerned Experience was used to support the need over the general attitude of member banks motivation for borrowing. A substantial toward borrowing from the Reserve Banks. spread between the discount rate and mar­ Many banks thought of borrowing from the ket rates was not unusual. Hence, it was al­ Reserve Bank in the same way as borrow­ leged that if member banks borrow primar­ ing from a correspondent—a source of ily for profit, market rates could not long funds to lean on when their own resources remain above the discount rate. Borrowing were short. Hence, Reserve Bank officials to take advantage of higher market rates tried to inculcate in bankers the philosophy would soon eliminate the spread. Neither that Reserve Banks should be regarded as a could market rates remain much below the lender of last resort. discount rate so long as there was any ap­ In the 1920’s two divergent views preciable volume of member bank indebt­ emerged (most of the analyses being in ac­ edness to the Reserve Banks. ademic literature) as to why member banks A significant implication of the need borrow. One view was that member banks theory is that the discount rate is not a borrow only when in need of additional major determinant of the volume of mem­ funds; the other put more emphasis on ber bank borrowing. Exponents of the doc­ profit motivation. These views had signifi­ trine thought the volume of member bank cant policy implications, especially for the borrowing had a greater influence on mar­ role of the discount rate. ket rates than changes in the discount rate. Need theory. One view that emerged in The discount window, although only a mar­ the early 1920’s and still prevails is that ginal source of funds, had an important in­ member bank borrowing is motivated pri­ fluence on market supply and hence on marily by need rather than by profit.2 In market rates. Evidence cited was that mar­ essence, the doctrine was that member ket rates moved closely with the volume of banks are reluctant to borrow from the Re­ member bank borrowing, and changes in serve Banks; they generally borrow only to the volume of borrowing usually preceded meet a reserve deficiency; and they repay changes in rates. indebtedness to the Reserve Bank as soon The discount rate had some influence on as practicable. In repaying, however, banks market rates, however. If the discount rate usually withdraw funds from the money is above market rates, banks may turn to market and shift the reserve deficiency to call loans or other market sources for re­ other banks. serves instead of to the discount window. It is obvious that need is substantially in­ But if the discount rate is below market fluenced by open market policy. If sufficient rates, the tendency would be for banks in reserves are supplied through open market need of funds to turn to the discount win­ dow.3 purchases, there is little need to borrow; if, however, insufficient reserves are supplied Profit theory. The profit theory, simply through open market operations, member stated, is that member bank borrowing from the Reserve Bank is motivated pri­ 2 For example, see Winfield W. Riefler, Money marily by profit. Member banks tend to Rates and Money Markets in the United States, pp. 19-32. Riefler was a leading advocate of the need theory. 3 For example, see Riefler, op. cit.

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borrow when it is profitable. Profitability of in the mid-1930’s, especially by Robert discounting or borrowing from the Reserve Turner who attempted to test the two theo­ Banks is a major determinant of the volume ries, both analytically and empirically. of member bank borrowing. A critical weakness of the need theory is The profit theory, although not expressly the nebulous nature of the basic concept. stated and developed, is implicit in a sub­ Advocates of the doctrine did not give a stantial part of System material dealing clear definition of need— usually referring with discount rate policy since World War to seasonal drains and temporary reserve I. Proceedings of policy discussions prior to deficiencies arising from market factors the Great Depression frequently reveal gen­ such as deposit flows. Need in this sense, eral acceptance of the principle that the dis­ however, should have little effect on the count rate should be a penalty rate in order total volume of member bank borrowing. to discourage borrowing for a profit; it was Seasonal drains and other market flows agreed, however, that implementation was shift reserves among banks but do not af­ impracticable in the United States because fect significantly reserve needs of the bank­ of the wide variation in interest rates re­ ing system. If, on the other hand, need is gionally and by type of loan.4 defined to embrace all types of reserve defi­ A more sophisticated version of the ciencies, reserve “needs” resulting from profit theory is that member banks, faced loan and deposit expansion, including lend­ with a reserve deficiency, will tend to select ing and investing to take advantage of a the lower cost among alternative reserve rate spread, would be included.6 adjustment media.5 When the discount rate Turner points out that a spread between is above market rates on assets available for market rates and the discount rate does not readjustment— so-called secondary reserve prove that member banks do not borrow assets— banks tend to turn to the market for profit, only that they do not borrow in instead of borrowing from the Reserve sufficient volume to bring market rates into Banks to cover reserve deficiencies. Banks line with the discount rate. Banks may bor­ are encouraged to borrow from the Reserve row to re-lend or invest at a profit, but lim­ Banks when the discount rate is below mar­ its imposed by discount policy and the tra­ ket rates on these assets. The view widely dition against borrowing may prevent a accepted since revival of the discount func­ volume sufficient to eliminate the rate tion in the post-World-War-II period— that spread. the discount rate should be equal to or Turner, using available statistical data, above market rates on commonly used alter­ attempted to test the validity of the profit native assets for reserve adjustment, espe­ theory. His findings may be summarized as cially in periods of restraint— implies ac­ follows: ceptance of this version of the profit theory. 1. There was no correlation (1) between Synthesis and evaluation. The need and the volume of member bank borrowing and profit doctrines came under close scrutiny the profit spread between the discount rate and bank customer loan rates, or (2) be­ 4 For example, see the following (for description tween borrowing and the profit spread be­ of conferences, see p. 163): Conference (1), Oct. 25-28, 1921 (p. 20 et passim); Conference (2), tween the discount rate and bond rates. In Nov. 19-21, 1919 (pp. 59-73 et passim), and Apr. other words, banks try to take care of their 12-15, 1921, vol. 1 (et passim). 5 For example, see Robert C. Turner, Member- 6 For an explanation and evaluation of the two Bank Borrowing, pp. 92-97. doctrines, see Turner, op. cit., chapters IV, V, and VI.

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customers regardless of whether they are borrowing, as well as administration of the able to borrow from the Reserve Banks at a discount window, inhibits such actions. profit. And apparently they do not borrow Nevertheless, a profit spread may induce from the Reserve Banks to invest in bonds some banks, especially the more aggressive even when the return affords a profit. ones, to pursue more liberal lending and in­ 2. There was a fairly close correlation vesting policies; and the relation of the dis­ between the volume of member bank bor­ count rate to rates on alternative reserve rowing and the profit spread for three types adjustment media surely influences banks in of open market paper: call loans to brok­ their choice of the source of funds to cover ers, time loans to brokers, and commercial reserve deficiencies. paper. There was also close correlation be­ tween the volume of borrowing and the Attempts to regulate final use of bank credit profit spread between the discount rate and The general philosophy underlying the dis­ the average of these three market rates. count provisions of the Federal Reserve Act 3. Changes in the profit spread for open was that Reserve Bank credit should be market paper appeared to be an important confined to productive uses in industry, determinant of changes in the volume of commerce, and agriculture. It should not be member bank borrowing in the period used to finance speculative activity of any 1922-30, but the correlation was not so kind— securities, real estate, or commodi­ close for the period 1931-36. ties— or to finance investments other than On the basis of his research and analysis, Government securities.7 Turner concluded that the profit theory is This philosophy of the discount function not a complete explanation of the volume was expanded and refined in the 1920’s. A of member bank borrowing but that it is a view prevalent inside and outside the Sys­ significant one. The volume of borrowing tem was that confining bank credit to tends to increase as the profit spread wid­ short-term productive purposes was the real ens, but because of the tradition against pathway to economic stability. Productive borrowing there is a point beyond which purposes included financing of an orderly widening of the spread has gradually less flow of goods from producer to consumer, effect. There is an observable tendency for but not the building up of inventories in an­ changes in the profit spread either to lead ticipation of higher prices. For example, the or to occur at the same time as changes in Federal Reserve Board’s Annual Report for the volume of borrowing. A negative profit spread is associated with a low volume of 7 Materials concerning the discount function in the borrowing, but it appeared not to be so im­ period prior to the mid-1930’s were taken principally from the following sources, all within the System: portant in determining changes in the vol­ (a) minutes of conferences of the Governors of the ume of borrowing. Finally, a general theory Federal Reserve Banks; (b) minutes of conferences of the Governors and the Chairmen and Federal Re­ of member bank borrowing must embrace serve Agents of the Federal Reserve Banks with the consideration of factors influencing reserve Federal Reserve Board; (c) minutes of meetings of the Open Market Investment Committee; and (d) positions as well as the profit theory. Annual Reports of the Federal Reserve Board. The Turner’s conclusions are valid. Bank minutes of the annual conferences of the Federal Re­ loan and investment policies are not di­ serve Board with the Governors and Chairmen of the Federal Reserve Banks, usually held in October rected toward taking advantage of every or November, in the first part of the 1920’s were es­ profit spread between their earning assets pecially useful because the meetings were devoted en­ tirely to papers and discussions of Federal Reserve and the discount rate. The tradition against policy.

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1923 stated, “the economic use of credit is spond to the changing needs of production to facilitate the production and orderly and trade. marketing of goods and not to finance the Events and experience soon demon­ speculative holding of excessive stocks of strated that eligibility requirements were materials and merchandise.” 8 Confining not an effective method of regulating use of bank credit to productive uses, as here de­ credit. To facilitate financing the large de­ fined, would automatically result in the ap­ fense expenditures incurred in World War propriate quantity of credit. This point was I, the Reserve Banks were given authority also well stated in the 1923 Annual Re­ to make loans to member banks against port: U.S. Government securities. More signifi­ It is the belief of the Board that there will be cant, however, experience soon demon­ little danger that the credit created and contrib­ strated that the kind of paper offered for uted by the Federal reserve banks will be in discount or put up as collateral for loans excessive volume if restricted to productive uses. . . . Administratively, therefore, the solution of afforded no indication whatever of the use the economic problem of keeping the volume of a member bank was to make of the pro- credit issuing from the Federal reserve banks ceeds. In fact, member banks came to the from becoming either excessive or deficient is found in maintaining it in due relation to the discount window to cover a reserve defi­ volume of credit needs as these needs are derived ciency that had already occurred and that from the operating requirements of agriculture, usually reflected the combined effects of a industry, and trade, and the prevention of the large number of transactions. uses of Federal reserve credit for purposes not warranted by the terms or the spirit of the Fed­ Preferential discount rates. Another early eral Reserve Act.9 experiment in trying to influence the use of Eligibility requirements. The initial view credit was the preferential discount rate. In was that confining bank credit to produc­ 1915, a preferential rate was established on tive uses could be implemented by eligibil­ trade acceptances to encourage development ity requirements. The original Federal Re­ of a market for acceptances and broaden serve Act limited access to the discount the use of this type of paper. A broader window primarily to short-term paper aris­ market for acceptances would tend to stim­ ing from, or the proceeds of which were to ulate U.S. exports and increase the liquidity be used in the financing of, industrial, com­ of member banks. In the same year a pref­ mercial, and agricultural activities. Except erential rate was established on paper based for a minimum gold reserve requirement of on some staple commodities to facilitate 40 per cent, eligible commercial paper seasonal financing of the marketing of agri­ could also be pledged as collateral against cultural products. the issue of Federal Reserve notes. Thus, ac­ In World War I and World War II, Sys­ cess to the discount window and to a large tem officials established preferential rates on extent the issuance of Federal Reserve discounts and advances “collateralled” by notes were directly related to holdings of el­ Government securities in order to facilitate igible commercial paper. As a result, it was the financing of large wartime expenditures. expected that Reserve Bank credit and Fed­ The preferential rate in World War II ap­ eral Reserve notes would automatically re­ plied to member bank borrowing “collater­ alled” by short-term Government securities. 8 Tenth Annual Report of the Federal Reserve Experiments with preferential discount Board: Covering operations for the year 1923, p. 5. 9 Ibid., pp. 34 and 35. rates, except against Government securities

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in wartime, were short-lived. There were To curb the demand of brokers for credit, it is two serious disadvantages. One was that necessary to destroy the confident belief that additional funds will always be forthcoming in banks in need of funds offered for discount response to an advance in rates. This can be the type of paper with the lower discount readily accomplished by the addition of a simple rate. The preferential rate was the effective provision to the Federal Reserve act, authorizing, or perhaps directing, the Reserve Banks to impose discount rate. Second, preferential rates a rate 1 per cent higher than the call renewal were discriminatory. Member banks hold­ rate upon rediscounts for member banks that are ing the types of paper with preferential lending on the Exchange at the time the accom­ modation is secured. If need be also a minimum rates could borrow more cheaply than borrowing period of seven days might be estab­ banks not holding such paper. Except for lished.11 Government paper in wartime, System Serious objections were raised to the officials— especially Reserve Bank officials Sprague proposal. In addition to the usual — were strongly opposed to preferential dis­ objections, it would be difficult to imple­ count rates; they thought that all types of ment such discretionary power wisely. Bank eligible paper should carry a uniform rate. credit was needed to facilitate distribution Preferential discount rates (or a penalty of new corporate securities, which in turn rate) have been proposed occasionally were needed at times to encourage business other than in wartime since the early exper­ recovery. It would not be easy to determine iments. In 1928 the System had been fol­ when securities loans were excessive. Pas­ lowing a policy of moderate restraint in sage of such legislation might also imply order to curb speculative use of bank that securities loans are objectionable per credit, but there was no need to curtail se.12 bank credit for business and agricultural Direct pressure. Ineffectiveness of eligibil­ purposes. A member of the Federal Reserve ity requirements along with immobilization Board recommended establishing a special of discount rate policy following World preferential discount rate for paper drawn War I because of Treasury financing re­ to finance the marketing of agricultural quirements resulted in a shift of emphasis products and a preferential buying rate for to “direct pressure” via the discount win­ bankers’ acceptances drawn for the purpose dow. There was substantial support within of seasonal crop movement. The intention the System to use direct pressure both to was to ease the impact of restraint on the regulate the final use of bank credit and to marketing of agricultural products. The prevent excessive member bank borrowing proposal, which was presented to the Open from the Reserve Banks. Market Investment Committee, was op­ In the spring of 1920 the Federal Re­ posed by the Reserve Bank Governors. serve Board asked the Reserve Banks to They opposed preferential rates as a matter submit a written report of methods used to of principle and also on the basis that such keep informed on how member banks were rates would not result in lower rates to using Reserve Bank credit. Some members farmers.10 of the Federal Reserve Board were ardent In the fall of 1928, Professor O. M. W. advocates of using discount policy to bring Sprague proposed a penalty discount rate for member banks making stock exchange loans. For example, he stated: 11 O. M. W. Sprague, “A New Device for Reserve Bank Control of Brokers’ Loan Inflation,” p. 599. 10 Minutes of the Open Market Investment Com­ 12 For example, see Harold L. Reed, Federal Re- mittee, Aug. 13, 1928. serve Policy 1921-1930, pp. 183 and 184.

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pressure on member banks to curtail credit officials would in turn cause borrowers to for nonessential uses. According to this be more careful in their applications for view, Reserve Bank officials should keep in­ credit. A potential borrower contemplating formed on member bank lending and in­ purchasing some luxury that he would “be vesting policies and should deny access to better off without,” for example, would the discount window to those extending likely decide not to buy if the appropriate­ credit for speculative and other nonessential ness of such borrowing were questioned.13 uses. Strong support for direct pressure to in­ In general, Reserve Bank officials did try fluence allocation of member bank credit to keep informed of their member banks’ emerged again in the latter part of the loans and investments through regular re­ 1920’s. System officials became concerned ports, bank examination reports, and inter­ as early as the mid-1920’s about the flow of views with officials of problem banks. Most credit into the stock market. The growing of the Reserve Banks, through circular let­ volume of bank credit being absorbed for ters and other methods, urged member speculation in securities confronted System banks not to make loans for speculative ac­ officials with a dilemma. The excessive flow tivities, such as in securities or to enable of bank credit into the stock market called borrowers to hold commodities for higher for a policy of restraint; a margin of unused prices. The Governor of one of the Reserve resources and declining prices called for a Banks stated that borrowing to buy auto­ policy of ease. mobiles was one of the most extravagant Actions to curtail the total quantity of things they had to cope with and that peo­ bank credit and to make it more expensive ple were buying cars who could not afford in order to curb speculation would have them. One Reserve Bank refused to dis­ harmful effects on legitimate business. The count paper arising from the sale of pleas­ solution, according to some officials, was to ure automobiles, on the basis that the in­ use discount policy to prevent member dustry was overextended. The policy was banks from making speculative loans. The soon abandoned, however. Some Reserve Federal Reserve Board, convinced that an Banks, upon receiving a request for dis­ increase in the discount rate would not be count accommodation from member banks effective in curbing speculation, sent a letter making speculative loans, followed the to the Reserve Banks on February 2, 1929, policy of asking the banks to liquidate such calling attention to the large volume of loans instead of borrowing from the Reserve speculative loans and to the fact that use of Bank. Reserve Bank credit to support such loans There was considerable sentiment that it is contrary to the spirit of the Federal Re­ was impractical to try to distinguish be­ serve Act. For example, the letter stated: tween essential and nonessential uses of The Federal reserve act does not, in the opinion bank credit in peacetime; however, discre­ of the Federal Reserve Board, contemplate the tionary discount policy could have benefi­ use of the resources of the Federal reserve banks cial results. Knowledge that Reserve Bank for the creation or extension of speculative credit. officials were scrutinizing their loans and A member bank is not within its reasonable claims for rediscount facilities at its Federal re­ lines of credit would cause member bank officials to be more selective in extending 13 See Conference (2), Apr. 10, 1920, especially their credit. This attitude of member bank pp. 515 and 516 et passim.

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serve bank when it borrows either for the pur­ 3. Direct pressure cannot be applied to pose of making speculative loans or for the pur­ the large number of banks not borrowing pose of maintaining speculative loans.14 from a Reserve Bank. The Board also stated that it had no inten­ 4. Direct pressure, at best, is feasible tion of interfering with the loan practices of only for preventing excessive borrowing by member banks so long as those practices the individual bank; it is impossible for Re­ did not involve the Federal Reserve Banks. serve Bank officials, in passing on loan ap­ But the Board did have a responsibility plications of member banks, to determine when member banks were maintaining spec­ what the total volume of reserves at the dis­ ulative securities loans with the aid of Fed­ posal of the banking system should be. eral Reserve credit. 5. The Federal Reserve Act does not From the very beginning, there was give either the Federal Reserve Board or a strong opposition to the policy of trying to Reserve Bank control over the loan policy use administration of the discount window of a member bank. A Reserve Bank cannot as a tool of selective bank credit control. compel a member bank to make a loan that For example, the Governors of the Reserve it does not want to make nor restrain a Banks were unanimous that it was not member bank from making a loan that it practical to try to distinguish between es­ wishes to make.16 sential and nonessential uses of credit in Another aspect of the policy of direct peacetime.15 The principal objections to a pressure was discussed in the early 1920’s. policy of direct pressure were as follows: There was considerable concern that some member banks might be investing too heav­ 1. It is impossible to determine the spe­ ily in bonds and that some of the smaller cific use a member bank makes of the pro­ ceeds of a loan from a Reserve Bank. The banks especially were being induced by loan is to replenish reserves already im­ salesmen to buy bonds of poor quality. One paired, usually by a large number of trans­ of the questions discussed by the Governors actions. was whether, when a member bank comes 2. Even if Reserve Bank credit should in to borrow, Reserve Bank officials should be denied to member banks making specu­ go over its statement and try to tell the lative loans or for other purposes not con­ bank what its investment policy should be; sidered desirable, reserves created by loans also whether the bank should be advised to to other member banks may be transferred sell some of its bonds before the Reserve through ordinary commercial and financial Bank would lend to it. Although discussed transactions to member banks making such at some length, there was vigorous opposi­ loans. tion to advising member banks on their in­ vestment policy because it would be undue 14 See “Review of the Month,” Federal Reserve interference in member bank management. Bulletin, Feb. 1929, vol. 15, p. 94. Another good source of information on pros and cons of direct pressure is U. S. Senate, Subcommittee of the Com­ 16 See Eighth Annual Report of the Federal Re­ mittee on Banking and Currency, Hearings S. 71, serve Board: Covering operations for the year “Operation of the National and Federal Reserve Bank­ 1921, pp. 95 and 96. A good statement of the objec­ ing Systems,” especially the statements of A. C. Miller tions to a discount policy of direct pressure is given of the Federal Reserve Board and George L. Harrison, in Interpretations of Federal Reserve Policy in the Governor of the Federal Reserve Bank of New York. Speeches and Writings of Benjamin Strong, pp. 15 See Conference (2), Apr. 8, 1920, pp. 287-90. 126-33 and 190-93.

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No action was taken toward trying to im­ affirmative vote of six members could estab­ plement such a policy.17 lish for each district the percentage of each A leading academic economist stated member bank’s capital and surplus that that the experiment of attempting to use could be represented by loans secured by discount policy to regulate use of bank stock and bond collateral, the percentage to credit was a failure. Attempts to curtail the be fixed “with a view of preventing the use of bank credit for speculation also af­ undue use of bank loans for the speculative fected the use of such credit for business carrying of securities.” Under an amend­ and agricultural purposes. At best, it might ment to Section 13, if any member bank, have held down total Reserve Bank credit while indebted to a Reserve Bank and de­ somewhat, with little effect on the alloca­ spite warning from a Reserve Bank or the tion of member bank credit among particu­ Board of Governors, increases its collateral lar uses. In his opinion, a real effort to carry loans or loans to securities dealers for the out the doctrine would have required: de­ purpose of purchasing or carrying securities nying Reserve Bank credit to member (other than U.S. Government securities), banks making loans on the stock market; its note to the Reserve Bank shall be imme­ extending liberal loan privileges at low diately due and payable, and the member rates to member banks not making such bank will be ineligible to borrow for a pe­ loans; and open market sales of securities riod to be determined by the Board of Gov­ as necessary to mop up any excess reserves ernors. created in the process.18 The financial crisis accompanying the Amendments in the early 1930’s. Additional Great Depression revealed a serious weak­ authority for selective regulation just about ness in trying to tie Reserve Bank credit too coincided with the termination of attempts closely to narrowly defined eligible com­ to use the discount window as a means of mercial paper. Eligibility requirements influencing final use of bank credit. Legisla­ handicapped the System in meeting member tion in the Great Depression, in addition to bank needs in two ways. First, some banks giving the Federal Reserve Board authority did not have enough eligible paper and to fix margin requirements on loans for Government securities so that they could purchasing or carrying securities registered borrow adequate amounts to meet reserve on a national exchange (excluding U.S. drains, especially if subjected to heavy de­ Government securities), also conferred ad­ posit withdrawals. Second, System open ditional powers to regulate member bank market purchases of Government securities loans for speculation in securities.19 Section to help check deflation resulted in a reduc­ ll(m ) of the Federal Reserve Act was tion in member bank indebtedness and the amended to provide that the Board on an supply of eligible paper available to be put up as collateral for the issue of Federal Re­ serve notes. As a result, ability to issue 17 See Conference (3), Oct. 10 and 11, 1922, pp. Federal Reserve notes was declining at the 336-56. same time public demand for currency was 18 See Charles O. Hardy, Credit Policies of the soaring. Some of the Reserve Bank Gover­ Federal Reserve System , pp. 140-46. 19 For a complete statement of legislation in the nors became concerned over this situation early 1930’s affecting the discount function, see How­ as early as 1930. ard H. Hackley, “A History of the Lending Func­ tions of the Federal Reserve Banks,” chapters 8-11. The Federal Reserve Act was amended

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to remove these handicaps. The Reserve the general business situation as well as the Banks were given authority to lend against general conduct and management of the any satisfactory asset under rules and regu­ applying bank.20 lations prescribed by the Board of Gover­ nors but at a penalty rate V2 per cent above Allocation among banks the discount rate on eligible assets. The Re­ Another objective in implementing the dis­ serve Banks were also given authority for count function, especially in the early the first time to extend credit directly to in­ 1920’s, was an appropriate allocation of dividuals, partnerships, and corporations Reserve Bank credit among member banks. (which included nonmember banks) for a Section 4 of the Federal Reserve Act di­ period not to exceed 90 days against U.S. rected that the affairs of each Reserve Bank Government securities as collateral, under shall be administered “fairly and impar­ rules and regulations prescribed by the tially” as among member banks and that Board. U.S. Government securities were each member bank should be extended such also made eligible as collateral for the issue discounts and advances “as may be safely of Federal Reserve notes. and reasonably made with due regard for Regulation A was revised effective in Oc­ the claims and demands of other member tober 1937. The revision was concerned banks.” primarily with bringing the regulation into Little use was made of the discount win­ conformity with amendments to the Federal dow prior to World War I because most Reserve Act; however, there was a state­ banks had ample reserves, and many banks ment of General Principles in a preface to still preferred to borrow from their corre­ the regulation. The General Principles may spondents as formerly. During the war, be summarized as follows: Federal Reserve policy was directed toward 1. The guiding principle underlying dis­ facilitating war financing, and member count policy is advancement of the public bank borrowing on Government securities interest; hence, the effect that the granting rose sharply. Discounts and advances to or withholding of credit by a Reserve Bank member banks continued to soar during the may have on a member bank, on its deposi­ postwar boom and then plummeted in the tors, and on the community is of primary depression. One of the problems confront­ importance. ing System officials after the depression was 2. Reserve Banks are expected to con­ a substantial number of habitual borrowers. sider not only the quality of paper offered A study revealed that in mid-1925 nearly for discount but also whether it is in the 900 member banks had been borrowing public interest to put additional funds at steadily for over a year. More than 250 na­ the disposal of member banks. tional banks had failed since 1920, and 3. Reserve Banks, in accordance with more than four-fifths of these banks were the provisions of the Banking Act of 1933, habitual borrowers from the Federal Re­ are to keep informed on the loans and in­ serve prior to failure. A large number of vestments of member banks and on whether the habitual borrowers still confronted funds are being used for speculative pur­ poses, fixed investment, and so forth. 4. In determining its discount policy, a 20 See “Regulation on Discounts by Federal Re­ serve Banks,” Federal Reserve Bulletin, Oct. 1937, Reserve Bank is to take into consideration p. 977.

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problems that had their origin in the war excess of a certain amount, such as its capi­ and early postwar periods.21 tal and surplus, or a basic line computed Banking policy, in contrast to credit pol­ for each member bank by the Reserve icy, was directed toward maintaining the Bank. In extreme cases, one Reserve Bank sound financial condition of individual compelled such member banks to put up member banks. This policy was considered extra collateral in order to reduce their to be the joint responsibility of the discount holdings of eligible paper and hence their function and supervisory authorities. Here capacity to discount or borrow from the we are concerned only with the discount Reserve Bank. function. Even though the device apparently was One of the problems confronting the Sys­ not widely used, it aroused criticism. John tem’s discount officials was preventing indi­ Skelton Williams, formerly Comptroller of vidual member banks from making exces­ the Currency and ex officio member of the sive use of Reserve Bank credit both with Federal Reserve Board, stated that some­ respect to what is sound banking policy and times the large additional margin— as much the member bank’s fair share relative to the as 50 or even 100 per cent— made it im­ needs and demands of other member banks. practical for country banks to get credit.24 The discount rate could not be relied on to Additional margins of collateral of this prevent excessive borrowing, as already magnitude, however, were apparently infre­ mentioned, because a penalty rate was con­ quent. sidered impracticable in our type of bank­ Progressive discount rates. In 1918 the ing system. Federal Reserve Board proposed for discus­ Additional collateral. One device used by sion the establishment of progressive dis­ several Reserve Banks to prevent excessive count rates on brackets of borrowing above borrowing was to require additional a member bank’s normal or basic line. The collateral.22 With use of the discount rate purpose was to prevent some banks from immobilized until early 1920 because of borrowing more than their proportionate Treasury financing requirements, System of­ share of Reserve Bank credit. ficials were pressed to seek other methods Several objections were raised against the of trying to deal with excessive borrowing. proposal, especially by the Governors of the Some of the Reserve Banks required a mar­ Reserve Banks, and it was decided that ag­ gin of collateral, in addition to the usual gressive borrowers could probably be better amount, for member banks borrowing more dealt with by moral suasion. The proposal than they considered appropriate.23 was made again in 1919. The Federal Re­ Additional collateral was usually re­ serve Act was amended in April 1920, on quired when a member bank borrowed in the recommendation of the Federal Reserve Board, providing authority for the estab­ 21 See the report on member bank borrowing by lishment of progressive discount rates. Professor O. M. W. Sprague in Conference (1), Nov. 4 and 5, 1925, pp. 72-86. There were two principal reasons for the 22 In the early post-World-War-I period, additional request for authority to establish progres­ collateral was frequently required also for purposes sive rates. One purpose was to prevent ex­ of safety. 23 See the following: Conference (3); Conference cessive borrowing by relatively few member (2), July 1 and 2, 1918, Mar. 20-22, 1919, and Apr. banks without penalizing those that bor- 7-10, 1920; U.S. Congress, Joint Commission of Ag­ ricultural Inquiry, Hearings, “Agricultural Inquiry,” vol. 2, p. 157. 24 See U.S. Congress, op. cit., p. 157.

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rowed infrequently and only moderate prices of such securities or to work a hard­ amounts. A second purpose was to achieve ship on those still carrying a large part of a better allocation of Reserve Bank credit the Liberty Bonds acquired on original among member banks in accordance with subscription.25 the provisions of the Federal Reserve Act The experiment with progressive discount that credit should be extended “with due rates lasted only a short time. One Reserve regard for the claims and demands of other Bank terminated progressive rates in the member banks.” In some districts borrow­ latter part of 1920, and the other three in ing was concentrated in a small number 1921. Only a small percentage of the mem­ of large banks, which in turn extended ber banks paid a rate of 10 per cent or credit to their smaller correspondents. Most more— 44 in the Atlanta District, 49 in St. large banks wanted to continue to serve Louis, 114 in Kansas City, and 20 in their correspondents instead of having them Dallas.26 Great publicity was given to the borrow directly from the Reserve Bank. fact that a member bank in the South paid Four Reserve Banks (Kansas City, Dal­ a discount rate of 87.5 per cent. The bank las, St. Louis, and Atlanta) established pro­ had experienced a large outflow of deposits gressive discount rates in April and May and its reserve balance dropped to $86, 1920. The schedule for the four Banks pro­ drastically reducing its basic line. The 87.5 vided that for each 25 per cent by which a per cent, of course, applied only to the member bank’s borrowing from the Reserve upper bracket of its total borrowing. Bank exceeded its basic line, a “super rate” Progressive discount rates resulted in of Vi percentage point was added to the widespread criticism, especially in political regular discount rate. circles. It was alleged that progressive rates The key part of the plan was establish­ resulted in member banks charging their ment of a basic line for each member bank. customers exorbitant rates; also that pro­ The consensus of the Governors of the Re­ gressive rates put great pressure on member serve Banks was that the basic line should banks to reduce their borrowings, which in represent the member bank’s contribution turn caused the banks to put pressure on to the lending resources of the Reserve their customers to repay their loans. Avail­ Bank. The latter, it was agreed, consisted able evidence, however, did not support the of a member bank’s reserve deposit and its charge that progressive rates resulted in paid-in capital to the Reserve Bank. The member banks charging excessive rates to Kansas City, St. Louis, and Atlanta Re­ their customers. Instead, data revealed that serve Banks adopted as a basic line a figure there was no difference in the rates charged 2V2 times a sum equal to 65 per cent of the by member banks borrowing from the Re­ reserve balance maintained or required to serve Banks and those not borrowing. In be maintained by the member bank plus its view of the criticism about exorbitant rates, paid-in subscription to the capital stock of the Atlanta and Kansas City Reserve Banks the Reserve Bank. The Dallas Bank estab­ 25 For example, see the Seventh Annual Report of lished as the basic line an amount equal to the Federal Reserve Board: Covering operations for the combined capital and surplus of each the year 1920, pp. 58 and 59. member bank. Advances to member banks 26 See Robert F. Wallace, “The Use of the Pro­ gressive Discount Rate by the Federal Reserve Sys­ “collateralled” by U.S. Government securi­ tem,” p. 61. Good outside sources on progressive dis­ ties were excluded from progressive rates in count rates are Wallace, op. cit., pp. 59-68, and Benjamin Haggott Beckhart, The Discount Policy of order not to affect adversely the market the Federal Reserve System, pp. 367-77, 405-10.

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rebated all interest paid by member banks rate. Moreover, adoption of progressive in excess of a 12 per cent rate. rates by all Reserve Banks would eliminate One of the principal beneficial results the problem of avoidance by borrowing claimed for progressive discount rates was a from correspondents in districts without better distribution of Reserve Bank credit such rates. among member banks. Progressive rates But there are serious weaknesses inherent discouraged large borrowings by city banks in progressive rates, regardless of how the in order to re-lend to smaller correspond­ basic line is computed. Borrowing beyond a ents and resulted in more of these smaller certain amount is assumed to be unwar­ banks borrowing directly from the Reserve ranted and hence should be discouraged by Bank. a penalty rate. Progressive rates are applied There was strong opposition to progres­ on the basis of amount without regard to sive discount rates both within and outside reasons for borrowing. The effect is to dis­ the System. First, member banks experienc­ criminate against member banks subject to ing strong seasonal pressures and aggressive large reserve drains, regardless of circum­ banks extending credit to meet the needs of stances or how well the banks are managed. their communities were likely to be penal­ A member of the Federal Reserve Board, ized. Second, as applied by the four Re­ discussing progressive rates, stated that he serve Banks, a hardship was imposed on hoped few Reserve Banks would resort to banks in rural areas that were experiencing “the mechanical and bureaucratic device of an outflow of funds as a result of the de­ that kind in order to control a situation that pression. Reserve drains reduced the basic ought to be controlled through firm, dis­ line and resulted in higher super rates. criminating governing.” 27 Third, politicians and demagogues seized Progressive rates apparently were not upon the relatively few instances of member effective in restricting member bank bor­ banks paying unusually high discount rates rowing. One Reserve Bank official stated to criticize and ridicule the System. Fourth, that member banks were not discouraged so a rigid, automatic rule was substituted for much by progressive rates as by the fear discretion in administration of the discount that they might not be able to borrow from window. Finally, with only four Reserve a Reserve Bank. The Federal Reserve Banks using progressive rates, banks could Board conceded that progressive rates ap­ evade the penalty by borrowing from a cor­ parently were not so effective as the flat 7 respondent in a Federal Reserve district per cent rate adopted by some other Re­ that did not have progressive rates. serve Banks. Some of the weaknesses of the progres­ Preferential rate. One of the staff papers sive rate experiment in 1920 resulted from in the discount study of 1953-54 dealt with the type of plan adopted. The basic line, a preferential discount rate on noncontin- above which penalty rates were applied, re­ uous borrowing.28 One suggestion was to flected an attempt to relate a member charge a preferential rate on member bank bank’s fair share of borrowing to its contri­ borrowing against Government securities bution to the lending resources of the Re­ for 15 days or less provided the bank had serve Bank. This was an erroneous idea, and there was no logical reason why a bank 27 See Conference (2), Apr. 10, 1920, p. 523. borrowing in excess of such a basic line 28 William J. Abbott, Jr., “A Preferential Rate on Noncontinuous Member Bank Borrowing,” in “The should be required to pay a higher discount Discount and Discount Rate Mechanism,” May 1953.

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not borrowed for at least a 15-day period. ber of the Board of Governors in 1957. He But other bases for applying a preferential suggested, however, a penalty discount rate rate to encourage noncontinuous borrowing for continuous borrowers; for example, could be used. banks borrowing for the third or possibly Some of the alleged advantages that the fifth successive reserve period.29 might result from such a preferential rate were as follows: Appropriate and inappropriate use 1. It would penalize the continuous use Even though two major considerations in of Reserve Bank credit and strengthen the discount administration in the 1920’s were sagging tradition against borrowing. influencing the final use of bank credit and 2. The device would have considerable a fair allocation of Reserve Bank credit flexibility as the spread between the prefer­ among member banks, appropriate uses in ential and the regular discount rate could the modern sense of the term were also dis­ be varied over time and among Reserve dis­ cussed. tricts. One of the problems was the attitude of member banks toward borrowing from the 3. The preferential rate could be new central bank. In general, member changed without the psychological impact banks thought of borrowing from a Reserve of a change in the regular discount rate. Bank in the same way as borrowing from a 4. An increase in borrowing at the regu­ correspondent. The widespread misunder­ lar discount rate would be an indication of standing of the discount function among growing tightness. member banks focused attention on educat­ 5. It would assist in policing the dis­ ing them as to the proper uses of the dis­ count window and encourage member count window. banks to maintain greater liquidity. The procedure followed by most Reserve But the proposal had serious disadvan­ Banks in administering the discount win­ tages. It would discriminate against member dow varied somewhat according to the banks that had heavy seasonal demands for borrowing record and condition of the loans and that might have to borrow in sev­ member bank. Well-managed banks that eral reserve periods, even after liquidating borrowed only infrequently were given only securities and aaking other asset adjust­ a routine investigation—determining eligi­ ments. In trying to solve one problem it bility of the paper offered for discount or as would create another—that of preventing collateral, and analysis of readily available one member bank from borrowing at the data on the bank’s condition. Continuous preferential rate in order to re-lend to an­ and frequent borrowers, banks borrowing other that could borrow only at the regular unduly large amounts, and banks with un­ discount rate. Finally, the public relations sound policies or in poor condition were impact of a preferential rate might be given much more careful scrutiny. Problem harmful. The conclusion was that continu­ borrowers were typically subjected to much ous borrowing could probably be prevented more careful analysis, covering such points more effectively through discretionary ad­ as the character of the bank’s loans and its ministration of the discount window than lending policies; behavior of its deposits; its by some mechanical device such as a pref­ erential rate. 29 See Minutes of Federal Open Market Committee, A similar proposal was made by a mem­ May 7, 1957.

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borrowing record from the Reserve Bank; lending rates. The Annual Report of the examination reports on its condition; and Federal Reserve Board for 1928 stated: “It perhaps discussion with bank examination is a generally recognized principle that re­ officials as to the quality of the bank’s man­ serve bank credit should not be used for agement. Such internal analysis and investi­ profit, . . 32 gation were often supplemented by inter­ Third, continuous borrowing from a Re­ views with the borrowing bank’s officers or serve Bank was inappropriate for several directors.30 reasons. It was inconsistent with the spirit Provisions of the Federal Reserve Act of the Federal Reserve Act in two respects: were often referred to for guidance as to Borrowing should be only for short term, appropriate uses of the discount window. In and according to the principles in Section general, member banks should use the dis­ 4 the discount window should be admin­ count window for only short terms to meet istered impartially and with due regard to seasonal, emergency, and other temporary the claims and demands of other member credit needs. With respect to member banks banks. Continuous borrowing was also un­ in poor condition, a Reserve Bank should sound banking policy. The Annual Report take a reasonable risk to prevent a member of the Federal Reserve Board for 1926 bank from failing, but it should not make stated that continuous borrowing “would advances on worthless paper or paper that not be in accordance with the spirit of the would result in loss. Federal reserve act and would not be fair More attention was devoted apparently to the other member banks which may be to inappropriate uses of the discount win­ active competitors of the borrowing bank. dow. First, Reserve Bank credit should not It may also impair the ability of the bor­ be used for either speculative purposes or rowing bank in case of insolvency to meet investments. The Annual Report of the its obligations to depositors.” 33 Discussion Federal Reserve Board for 1923 stated: at policy meetings identified three types of Tt is not a system of credit for either investment continuous borrowers: banks in an overex­ or speculative purposes. . . . The exclusion of tended position; those using Federal Re­ the use of Federal reserve credit for speculative serve credit as a means of enlarging their and investment purposes and its limitation to own operations; and banks borrowing to agricultural, industrial, or commercial purposes thus clearly indicates the nature of the tests profit from a differential between the dis­ which are appropriate as guides in the extension count rate and their own lending rates. of Federal Reserve credit.31 Other instances of inappropriate dis­ Second, member banks should not bor­ counting or advances to member banks row to take advantage of a differential be­ were cited in System discussions. For exam­ tween the discount rate and the bank’s own ple, a Reserve Bank should not discount or make advances to member banks when the 30 Minutes of meetings of practically all of the effect is to perpetuate unsound policies and policy-making groups in the 1920’s contained some poor management. Illustrations of the latter discussion of discount policy and administration of the discount window. For example, see the follow­ were when 60 per cent of a member bank’s ing: Conference (1), Nov. 12-16, 1923, especially pp. 102-36, and Nov. 4 and 5, 1925; Conference (4), Nov. 4-10, 1926, pp. 503-25; and Conference (3)> 32Fifteenth Annual Report of the Federal Reserve Mar. 22-24, 1926, pp. 43-59, and Nov. 8-10, 1926, Board: Covering operations for the year 1928, p. 8. pp. 28-53. 33 Thirteenth Annual Report of the Federal Re­ 31 Annual Report, Federal Reserve Board, 1923, serve Board: Covering operations for the year 1926, p. 33. p. 4.

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assets consisted of loans to officers and 2. To assist member banks in providing directors, or when an increase in borrowing short-term and, to a limited extent, seasonal from the Reserve Bank was accompanied credit to facilitate production and the by a persistent decline in the bank’s depos­ movement of goods through the productive its. In such cases, a Reserve Bank should process from raw material to the ultimate make advances only when it appears the consumer. According to the foreword to member bank can be salvaged, and only Regulation A, Federal Reserve credit may after a plan is agreed on for eliminating the be extended to cover “seasonal require­ unsound policies and practices; otherwise, ments for credit beyond those which can extension of Federal Reserve credit enables reasonably be met by use of the bank’s own some depositors to be paid at the expense resources.” of other depositors. Permitting member banks to use the dis­ count window to meet all of their seasonal Disuse and revival reserve needs was considered undesirable From the Great Depression until the Treas­ because such a policy would probably re­ ury-Federal Reserve accord in March sult in the creation of excess reserves for 1951, the discount function fell largely into the banking system as a whole and interfere disuse, and problems other than discount with appropriate monetary policy. More­ policy were of concern to System officials. over, such a policy would not contribute to Discount rate policy also received relatively sound banking practice. Member banks little consideration. should manage their assets so as to be in a Restoration of a flexible monetary policy position to meet normal or expected sea­ and revival of the discount function focused sonal fluctuations.34 attention once again on the role of discount 3. Borrowing for longer periods is ap­ policy. A System Committee was established propriate, according to the foreword to the in 1953 to make a study of the discount regulation, “when necessary in order to as­ mechanism and its role in the new environ­ sist member banks in meeting unusual situ­ ment. Several staff studies were made, and ations, such as may result from national, re­ the committee submitted its report in gional, or local difficulties or from excep­ March 1954. Regulation A was revised in tional circumstances involving only par­ 1955. ticular member banks.” In other words, The revision of Regulation A largely re­ borrowing for longer periods may be appro­ affirmed the guiding principles for discount priate to enable member banks to meet sit­ policy that had been developed earlier. Ap­ uations arising out of adverse economic propriate uses of the discount window, conditions, money panics, or other eco­ stated in the form of general principles in nomic crises that threaten maintenance of the foreword of the revised regulation, were sound banking and credit policies or the analyzed in more detail in the staff papers public interest. and committee report. Inappropriate uses of the discount win­ Appropriate uses of the discount window dow included: may be summarized as follows: 1. To help finance speculative activities 1. To assist member banks in making whether in securities, real estate, or com­ very short-term reserve adjustments re­ quired by a temporary loss of deposits or 34 See System Committee on the Discount and Dis­ count Rate Mechanism, “Report on the Discount impairment of liquidity. Mechanism,” Appendix D.

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modities or to enable a member bank to in­ that present eligibility requirements be re­ crease its investments (except to assist in pealed and that the Reserve Banks be au­ the secondary distribution of U.S. Govern­ thorized to make advances to member ment and other securities). banks on their own notes secured to the sat­ 2. Borrowing to take advantage of a rate isfaction of the Reserve Banks, subject to differential or for tax avoidance. rules and regulations prescribed by the 3. Borrowing for a purpose that is in­ Board of Governors. The recommendation consistent with the objectives of sound was approved by System officials, and the credit policy or the public interest. Chairman of the Board of Governors in a letter to the Chairmen of the Senate and 4. Continuous borrowing—in effect us­ House Banking and Currency Committees ing Reserve Bank credit to supplement a of August 21, 1963, recommended legisla­ bank’s own resources. tion to achieve these results. A draft of a The committee report offered several proposed bill accompanied the letter. objections to continuous borrowing. First, such borrowing would convert the discount There were several reasons for the rec­ window from a source of temporary and ommendation to eliminate present eligibility emergency assistance to one of semiperma­ requirements and broaden access to the dis­ nent investment for a relatively small num­ count window. First, drastic changes in the ber of member banks. Second, a small economy since 1914 have resulted in number of banks would probably get an marked changes in commercial bank assets. undue proportion of the reserves that A marked trend toward loans of longer ma­ should be made available through the dis­ turity and an increase in investments in the count window consistent with an appropri­ past three decades have resulted in a sub­ ate monetary policy. Third, large and con­ stantial decline in the proportion of bank tinuous indebtedness would contribute to assets eligible for discounting. In the post­ an unsound banking practice, create sub­ war period there has also been a downward stantial claims prior to that of depositors, trend in bank holdings of U.S. Government and could threaten the stability of the securities. In view of the basic changes that banking system. And fourth, a policy of have occurred, elimination of eligibility re­ permitting continuous borrowing might re­ quirements is desirable in order that the sult in the injection of more reserves than Reserve Banks, “will always be in a posi­ would be desirable for monetary policy.35 tion to perform promptly and efficiently one Perhaps it should be pointed out that in of their principal responsibilities—the ex­ the staff studies, the committee report, and tension of appropriate credit assistance to the revision of Regulation A no sentiment member banks to enable the latter to meet was expressed for using discount policy to the legitimate credit needs of the influence the final use of bank credit, ex­ economy.” 36 cept that borrowing to support speculative A second important reason for the rec­ activities and investments was considered ommendation is that the narrowly defined inappropriate. eligibility requirements serve no useful pur­ pose. Initially, it was expected that the re­ Elimination of eligibility requirements quirements would result in Reserve Bank The System Committee on Eligible Paper, in its report of May 1962, recommended 36 Letter from Chairman William McC. Martin, Jr., to the Chairmen of the Senate and House Bank­ 35 Ibid. ing and Currency Committees, Aug. 21, 1963.

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credit, including Federal Reserve notes, au­ Role of the discount rate. The role of the tomatically responding to changing needs of discount rate depends largely on the reli­ business. Experience soon proved these ex­ ance that monetary authorities put on dis­ pectations unjustified. Departures from the count policy and other instruments, such as principle that Reserve Bank credit should open market operations and changes in re­ be extended only on the basis of short-term, serve requirements. A widespread belief self-liquidating commercial paper began in that frequent borrowing is a sign of weak­ 1916 when the Reserve Banks were author­ ness and unsound banking policy, a consen­ ized to make advances up to 15 days on sus that a penalty discount rate relative to U.S. Government securities. As already customer loan rates is impractical, a belief pointed out, even more significant depar­ that the Reserve Banks should be lenders of tures were made in the early 1930’s. last resort, and reliance on open market op­ Inasmuch as present eligibility require­ erations as the principal tool of monetary ments serve no useful purpose, and at some policy have all tended to relegate the dis­ future time might seriously handicap the count rate to a minor role. Reserve Banks in meeting legitimate mem­ There was little in the way of a theory or ber bank reserve needs, the emphasis philosophy of discount rate policy prior to should be on “the soundness of the paper the 1920’s. System officials had had no ex­ offered as security for advances and the ap­ perience in central banking, and initially propriateness of the purposes for which there was a wide range of views on the member banks borrow.” 37 principles that should be followed in estab­ lishing discount rates—some being relevant Discount rate policy for a central bank while others reflected A thorough analysis and review of the evo­ thinking more appropriate for a commercial lution of academic and System thinking bank. There were two main views: one that about the discount rate as an integral part the discount rate should be above bank of monetary policy is outside the scope of lending rates in order to discourage dis­ this study. The focus of the study is di­ counting for a profit, and the other that the rected primarily to the role of the discount discount rate should be low enough to en­ rate as a part of the discount mechanism, courage use of the resources of the new Re­ particularly the aspects of significance for serve Banks. current appraisal of the discount function Conditions prior to World War I were as a whole. Thus there is no attempt to give not favorable to the development of a dis­ a complete chronological evolution of the count rate philosophy. Lower reserve re­ discount rate’s role in monetary policy. Ac­ quirements provided in the Federal Reserve cordingly, this section deals with the Act and an inflow of gold supplied banks broader course of thinking on the function with ample reserves, so there was little need of the discount rate, with guides for deter­ to borrow or discount at the Reserve mining changes in the discount rate, and Banks. During the war and the postwar pe­ with the effects of changes in the discount riod prior to 1920, discount rate policy was rate. The bulk of the material covered deals directed toward assisting the Treasury in with the period prior to the Great Depres­ financing the war and the large volume of sion. expenditures that continued into the post­ war period. The marked change in economic envi­ 37 Ibid. ronment from the prewar period and the

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postwar boom and depression emphasized to prevent liquidation from becoming a the need for serious study and consideration strait jacket of deflation. Most System of­ of the objectives and instruments of Federal ficials believed there was little danger that Reserve policy. In the first part of the a low discount rate in depression would 1920’s annual meetings attended by mem­ stimulate borrowing for inappropriate pur­ bers of the Federal Reserve Board, and the poses, as some feared. Business firms do not Governors and Chairmen of the Federal borrow merely because credit is cheap. Reserve Banks were devoted entirely to This type of discount rate policy was Federal Reserve policy. The consensus was considered consistent with the provision in that policy should be directed primarily to­ the Federal Reserve Act that the rate ward maintaining sound credit conditions should be established with a view to accom­ and business stability. modating commerce and business. The dis­ There was a sharp difference of opinion count rate should be low in depression pe­ within the System on the discount function, riods: . . you do not accommodate com­ as already mentioned. Some favored direct merce and business by high rates when four pressure to regulate the use of credit; others million men are out of employment and thought more reliance should be placed on business is sick for lack of markets and the discount rate. The latter thought the markets are lacking because the world is discount rate had several advantages over more or less in commercial chaos.” 39 A re­ direct pressure as a means of credit control: duction in rates when business is in a slump it was impersonal, and it applied to all bor­ can have a considerable effect in accelerat­ rowers alike; it was suitable for regulating ing business revival; an increase when busi­ the total volume of bank credit, whereas di­ ness is booming can do much to restrain, rect pressure was effective only in regulat­ if not prevent, inflation. In implementing ing borrowing of individual banks; and rate this type of discount rate policy, however, changes did affect willingness of individual “(t)imeliness of action is of the essence of banks to borrow. It was not necessary for successful Federal reserve action.” 40 the discount rate to be above bank lending The role of the discount rate was influ­ rates to have some restraining influence.38 enced significantly by two developments A modern, forward-looking type of phi­ that emerged in the 1920’s. First, open losophy regarding discount rate policy market operations began to be used in the began to emerge in the early 1920’s. Dis­ early 1920’s as an instrument of monetary count rate policy should be directed toward policy. This diminished reliance on the dis­ mitigating the upward and downward count rate and raised the problem of coor­ swings of the business cycle. In order to dinating the two instruments. Second, there achieve this objective the discount rate was growing support for using Federal should lead market rates on the upswing to Reserve tools to regulate the total quantity prevent or at least mitigate inflation; it of bank credit instead of its quality or use. should lead market rates on the downswing The shifting emphasis toward regulating quantity instead of quality of bank credit was accompanied by greater reliance on the 38 Some of the better sources of information on discount rate and less on discount policy. the discount rate in the 1920’s are: Conference (1), Oct. 25-28, 1921, Oct. 10-13, 1922, and Nov. 12-16, 1923; Conference (4) Oct. 25-28, 1921; Conference (3), Nov. 2-5, 1925; and “The Discount and Dis­ 30 See Conference (1), Oct. 25-28, 1921, p. 160. count Rate Mechanism,” statements (June 21, 1954). * °Ib id ., p. 156.

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Discount rate policy was of relatively lit­ Encouraging a decline in interest rates tle significance during the long period from would relieve some of the pressure for liq­ the mid-1930’s until the accord of March uidation and help to stimulate a revival in 1951, for reasons already given. Studies of business activity. There would be no dan­ the discount mechanism in 1953 and the ger, according to this view, of stimulating System Committee’s report in 1954 dealt speculation and other improper uses of mainly with discount policy. Consideration credit. Another school of thought, however, of the discount rate was largely in terms of was that on the downswing the discount coordination with open market operations. rate should follow market rates down. The Discussion of discount rate policy, espe­ discount rate should not be lowered until cially in the 1920’s, dealt largely with an accumulation of funds had brought a de­ guides and effects of rate changes and coor­ cline in market rates. Leading market rates dination of the discount rate with open down involved the danger of encouraging market operations. speculative borrowing, and the lower rate Guides to discount rate action. Prior to the would not stimulate borrowing for produc­ 1920’s the reserve ratio was frequently tive purposes. mentioned as a guide for determining The objective of trying to maintain eco­ changes in the discount rate, but proceed­ nomic stability and a growing belief that ings of policy discussions indicate that it this required regulation of the total quantity was rarely, if ever, a major reason for a of bank credit shifted attention from main­ rate change. A much more important con­ taining a certain relationship to market sideration was the relation of the discount rates to a much broader range of informa­ rate to market rates—usually the market tion. The Federal Reserve Board in its An­ rate on prime commercial paper prior to nual Report for 1923 stated: “Broadly the Great Depression and the market rate stated, an effective Federal reserve discount on 3-month Treasury bills since World War rate will be one that gives effective support II. As already mentioned, the penalty rate to a Federal reserve bank’s credit and dis­ was generally accepted in principle but was count policy. The objective in Federal re­ considered impractical in terms of bank serve discount policy is the constant exer­ lending rates. cise of a steadying influence on credit There was a consensus that the discount conditions.” In deciding whether to change rate should lead market rates up in a period the discount rate, officials should look to of expansion; a discount rate below market the total flow of credit and general business rates would likely encourage speculative ac­ and financial conditions. In 1931, a System tivity and borrowing to invest at a profit. official stated, “(I)f central banking au­ Keeping the discount rate generally above thorities see and have reason to believe in market rates in a period of expansion view of the statistics available to them that would discourage development of a specu­ the total volume of credit of the country is lative boom and misuse of the discount expanding at a rate and volume faster than window. any normal growth of business could jus­ There was a difference of opinion as to tify, it is incumbent upon the central bank­ the proper relationship in a downswing. ing authorities to put pressure or restraint One school of thought was that the dis­ on that growth by an increase in the redis­ count rate should lead market rates down count rate.” 41

in a period of declining business activity. 41 U.S. Senate, o p . cit., pp. 67-68.

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Discretion based on a large amount of There were two linkages whereby a business and financial information instead change in the discount rate might influence of a few guides was needed for sound deci­ the volume of bank credit. First, an in­ sions in making discount rate changes. This crease in the discount rate made borrowed view was well stated in the Board’s Annual reserves more expensive and caused mem­ Report for 1923: ber banks to scrutinize their loan policies No statistical mechanism alone, however carefully more carefully. Second, the discount rate contrived, can furnish an adequate guide to credit served as a signal to the public of Federal administration. Credit is an intensely human Reserve policy intentions. An increase in institution and as such reflects the moods and the rate was interpreted as an indication impulses of the community— its hopes, its fears, its expectations. The business and credit situation that credit was likely to be less readily at any particular time is weighted and charged available as well as more expensive. As a with these invisible factors. They are elusive and result, business enterprises were less willing can not be fitted into any mechanical formula, but the fact that they are refractory to methods to enter into future commitments in antici­ of the statistical laboratory makes them neither pation of higher prices or for other reasons. nonexistent nor nonimportant. They are factors Attempts were made to determine which must always patiently and skillfully be evaluated as best they may and dealt with in whether changes in the discount rate af­ any banking administration that is animated by fected the rates that banks charged their a desire to secure to the community the results own customers. Surveys and discussions of an efficient credit system. In its ultimate anal­ with bankers indicated there was little effect ysis credit administration is not a matter of mechanical rules, but is and must be a matter of on the lending rates of smaller banks; how­ judgment— of judgment concerning each specific ever, there was some effect on rates charged credit situation at the particular moment of time by the larger banks in financial centers. when it has arisen or is developing.42 Large borrowers with alternative credit The view that policy actions should be sources would often use a reduction in the based on informed judgment instead of discount rate as a bargaining point for rules or a few statistical guides still prevails. lower rates. The discount rate also had Effect of rate changes. The effect of dis­ some effect on loan rates tied more closely count rate changes was also the subject of to market rates, such as brokers’ loans and considerable study in the early 1920’s. bankers’ acceptances. Many System officials thought the discount Academic economists apparently had rate had little influence on the volume of more confidence in the effectiveness of the member bank borrowing. The principal rea­ discount rate than most System officials. son was that it was impractical to keep the Leading economists thought that low dis­ discount rate above bank lending rates, count rates were largely responsible for with the result that banks could usually em­ credit expansion and rising prices after ploy profitably funds borrowed from a Re­ World War I and that increases in the dis­ serve Bank. count rate in 1920 had been a major factor Some officials disagreed. They thought in checking the expansion. They, too, the cost effect of rate changes influenced thought that increases in the discount rate willingness to obtain additional reserves by caused banks to be more careful about borrowing even though the discount rate loans and induced some of them to raise might be below bank lending rates. their own lending rates. An increase was also interpreted by the public as a signal of 42 Annual Report, Federal Reserve Board, 1923, p. 32. more expensive and tighter credit. Some

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economists disagreed, pointing out that in­ enable the System effectively to encourage terest cost is only a small part of total or discourage expansion.44 costs.43 Coordination of the discount rate with Coordination with open market operations. open market operations was discussed occa­ Open market operations were discovered as sionally in the 1950’s. There was some dif­ a valuable tool of Federal Reserve policy in ference of opinion as to whether a policy the early 1920’s. It was soon recognized shift should be initiated by open market op­ that when properly coordinated the two in­ erations or by a change in the discount rate. struments used in combination were more Some favored probing with open market effective than either used singly. For re­ operations, pending clearer evidence as to straint, open market operations could be whether a definite move toward restraint or used to force member banks to the discount ease would be desirable. Open market oper­ window, thus making an increase in the dis­ ations have less psychological impact than a count rate more effective. And a policy of change in the discount rate and are flexible ease would be more effective if a reduction as to both timing and amount. Such opera­ in the discount rate were combined with tions could be reversed, if desirable, with­ open market purchases to supply reserves out the risk of serious psychological reper­ and reduce member bank indebtedness to cussions that might accompany a rollback the Reserve Banks. in the discount rate. Turner, as a result of his studies in the Others favored discount rate action to ini­ mid-1930’s, concluded that Federal Reserve tiate a change in policy. Leading with open policy would be more effective if more em­ market operations to implement a restric­ phasis were placed on the discount rate and tive policy would likely result in the dis­ less on open market operations. Open mar­ count rate being below market rates much ket operations could be used to offset the of the time. There would be an inducement reserve effect of market factors and to for banks to borrow from the Reserve maintain a more stable and continuous vol­ Banks instead of adjusting reserve positions ume of borrowing from the Reserve Bank. in the market, and to borrow from the Re­ The latter would provide the basis for more serve Banks in order to invest the proceeds effective use of the discount rate. Adjusting at a profit. Monetary restraint would be the discount rate relative to market rates on rendered less effective. With the discount alternative reserve adjustment media would rate leading market rates upward, the re­ strictive effects of open market policy would be reinforced instead of alleviated.45

43 See Beckhart, o p . cit., pp. 467-71; and Caroline 44 See Turner, op. cit., pp. 145-60. Whitney, Experiments in Credit Control: The Fed- 45 For example, see Minutes of the Federal Open eral Reserve System, pp. 211-17. Market Committee, Aug. 23, 1955.

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BIBLIOGRAPHY

Books Beckhart, Benjamin Haggott. The Discount Policy of the Federal Reserve System. New York: Henry Holt & Co., 1924. Burgess, W. Randolph, (ed). Interpretations of Federal Reserve Policy in the Speeches and Writings of Benjamin Strong. New York: Harper & Bros., 1930. ------. The Reserve Banks and the Money Market, rev. ed. New York: Harper & Bros., 1936. Currie, Lauchlin. The Supply and Control of Money in the United States. Cambridge: Harvard University Press, 1935. Hardy, Charles O. Credit Policies of the Federal Reserve System. Washington, D.C.: The Brookings Institution, 1932. Harris, Seymour E. Twenty Years of Federal Reserve Policy, vols. 1 and 2. Cambridge: Harvard University Press, 1933. McKinney, George W., Jr. The Federal Reserve Discount Win­ dow. New Brunswick: Rutgers University Press, 1960. Reed, Harold L. Federal Reserve Policy, 1921-1930. New York: McGraw-Hill Book Co., 1930. Riefler, Winfield W. Money Rates and Money Markets in the United States. New York: Harper & Bros., 1930. Turner, Robert C. Member-Bank Borrowing. Columbus, Ohio: The Ohio State University, 1938. Whitney, Caroline. Experiments in Credit Control: The Federal Reserve System. New York: Columbia University Press, 1934.

Other References Cassel, Gustav. “The Connection between the Discount Rate and the Price Level,” Scandinaviska Kreditakliebolaget Quarterly Report (Oct. 1927). Currie, Lauchlin. “Member-Bank Indebtedness and Net Demand Deposits in The Federal Reserve System,” Quarterly Journal of Economics (Aug. 1928). “The Discount and Discount Rate Mechanism,” special studies prepared by Board of Governors and Reserve Bank personnel (May 1953). “The Discount and Discount Rate Mechanism,” statements of associate economists of the Federal Open Market Committee before the Conference of Presidents of the Federal Reserve Banks (June 21, 1954). Federal Reserve Board, Annual Reports.

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Goldenweiser, E. A. “Significance of the Lending Function of the Federal Reserve Banks,” Journal of the American Statis­ tical Association, vol. 31 (Mar. 1936), pp. 95-102. ______“Instruments of Federal Reserve Policy,” Banking Studies. Washington, D.C.: Board of Governors, 1941. Hackley, Howard H. “A History of the Lending Functions of the Federal Reserve Banks” (Apr. 1961), mimeographed. Leffingwell, R. C. “The Discount Policy of the Federal Reserve Banks: Discussion,” American Economic Review (Mar. 1921). Minutes (or Proceedings) of Federal Reserve Conferences (ref­ erences to conferences are by numbers shown below): (1) Conferences with the Federal Reserve Board of [the] Governors and Chairmen and Federal Reserve Agents of the Federal Reserve Banks, 1914-35 (2) Conferences of Governors of the Federal Reserve Banks with the Federal Reserve Board (3) Conferences of Governors of the Federal Reserve Banks, 1914-35 (4) Conferences of [Chairmen and] Federal Reserve Agents of the Federal Reserve Banks, 1914-35. Smith, Warren L. “The Discount Rate as a Credit-Control Weap­ on,” Journal of Political Economy, vol. 66 (1958). Sprague, O. M. W. “The Discount Policy of the Federal Reserve Banks,” American Economic Review (Mar. 1921). ______“A New Device for Reserve Bank Control of Brokers’ Loan Inflation,” The Annalist (Oct. 19, 1928). Steiner, W. H. “Paper Eligible for Rediscount at Federal Reserve Banks: Theories Underlying Federal Reserve Board Rulings,” Journal of Political Economy (June 1926). System Committee on the Discount and Discount Rate Mecha­ nism, “Report on the Discount Mechanism” (Mar. 12, 1954). U. S. Congress, Joint Commission of Agricultural Inquiry, Hear­ ings, “Agricultural Inquiry,” 1931. U. S. Senate, Subcommittee of the Committee on Banking and Currency, Hearings, S. 71, “Operations of the National and Federal Reserve Banking Systems,” 1931. Wallace, Robert F. “The Use of the Progressive Discount Rate by the Federal Reserve System,” The Journal of Political Econ­ omy, vol. 64 (1956), pp. 59-68. Youngman, Anna. “The Efficacy of Changes in the Discount Rates of the Federal Reserve Banks,” The American Eco­ nomic Review (Sept. 1921).

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George Garvy Federal Reserve Bank of New York

Contents

Part 1 The Discount Mechanism as a Tool of Monetary Control______167 Part 2 The Discount Mechanism in Individual Countries______199

Foreword

The objective of this study was to acquaint the Steer­ The author has benefited from comments and sug­ ing Committee with discount policies and techniques gestions by Ralph A. Young and Robert F. Gemmill, used by the central banks of leading industrial coun­ members of the Secretariat, who had special responsi­ tries, in particular since World War II. Interest bilities for this project. Robert C. Holland made focused on the role of discounting as a tool of substantial contributions to the analysis embodied in monetary policy in relation to other tools for each of several chanters of Part 2. The initial drafts of the 11 countries, as discussed in some detail in Part 2 of country studies that constitute Part 2 were written by this paper. No attempt was made to appraise the Ruth Logue of the Board’s staff (France, Netherlands, efficiency of discount policy in each country. Such and Switzerland) and by Dorothy B. Christelow (Bel­ an endeavor would have required review and evalua­ gium and Sweden), Rachel Floersheim (Austria and tion of a wide range of factors and conditions, which Federal Republic of Germany), Leon Korobow far exceed the resources and time available. (United Kingdom), Isaac Menashe (Canada and Given the considerable differences in the frame­ Italy), and Joachim O. Ronall (Japan), of the Federal work in which the discount mechanism operates in Reserve Bank of New York. Mr. Stephen V. O. the United States and in each of the countries cov­ Clarke of the New York Bank also participated in ered, the first part of the monograph attempts to preparing Part 2. I am also indebted to officials of bring out the main differences in institutional and the central banks of the individual countries whose policy environments that must be kept in mind when discount mechanisms are described in Part 2 for analyzing the potential of the discount mechanism in their invaluable assistance. the United States against the background of foreign The present study is a revised version of the report experience. In view of the general objective of the submitted to the Steering Committee in early 1968. study, the review is not limited to policies and tech­ For the most part the various country chapters in niques that were being used at the time of the study, Part 2 do not include data or comments concerning because in some cases discarded or radically modified the period after mid-1970. A Spanish translation of arrangements represent interesting variants, and the Part 1 of this study was published in 1969 by the reasons for dropping or for changing the original Centro de Estudios Monetarios Latinoamericanos, techniques cast some light on the problems en­ Mexico City, under the title “El Mechanismo de countered. Discuento Como Instrumento de Politica Monetaria.”

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THE DISCOUNT MECHANISM AS A TOOL OF MONETARY CONTROL

Contents

Introduction______169 Provision of Central Bank Credit at the Initiative of the Banks______170 Discounts Advances Widening of the Range of Objectives and Tools of Monetary Policy______176 Main Contrasts with the United States______179 Rate Policy______185 Quantitative Controls______188 Selective Controls Through the Discount Window______192 Indirect Access to the Discount Window______193 Uniformity of Administration______195 Concluding Remarks______195

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INTRODUCTION Generalizations concerning the role played War II, along with an older concern about since World War II by the discount mecha­ the need to stimulate exports. nism in the monetary policy of each of 11 The way in which discounting is used in leading industrial countries surveyed in this each country at a given time generally de­ study 1 are difficult to make. In each coun­ pends less on theoretical considerations and try discount policy has been shaped by the preferences than it does on policy objectives specific characteristics of the country’s and on institutional realities, possibilities, economy and financial structure, the evolu­ and constraints. In particular, discounting tion of its economic philosophy, and its ac­ depends on (1) the extent to which foreign tual postwar experience. Generalizations exchange surpluses or deficits are subject must be distilled largely by rationalizing the to short-term variations; (2) the availabil­ reasons for observed differences in policies ity of alternative control mechanisms (such and their evolution over time. as cash reserve requirements, liquidity ra­ The specific role played by the discount tios, and open market operations); (3) the mechanism has depended in each instance ability of banks to make short-run adjust­ on the policy objectives of the central bank, ments through their investment portfolios; and in particular on the way in which the and (4) the existence of facilities to redis­ bank has supported government economic tribute excess reserves through an interbank policies other than the traditional endeavors money market. to defend the internal and external value of The choice of instruments to implement the national currency and to insulate it policy goals normally depends on the from disruptive influences from abroad. trade-offs in terms of positive and negative Concern with the widening and proper side effects and, most importantly, on the functioning of capital markets, including degree of precision that may be expected assistance in the financing of the public sec­ from relying on any one of the instruments, tor, has grown in importance since World singly or in combination, to achieve the de­ sired effect.2 Moreover, in each of the coun­ 1 Austria, Belgium, Canada, France, Federal Republic of Germany (West Germany), Italy, Japan, 2 In some countries the authority for monetary Netherlands, Sweden, Switzerland, and United King­ control is quite diffused. Different agencies may have dom; “foreign central banks” or “other banks” al­ the authority to set the discount rate, liquid assets ways refer to such banks in these 11 countries. Par­ ratios, or credit and reserve ceilings and to determine enthetical references in Part 1 are not intended to be eligibility requirements (or give final approval to exhaustive, but merely to refer the reader to one or such actions). Their actions are not always perfectly two specific examples that can be found in the coun­ coordinated, even when elaborate coordinating agen­ try chapters in Part 2. cies or arrangements exist.

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tries surveyed, the current role of the dis­ Against the background of the experi­ count mechanism reflects not only the ence of the leading industrial countries, policies of the central bank with regard to the discount mechanism in the United the means it chooses (or has at its dis­ States, no less than our entire monetary and posal) to influence the cash position of banking system, appears to be unique banks but also the willingness of banks to rather than a variant among many similar fully use the discount facilities available. systems.

PROVISION OF CENTRAL BANK CREDIT AT THE INITIATIVE OF THE BANKS Discounting is the oldest instrument of cen­ arrangements and linkage processes, as well tral bank policy, and for a long period it as on prevailing monetary views. Foreign was practically the only such instrument. experience provides illustrations for the two Discounts and advances together are still basic approaches and for a number of var­ the most important avenue for changing the iants. reserve base at the initiative of commercial An example of the first approach is banks. The flexibility inherent in discount­ found in countries where the authorities ing has preserved the usefulness of the de­ aim at maintaining a level of short-term vice even where the range of tools available rates consistent with domestic and external to the central bank has been expanded con­ objectives. The discount rate is used as an siderably. Our review of foreign experience anchor for the entire structure of interest encompasses both discounts and advances, rates. Banks then determine how much even though in none of the countries sur­ they want to borrow at the discount veyed are the two methods of obtaining re­ rate.3 The alternative approach is to place serves strictly equivalent in terms of cost, as primary reliance on regulation of the vol­ they are in the United States. ume of reserves rather than on their price. Basically, central bank policy becomes Access to reserves may be governed by effective by affecting first the liquidity of quantitative controls as well as by restric­ commercial banks; through it, the liquidity tive eligibility requirements. Such controls of the entire economy; and finally, the level are tantamount to nonprice rationing, and of real activity and the country’s interna­ they may be designed to achieve multiple tional payments position. Changes in bank objectives. Nevertheless, countries that rely liquidity are normally reflected in market on quantitative controls to influence the rates of interest—which as a rule are cash position of banks may still assign to closely related to the volume of borrowing the discount rate an important role in regu­ from the central bank—and in the volume lating international capital movements, or of money and credit available to the econ­ they may use changes in the rate to support omy. quantitative and related control techniques; Central bank policy may aim primarily to influence either market rates or the vol­ 3 A variant is to consider the discount rate as the upper limit of the proper range of short-term rates, ume of money and credit. The choice be­ and to make it effective by open market or foreign tween these two basic approaches to mone­ exchange operations when market rates tend to fall tary control depends in each country on away from it. Another variant is the tying of the dis­ count rate to a market rate that becomes the focus specific conditions, including institutional of central bank control.

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but in such instances administrative disci­ World War II has been an effort in several pline, rather than price, is the main tool of countries to shift the initiative for injecting monetary management. (and withdrawing) reserves from commer­ In the absence of significant alternatives, cial banks to the central bank. most of the countries surveyed regard dis­ Operations at the discount window can counts and advances as a normal means for influence the supply of bank credit and adjusting bank liquidity positions. In fact, money (by affecting the reserve base or in some countries discounting is considered through the rate effect, or both) only if the a usual source of a considerable part of the banking system needs to borrow. A central banking system’s cash reserves rather than bank may use various means to force banks merely as a safety valve, available for the to seek additional cash from it in order to most part to provide credit for only very make the rates on discounts and advances short periods, pending adjustment of banks’ effective. Specific techniques include opera­ assets and liabilities. Other central banks, tions in exchange markets, open market however, still insist that funds should be sales of securities (United Kingdom), in­ sought at the discount window only to meet creases in reserve requirements (Austria), seasonal and other specific temporary and and reductions in discount quotas to force reversible needs. banks to seek accommodations at the If the central bank has alternative means higher rate on advances (West Germany). for injecting and absorbing reserves, it may To achieve sufficiently tight control over use these tools in various combinations to bank cash, the central bank must be able to achieve the desired effects and it may also estimate with a good deal of precision the vary reserve requirements. It normally pur­ timing and amount of open market or for­ sues its rate or reserve-base aims by absorb­ eign exchange operations required to ing or supplying bank cash. It is possible achieve the desired rate effects. By provid­ for the central bank (1) to control (and ing less than the full amount of reserves re­ vary) the conditions under which banks quired to support seasonal, cyclical, or sec­ may obtain additional reserves at the dis­ ular expansion of bank credit (for instance, count window (through rate, qualitative, or by abstaining from purchasing securities in quantitative controls, or through some com­ the open market), the central bank will bination of these three means) but to re­ force the banking system to the discount frain from modifying the resulting volume window. (The classical case of this is in the of borrowing; or (2) to adjust the quantity United Kingdom where, however, the bor­ of reserves obtained at the initiative of the rowing is undertaken indirectly, through banks to its own targets by undertaking discount houses). The volume of discounts, offsetting (or supporting, as the case may interpreted in relation to changes in the be) operations through other channels. In central bank’s securities portfolio and to this case, the extent to which commercial changes in relevant cash and liquidity ra­ banks adjust their cash positions through tios, will be a direct indication of the state the discount window depends on the vol­ of monetary stringency. ume of reserves that the central bank In some countries, “refinancing” of bank makes available to the market by other credit at the central bank is common. A means. One of the significant aspects of the considerable part of the credit in use in the closer integration of monetary management private economy is, in the final instance, with over-all public economic policy since provided through the discount window.

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Moreover, the cash positions of banks are generated liquidity. In subsequent years and usually so tight in these countries that in varying degree, the individual countries banks must go to the central bank for addi­ covered by this study also experienced bal­ tional refinancing during periods of sea­ ance of payments surpluses—in large part sonal or cyclical pressures. In countries the counterpart of U.S. deficits—and at where cash reserve requirements exist, times were exposed to speculative inflows quasi-permanent borrowing by individual of foreign capital. banks is tantamount to an offset to such In such circumstances the need for the requirements.4 In countries where reserve commercial banking systems of most of the requirements do not exist, but where banks countries covered, and in particular those maintain (or are expected to observe) con­ of continental Europe, to obtain liquidity at ventional liquidity ratios, resort to discount­ the discount window was much reduced. In­ ing in effect reduces the borrowing bank’s deed, in many countries the balance of pay­ net liquidity position. Thus, in all coun­ ments surpluses during extended periods tries the frequency of borrowing by in­ were much too large to be neutralized by dividual banks and the aggregate amount of any means of monetary policy, and in sev­ discounts and advances outstanding are ele­ eral the central problem of monetary policy ments that must be considered in interpret­ since World War II has been to limit the ing (and influencing) the central bank’s monetization of the inflow of foreign ex­ policy posture. change. In countries where rediscounting is in­ Thus, since World War II in most of the significant (either in relation to bank cash, countries covered by the present study, or as a means of making seasonal adjust­ discounts and advances have provided only ments in it), the reason is usually traceable a small—and in many cases, an insignifi­ either to excessive liquidity caused by for­ cant—part of the funds needed to offset eign exchange inflows or postwar monetary seasonal and cyclical fluctuations in the overhangs (as in Switzerland; and for part cash base and to meet growth requirements. of the past decade, in Sweden and Austria) Although excess liquidity and the opportu­ or to other circumstances that have reduced nities for obtaining funds abroad reduced the importance of discount policy. sharply the need to borrow from the central Indeed, the ability of a central bank to bank, a complete atrophy of the discount use rediscounting as the main tool of mone­ function (similar to the U.S. experience in tary control relates directly to the size and the period after the depression of the types of commercial banks’ assets. These 1930’s and well into the post-World-War-Il portfolios must not be such as to provide period) did not develop. The reasons for automatic or semiautomatic access to cen­ this were the wider seasonal swings in for­ tral bank credit. Over long periods many eign exchange surpluses and in circulating central banks were confronted with the currency, a less-developed interbank money problem of controlling excess liquidity in market, and a lesser use of open market their banking systems and of neutralizing operations.5 The accompanying table indi­ the effects of foreign exchange surpluses. In cates that, in contrast to the United States, the immediate postwar years, banks every­ changes in holdings of foreign assets since where generally had an overhang of war- 5 Development of a national market for reserves 4 Borrowing in excess of applicable reserve require­ reduces the need for borrowing from the central ments has severely affected the usefulness of this bank, as does concentration of banking and the monetary tool in several Latin American countries. growth of branch-banking systems.

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the return to convertibility in most of the made of the funds supplied or to consider countries covered have been a very impor­ that lending for productive purposes is tant, or even predominant, factor in more appropriate than for other uses. changes in total asset holdings of central Terms and conditions, including eligibility banks; in some countries this was true even requirements and maturity, are usually in the earlier postwar period. specified in a broad way by legislation and are administered by the monetary authori­ CHANGES IN CENTRAL BANK ASSETS ties, which set policy objectives and pro­ (In billions of national currency units) mulgate various operating rules that may Net Net Central Period foreign domestic include differentiated rates. In most coun­ bank of— assets assets tries the applicable discount rate depends Austria ...... 1958-69 26.3 3.6 Belgium ...... 1958-69 70.1 — 1.8 on the nature of the paper offered (in some Canada ...... 1958-69 1.4 1.0 France ...... 1958-69 10.1 37.3 West Germany ...... 1958-69 4.2 22.9 cases this applies to advances as well). Italy ...... 1961-69 1,003.0 5,217.0 Japan ...... 1958-69 1,056.0 3,038.0 The ability to rediscount a particular Netherlands ...... 1958-69 5.4 —.2 Sweden ...... 1958-69 .9 5.8 credit is usually an important factor in de­ Switzerland ...... 1958-69 .1 1.1 United Kingdom .. 1963-69 —2.2 3.5 termining bank attitudes toward loan appli­ United States ...... 1958-69 —7.5 43.4 cations. In particular, the status of the trade Note.—Net foreign assets = foreign assets — foreign liabilities. bill at the discount window has been an im­ Net domestic assets = (claims on government — govern- ment deposits) + claims on other official entities -f- claims portant factor in preserving the role of the on private sector + claims on deposit money banks — other items, net. bill. In a few countries, such as Japan, S o u rc e.—IMF, International Financial Statistics. changes in eligibility requirements have been used as a tool of monetary control. Discounts Varying eligibility requirements in accord­ Central banks of the countries surveyed ance with policy objectives give the central (and of many of those elsewhere) have re­ bank additional flexibility but—as in other tained traditional forms and practices of instances—policy requirements may not be providing credit to the banking system— consistent with other considerations, such that is, they have given preferential treat­ as safety. ment to credit extended by discounting However, eligibility rules by themselves promissory notes. This prominence of redis­ are of limited significance in controlling counting abroad reflects in part the survival the aggregate volume of discounts if com­ of the trade bill as an instrument for short­ mercial banks dispose of an adequate term credit accommodation. The continu­ volume of paper that can be substituted for ing, although perhaps diminishing, use of any specific items judged substandard. Simi­ such bills in turn is traceable in some coun­ larly, the prior-authorization procedure (in tries to the very significant role played by France and Belgium) is by itself an insuffi­ foreign trade in relation to gross national cient means of controlling discounts if product. credit demands are strong enough to pro­ Access to the discount window is tradi­ duce alternative requests to replace rejected tionally based on eligibility requirements applications. with regard to purpose, maturity, and the While in all countries the discount func­ credit standing of drawee and endorser. tion had its origin in the “real bills” doc­ While the stress is on the self-liquidating trine, the degree to which it has weathered character of the paper discounted, there is the changes in credit needs and financial no tendency on the part of the central structure that have occurred since the de­ banks surveyed to question the ultimate use pression of the 1930’s varies from country

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to country. However, the administration of In many cases, compliance by commer­ the discount window everywhere is now cial banks with the wishes of the central generally subordinated to over-all objectives bank is also reinforced by various supervi­ of monetary policy. Indeed, in several sory powers of the central bank and by the countries the central bank has wide discre­ threat of requests for additional powers if tionary powers under the law to regulate voluntary cooperation is not forthcoming. access to discount facilities and to vary the Informal arrangements to obtain compli­ conditions under which it will make dis­ ance may involve (1) a “gentlemen’s agree­ counts. These powers generally permit the ment”; (2) periodic conferences between central bank to refuse (usually without the head of the central bank and heads of having to give any reason) accommodation the large commercial banks; or (3) formal even when the commercial bank can submit “window guidance,” as in the case of Japan stipulated types of paper. in certain periods. This discretionary power may lend con­ siderable effectiveness to the central bank’s Advances over-all ability to influence commercial While rediscounting of bills of exchange in bank behavior. In effect, discounting as­ many of the countries covered is still an im­ sumes the role of an enforcement mecha­ portant channel for supplying central bank nism, because some central banks make it credit to the private sector of the economy, clear that access to the discount window de­ foreign central banks have found it neces­ pends on compliance with the over-all sary to broaden discounting techniques and objectives of monetary policy and that such to introduce additional ways to provide compliance is often the price to be paid for credit for reserve adjustment purposes. One extending the discount privilege to certain way has been through advances against col­ classes of institutions other than commercial lateral. Such advances originally played the banks. In some countries, however, access role of a safety valve, but in recent years to the window within stipulated ceilings they have become in some countries the and quotas is considered by the commercial normal way to obtain short-term accommo­ banks as a right. dations at the central bank. Other recent The review of paper offered for redis­ techniques include repurchase agreements 6 counting gives central banks an insight and direct purchase of acceptances. Such into the credit policies followed by com­ credit may be extended at the initiative of mercial banks. This is an important feature, the central bank or at the initiative of bor­ because in most of the countries that have rowers (as in the case of money market large numbers of commercial banks the dealers in Canada, within credit lines estab­ central bank has few or no direct and cur­ lished for them). For decades most borrow­ rent contacts with many commercial banks, ing at the Federal Reserve Banks has except at the discount window. In countries

where the central bank typically provides a G The need for repurchase agreements arises pri­ large proportion of total bank reserves marily when conditions applicable to regular dis­ through the window, the need to renew the counting are too restrictive (when paper offered must have a specific minimum maturity, or discounts are discounted portfolio affords the central made for the remaining life of the instruments only) bank a means for continued surveillance of or when the borrower cannot be expected to dispose of an adequate volume of eligible paper (as in the commercial banks’ lending. case of Canadian money market dealers).

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been in the form of advances instead of dis­ Although some countries have gone to counts. Central banks in most foreign coun­ considerable lengths to maintain the con­ tries, however, still make a distinction be­ ceptual and operational distinctions be­ tween discounts and advances and in some tween discounts and advances,7 most coun­ the distinction serves to differentiate access tries do rely more on one than on the other. as a right and access as a privilege. In most of the countries surveyed advances There is little uniformity between ad­ are regarded as a less normal and less desir­ vances and rediscounting in the ease or rel­ able means of providing reserves, and such ative cost of obtaining funds. Normally, the accommodations are extended at a higher rate structure and other terms and proce­ rate (as in West Germany and Austria, for dures are designed to make advances instance) and/or for a limited time only. available from the central bank— when Advances at the discount rate may be made banks have reached their discount ceilings up to a ceiling amount set for each bank (West Germany) or have run out of paper (which may be confidential); advances of eligible for discounting— only at a penalty additional amounts may be made at a pen­ rate. Advances (referred to in some Euro­ alty rate (as in Canada, where this rate is pean countries as “Lombard credit”) are subject to case-by-case negotiation). The often made on collateral that is not eligible rate on advances (or its equivalent, which for rediscounting, such as long-dated gov­ represents the highest rate at which banks ernment debt. The required collateral may actually borrow from the central bank) be limited to government securities (as in tends to set an effective ceiling on money West Germany and Belgium) or to a market rates. broader list of specified securities. In other countries (as in Italy and the In line with traditional “real bills” Netherlands), advances rather than dis­ theory, advances are usually made only for counts have become the common technique very short periods. Sometimes it is more ad­ for extension of central bank credit. This is vantageous to borrow for a shorter time at true in particular where the central bank the (typically higher) rate on advances encourages the use of advances by making when such loans can be paid off without re­ them available on essentially the same striction (West Germany) than it is to re­ terms as discounts. Greater reliance on ad­ discount. And even if the rates for dis­ vances reflects, by and large, changes in the counts and advances are identical, other structure and techniques of bank lending as terms may favor one of the two. This is well as a shifting away from the “real bills” often true, for example, in the United King­ doctrine. On the whole, advances may be dom, where the fact that advances can be regarded as the method likely to grow in obtained for shorter periods than discounts relative importance over the years. makes advances a less expensive source of All central banks recognize that their funds (to the discount houses, in the given role as lender of last resort is a crucial one, case), provided, in accordance with its pol­ and discounting continues to be widely used icy (rate) objectives, the Bank of England to implement this role. Even in countries is willing to make advances at the given that use discount ceilings or where alterna­ time. On the other hand, the opposite is tive means for injecting liquidity on a mas­ true in Canada, where the minimum dura­ 7 In West Germany, discounted bills, but not ad­ tion of advances is 7 days. vances, qualify as cover against note issue.

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sive scale (for instance, through open mar­ would-be borrower meets the formal re ket operations) are available, central banks quirements with regard to collateral or eli­ may not refuse to lend at some price if the gibility.

WIDENING OF THE RANGE OF OBJECTIVES AND TOOLS OF MONETARY POLICY

In all of the countries surveyed the scope of ing attainment of targets that were set in official economic policies has been broad­ terms of capacity, output, and/or techno­ ened since World War II to include logical progress. Such implementation often objectives similar to those proclaimed by involved subsidy-level interest rates, “direc­ the U.S. Employment Act of 1946; and in tion” of credit, and use of rediscounts several countries the use of the discount as a means of providing funds for specific mechanism has been adapted in various activities in preference to budget financing ways to the new policy objectives. Indeed, or as a substitute for private capital forma­ for this and other reasons— some of which tion. are discussed below— in most of the coun­ Excessive credit demands and lack of tries surveyed the discount mechanism has sufficient internal funds to support high undergone considerable change over the rates of capital formation have character­ last quarter of a century, and no country ized the economies of the countries studied currently relies on it as the sole tool of during much of the period since World War monetary policy. Adaptation of the tradi­ II. In general, monetary policies of these tional discount mechanism (including the countries (with the exception of the United shift from rediscounts to advances) to new Kingdom and Canada) in this period have needs and to new conditions has been ac­ endeavored to limit and regulate access to companied by the development of new tools the discount window by specific rules, in­ of monetary management. Many of these cluding quantitative provisions (allowing in tools were pioneered by the Federal Re­ some cases for procedures that amounted to serve System. little less than direct extension of credit for In considering the evolution of the dis­ purposes having national priority); this has count mechanism since World War II, one been true in particular of countries in must keep in mind that each of the coun­ which banks were not reluctant to remain in tries covered by this study— with the excep­ debt to the central bank. In several coun­ tion of Canada, Sweden, and Switzerland tries this condition led to the establishment — has gone through a long and difficult of discount ceiling quotas for individual period of economic adjustment and re­ banks. In some countries the authorities construction in which various types of di­ have gone even further by establishing di­ rect controls were used, some of which rect ceilings for bank credit expansion; in were continued into the 1960’s. Because of others they have endeavored to keep the urgency of the postwar reconstruction, growth of bank credit in line with official financial aspects were often pushed into the objectives through informal directives. background; monetary policy was expected Indeed, the conditions and challenges to contribute by facilitating and implement­ that emerged after World War II caused

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several of the central banks surveyed to inhibiting free and frequent use of changes seek broader powers and to develop new in the discount rate. The reasons for these tools of monetary management rather than developments may be summarized as fol­ to try to meet the new conditions by relying lows: on the adaptability of the discount mecha­ (1) Fear that the signal would be over­ nism. In most countries the discount mech­ interpreted. anism has been increasingly supplemented (2) Fear that large fluctuations in the by other tools of monetary management; in rate would produce disruptive ef­ particular, constraints on the use of changes fects on the market for government in rates have led to the development of al­ securities and, more generally, on ternative policy tools and techniques and to capital markets. the introduction of new ones. (3) Fear that automatic linkage be­ The need to supplement the discount tween the discount rate and bank window by other control mechanisms can loan and/or deposit rates would be traced to several factors, including (1) tend to produce politically unac­ changes in the structure of commercial ceptable levels of interest rates. bank portfolios, with a declining proportion of discountable paper; (2) various con­ (4) Fear of inducing undesirable inter­ straints that tend to limit the central bank’s national capital flows that would latitude for using the discount rate as a ra­ offset intended effects of changes in tioning device; and (3) the tendency of rates on the domestic economy. commercial banks to make excessive use of Because of these restraints on a flexible the discount window in view of the willing­ use of the discount rate, nonrate rationing ness of the banks’ customers to borrow at of loans and manipulation of reserves ac­ rates considerably higher than the discount quired through balance of payments sur­ rate. In several countries, as indicated ear­ pluses became supplementary, and in some lier, the discount window was inadequate to cases alternative, tools of monetary control. deal with the consequences of huge and Variable cash reserve requirements, liquid­ fairly persistent balance of payments sur­ ity ratios, and open market operations have pluses. The need for new tools was felt been introduced since World War II in a most keenly in countries where external and number of countries as additional monetary internal considerations were flashing con­ tools, but in most countries they remain of flicting signals with regard to the discount limited significance (particularly for day-to- rate. day control of reserve availability). As a result, the discount mechanism has Most of the countries surveyed (the undergone considerable change. The most United Kingdom and Canada being the significant aspect of this change has been conspicuous exceptions) have not suc­ the resort to quantitative limitations, and ceeded in developing markets for short- thus to a lessened dependence on changes dated government debt that are broad in level of the discount rate itself. After enough and active enough to provide a World War II it became clear that the po­ main avenue through which to supply or litically acceptable range within which the absorb bank reserves, and such Treasury discount rate could be varied had narrowed bill markets as do exist are extremely nar­ and that a number of developments were row. In such countries operations to adjust

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bank liquidity (as well as Treasury debt op­ In some countries the discount window erations) often involve direct dealings be­ has been used to influence credit flows, tween the central bank and the commercial usually by compartmentalizing discount bank, rather than impersonal transactions procedures and by establishing a whole hi­ through the market. In several countries erarchy of rates from preferential to pen­ bank liquidity can be affected by issuing to alty. Central bank credit has also been used banks special Treasury instruments (usually rather widely as a supplement, or even as a special category of Treasury bills, not an alternative, to budgetary financing in available to the general public). These implementing a variety of officially spon­ carry rates that are deemed appropriate by sored programs, including implementation the authorities, not rates that are set by of national investment plans. In such cases, market bidding; and they are repurchased institutional arrangements have been made not at market rates, but at posted rates, as for formally meeting the requirement that in West Germany. discountable paper be short term by sub­ Because of the unavailability or limita­ stituting a series of short-term notes for the tions of new monetary tools, most of the original medium-term loans.8 Other exam­ countries covered sought to achieve greater ples of the use of discounting as a means of monetary restraint through nonprice ration­ financing governmental programs are found ing at the discount window, and some in Switzerland (financing of defense stocks sought to shield certain sectors (for exam­ of raw materials) and Italy (agricultural ple, export financing, municipal borrowing, price-subsidy programs). home mortgages, and so forth) from the ef­ The discount mechanism thus has grown fects that would have resulted from price in complexity in part because in many rationing. Regulation of access to discount countries it is being used to meet specific credit through quantitative limitations on objectives for which it offers certain advan­ borrowing (rather than by tightening eligi­ tages, both technical and budgetary. The bility requirements) became a policy tool. need to resort to a variety of artifices to fit Hence, availability of eligible paper became the letter of the requirements of the dis­ a necessary, but not sufficient, condition for count window arose, in part, from the in­ access to central bank credit, thus moving flexibility of the banking laws of various away from the automatism of the real bills countries and the unwillingness or inability doctrine. of governments to introduce desirable Eligibility and collateral requirements for changes. discounts and advances have always tended New techniques had to be introduced to to influence the composition of commercial sterilize the inflow of foreign exchange and banks’ portfolios (and, presumably to a to adjust monetization of domestic assets to lesser extent, the portfolios of other finan­ variations in balance of payments surpluses. cial institutions having direct or indirect ac­ Central banks have endeavored (paralleling cess to the discount window). In recent similar efforts with regard to meeting do- years several countries (for example, France and Japan) have added restrictive s It should be noted, however, that use of the dis­ features to the discount mechanism with a count mechanism for stimulating investment, includ­ ing provision of central bank credit on a semi­ view to restraining excessive use of central permanent basis, has resulted from shortcomings bank credit and to channeling bank credit in capital market structure and processes, not from any inherent superiority of discounting as a means of into priority uses. achieving policy objectives in this field.

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mestic challenges) to develop alternative generally to develop a foreign exchange policy tools that would reduce reliance on policy that would support other monetary the discount rate to prevent or correct im­ tools. Management of official exchange re­ balances in international accounts and, in serves can supply some of the day-to-day particular, to cope with wide swings in for­ flexibility that otherwise would be lacking eign exchange flows. because of the limited scope (or absence) Because foreign commercial banks of open market operations and because of a usually keep part of their liquid assets variety of factors that reduce the flexibility abroad, mainly in the form of interbank of other policy tools. Several techniques are balances and money market assets (subject used to influence liquidity positions of to applicable foreign exchange control reg­ banks in the countries covered. Among ulations), regulation of foreign exchange these are: (1) extension of foreign cur­ holdings of commercial banks has become rency loans (by the central bank or by a one of the most important tools of mone­ separate foreign exchange institution typi­ tary policy in several countries. Since con­ cally managed by the central bank), (2) vertibility of major currencies was re-estab­ spot and forward swap arrangements, (3) lished in 1958, closer integration of forward exchange transactions, and (4) ma­ financial markets and the growing impor­ nipulation of reserve requirements against tance of banks and other financial institu­ foreign deposits (West Germany, Switzer­ tions that operate across national borders land). A variety of techniques have been — borrowing from their foreign branches applied in several countries to cope specific­ and/or in foreign money markets, including ally with international capital movements; in more recent years the Euro-dollar mar­ one of these— used in Italy, Switzer­ ket— have provided commercial banks with land, and Germany— prohibits payment of additional sources of liquidity in periods of interest on foreign deposits. Furthermore, temporary strain and thus have further re­ some central banks have taken measures to duced the need for these banks to seek ac­ control commercial banks’ borrowing commodation at the central bank. abroad and to regulate their net positions in A common objective of measures adopted foreign currencies— by placing limits on the in individual countries has been to control amounts of liabilities or foreign currency commercial bank liquidity that has resulted claims that banks (and nonbank institu­ from foreign exchange inflows, and more tions) may assume and by other means.

MAIN CONTRASTS WITH THE UNITED STATES

On the whole, since World War II the count mechanism in each of the countries countries covered have relied more heavily covered by this study, it might be useful to upon the discount mechanism than the comment on the nature and extent of differ- United States has to achieve domestic and ences in the setting in which monetary pol- external monetary policy goals by influenc- icy operates in the United States and in the ing the supply of credit, the cost of money, countries surveyed. These differences range and the market pattern of rates. Before re- from forces that cause fluctuations in the viewing the various technicalities of the dis- reserve base to institutional factors in the

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financial area and beyond. But quite gener­ Another significant difference in many of ally, access to central bank credit in each the countries studied is that an important country is embedded in policy considera­ segment of the commercial banking system tions, institutional arrangements, and proce­ is nationalized (as in France and Italy); in dures that are somewhat different from such instances public and specialized quasi­ those in the United States. public credit institutions have access to In all of the countries surveyed, foreign the discount window. While nationalized trade accounts for a much larger proportion commercial banks usually operate in much of gross national product than it does in the the same way as those privately owned and United States. For this reason international do not enjoy any preferential treatment at considerations are traditionally a main the discount window, subtleties may be in­ focus of monetary policy, and day-to-day volved that are difficult to detect. management of foreign exchange reserves Specialized quasi-public credit institu­ requires considerable official attention. tions usually combine several activities; Since commercial banks in these countries these include (1) centralizing temporarily keep part of their liquidity abroad, mainly redundant resources for national networks in the form of interbank balances and of institutions with similar specialties; (2) money market assets (which are subject to providing rediscount facilities for these in­ foreign exchange control regulations), reg­ stitutions; (3) attracting certain types of ulation of foreign exchange holdings of savings; and (4) channeling government commercial banks in several of the coun­ funds into long-term investment. Giving tries is one of the most important expres­ such institutions direct access to the dis­ sions of monetary policy. count window broadens the original func­ Bank credit accounts for a much larger tion of the discount window because central share of domestic credit flows in the coun­ bank credit is used to implement certain tries surveyed than it does in the United priorities set by national economic policies, States; we would go too far afield if we at­ to influence the direction of investment tempted to examine the underlying reasons flows, and to implement or support a broad for this variation. However, some of the range of specific economic policies, includ­ reasons may be stated, although they apply ing the diversion of central bank resources to a different degree for each given country. to nonbudgetary financing. This widening Among the reasons are the relative narrow­ of the discount function has no direct coun­ ness of capital markets; the fact that a large terpart in the United States. part of capital formation bypasses these A related structural difference is reflected markets; the pre-emption of a considerable in the origin of the paper that reaches the part of savings by the national government discount window.9 In several of the coun­ and by quasi-governmental institutions; and tries surveyed, large segments of industry the lesser importance of financial intermedi­ are nationalized and other important units aries (in some cases a direct effect of ear­ involve some degree of government partici­ lier disastrous inflations). On the other !> Also worth noting is that while the Federal Re­ hand, the predominant role of commercial serve System has been engaged almost since its in­ banks in credit markets— especially in serv­ ception in developing the acceptance market, it has ing credit needs of private business— has chosen to monetize acceptances through open market purchases rather than through discounting, whereas usually resulted in rapid transmission to the in the other countries paper arising from foreign central bank of fluctuations in credit de­ trade is not only typically an important part of the discounts but also enjoys preferential terms in some mands. cases.

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pation or sponsorship. Municipal ownership gaged in such activities, and the older ones of public utilities is widespread, and the are trying to close them out. communications industry as well as impor­ By and large, the relative volume of di­ tant railroads, airlines, and shipping lines rect lending to private borrowers through are usually government-owned, directly or discounts or advances is negligible. Further­ indirectly. Contractors and some others that more, such lending has no policy purpose, supply government owned enterprises (such except in the United Kingdom where the as shipyards) enjoy official support that Bank of England acquires a certain volume may extend to special facilities at the dis­ of commercial bills regularly so as “to be in count window. In some countries with a touch with the market” and to ascertain the significant public sector (and in particular quality and composition of the bills being in France and Italy, but also in Japan offered in the market. Since this paper is where government tutelage, rather than out­ concerned with the use of the discount win­ right ownership, is involved), the use of the dow by foreign central banks as a tool of discount mechanism as a means of directing monetary policy, we shall not discuss tech­ credit has become a significant and integral niques for discounting paper of private part of the central bank policy. customers.10 Thus, a considerable proportion of the Foreign central banks do not administer assets of commercial banks (whether pri­ their discount windows on the basis of rigid vately or publicly owned) consist of loans rules on the public record (and, it is hoped, (and other credits) to public enterprises, uniformly interpreted and understood by even though the form of the accommoda­ all), comparable with the Federal Reserve tions extended (and the eligible paper that Regulation A as issued in 1955. The notion they generate) may be so much like that of “appropriate borrowing” is not encoun­ used to accommodate private borrowers tered in the operations of foreign central that the two are indistinguishable, on the banks. surface at least. In effect, these assets repre­ Only a few of the central banks surveyed sent credits extended to official entities or administer the discount window on the as­ credits guaranteed by government institu­ sumption that commercial banks are reluc­ tions or instrumentalities, some of which tant to borrow (and to stay in debt), even have been set up to implement specific gov­ though it is well known that banks prefer to ernment policies. obtain liquidity elsewhere and that they go Also in contrast to the United States, to the central bank only as a last resort. In some of the central banks of Western Eu­ most countries surveyed, commercial banks rope (having evolved from commercial tend to regard access to the discount win­ banks) continue to have some private clien­ tele, which have access to central bank re­ 10 We shall also pay only passing attention to dis­ sources through direct discounting (and in counting of, or lending on, government securities un­ dertaken either to accommodate the Treasury in peri­ some cases also through advances, as in ods when its expenditures exceed receipts, or to West Germany, Italy, and Switzerland). Di­ cover budget deficits, since such activities do not fall under the heading of credit policy (although mone­ rect lending to private borrowers (even to tary policy must, of course, cope with the resulting individuals, rather than to business borrow­ reserve creation). In some countries, borrowing by ers, as in Italy) is in most cases a car­ the national government takes the form of advances from the central bank rather than of marketable ryover from the time when the central paper. In most countries, legislative safeguards exist banks were privately owned. The newer to protect the central bank against abusive use of its facilities to cover budgetary deficits directly or indi­ central banks (Canada) have never en­ rectly.

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dow as a right rather than a privilege Access to the discount window is deter­ (within applicable limitations, such as quo­ mined by law and/or administrative deci­ tas) even though the central bank normally sions; in none of the countries surveyed can has discretionary authority. This attitude, banks elect to escape regulation by the cen­ confirmed by banks’ experience, is traceable tral bank by acquiring a “nonmember” in some cases to the availability in their status and by so doing lose their direct ac­ portfolios of specific types of paper that the cess to the discount window. By and large, central bank must discount automatically, however, reserve (and liquidity) require­ but generally to the inherent function of the ments abroad are administered more flexi­ central bank as “lender of last resort.”11 bly than in the United States. The greater The United States, Canada, and Switzer­ flexibility that foreign commercial banks land are the only important examples of have in meeting legal reserve requirements countries that limit direct access to the dis­ and/or liquidity ratios frees both them and count window to commercial banks and the central banks from some of the prob­ that deny it to other money market lems of day-by-day reserve management participants.12 Other foreign central banks that are rooted in our system of administer­ interpret their role as lender of last resort ing member bank reserve requirements. more broadly; as a result, a variety of finan­ Because of the prevalence of nationwide cial institutions other than commercial branch-banking systems and the virtual banks usually have direct access to central absence of secondary financial centers,13 bank credit. some of the problems of reserve manage­ Some of the central banks surveyed ex­ ment inherent in our fragmentized com­ tend (depending on historical and institu­ mercial banking system do not exist to the tional factors) discount privileges or ad­ same extent in the countries studied.14 While vances to most or all of the following important regional, and even local, banks groups: public and quasi-public credit insti­ exist in most countries studied, nowhere is tutions; central bodies of such sectoral there a counterpart of the reserve manage­ credit institutions as national groupings of ment problems with which thousands of our savings banks, farm credit associations, and banks must cope. credit unions (Italy); municipal savings This does not necessarily mean that banks (Italy, Japan); credit cooperatives offsetting of a much larger part of the local (Netherlands); stockbrokers who act as and regional day-to-day fluctuations in the dealers in government securities (Canada, demand for, and supply of, banking funds Netherlands); and private borrowers. Such within the nationwide branch system tends access may be available at all times (al­ to diminish to any significant degree the though it may, in fact, be resorted to over-all seasonal variations in the demand rarely) or under specific conditions. for cash. In fact, forces operating in the op­

11 In some countries at least (Italy being perhaps 13 With some exceptions, however; but even Can­ the most conspicuous example), access to the dis­ ada and the Netherlands each has only one addi­ count window was, originally, considered to be a tional financial center of real significance. quid pro quo for establishing the note privilege of the 14 While there are some parallels (the United central bank. Kingdom comes first to mind) to the limitation of 12 In the United States a bank must be a member the impact of our policy actions on member banks, of the Federal Reserve System in order to have ac­ the problem of “nonmembership” is not duplicated cess to the discount window. abroad.

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posite direction may be equally significant. erally considered as a residual mechanism For instance, banks’ cash positions in the through which over-all availability of re­ countries surveyed are more exposed to fluc­ serves is adjusted to longer-run growth re­ tuations in the public’s demand for cash be­ quirements. cause the portion of the banks’ money sup­ Most central. banks use the discount ply that consists of currency is so much mechanism— almost routinely-—to minimize larger than it is here in the United States. day-to-day and week-to-week fluctuations in Fluctuations in currency in circulation af­ money market rates and gyrations in bank fect bank reserves one for one, whereas fluc­ reserves caused by tax payments, or other tuations in deposits affect such reserves market stresses that recur regularly, such only fractionally.15 as those around the month-end. The extent The main objective of day-by-day dis­ to which discounting is relied upon to regu­ count operations is to neutralize the effects late bank reserve positions on a day-by-day of seasonal and cyclical factors on the basis depends on institutional factors and on money market— in other words, to provide the availability of alternative mechanisms normal seasonal reserves and to accommo­ in a given country. Specific situations are date, within broad policy considerations, discussed in several of the country reports cyclical swings in reserve availability— and in Part 2; although by and large central in some instances to provide for secular banks can and do rely to a considerable growth. In none of the countries surveyed extent on control at the discount window, does there seem to be any specific philos­ it is also appropriate to add that they ophy or policy with regard to the way in have no preference for discounting if other which the cash base of the banking system methods of adjusting reserves, such as in­ should be enlarged to provide for secular tervention in foreign exchange markets growth. This lack may reflect, in part, an or use of open market operations, are avail­ overhang from the real bills doctrine, able. which assumed, at least implicitly, that Indeed, in most of the countries sur­ growth of “commerce” would generate an veyed, day-by-day adjustments in reserves enlarged flow of bills to the central bank, are made mainly by manipulating foreign which in turn would increase the reserve assets and through the domestic interbank base. More importantly, in most of the money markets (similar to our market for countries studied, inflows of foreign ex­ Federal funds). This is true despite the fact change and — intermittently — government that nowhere is the interbank money mar­ deficits have focused attention on the means ket so developed and so actively used as it for controlling excess liquidity rather than is in the United States and that there are no on the need to provide banks with reserves close counterparts of our correspondent to assure adequate monetary growth. On the banking system, which involves interbank whole, therefore, it is proper to conclude borrowing on the basis of credit lines. that discounting in those countries is gen­ Banks obtain only limited amounts of funds in the regular money market, and in most countries, except the United Kingdom and 15 Currently, between one-third and one-half of the money supply of Italy, France, and Germany still Canada, nonbank participation in that mar­ consists of currency, and there is little reason to be­ ket is- either nonexistent (by tradition or lieve that the composition of the m arginal demand for cash is different from its average composition. formal arrangements) or of marginal im­

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portance (as in the Netherlands). Open Even in those countries in which open market operations are conducted in most market operations have become part of the countries by the central bank only with range of policy instruments used by the commercial banks and/or with a limited central bank, such operations are not al­ number of other private financial institu­ ways continuous and are not necessarily un­ tions, including dealers in government se­ dertaken “at the market”; indeed, transac­ curities and government and quasi-public tions may be consummated at rates posted institutions active in the capital market. by the central bank (as in West Germany) The development and routine use of or negotiated in each case (as in Japan). open market operations have been thwarted In such circumstances both sales and pur­ in many countries by the narrowness of the chases usually take the form of special trans­ market for government securities. The ac­ actions. In some instances it becomes neces­ tivity in a market for government debt de­ sary to transform book credits to the govern­ pends to a large extent on the size, struc­ ment into marketable securities before any ture, distribution, and origin of that debt; sales can be undertaken in the open market. considerable differences in these factors The traditional reliance on discounting, exist among the countries surveyed. In none together with the fact that commercial of these countries is the (central) govern­ banks as a whole are continuously “in the ment debt so widely held and actively Bank” for considerable amounts, has traded as in the United States. And most of tended to inhibit the extensive use of open these countries (exceptions: United King­ market operations even where suitable se­ dom and Canada) have not succeeded in curities and appropriate market arrange­ developing a market for short-dated govern­ ments are available. For example, when ment debt that is sufficiently broad and ac­ banks acquire excess cash, they tend to pay tive to provide the main avenue for supply­ off or reduce their borrowing (or sell funds ing and/or absorbing bank reserves. in the interbank market, and by this means In countries where it is not feasible to obviate the need for banks with deficiencies use open market operations for adjusting to borrow at the central bank); hence, the reserves and where the means of regulating central bank does not need to sell securities the impact of flows of foreign exchange are in the open market to mop up the excess insufficient, central bank intervention for funds. On the other hand, if the central balancing out end-of-period positions and bank permits commercial banks to borrow for fine tuning of the money market (where almost continuously, the commercial banks this is an objective) has been attempted through other means, including, typically, have little inducement to hold eligible se­ outright transactions and repurchase agree­ curities. Thus, in many countries, the pivotal ments with the call-money market. In some assets used for reserve adjustment are not cases such adjustments take the form of the lowest-yielding government securities special arrangements at the discount win­ (such as Treasury bills), the yield on which dow at the initiative of the central bank (as is usually lower than the discount rate, but in France); such arrangements perform a the lowest-yielding paper that is auto­ function similar to repurchase agreements matically rediscountable (such as medium- in the United States. term paper in France).

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RATE POLICY Many of the changes that have been intro­ rates are changed by 0.365 of a percentage duced in the traditional discount mecha­ point, or multiples thereof, this figure being nism since World War II stem from the equivalent of a rate of one-thousandth modifications introduced during the depres­ of 1 per cent per day.) Decisive action is sion of the 1930’s. We shall discuss succes­ usually symbolized by moves of a full per­ sively rate policy, quantitative controls, and centage point in either direction, and in re­ the use of the discount window as a tool of cent years there have been even larger selective control. changes (United Kingdom) to cope with The discount rate is first of all the cost at serious external disequilibria. By and large, which cash may be obtained from the cen­ moves undertaken for external reasons in­ tral bank. Discounts have not only a rate volve changes by relatively larger amounts dimension but also a time dimension. A than those for purely domestic reasons, in technique widely used abroad is to require particular if the central bank tends to fol­ discounts to be for a certain minimum pe­ low rather than lead market developments. riod, whereas in the United States empha­ Borrowing from the central bank usually sis is placed on maximum terms. Banks involves a hierarchy of instruments carrying normally endeavor to borrow at the low­ successively higher rates (and/or related est cost, depending on the availability of terms that tend to raise the real cost of bor­ required collateral and on applicable terms rowing), so availability of specific catego­ (such as minimum duration of a given ac­ ries of collateral determines the marginal commodation) . cost of borrowing. This is true even when Responsibility for setting the discount quantitative limitations are applied at the rate and related rates (such as the rate on window. As long as adequate collateral of a advances) usually rests with the board of given category is available within the bank­ directors of the central bank, although in ing system, the rate that it carries (such some cases this responsibility is lodged with as the Lombard rate in West Germany) a separate monetary authority (such as the tends to become the effective ceiling on fluc­ Monetary Policy Board in Japan). Prior tuations in money market rates. The cost of consultation of the central bank with the marginal borrowing from the central bank Treasury is usual in view of the generally (whether determined by eligibility require­ close relationship between the two insti­ ments or quantitative restrictions) tends to tutions or, less frequently, as a result of determine market rates, unless conditions specific legal requirements (as in the are sufficiently easy to drive market rates United Kingdom). below the lowest applicable central bank The minimum amount by which rates are lending rate. typically changed differs from country to When commercial banks are free to country and reflects tradition and trade uses make the fullest possible use of credit facili­ as well as policy objectives. In general, the ties offered, the restrictiveness of any given minimum change is normally V2 percentage discount rate depends on a number of fac­ point, but some banks use steps of !4 per­ tors including the terms of borrowing and centage point, and there is some tendency the relation of the discount rate to market to make increases by the larger amount and rates (or, more generally, to the cost of decreases by the smaller amount. (In Japan, funds from alternative sources). Because

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of the signal role of the discount rate and/or Progressive-rate structures are used es­ the relative inflexibility of that rate, and be­ sentially to reduce administrative problems cause certain rates on bank loans and de­ at the window. In some cases progressive posits are tied to it, in actual practice dis­ rates are applied without introducing dis­ counts and advances in some countries are count quotas, and in some countries it is in­ made at rates below or above the official deed believed that such rates are an alter­ rate, as policy requires. native to quantitative regulations. Foreign All countries covered by the present experience includes a great variety of exam­ study have a multiple-rate structure for cen­ ples of (1) progressive-rate structures as a tral bank credit. Public reference is typically function of size of borrowing (related to made to “the” discount rate, which is the capital, reserves, assets, or some other mag­ particular rate considered to be the key to nitude) and duration of borrowing (Swe­ the whole structure of official rates. A mul­ den, France); (2) posted or negotiated tiple-rate structure is applied either by re­ rates for borrowing in excess of basic quo­ lating rate to the characteristics of the paper tas (Japan, France); and (3) preferential discounted or accepted as collateral, or by rates for specific types of instruments or establishing a progressive- or stepped-rate categories of loans (France). structure designed to make it more expensive When the central bank endeavors to keep to borrow larger amounts or to borrow for its discount rate above important market longer periods. In the first case the discount rates at all times, or to make the effective rate may be differentiated according to the cost of borrowing higher than for compara­ type and/or maturity of collateral, or by ble borrowing in the market, such rate is different institutional classes of borrowers. usually referred to as a “penalty rate.” 17 When a whole family of rates is used When a central bank has a progressive-rate instead of a single discount rate, subsidiary structure, all rates above the basic rate are rates may be linked to the main rate in a usually considered penalty rates. If deemed variety of ways, including fixed or variable necessary, the central bank may operate in differentials; alternatively, subsidiary official the call-money or government securities rates may be linked to a significant market market with the specific purpose of keeping rate (for instance, the Treasury bill rate) as market rates below a certain penalty-rate well as to the main discount rate. Such level. multiple-base linkage offers greater flexibili­ Penalty rates are also used (1) to sup­ ty for adjusting the cost of borrowing to port other tools of monetary control, such market conditions without requiring fre­ as observance of liquidity ratios (Sweden); quent changes in the discount rate itself (2) to penalize re-lending of borrowed re­ (as in the case of the double-base system serves by banks; and (3) as a means of for lending to money market dealers in regulating borrowing above quotas or as a Canada). More generally, under a multiple- measure of restraint if there are no quotas. rate structure with variable differentials, Continuous or too-frequent borrowing may changes in the structure of effective rates can be made more frequently than in the of the Bank of France (the total number of changes was 17), whereas the basic discount rate was basic discount rate.16 changed only eight times. ™ For instance, from Dec. 3, 1959, to Apr. 8, 17 In the context of this study, the term “penalty 1965, there were a number of changes in one or rate” refers to a level in relation to market rates, more of the specific rates for discounts or advances and “progressive rates” to the structure of rates.

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be reduced by applying penalty rates after propriate (Canada) may lead to periods of a set period or for repetitive recourse to the excessive ease if reserves are supplied window within a determined period; in the through open market operations in order to last case, penalty rates may apply to an in­ prevent a rise in market rates. dividual bank (as in Canada), or they may In many countries deposit and/or lend­ apply to all commercial banks, when such ing rates (or important segments of the rate banks, collectively, have been in debt for structures) of commercial banks are auto­ more than a specificed number of days (5 matically tied to the discount rate. Such days in Sweden). In some cases the penalty linkages have come into existence in a vari­ rate is graduated in such a way as to become ety of ways: (1) as a result of the depres­ almost prohibitive if borrowing reaches a sion of the 1930’s, (2) under war emergen­ certain margin above the normal quota (the cies, (3 ) as part of control measures “superhell” rate in France) or so high as instituted by totalitarian governments, or not to be used because funds can be ob­ (4) as . a result of actions by bankers’ asso­ tained more cheaply by other means. ciations, with or without official review A willingness to borrow at a cost higher and/or sanction. When lending rates are than the basic discount rate has been inter­ rigidly linked to the basic discount rate, the preted in several countries (France and cost of discounting at higher (including Japan, for the second tranche of progres­ penalty) rates cannot be passed on readily sive rates) as prima-facie evidence of ex­ to customers; the resulting pressure on profit treme tightness in credit. The central banks margins constitutes an additional restraint of these countries have made it a policy for meeting customers’ loan demands. rule in such cases to relieve the pressure by Tying of commercial bank rates to the injecting reserves through open market op­ discount rate may have a certain degree of erations or by other means in order to flexibility. Margins relating commercial avoid high marginal rates (such as the “su- bank rates to the discount rate may be var­ perhell” rate in France and the second-tier ied from time to time; also, commercial penalty rate in Japan) and to avoid push­ bank rates may follow changes in official ing money market rates to excessively high rates not automatically but rather with a levels. Foreign experience also suggests that delay of a varying length. In some countries a progressive structure of the discount rate at least, and depending on credit condi­ tends to produce discontinuities in the rate tions, undercutting of stipulated minimum curve around the steps and that the steps rates or concealed additional charges are may pose problems for monetary policy. not unknown. The principle that central bank credit Rigid tying of deposit and lending rates should always be available— though at pen­ to the discount rate is inimical to flexible alty rates— is thus preserved, but the ulti­ use of the discount rate for monetary policy mate penalty rate is used mainly to encour­ purposes. As already mentioned, some age banks to adjust their reserve positions countries have tried to resolve the problem through borrowing in the open market or by by lending to banks at rates that were ac­ selling securities. It may be noted, however, tually higher or lower than the official dis­ that a policy of maintaining the penalty- count rates. In recent years there has been rate status of the discount rate when an a tendency to loosen or remove such tradi­ increase in the discount rate appears inap­ tional or institutionalized linkages.

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QUANTITATIVE CONTROLS Most of the countries surveyed have not Controls may involve fixed limits for been able to place exclusive reliance on the loans or total assets or maximum permissi­ discount rate for controlling aggregate bank ble rates of increase during specified time reserves, that is, to rely on rationing through periods. Alternatively, the ratio of loans to rate alone and on keeping an “open win­ deposits, or to some other total among a dow” at that rate. Those that traditionally bank’s assets or liabilities, is made subject relied on regulation through rate (for ex­ to regulation. Still another method of con­ ample, the United Kingdom) have found it trolling demand at the discount window is necessary in recent years to make consider­ by freezing a certain volume of eligible as­ able use of moral suasion, aiming at quanti­ sets in bank portfolios through separate tative limitation (but avoiding overt, rigid liquidity ratios.18 From time to time the control) of commercial bank lending, and central bank may vary the list of liquid assets that qualify for inclusion; further­ to apply such limitation to a steadily widen­ more, it may stipulate minimum percent­ ing circle of credit institutions. Even those ages of specific assets (such as Treasury central banks that have continued to place bills) to be held within the over-all liquid­ exclusive or primary reliance on the rate ity ratio. The (variable) liquidity ratio have found it necessary in recent years to (coefficient de tresorerie) in France, no differentiate the cost of accommodation at longer in force, was an outstanding example the discount window; a recent example of of this technique. the need for greater flexibility in rate ad­ Some central banks use discount quotas ministration to differentiate between the cost (credit lines) as a means of influencing di­ of discounts relevant for the international rectly the total volume of bank credit. flow of funds and for regulating the domes­ These quotas are the fulcrum against which tic money market without changing the rate rate policy becomes effective. Discount quo­ was provided in the United Kingdom. tas are typically used in countries where al­ Some of the countries surveyed have at­ ternative monetary policy tools (such as tempted to limit the growth of bank credit open market operations) to control the re­ to specific maximum amounts; in so doing serve base are not available or cannot be they have used a variety of quantitative re­ used meaningfully and/or where variable strictions. Quantitative controls may apply cash reserve requirements are not available to reserves (usually, to the aggregate vol­ to control the credit multiplier. In several ume of discounts) or directly to some or all countries discount quotas have proved inad­ bank assets. They may be geared, as in equate to achieve this goal, and they have France, to credit targets specified in na­ had to be supplemented later by ceilings on tional economic plans. Various techniques total loan volume or by other quantitative to limit bank credit expansion directly have controls. been used at different times in various Still other countries have concluded that countries. Direct control of total redis­ only a direct control over bank credit counts, reserves, and/or loan volume is would achieve their policy goals, but they usually supported and reinforced by various forms of moral suasion; Japan is a conspic­ 18 In other countries, such as West Germany and Switzerland, liquidity ratios are imposed for other uous example. than monetary policy reasons.

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have retained discount quotas as part of the lected balance sheet items, or a number of control mechanism. Indeed, a central bank other variables.21 Quotas need to be adjusted that directly controls the total volume of upward over time to keep in step with the bank credit may downgrade the role of dis­ growth of the economy and its expanded count quotas— or may dispense with them credit needs because the variables on which altogether— and supply reserves readily quotas are based, such as capital funds, do (while at the same time taking into consid­ not necessarily grow at the same rate as do eration the volume of reserves acquired the needs that the quotas are designed to from, or absorbed by, other sources) as meet. Adjustments may be automatic or may long as credit expansion remains below tar­ be subject to discretionary determination. get limits. Techniques used for setting and changing Quotas to regulate the volume of dis­ discount quotas for individual institutions 22 counts are set— and modified— on the basis range from complex formulas (as in West of broad policy considerations. Such quotas Germany) to informally determined across- may be set for total borrowing from the the-board percentages (as in the case of ad­ central bank, or for discounts (as in West vances in Italy). Various approaches have Germany after 1952); and additional credit been developed to revise ceilings in the light lines may be established for advances.19 Ad­ of growth requirements and, in some coun­ ditional quantitative limitations may apply tries, changing policy objectives. to the permissible amounts of specific types Quotas may be left unchanged for long of assets within the total discount quotas. periods (as in Canada) or recalculated fre­ In fact, discount quotas may be equivalent quently on the basis of formulas (monthly to credit lines with no questions asked, or in West Germany, quarterly in Japan), or they may be conditional on the borrower’s they may be administered informally, in the conforming with the wishes of the central guise of approximate guidelines (as in bank or on the observance of specific, Italy). Attempts to reduce the area of ad­ stated ground rules.20 ministrative judgment and/or to provide for Quantitative regulation of access to the gradual increases in quotas by linking them discount window always raises questions of to such balance sheet items as short-term equity and flexibility. Setting of discount liabilities (and medium-term liabilities, if quotas for institutions (and administration the borrowing financial institution is a sav­ of these quotas) must steer between exces­ ings bank) foundered on the hard fact that sive generosity, which might interfere with any addition to reserves may lead to sec­ the conduct of monetary policy, and exces­ ondary credit expansion, which in turn sive restrictiveness; in the latter case, the would provide the justification for a further problem of above-quota accommodations rise in the quota. Indeed, any automatic becomes chronic. Quotas may be geared to linking of quotas to bank assets or liabili­ bank capital, liabilities, past changes in se- ties (or other growth variables) carries 19 In several countries in which dealers in govern­ with it the danger of an automatic inflation ment securities are an important element in the mechanism through which monetary policy is imple­ of quotas. Obviously, when quotas are mented, separate lines of credit may be established for them. A related reason for such credit lines is 21 The smaller banks may be given special consid­ the endeavor to develop a national capital market. eration in setting or administering discount or loan 20 Access to central bank credit still depends quotas. on availability of proper collateral in an individual 22 In at least one country (France) revisions of institution’s portfolio. ceilings were negotiated with the banks involved.

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based on capital accounts, some degree of comfortable position. As a result, total bor­ manipulation of the base by individual rowings tend to rise toward the aggregate banks is possible because the banks can in­ quota ceiling; market rates also tend to rise, crease their capital accounts. and the upward pressure on rates is rein­ Some degree of flexibility is generally forced as some banks begin to borrow at provided in one of the following ways: (1) penalty rates. In effect, while offering addi­ by permitting banks to exceed over-all dis­ tional accommodation at a penalty rate and count quotas at a penalty rate or under spe­ under restrictive conditions, as a privilege cial conditions, (2) by exempting from rather than as a right, the central bank the quota certain categories of paper (such counts on the rate to inhibit credit expan­ as medium-term paper covering approved sion beyond the limits set by quotas. financing of equipment or of exports), (3) The effectiveness of discount quotas de­ by establishing additional quotas for. spe­ pends on a skillful combining of quantity cific categories of credit instruments, (4) and rate controls. But it also depends on by granting or negotiating temporary sup­ the availability and cost of alternative plementary quotas for purposes and sources of reserves and on the volume of amounts specified in advance (such as to liquid assets the banks have at their dis­ meet money market pressures at the end of posal, as well as on whether or not the bal­ the month), or (5) by negotiating such ance of payments is generating a significant quotas on a case-by-case basis to accommo­ surplus. From the point o f view of mone­ date specific situations (West Germany). tary policy,23 the main advantage of a Some flexibility is essential where the central formal quota is that it reduces problems of bank does not possess adequate alternative day-to-day administration of the discount tools for meeting exceptional or unexpected window by stating unequivocally how much situations. each bank may borrow within the frame­ Such “overline credit” may take the form work of established discount policy. In fact, of (temporary) supplementary quotas at a discount quota indicates the amount that regular rates granted for specific reasons an individual bank feels it can borrow as a and for limited periods (West Germany). right, as long as it adheres to clearly stipu­ Normally, however, borrowing above the lated ground rules. To a large extent, ad­ quota is available only at a penalty rate and ministrative problems are shifted from the is subject to quantitative restrictions or control of total borrowing to the control of “window guidance.” The cost of above­ “overline” borrowing. quota accommodation may be stepped in The use of discount quotas as a tool of such a way as to become, in effect, prohibi­ monetary control raises at least two ques­ tive beyond the first “tranche” above the tions: (1) what is the role of unused quo­ basic quota (France). Alternatively, bor­ tas (the “unused margin”) and (2) how rowing above. ceilings may involve merely can changes in quotas be used to implement the obligation to adjust borrowing down­ policy. ward in subsequent periods. 1. One of the widely recognized limita­ Under a system of discount quotas, tions of quotas is the stated or implied right tighter monetary policy usually has a perva­ sive effect, inasmuch as banks that are close -3 As distinct from the use of rediscount quotas to to exhausting their leeway under quotas tend protect the central bank from possible losses as a re­ sult of excessive lending to individual banks (as in to sell discounted bills to banks in a more West Germany before 1951).

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on the part of banks to make full and con­ tries in which re-lending (through an inter­ tinuous use of the quotas; such use, except bank money market) is recognized as part for the cost involved, amounts in effect to of the adjustment process, borrowing in an equivalent reduction in reserve require­ order to re-lend in the interbank market ments or in prescribed liquidity ratios. and/or for buying bills from banks that Usually, there are considerable differences have exhausted their quotas is common. in the actual use that various categories of Even when a penalty rate is involved, banks make of the credit lines available to banks with unused margins may still have a them. On the other hand, the effectiveness strong inducement to discount for the pur­ of discount quotas depends, in part, on the pose of lending to the market (France). policy of banks to exhaust the quotas and 2. Discretionary changes in credit lines to require additional accommodations when are used: loan demands build up and/or on the un­ a. To meet special situations (such as willingness of the central bank to permit the reduction in these lines in West Ger­ continuous use of the full quotas. In some many in 1964 to offset foreign borrowing). countries banks normally use only part b. As a sanction against nonobserv­ (but typically a substantial part) of their ance of the rules of the game or for non- credit lines but shift to fuller use when compliance with the expressed wishes of the official credit policy becomes more central bank. (For instance, in West Ger­ restrictive.24 The typical attitude of banks many; in 1965, the Governor of the Bank toward utilization of quotas thus becomes of France in his capacity as Vice-Chairman an element in setting their over-all level. In of the National Credit Council, in a pub­ formulating its day-to-day operating objec­ lished letter to the Banking Association, tives, a central bank must take into account threatened to reduce quotas of banks that the willingness of banks to reduce further expanded credit too rapidly.) the leeway available under credit lines. On c. As a countercyclical measure. The the other hand, under a system of discount central bank can achieve greater ease or quotas, the margin between current borrow­ tightness merely by changing aggregate ings and the quota ceiling tends to become quota ceilings and in this way bring about a an important consideration in determining a commensurate change (other things being commercial bank’s lending policy.25 equal) in the amount of the “unused mar­ The attitude of central banks toward in­ gin” (Japan). terbank trading in excess reserves is not d. For ordinary business reasons, such uniform. Not all foreign central banks as failure to meet bank examination stand­ frown upon or penalize re-lending at a ards, deterioration of bank management, or profit. In most European countries bor­ adverse developments in the financial posi­ rowing to re-lend is considered consistent tion of the borrower (West Germany). with the normal use of lines of credit; in Thus, the role of discount quotas as a others (such as Sweden) it is not. In coun­ tool of credit control depends on prevailing bank attitudes toward them; these attitudes in turn depend in large part on whether, 24 This is even true when, as in Italy, banks are expected to repay their advances completely from under what conditions, and at what cost a time to time and not to return to the window imme­ given category of credit institution can ex­ diately. pect to obtain central bank credit beyond 25 Italian and West German banks even include the unused margin in computing their liquidity positions. the unused portion of the quota. Uncer-

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tainty about bank attitudes toward this un- West German experience also suggests that used margin is, indeed, one of the basic dif- these attitudes may not be consistent over Acuities of operating with discount quotas. time.

SELECTIVE CONTROLS THROUGH THE DISCOUNT WINDOW

In countries in which discounting is used as Sometimes a privileged status is given to a means of selective credit control to influ­ credits that private lenders would not have ence the distribution of bank credit undertaken without what really amounts to (France, West Germany, and Japan being a take-out commitment by the central bank the most important examples), certain (France); private credit is thus substituted, types of loans may be exempt from over-all at least temporarily, for central bank credit quota ceilings or may benefit from specific or Treasury resources. Endowing certain additional quotas.26 credits with privileges at the discount win­ Typically, certain types of investment dow has the double aspect of selective and export credits are favored, and prefer­ credit controls (credit direction) and crea­ ential discount rates may apply to such tion of additional bank liquidity. The fa­ paper (as in France). Conversely, low- vored assets become, in effect, instruments priority activities may be discouraged by of secondary liquidity that give their holder quantitative, cost, or eligibility restraints at automatic access to central bank credit at the window. In some countries discount his option, since they can be converted into rates are structured in such a way as to en­ reserves without prior notice. courage specific categories of lending, or of Extension of preferential treatment to lending on specific terms. The structure of specific types of credit (or instruments) rates at the window becomes an indirect usually involves obtaining a preliminary au­ means of influencing portfolio composition. thorization—usually in the form of a certi­ Distributive considerations (selective con­ fication by affixing a “stamp” or “visa” trols) may also be made effective within from the central bank or the proper pri­ over-all discount (or credit) quotas if pref­ mary discount institution (see below) — erence is given to certain categories of which is tantamount to a commitment to paper, either through automatic access to discount the particular loan on presenta­ the discount window (frequently after prior tion, at the holder’s option.27 “Stamped approval of credit by the central bank) or bills” (Japan) or “visaed bills” (France), through preferential rates, or through a kept in the portfolio of the original lender combination of such techniques. In fact, (commercial banks), are in effect instru­ such policies amount to direct central bank ments of secondary liquidity since they may financing of favored economic activities, provided the funds supplied are in effect 27 More generally, in some countries commercial used for the purpose intended; evidence banks may obtain, in the form of a “visa” or on this point is contradictory. “stamp,” the central bank’s advance certification that a particular credit is eligible for discount. Some cen­ 26 As an alternative to using the discount mecha­ tral banks review in advance all bank loans, or all nism directly as a means of qualitative credit regula­ credits above a certain amount, to determine their el­ tion, it may be used indirectly to enforce compliance igibility at the window (Belgium). Such review with selective credit policies applied through other usually amounts, in effect, to screening and tends to techniques (West Germany, Italy). have some selective control aspects.

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be converted into cash without question at banks of over-all credit expansion. As a re­ any time. After banks have obtained an of­ sult, certain central banks have found it ficial seal of approval, they may be more necessary to put an outside (global) limit willing to hold such paper in their portfo­ on the volume of such preferred paper that lios than they otherwise would. they would discount (West Germany).28 Indeed, some countries have used the ad­ Pursuance of multiple-policy goals by vance approval technique (in particular, countries using quantitative credit tools when coupled with the availability of pref­ sometimes results in complex schemes erential rates) to induce commercial banks under which the over-all effectiveness of to enter new fields of lending (medium- ceilings is undermined by various excep­ term loans) or to expand their assets in tions. More generally, the use of the dis­ specific areas in line with over-all govern­ count mechanism as a tool of selective ment economic policy. In effect, an uncon­ credit control tends to render more difficult ditional agreement to discount through the the implementation of over-all monetary technique of formal advance agreements policy, especially when the discount win­ permits the central bank to add at its own dow is used to stimulate particular activi­ discretion (and under certain conditions, in ties. a discriminatory manner) to the liquidity of the banking system. In some countries, dis­ 28 For description of a special technique to restrict counting of certain instruments outside of rediscounting of exempt paper, see the chapter on quotas has impaired the control by central France.

INDIRECT ACCESS TO THE DISCOUNT WINDOW

Access to the discount window need not be quirements have often proved too rigid to direct. It may involve the use of a discount permit injection of needed liquidity. To cope market or of primary discount institutions. with this type of problem some countries The oldest and classical example is the in­ have created separate official institutions, terposition of the discount market. Through the specific purpose of which is to redis­ discount houses in the United Kingdom it is count paper not eligible at the central possible for banks to even out some of their bank’s discount window. In order to carry reserve surpluses and deficits at rates that portfolios of such instruments, these institu­ may be below the official discount rate, if tions usually also borrow in the short-term warranted by money market conditions. money market—sometimes on call—and And if banks that have deficits obtain cen­ from the central bank, and they are given tral bank credit through discount houses, access to the latter’s rediscounting facilities. they may be able to conceal their identity, These institutions (1) provide credit for at least temporarily (Canada). carrying out certain government economic In other countries— in some cases as a policies without directly involving the cen­ result of the financial crisis of the 1930’s— tral bank; (2) extend credit on terms that special primary discount institutions have are more flexible with regard to maturity, been created, and these in turn rediscount collateral, and quality than available from with the central bank. But in particular in the central bank; (3) give additional flexi­ periods of stress, traditional eligibility re­ bility to the conduct of credit policy, in

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particular when expansion is desired; and The official rediscounting institution may (4) contribute to broadening credit and provide the additional endorsement (usually capital markets by substituting their own the third “name”) required to make the credit for that of their borrowers, by bor­ instrument rediscountable at the central rowing at short term in order to discount bank. It also normally examines the loan medium-term debt, and in other ways. application and issues an advance discount Some countries have created specialized commitment without which the original credit institutions to close a credit gap and lender would not make the loan or would in particular to stimulate medium-term accommodate the borrower only at a higher financing. These institutions, which nor­ rate (France). mally are government sponsored, also act as By changing the conditions under which primary discount institutions by discounting it makes such rediscounts, or by varying the credits that originate in specific activities ceiling for such rediscounts, the central considered worthy of official support (typi­ bank has a potentially powerful means of cally export trade, but also public construc­ controlling the activities of these public in­ tion, equipment financing, and others). vestment and primary rediscounting institu­ They have access to rediscounting at the tions. Frequently, however, there is little central bank to the extent that alternative room for use of discretionary policy be­ sources of funds to finance their activities cause the central bank is expected to imple­ are insufficient. Such sources typically in­ ment government policies carried out by clude: (1) their own funds; (2) borrowing the specialized institutions. in the money market; or (3) special re­ In some respects the specialized central sources, such as Treasury deposits or long­ credit institutions resemble similar govern­ term funds raised in capital markets ment credit institutions in the United States, (Belgium). Primary discount institutions which also use borrowed or Treasury funds have extensive direct dealings with commer­ to finance certain sectoral activities (such cial banks and usually cooperate closely as housing). In contrast, foreign specialized with their respective central banks. credit institutions typically rely in the main In fact, primary discounting institutions on the rediscount technique for obtaining are a conduit for central bank credit on the official financial assistance. basis of collateral of a maturity or quality Credit activities of primary discount in­ not acceptable for regular central bank op­ stitutions require adequate and continuous erations. Typically, short-term instruments coordination with over-all objectives of (eligible at the discount window) are is­ credit policy. These institutions are usually sued against a portfolio of debt instruments subject to direct and close supervision by of longer maturity; this procedure is known the Ministry of Finance, and there is nor­ as “liquefying” or “mobilizing” long-term mally little room for policy conflicts. To assets. An alternative technique is for these meet such conflicts, if they do occur, sev­ institutions to hold medium-term paper eral countries have created special coordi­ until it moves close enough to maturity to nating bodies, such as the National Credit become eligible at the discount window. Council in France.

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UNIFORMITY OF ADMINISTRATION

Uniform administration of the discount fa­ head office of the central bank. The cash cility does not pose significant problems position of a branch system is normally abroad because the central bank operations managed centrally by the head office. When are directed from one single center. This is need to rediscount arises, the head office, true even in Germany where the “Landes- in its dealing with the central bank’s main zentralbanken” are the closest counterpart office, offers paper that originates at branch of Federal Reserve Banks that can be found offices as well as at the head office. This is abroad. Discounts are usually available at not necessarily true in countries where the all branches of the central bank, whether the headquarters of some of the leading na­ branches are few (as in the United King­ tional branch-banking systems are not lo­ dom) or relatively numerous (as in Italy or cated in the capital (as in Japan) or where France). Uniform discount administration important regional branch systems exist (as is assured by issuing rules and regulations in France, Italy, and West Germany). to regional and local offices. When neces­ Uninhibited access to the discount win­ sary, quotas are assigned to each office to dow and transactions undertaken by the assure that the aggregate amount of dis­ central bank to bridge short-term swings in counts does not exceed over-all ceilings reserve availability permit banks in most determined by the head office. Daily report­ countries to reduce the demand for excess ing of discounts and advances made (and reserves to near zero.29 maturing) permits the head office to exert 29 Also, in some countries, the reserve ratio needs tight and current control and to make quick to be observed only on specified control days, such changes in individual branch-office quotas as the end of the month. The absence of the need for meeting cash reserve requirements within rela­ when necessary. tively short periods reduces the pressure for develop­ Because of the prevalence of branch ing detailed and up-to-date data of the kind on which the Federal Reserve System bases its elaborate banking, a large proportion of the paper and continuously revised projections of reserve needs that originates locally is discounted at the and availability.

CONCLUDING REMARKS

Although still an important tool of mone­ varying degree, to reducing the original sig­ tary policy, discounting has lost the central nificance of the discount tool. World War position it held so long; the change began II created conditions of excess liquidity and after the banking crises of the 1930’s and caused significant changes in the institu­ has become clearer since World War II. In tional environment. These in turn required almost all of the countries surveyed, central the introduction of new monetary tools (in bank policy has come to rely on additional some cases, following their development in tools of monetary control, while the discount the United States) and led— in some coun­ mechanism itself has undergone in many tries at least—-to closer integration of mon­ countries considerable changes, with great etary management with over-all economic emphasis placed on quantitative limitations controls and planning. It is, indeed, not im­ rather than on eligibility requirements. proper to speak of a “politization” of the Several developments contributed, in discount rate inasmuch as practical limits

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for discount rate variation, and in some the year is relatively small, the marginal role cases conflicting domestic and balance of of these reserves may be important. Simi­ payments considerations, have tended to re­ larly, changes in the discount rate may have duce the scope of control through manipu­ considerable significance even though they lating the rate. affect directly the cost of only a small frac­ In some countries where progress toward tion of the reserves in use. One reason is developing flexible and effective open mar­ that deposit and lending rates of commer­ ket operations has been slow, one can cial banks are geared to the discount rate; discern a tendency to regard changes in re­ another is that changes in the rate may serve requirements as an alternative. By be of crucial significance in achieving desir­ and large, however, there has been some dis­ able flows in international accounts. enchantment with the potency of variable In some countries (Netherlands, Bel­ reserve requirements as a tool of monetary gium) the rate still has an important do­ control, and as a result there has been a mestic signal function through its announce­ tendency to introduce or expand direct con­ ment effect, but that function has been trols. In the larger continental countries in lost in others, mainly because changes particular, but also in Japan and in several have always been very infrequent (Italy) or other countries, direct quantitative regula­ because the rate has been tied to a market tion of bank liquidity and/or bank credit rate (as in Canada, 1956-62). Except in has become an integral and important part Canada and Switzerland—where discounts of monetary controls. and advances are of quite marginal signifi­ Inability of central banks to use open cance, although for different reasons—dis­ market operations as a main tool of mone­ counting continues everywhere to be an im­ tary policy, as well as difficulties encoun­ portant tool of central bank policy, and in tered in developing adequate new tools of some countries it has become an important monetary policy (such as variable reserve avenue for achieving economic objectives of requirements, or even fixed reserve require­ government policy outside the credit field. ments), have tended to keep the discount In these countries the use of the discount function as one of the important tools of window was broadened—not primarily be­ monetary policy, as well as a tool that is cause it was judged to be a more powerful useful in the management of liquidity of ex­ means for controlling money and credit, ternal origin. The only routine means by but because it provided a convenient way which central banks can help commercial for achieving certain government policy banks meet short-term fluctuations in their objectives. To some extent it appeared to reserve positions is by rediscounting the be a natural way of utilizing the money-cre­ paper held by these banks or by making ad­ ating power of the central bank to meet vances to them. But with its rationing func­ some of the new challenges of the post- tion much reduced, the discount rate has World-War-II era and to provide another become in several countries mainly a peg indirect way for government guidance of for manipulating the structure of a variety the economy—by now an unquestioned of commercial bank and other rates. principle in all of the leading industrial Even when the average amount of re­ countries surveyed. serves provided to the banking system as a Many countries expect to achieve greater whole through the discount window over policy flexibility by developing open market

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operations and a more sophisticated man­ undergone in most of the countries sur­ agement of fluctuations in foreign exchange veyed, it seems safe to assume that further reserves, rather than by rejuvenating the evolution is likely, as conditions change discount mechanism. But understandably, and new challenges arise. Only history will central bank attitudes vary toward the pres­ show in what countries, and in what ways, ent role of discounting in relation to other changes in the setting and objectives of tools of monetary control and potential use monetary policy and the gradual emergence in the future. of other tools of monetary management will In view of the numerous modifications change the relative role of discounting as a that the discount mechanism has already tool of monetary policy.

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THE DISCOUNT MECHANISM IN INDIVIDUAL COUNTRIES

Contents

Introduction 201 Austria ___ 201 Introduction Banking system Reserve requirements Discounts and advances Other instruments of monetary policy B e lg iu m ______207 Introduction Institutional framework Discounts and advances Other instruments of monetary policy C a n a d a ______214 Introduction Institutional framework Discounts and advances F r a n c e ______219 Introduction Institutional structure Instruments of monetary policy Discounts and advances Federal Republic of G erm any______233 Introduction Banking system Discounts and advances Other instruments of monetary policy Italy 239 Introduction Institutional framework Discounts and advances Other instruments of monetary policy

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J a p a n ______246 Introduction Institutional framework Discounts and advances Commercial bank interest rates Other instruments of monetary policy Quantitative role of central bank credit policy N e th e rla n d s______253 Introduction Structure of the banking system Mechanism through which monetary policy operates Discounts and advances S w e d e n ______259 Introduction Institutional framework Discounts and advances Other instruments of monetary policy S w itz e rla n d ______263 Introduction Banking structure Instruments of monetary policy Discounts and advances United K ingdom ______268 Introduction General background Institutional framework Discounts and advances Other instruments of monetary policy Relationship of other interest rates to the discount rate

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INTRODUCTION

The chapters in this part describe the essen­ to trace the historical evolution of the dis­ tial aspects of the discount mechanism in count mechanism in each of the 11 coun­ the 11 countries covered by this study. No tries. In some cases, however, it seemed attempt has been made to keep the struc­ useful to describe policies or techniques ture and coverage of the individual chapters now supplanted. uniform. The general aim has been to in­ It has not proved possible to present a clude only those details that seem essential comparative analysis of the role of dis­ to bring out the framework in which the counting in quantitative terms without at discount mechanism is operating in each of the same time adding considerably to the the countries covered, to relate the mecha­ explanatory material. Therefore we con­ nism to other tools of monetary control, cluded that little would be gained—con­ and to describe specific processes and tech­ sidering the over-all objective of the study niques. The emphasis is on post-World-War- —by including statistical data that were II developments; it did not seem necessary limited and not entirely comparable.

AUSTRIA

Introduction monetary control was to minimize any dis­ ruptive effects of changes in the cash base From the time Austria recovered sover­ arising from changes in central bank inter­ eignty—through the 1955 State Treaty— national reserves. The increase in Austria’s until the National Bank Law was amended international assets in the 5 years ending in 1969, the country was obliged to con­ December 1965 was equivalent to two- duct its monetary policy with narrowly cir­ thirds of the cash base of the banking sys­ cumscribed central bank powers. After re­ tem at the end of 1960, which totaled only covering sovereignty, Austria had little $900 million. Maintenance of monetary choice but to integrate as closely as possible control under such conditions requires pow­ with the international economy and to live erful tools, but the monetary authorities with the ebb and flow of international capi­ tal. Nevertheless, it still had to face the were not well equipped even with the tradi­ problem of domestic monetary control. tional policy tools. Owing to the small size of the country’s Prior to the 1969 amendment monetary cash base in relation to international flows policy had been implemented primarily of funds, the most important problem of through official ceilings on the volume of

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bank credit. The discount mechanism had gether. When total bank credit approached played only a subordinate role. Moreover, the ceiling in 1966, the authorities raised in rudimentary money and capital markets, the ceiling. the central bank’s open market powers were Under the 1969 amendment to the Na­ virtually useless as a means of offsetting the tional Bank Law, the Austrian National effects on the cash base of the large growth Bank was given far wider powers to pursue of the central bank’s holdings of interna­ an effective monetary policy. In particular, tional assets. Likewise, its authority to vary the National Bank’s power in the field of reserve requirements was too narrow in reserve requirements and open market pol­ scope—certainly too narrow to absorb into icy was increased considerably. The Bank reserve balances the funds that the commer­ now has the authority to sterilize large in­ cial banks had acquired as the result of sur­ creases in foreign deposits. Although not pluses in Austria’s balance of payments. enough time has elapsed to make a firm Realizing their predicament, the authori­ judgment on the over-all effects of the ties rarely used the discount rate for domes­ changes in the National Bank Law, it ap­ tic monetary control purposes. However, pears that the National Bank has tended to borrowing at the central bank was con­ take a more active posture in monetary pol­ trolled to some extent— with access to cen­ icy, particularly since signs of inflationary tral bank credit (whether in the form of pressures began appearing in the economy discounts or advances) being regarded as a in late 1969. While the 1969 amendment privilege. For control purposes, the authori­ of the central bank law does not contain ties resorted fairly often to changes in cash any provisions relating specifically to the reserve requirements—more often than to discount mechanism, the over-all strength­ changes in central bank rates. ening of the National Bank’s powers may Monetary powers in Austria are shared increase the importance of the discount to some extent with the Ministry of Fi­ mechanism in the future. nance. Inasmuch as they had little influence In its current state of evolution, Austrian on the cash base of the banking system, the monetary policy seems to be in transition authorities implemented their monetary pol­ from a stage where the volume of credit icy primarily through direct controls over was controlled chiefly by direct means to bank credit. These controls included the one where the conventional tools of mone­ so-called voluntary credit ceiling agree­ tary policy are becoming more important. ments between the Ministry of Finance During most of the 1960’s Austria was (rather than the National Bank) and the troubled by a slow rate of growth and had credit institutions, and also prescribed ob­ few problems with inflation. The primary servance of compulsory liquid asset ratios. task of monetary policy in this period was The ceiling applied to all types of credit in­ to deal with the effect of fluctuations in in­ cluding credit to the Government and credit ternational reserves on the money supply. to the private sector; exceptions were made In times of capital inflows the use of con­ only for special categories such as export ventional monetary policy instruments leads credit. The ceiling was set in terms of per­ to higher interest rates, which encourage in­ centages of the bank’s total liabilities and creased inflows of capital and thus further of its net worth. No penalty was imposed aggravate the problem. Hence, prior to for violation of the ceiling, but the latter 1965, when there was a surplus in the bal­ was not exceeded by all the banks taken to­ ance of payments, the Austrian authorities

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had to rely on direct controls to achieve operate a nationwide system of branches; their monetary aims. In 1965 and 1966 several other commercial banks serve var­ when the country began to experience bal­ ious regions of the country. In addition, ance of payments deficits, this policy be­ there are several types of specialized credit came less effective. In the backspin of the institutions. German recession, Austria’s rate of growth slowed considerably during 1967, and the Reserve requirements authorities were forced to give primary con­ Prior to the 1969 amendment to the Na­ sideration to domestic rather than balance tional Bank Law, the maximum rate for of payments objectives in their monetary cash reserve requirements that the National policy. Liquidity ratios and credit ceilings Bank could set for any category of credit remained unchanged, but monetary policy institution was 15 per cent.1 The 1969 was eased by lowering reserve requirements amendment left this ceiling unchanged for and the discount rate. And in 1965 the Na­ time and savings deposits, but raised it to tional Bank began to engage in open mar­ 25 per cent for demand deposits. This re­ ket operations. serve ratio can also be applied to borrowed funds and to foreign liabilities and liabili­ Banking system ties in foreign exchange to Austrian resi­ Half of the stock of the Austrian National dents, to the extent that they exceed foreign Bank is owned by the Government; the assets and credits in foreign exchange to other half is held partly by bodies repre­ Austrian residents. In addition, the Na­ senting the interests of businesses and their tional Bank may impose reserve require­ employees and partly by credit institutions ments of up to 50 per cent on increases in and insurance companies. The majority of the excess of foreign liabilities over foreign the board of directors is appointed by the assets of the credit institutions. This latter Government (the remaining members being provision represents the most powerful tool elected by the shareholders other than the yet available to the authorities to control Government), and the President of Austria inflows of foreign capital, which have often appoints the president of the Bank. The proved disruptive to the conduct of mone­ board of directors appoints the Bank’s gen­ tary policy in the past. eral manager, his deputy, and four manag­ In the 1969 amendment the interest rate ers to conduct the day-to-day affairs of the payable on shortfalls in meeting reserve re­ Bank and to implement its monetary policy quirements was raised from 3 percentage decisions. A commissioner appointed by the points to 5 percentage points above the dis­ Ministry of Finance attends the board’s count rate. Deposits held for reserve pur­ meetings to assure that the policy actions poses are counted as part of the liquid as­ taken are in conformity with the law. In re­ sets held under credit-control agreements cent years, the formulation and implemen­ with the Ministry of Finance. tation of monetary policy have involved close Savings banks or urban and rural credit cooperation between the central bank and cooperative (Reiffeisen) societies are nor­ the Ministry of Finance, which is vested mally affiliated with their own central credit with important monetary control powers. institutions. They may hold their required The banking system with which the au­ thorities deal is one that is highly concen­ 1 This term covers commercial banks, savings banks, mortgage banks, urban and rural credit coop­ trated. Two large commercial banks each erative societies, and the Postal Savings Bank.

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deposits with such institutions, which in National Bank Law from an absolute limit turn are required to hold equivalent depos­ of 1 billion schillings to 5 per cent of Fed­ its with the Austrian National Bank. Simi­ eral Government revenue, or almost 5 bil­ larly, commercial banks and other credit in­ lion schillings on the basis of projected rev­ stitutions, such as mortgage banks, may enue for 1970. Bills arising from export deposit their reserve balances with the transactions under the export promotion Postal Savings Bank, which in turn is re­ program were for awhile rediscountable at quired to make an equivalent deposit with a preferential (lower) rate, but no longer the National Bank. are. In addition, the National Bank may The National Bank tends to adjust mini­ discount securities or coupons of securities mum reserve requirements to the interna­ eligible as collateral for central bank ad­ tional flow of funds. As of September 1970, vances, provided they are payable within 3 reserve requirements for institutions with months. total deposits of 40 million schillings or Decisions as to whether bills offered are more were 9Vi per cent on demand deposits, rediscountable are made by an outside IVi per cent on time and savings deposits Committee of Scrutiny appointed by the up to 12 months, and 6 V2 per cent on time National Bank’s board of directors. How­ and savings deposits of more than 12 ever, the advice of the committee is not months. For institutions with less than 40 binding on the board of directors. million schillings in deposits, reserve re­ The National Bank may also make loans quirements for demand deposits were 5Vi against collateral for a period of not more per cent, while time and savings deposit re­ than 3 months. Assets accepted as collat­ quirements were 5 per cent. eral are gold coin or bullion, bonds listed on the Vienna stock exchange, bills of ex­ Discounts and advances change or promissory notes payable in na­ Legally, all credit institutions have access tional or specified foreign currency with a to facilities at the Austrian National Bank. maturity of no more than 3 months, foreign Until the 1969 amendment to the National exchange, and warehouse receipts issued by Bank Law prohibited the practice, some officially authorized warehouses. private firms and individuals could discount There are no explicit limits on redis­ paper with and obtain advances from the counting or granting of loans at the stated Bank. The ability of credit institutions to rates for discounts and advances. Neverthe­ discount and borrow depends mainly on the less, the National Bank maintains informal availability of paper eligible for rediscount­ ceilings on the amount of central bank ing or as collateral against advances. credit extended to each credit institution. Paper eligible for discount includes When it believes that an institution’s dis­ schilling-denominated bills and promissory counting is bordering on the excessive, it notes issued by private or publicly owned requires that further borrowing by that in­ enterprises, provided such paper has the stitution be in the form of advances (at a signatures of two parties known to be sol­ higher cost). The National Bank will raise vent and is payable (in Austria) within 3 the ceiling if in its judgment such an adjust­ months. The Federal Government may ob­ ment is justified. The basis for this informal tain advances by using Treasury certificates control is the provision in the law that the as collateral. The ceiling for such advances National Bank may refuse rediscounting was raised by the 1969 amendment to the and advances against collateral without

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statement of reason. The only quantitative ings, liquidity ratios, open market opera­ restraints and ceilings apply to Government tions, and moral suasion. borrowing and to export promotion bills Credit ceilings. Under the Credit Control (currently 3 billion schillings), which are Agreement (originally made in 1951 and not subject to the credit ceilings applicable fundamentally revised in 1957) the author­ to commercial banks. ities have negotiated voluntary credit ceil­ During the 15-year period since the Na­ ings with credit institutions that apply to the tional Bank was organized in its present total volume of loans and advances that form, the discount rate has been changed credit institutions may make. These ceilings nine times within the range of 3% to 5 per are stated as fixed proportions of a credit in­ cent, two of the nine changes having taken stitution’s net worth and liabilities. They place in 1969 and 1970 (through July). apply to the total of schilling loans on cur­ These changes serve as a widely recognized rent account, acceptances, advances to pub­ signal of the National Bank’s view of the lic authorities, advances against mortgages, direction in which monetary and credit con­ and loans to credit institutions to which ditions should move, in part because of ceilings or voluntary agreements do not their possible effects on the structure of do­ apply. Discounted and rediscounted bills mestic interest rates. Changes in the central are included in this total, but export pro­ bank discount rate are usually accompanied motion bills, European Recovery Program by changes in the rates on advances, which bills,2 and certain other types of financing are higher than the discount rate and are are excluded. sometimes instrumental in affecting the Net worth is defined to include not only lending rates of credit institutions. paid-in capital and reserves but also pen­ There is no rigid link between the dis­ sion reserves (which usually expand more count rate and the lending rates of credit rapidly than capital and regular reserves). institutions, which move in response to Liabilities consist of schilling deposits of other forces as well. Changes in the dis­ Austrian and nonresident depositors and count rate have at times preceded, and at promissory notes. To avoid double count­ other times followed, the general trend in ing, deposits belonging to Austrian credit interest rates. In 1963 a reduction of the institutions that are subject to voluntary or discount rate to 4lA per cent produced no imposed ceilings are not considered liabili­ effect on interest rates, and the monetary ties for the purpose of extension of credit. authorities negotiated agreements with the Schilling deposits of foreign credit institu­ credit institutions to lower their loan rates tions that may be included in liabilities for by Vi to 1 percentage point. The discount this purpose are limited to the level of such rate has recently been more important in deposits on December 31, 1963. Thus, ac­ determining the structure of interest rates, quisition of additional schilling deposits of but only when used in conjunction with foreign credit institutions cannot increase other instruments, such as the issuance of the credit ceilings. short-term cash certificates to commercial Since July 1966 the ceiling for commer­ banks and their subsequent redemption. cial banks has been equal to 70 per cent of Other instruments of monetary policy 2 ERP bills arise from loans made for industrial In its direction of monetary policy, the Na­ and other development purposes by the National Bank out of a revolving fund consisting of the schill­ tional Bank also makes use of credit ceil­ ing counterpart of Marshall Plan aid to Austria.

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liabilities plus 75 per cent of net worth.3 banks is currently 30 per cent. Different The net worth ratio has been unchanged ratios with regard to primary and secondary since April 1957, but the liability ratio was assets apply to other categories of credit reduced on three occasions between 1962 institutions. Any deficiency in primary and 1964 and raised in July 1966. Thus liquid assets incurs a penalty charge equal this tool was frequently used in response to to the discount rate, but the penalty for a changes in monetary conditions. Individual deficiency in secondary liquidity is only 1 banks and other credit institutions have ex­ per cent. ceeded their credit ceilings from time to Open market operations. In view of almost time, but credit expansion of all credit insti­ continuous surpluses in the Austrian bal­ tutions has remained below the aggregate ance of payments, the National Bank did ceiling, and only recently has the margin not use the authority to undertake open available for expansion been reduced sub­ market operations for the purpose of regu­ stantially. lating the money market until 1965, except Liquidity ratios. Liquidity ratios, originally for two special transactions in 1962. In established for the protection of depositors, 1965 a law provided for the conversion of have been employed on occasion in recent the central bank’s claims on the Govern­ years for monetary policy purposes. These ment— up to a total of 3 billion schillings ratios, also established under the Voluntary — into 2 per cent Treasury certificates Credit Control Agreement, prescribe the (with maturities from 3 months to 2 years) form in which credit institutions must hold for use in open market operations. A favor­ a certain proportion of their assets; this able balance of payments situation and the proportion is set in terms of the liabilities lack of money market facilities so far have of the credit institution. Such liabilities are restricted the scope of open market opera­ defined as all-schilling deposits of Austrian tions, but since October 1966 the Austrian and foreign depositors (including credit in­ National Bank has occasionally appeared as stitutions), promissory notes, and accept­ a buyer in the open market. Fixed-interest- ances. bearing securities that fall due within 1 Currently, “primary” liquid assets are de­ year from the purchase date are eligible for fined as vault cash and deposits with the such purchases. National Bank and the Postal Savings The 1969 amendment to the central Bank, and for banks the ratio of such assets bank law contained several new provisions to liabilities is presently 10 per cent. “Sec­ designed to enable the National Bank to ondary” liquid assets are defined as securi­ conduct open market operations more ties acceptable by the National Bank as col­ effectively. Chief among these was a provi­ lateral for advances and bills eligible for sion allowing the National Bank to issue rediscount, net foreign assets, and collection short-term debt certificates and to deter­ items sent to other credit institutions as well mine their amounts, maturities, and interest as demand balances held with them; the li­ rates. In January 1970, when the discount quidity ratio on “secondary” assets for rate was raised to 5 per cent, the National Bank used its authority for the first time by 3 Net worth is defined to include paid-in capital issuing 1.5 billion schillings ($57 million) and reserves (also pension reserves) less the value of of cash certificates. At the end of May certain assets, such as real estate and buildings owned and permanent investment in other enter­ 1970, when the National Bank believed prises. that the possibility of a severe liquidity

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squeeze existed, it redeemed two-thirds of and (2) the agreement with selected banks these certificates. With its broadened pow­ in 1964 not to repatriate foreign assets. A ers and its increasingly activist stance, the more recent example was a letter issued in National Bank will most probably pursue August 1966 to the credit institutions from open market operations more vigorously in the Ministry of Finance stating that, accord­ the future. ing to the Credit Control Agreement, credit Moral suasion. Moral suasion has been was to be granted only for economically used by the authorities from time to time. justified purposes, and that consumer credit Examples are (1) the agreement with most at that time was not economically justified categories of credit institutions to reduce unless all credit demands for investment the cost of credit to the nonbank public, purposes had been satisfied.

BELGIUM

Introduction supplying funds to the Treasury when infla­ In Belgium monetary policy is administered tionary pressures resulted in an increase in by the National Bank, under the direction bank deposits, and the opposite effect in the of the Minister of Finance. Open market case of deflationary trends; hence such ra­ operations are executed by the Securities tios defeated their purpose. For that reason, Stabilization Fund (SSF), which is admin­ toward the end of the 1950’s and in the early 1960’s the ratios were successively istered jointly by the Minister of Finance modified and ultimately abolished. and the National Bank. When other means of financing its operations prove insufficient, In recent years credit demands of busi­ the SSF may obtain advances from the Na­ ness and industry have been extremely large tional Bank. during certain periods, and it has not been At the end of World War II the liquidity possible to control these demands exclu­ of Belgian commercial banks was very sively by manipulation of the National high, because these banks had accumulated Bank’s rates. Moreover, the monetary au­ a very large portfolio of short-term Treas­ thorities could not expect to influence in a ury certificates. In order to control credit significant way the volume of bank lending expansion in the early postwar period, the to the private sector by regulating bank li­ authorities required the banks to maintain quidity, for the banks have, in effect, many high liquidity ratios by holding Treasury possibilities for obtaining funds for such certificates— thus preventing massive liqui­ lending. Included among these possibilities dation of such securities to meet loan de­ are (1) sale of holdings of short-term Gov­ mands. ernment securities and (2) rediscounting of However, for a number of years after the loans (trade bills). In April 1969, how­ war, credit demands of business and indus­ ever, ceilings were established for redis­ try were never long lasting, and they could counts and certified paper. be regulated quite easily through changes in Indeed, the rediscounting of a large official interest rates. On the other hand, proportion of trade bills is an important the requirement that banks maintain high characteristic of the Belgian credit system. liquidity ratios had the indirect effect of Domestic trade bills that meet the eligibility

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conditions of the National Bank may be re­ However, Belgium is a clear example of discounted with that institution, but since how inadequate the discount mechanism of April 1969 only within the limit set by the a small country may be to control domestic ceiling on rediscounts and certified paper. liquidity in the face of strong international Foreign trade acceptances if previously cer­ influences. Furthermore, until the introduc­ tified by the National Bank (see p. 210) tion of rediscount ceilings in April 1969, may be discounted at the Rediscount and when the authorities acquired new control Guarantee Institute (Institut de Reescompte tools, they used existing tools sparingly; for et de Garantie (IRG)), which operates as instance, the highest reserve ratio imposed a primary discounting institution; or, when on deposits was 1 per cent. While discount these acceptances have a remaining term of and other domestic operations have usually less than 120 days, they may be discounted tended to dampen the effects of interna­ at the National Bank. Moreover, banks may tional factors on bank liquidity, the contri­ buy and sell in the market any bills regard­ bution of reserves of foreign origin to bank less of whether the bills are rediscountable liquidity (in some important instances re­ at the National Bank or at the IRG, which lated to Government borrowing) generally acts as a broker for the greater part of the far exceeds the volume injected by discount bills that it does not acquire for its own operations. account; these include uncertified bankers’ acceptances, uncertified trade bills, and Institutional framework medium-term investment credits. Finally, The private banking system consists of the banks may obtain from the National about 80 commercial banks. The three Bank advances against Government securi­ largest—Societe Generate de Banque, ties for very short periods. Banque de Bruxelles, and Kredietbank— During periods of very active demand for are countrywide branch systems that to­ credit by business and industry, the Na­ gether account for more than 75 per cent tional Bank has established guidelines for of all commercial bank deposits. There are maximum expansion of bank loans and has several medium-sized banks (such as asked the banks not to exceed the amounts Banque Lambert) and a few small banks allowable under the guidelines. For a time that are of importance in specialized fields these recommendations were supported by —such as the diamond trade, public works, a cash reserve requirement of 1 per cent. industrial finance, and consumer credit— as As in previous periods when the National well as some private savings banks and Bank had set credit expansion guidelines some other categories of private credit insti­ for the banks, the appropriate supervisory tutions. authorities applied similar regulations to Public credit institutions, the combined other financial intermediaries. The Belgian assets of which are about equal to those of two-layer discount mechanism (IRG and the commercial banks, have an important National Bank), in which two sets of dis­ impact on the money market and on bank­ ing practices. These institutions include: count rates are used at each level, gives the (1) the Government-operated postal giro monetary authorities great flexibility in con­ system, which has substantial deposit liabili­ trolling the volume, composition, and cost ties that are invested exclusively in Treas­ of central bank credit, while providing a ury securities; (2) a nationwide public sav­ safety valve by making it possible to obtain ings bank (General Savings and Pensions secured advances for very short periods. Fund), which channels savings of individu­

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als into Government bonds, construction, discounting power is limited to paper with and medium- and long-term loans to indus­ maturities of 4 months or less, and its open try; (3) the Belgian Municipal Credit Insti­ market activities are circumscribed by legal tution, which makes loans to local govern­ limitations on the volume of Government ments from savings deposits and the debt it may hold.5 deposits of municipal funds it receives but The Belgium-Luxembourg Foreign Ex­ obtains more than half its funds by issuing change Institute, established in 1944, has bonds; and (4) the National Industrial the ultimate responsibility for the adminis­ Credit Company (NICC), which raises tration of exchange control in the Belgium- funds by soliciting time deposits and issuing Luxembourg Economic Union. The Insti­ Government-guaranteed bonds and in turn tute is under the supervision of the Minister uses these funds to make medium- and of Finance, who exercises such supervision long-term loans to industry. through a commissioner. It is administered Since these public credit institutions keep by a board, the chairman of which is the accounts with the National Bank, their op­ Governor of the National Bank of Belgium. erations affect directly the credit base of the Its day-to-day management is entrusted to commercial banks. The nature of this im­ the National Bank, and its exchange control pact is complex, however, because these functions for most payments and transfers public institutions make sizable purchases are delegated to authorized banks. of bills and acceptances, originated by the Several special official institutions partici­ banks, and place any free balances they may pate in the operation of three of the main have in the day-to-day market. Competition instruments of monetary policy; that is, re­ from public credit institutions has caused discounting and lending on collateral, open commercial banks to enter new fields; for market operations, and the setting of var­ example, the success of the postal giro sys­ ious minimum liquidity and reserve ratios. tem has stimulated the banks to broaden The central bank determines discount their branch-banking facilities, and the policy, while the IRG operates as a primary thriving term-loan business of NICC has discounting facility for certain credit instru­ led them to expand their medium-term loans ments. The IRG was established in 1935 to industry. in an attempt to prevent repetition of the The National Bank of Belgium4 was difficulties of the early 1930’s. At that time founded in 1850 as a joint stock company. the banks were unable to meet demands for The Bank’s activities have been modified by cash by rediscounting with the central bank various laws and royal decrees since 1938. because much of the paper they held was The most important laws affecting the Bank were those of 1948 that permitted the Gov­ ineligible—for maturity or other reasons. ernment to acquire half of the capital stock Capital of the IRG was supplied by the of the central bank and introduced impor­ commercial banks, but it operates as a para­ tant changes in the Bank’s organizational structure. 5 The limit, set in an agreement between the Bank and the Government, was originally 44,333 million The National Bank possesses most of the Belgian francs (B.F.) (including B.F. 34 billion rep­ usual central bank powers. However, its resenting consolidated war debts), plus an amount equal to the Bank’s capital, reserves, depreciation, and pension funds, but was raised by 6.2 billion in 4 Since 1935 the National Bank has also offered September 1968. It will be reviewed after 3 years. some central banking services to Luxembourg (which There are also provisions for a supplemental credit joined in economic union with Belgium in 1921), but line in certain contingencies, such as large withdraw­ not all of these have been used. als from the postal giro system.

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governmental organization, under a board ber of other Government credit institutions, of eight members appointed by the Govern­ largely by rediscounting commercial bills ment.0 and bankers’ acceptances. Trade bills must The Securities Stabilization Fund was bear signatures of three persons or entities established in 1945 to regulate the market known to be solvent (including that of one for long- and medium-term Government Belgian bank) and must meet the National securities by conducting open market opera­ Bank’s standards for quality and maturity. tions in such securities. In 1959 the SSF’s Rediscounts—except those for the IRG— power to engage in open market operations are made for a minimum of 10 days, and was extended to short-term Government discounted bills are kept until maturity. paper. Whereas in the first few years the The Bank consolidated in July 1969 its SSF financed itself primarily by borrowing seven discount rates into two; it also has in the money market, since 1957 it has three different rates on advances. been issuing its own securities to commercial In order for bills and acceptances arising banks and, more recently, to other financial from foreign trade to be eligible for redis­ institutions. counting when they come within 120 days Operations of commercial banks are su­ of maturity (the maximum term legally per­ pervised by the Banking Commission estab­ mitted for central bank discounting), they lished in 1935. It has authority to impose must have been “certified” by the National liquidity and reserve ratios, after obtaining Bank. The Bank’s review is designed pri­ governmental approval; the National Bank marily to assure: (1) that an identifiable has authority to make recommendations for commercial transaction is covered by the those ratios, which are set in the light of paper, and (2) that the term of the paper policy considerations. However, not until is consistent with the period of time needed 1946 did the Banking Commission use its to complete the underlying transaction, authority to set a liquidity ratio; the one set which may range up to several years. Until then was designed mainly to freeze bank June 1970 such certification was “uncondi­ claims on the Government resulting from tional.” Since June 1970, however, the “un­ World War II. That ratio was eliminated in conditional” certification (“visa”) has been 1962. Subsequently the Commission has replaced, in the case of short-term bills and imposed cash reserve ratios from time to acceptances covering exports to other coun­ time. The Commission also has the author­ tries of the European Economic Commu­ ity to impose capital ratios and has done so nity, by a “conditional” certification (“certi­ since 1946. fication”). The main difference between a Public credit institutions are supervised conditional and an unconditional certifica­ by the Ministry of Finance and private tion is that a bill, when granted the latter, savings banks by the Central Office for was charged at once to the bank’s ceiling Small Savings, of which the Governor of (for rediscounts and certified paper) and the National Bank is the president. was certain thereafter to be accepted for re­ discount by the National Bank, whereas, Discounts and advances with a conditional certification, a bill will The National Bank extends credit to com­ be accepted for rediscount by the National mercial banks, to the IRG, and to a num­ Bank only if the bank’s ceiling shows at the 6 While there is no statutory requirement that any time the necessary unused margin. of these members shall be representatives of the Na­ tional Bank, in 1969 three of the board members in Until recently separate discount quotas fact were. for certified bills and for other bills were

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set for individual banks on the basis of bank if they are within 2 years of maturity; their capital and reserves;7 prior to April for bills that mature within the 120-day 1969 these quota ceilings were reached limit, it offers terms that are even more fa­ only in exceptional circumstances and the vorable than those of the central bank. The National Bank had almost never refused to IRG also provides the third name necessary discount bills that satisfied the qualitative to make the paper discountable at the cen­ eligibility requirements. However, in April tral bank. The IRG acts both as broker and 1969 the informal quota system was re­ as principal. It sells to commercial banks placed by a more formal system of ceilings and public credit institutions some of the on rediscounts and certified paper that set paper offered to it.8 a limit on each bank’s ability to borrow Before 1962, 75 to 90 per cent of the from the central bank, either directly or via bills and acceptances certified by the Na­ the market. The new policy instrument also tional Bank were offered to the IRG. Since enables the Bank to influence directly the 1962, when the high liquidity ratios that size of bill holdings that are eligible for re­ had required banks to hold large amounts discounting. of Government securities were eliminated, As a matter of policy, the National Bank banks have found it possible to retain some does not do any direct discount business eligible paper for longer periods in their with firms domiciled in Brussels, but it does own portfolios—sometimes discounting the engage indirectly in such business through paper as it approached maturity. Neverthe­ most of its agencies. These agencies have less, in recent years between 50 and 65 per local discounting committees consisting of cent of the paper certified by the National wealthy individuals who scrutinize and en­ Bank was still acquired by the IRG. Of the dorse (for a fee) the paper offered, and the bills and acceptances acquired by the IRG, Bank relies on the recommendations of both certified and not certified, and not these committees. subsequently sold in the market, the pro­ Advances provide liquidity at a higher portion rediscounted with the National cost than discounts and for very short peri­ Bank has fluctuated between about 45 and ods only. Between 1966 and 1969 advances 80 per cent in recent years. to banks against collateral of Government The IRG also makes a secondary market securities (including Treasury certificates (as an intermediary) for commercial paper and certificates of indebtedness of the SSF) —primarily that which has not been certi­ accounted for less than 2.5 per cent of total fied by the National Bank—with maturities central bank credit. These loans may be re­ ranging from a few days to 5 years. Some paid after 1 day, and the central bank does of the paper traded in this market meets the not allow these credits to be utilized for more than a few days. 8 The IRG also extends credit lines to banks for general use and to finance manufacturing operations, The IRG operates as a rediscounting customers’ receivables, and public works. While origi­ nally only one of its main activities, IRG’s redis­ agency for certified bills and acceptances. It count business has grown in the postwar period to purchases (or rediscounts) bankers’ accept­ become its principal function. The ceiling for these ances and trade bills certified by the central credits, which are not discountable at the National Bank, as established by the directors of the IRG, was increased from 20 billion to 27.5 billion B.F. in 7 The quotas were computed as multiples of capital January 1970. In recent years a relatively small por­ funds for the two main categories of discountable tion of the credits granted have been taken up. The paper: domestic commercial bills and foreign trade IRG charges a commission of V\ percentage point bills and acceptances. The quota for certified bills for for these credits and remits half of this fee for any each bank was communicated to that bank. unused credits.

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requirements of the National Bank and bank, albeit sometimes with a lag) occupy therefore would be eligible for rediscount key positions in the short-term interest rate with the central bank. Although the IRG structure. Since commercial banks tend to does buy commercial paper, it has a ceiling rediscount a portion of their portfolios of on the total amount of noncertified paper bills and acceptances, rediscount rates in and promissory notes of banks that it will the secondary market move with the rates hold. set by the central bank and the IRG. In The IRG finances its operations by bor­ fact, banks often quote interest rates in rowing in the day-to-day market, by redis­ terms of the National Bank discount rate. counting with the central bank, and by sell­ Rates on bank deposits are set by agree­ ing bills either outright or under repurchase ment between the National Bank and the agreement.9 It alone among the day-to-day Belgian Bankers Association. market participants is a borrower only. The The extent to which the specialized agen­ SSF is sometimes a substantial lender and cies can expand rediscounts and open mar­ sometimes a substantial borrower. Other ket purchases without involving central participants are usually small net lenders. bank credit, directly or indirectly, is of (Other Government and quasi-governmental course limited. By providing highly liquid financial institutions, commercial banks, assets to banks and other credit institutions and private savings banks are not allowed and by trading in short- and medium-term to be net borrowers on balance in any commercial obligations (in the case of the quarter (see pp. 213 and 214) and, taken IRG) or Government obligations (in the together, are heavy net lenders.) case of the SSF), the IRG and the SSF The cost of credit available from the have undoubtedly contributed to the devel­ IRG tends to follow market rates. When opment of the money market and of the the IRG has to increase its borrowing from market for commercial paper and Govern­ the central bank, its discount rates tend to ment securities in Belgium. approach the official discount rates. IRG Nevertheless, the ability of the IRG and intermediation adds considerable flexibility the SSF to finance their operations outside to the availability and cost of central bank the central bank—in the day-to-day mar­ credit to the banking system, directly or ket, for example—is immediately depend­ indirectly.10 ent on bank credit and ultimately on cen­ The discount rates set by the National tral bank credit. In Belgium, where almost Bank and the IRG (which generally adjusts 50 per cent of the money supply consists of its rates to conform with rates of the central currency issued by the central bank, the banks have little leeway for credit expan­ 9 Financial commitments of the IRG are limited sion without the support of the central by the amount of the Government guarantee on IRG obligations, which stood in January 1970 at 27.5 bil­ bank. In fact, in recent years operations of lion B.F.; this guarantee covers not only borrowing the IRG and the SSF have been supported in the day-to-day market but also contingent liabili­ ties created by credit lines extended to banks indirectly by the central bank in one way or (whether or not taken up by them), liabilities under another. repurchase agreements, and, most important, the con­ tingent liabilities inherent in its endorsement of com­ Other instruments of monetary policy mercial bills and bankers’ acceptances rediscounted with the central bank. Until recently the monetary tools used, in 10 For example, between July 6, 1964, and June 3, 1966, the official discount rate was not changed, but addition to the discount mechanism, were the schedule of IRG rates was altered 14 times. open market operations and foreign ex­

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change operations and controls. Very little on the “free” foreign exchange market part resort has been made to reserve require­ of the proceeds of the Government’s foreign ment ratios, but liquidity ratios, not used borrowing in an effort to reduce the effects since 1962, were reintroduced for a 1-year of such borrowing on domestic liquidity by period in June 1969. Moreover, since 1969 encouraging capital outflows. Most capital the National Bank has again employed outflows and certain other payments must credit ceilings. The reason is that in cir­ be effected via the “free” as opposed to the cumstances that call for a rapid change in “official” market. The free foreign exchange credit conditions— such as was necessary market, which is fed by the proceeds of in that period—exclusive reliance on the capital inflows, limits capital outflows; any discount mechanism is unlikely to produce official additions to the supply of “free” for­ the desired results with sufficient speed, be­ eign exchange would normally encourage cause the effectiveness of discount policy capital outflows, but the incentive may depends, to a large extent, on the banks’ prove ineffective in periods when tight need to borrow and/or on the elasticity of money markets at home favor borrowing loan demands. In this same period direct abroad. The Belgium-Luxembourg Foreign controls were introduced over the money Exchange Institute also occasionally im­ market. poses controls on the foreign exchange op­ The SSF influences the liquidity of the erations and the net foreign positions of monetary system by increasing or decreas­ banks.11 ing its borrowing from the National Bank Credit ceilings have been imposed on a and by making deposits with, or withdraw­ “voluntary” basis since 1964 by the Na­ ing them from, that Bank. While operations tional Bank on commercial banks and by of the SSF are often quite substantial, a the Finance Ministry on Government credit large portion of these operations usually do institutions and insurance companies. Ceil­ nothing more than release existing bank ings for lending by savings banks are set by liquidity; they do not inject central bank the agency supervising this sector. At var­ credit into, or withdraw it from, the bank­ ious times in recent years, the central bank ing system. has applied direct restrictions on bank Reserve requirement ratios were imposed credit expansion by setting credit ceilings early in 1962, as one of the moves to in­ for individual banks. Related ceilings for crease the central bank’s control powers. Government credit institutions, insurance The Banking Commission has the authority companies, and private savings banks have to set reserve requirements of up to 20 per been set concurrently by other authorities. cent of sight (demand) and short-term de­ Direct controls have been employed re­ posits and up to 7 per cent of other liabil­ cently in the day-to-day (interbank) mar­ ities and savings deposits, if requested to do ket as well. Since this market appeared to so by the central bank. But in fact, this con­ trol tool has been used in Belgium very 11 Most recently, in April 1969, the Belgium-Lux­ sparingly; a 1 per cent rate was in effect embourg Foreign Exchange Institute established a from mid-1964 to mid-1965 only. ceiling for each Belgian and Luxembourg bank for working balances in foreign exchange drawn from The Belgian National Bank has also the controlled market as well as for the amount of been experimenting with foreign exchange Belgian franc advances in convertible accounts to for­ operations as a means of influencing do­ eigners; later in the year the ceiling was reduced and applied separately to the two types of foreign ex­ mestic liquidity. In 1966 for instance it sold change assets.

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be used for more than the very short-term but which lapsed a year later, was the liquidity adjustments it is designed to pro­ “reinvestment” ratio. This ratio was defined vide, directives were issued to banks, public as the relationship between easily negotia­ credit institutions, and private savings ble assets and short-term liabilities of banks requiring that the loans of each insti­ banks. It differed from the “cover ratios” tution to the market must at least equal, abandoned in 1962 because it included during the quarter, its borrowing from the commercial paper. It was designed to in­ market; however, the new ruling does not crease gradually to 60 per cent over a 12- apply to the SSF or to the IRG. month period the percentage of short-term Still another tool, which was introduced Belgian franc liabilities covered by easily by the Banking Commission in June 1969 negotiable assets.

CANADA

Introduction well stated in the following excerpt from a In Canada monetary policy is a major ex­ report submitted by the Governor of the pression of official economic policy, which Bank of Canada to the Royal Commission has an influence on aggregate demand and on Banking and Finance: 12 on flows of capital into and out of the The present arrangements under which such ad­ country. Economic developments and credit vances may be obtained are designed to limit the Bank’s role as lender of last resort to exceptional conditions in the United States are of con­ circumstances and to encourage the chartered siderable importance for Canada, and the banks to use, whenever practicable, alternative maintenance of certain relationships be­ methods of adjusting their cash reserves in the tween Canadian interest rates and those in markets such as calling day-to-day loans or selling securities. the United States is frequently an objective of, as well as a limiting factor on, monetary There are several reasons why the dis­ policy. Nevertheless, interest rate spreads count window has never been an important between the two countries do vary con­ and continuous source of funds for the Ca­ siderably at both the short and the long end nadian banking system and has customarily of the maturity spectrum. There is also con­ been used only for short periods in particu­ siderable scope for differences in monetary lar circumstances. The chief one is that the conditions to occur as a result of variations banks can adjust their cash positions by in the mix of monetary, fiscal, and debt calling loans made to money market deal­ management policies. ers; by selling short-term securities in a The Bank of Canada employs open mar­ well-functioning money market; and to ket operations, two types of reserve require­ some extent, by converting short-term for­ ments, the discount mechanism, and man­ eign assets into Canadian dollars. Other agement of the Government’s cash balances reasons are (1) the concentration of bank­ as its principal tools for carrying out ing reserves in nine branch-banking systems monetary policy. For a number of reasons, in which cash gains and losses of individual as will be discussed below, the banking sys­ branches tend to be offset; (2) the method tem normally makes use of the discount 12 Bank of Canada, Evidence of the Governor of window only as a last resort. The principle the Bank of Canada before the Royal Commission underlying discount policy in Canada is on Banking and Finance, May 31, 1962, p. 148.

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of computing reserve requirements and a nucleus of the system, and they operate relatively long averaging period (one-half over 6,000 branches and/or offices through­ month), which gives the banks considerable out the country. In addition, the financial flexibility in adjusting their reserve posi­ system includes a variety of other institu­ tions; and (3) a reluctance to borrow at tions that carry on certain types of banking the end of a month, in order to avoid show­ business: savings banks; mortgage loan and ing such borrowings in the published trust companies; and credit unions and month-end statement of assets and liabili­ consumer credit companies. Some of these ties. institutions operate nationally, while some The Bank of Canada usually influences serve whole provinces and others more the liquidity of the banking system by open limited areas. market operations in Government securities Until July 1967 the law required the of all maturities and by shifting the Gov­ chartered banks to hold vault cash and/or ernment’s cash balances between its own deposits with the central bank that would books and those of the chartered banks.13 It equal 8 per cent of their total Canadian- can also change the statutory secondary re­ dollar deposit liabilities.14 Under a volun­ serve ratios, which establish the banks’ min­ tary agreement with the Bank of Canada, imum holdings of the total of cash in excess these banks also held a secondary reserve of the cash reserve requirement, Treasury —consisting of day-to-day loans and Treas­ bills, and day-to-day loans. In addition, the ury bills—equal to 7 per cent of their total central bank may influence the behavior of Canadian-dollar deposit liabilities. The two the banks by moral suasion. One recent ex­ reserves brought the liquidity ratio to 15 ample was its request, in 1969, that banks per cent. In addition, the chartered banks make no further upward adjustments in in­ normally held a liquidity cushion consisting terest rates paid for large fixed-term depos­ of additional Treasury bills, day-to-day its. loans, other loans to investment dealers and brokers callable on demand, and a large Institutional framework portfolio of Canadian Government bonds The Bank of Canada, established in 1934 concentrated in the shorter maturity area. and the youngest central bank among those Under the new Bank Act, which became covered by the present study, is vested with law on May 1, 1967, and provided for im­ customary central banking powers. It is plementation beginning July 1967, reserve fully owned by the Canadian Government, requirements (still to be held in the form of and its board of directors is appointed by vault cash or central bank deposits) were the Government. raised gradually between July 1967 and The commercial banking system is highly February 1968 to 12 per cent for demand deposits and lowered to 4 per cent for time centralized. Nine chartered banks form the deposits, and the Bank of Canada’s power 13 Shifting of Government balances by the Bank of to vary them was removed. However, the Canada—with the approval of the Finance Minister —provides a technique for smoothing fluctuations in Bank of Canada was given the power to re­ bank liquidity resulting from payments into and out of the Government’s account at the central bank 14 Actually, the Bank of Canada had the power to and, in addition, serves as an important instrument raise cash reserve requirements to 12 per cent, but it for short-term adjustments in bank reserves. The never used that authority. While a penalty of 10 per share of Government deposits placed with each bank cent per annum is levied on any deficiency in re­ is determined by a formula worked out by the banks quired cash reserves, the banks are careful to avoid themselves. deficiencies.

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quire the banks to maintain their statutory Availability of central bank credit. Although cash reserve requirements over a semi­ rediscounting of commercial paper is an monthly instead of a monthly period. Also, important feature of Canadian banking op­ the Bank of Canada was empowered to erations, commercial banks in fact obtain impose a variable secondary-liquidity ratio central bank accommodation entirely ranging between 6 and 12 per cent of total through advances because they hold a large Canadian-dollar deposit liabilities, to be portfolio of Government securities that they held at the commercial bank’s discretion in can use as collateral. any mix of (1) cash reserves in excess of The Bank of Canada has authority to the minimum requirements, (2) Treasury make advances to banks on such terms and bills, and (3) day-to-day loans; this ratio is conditions as it deems appropriate. It may currently set at 9 per cent.15 accept a wide variety of paper as collat­ Canada has no market equivalent to the eral,17 but in practice all of its advances Federal funds market in the United States. have been secured by Government paper. The chartered banks normally adjust their The Bank of Canada does not put a ceil­ cash positions by calling day-to-day loans ing on commercial bank borrowing from or by disposing of Government securities. the central bank. However, it may reduce These banks also have some scope for ob­ the attractiveness of such borrowing by pro­ taining temporary liquidity from foreign gressively increasing the discount rates on sources by drawing down their foreign as­ consecutive advances in any one half-month sets (consisting mostly of call loans, short­ reserve period. The first advance to a chart­ term securities, and deposits with foreign ered bank in any reserve period (up to a banks) or by increasing their short-term certain confidential amount for each bank) foreign currency liabilities and converting is made at the official discount rate, which the proceeds into Canadian dollars. Re­ is a penalty rate in that it has always been cently there has been increased use of com­ above the rates on day-to-day loans and mercial paper and bankers’ acceptances as short-term Treasury bills. A second ad­ sources of liquidity. vance in the same reserve period, or a re­ Discounts and advances newal of an advance, or an advance in ex­ cess of the amount specified by the Bank of Central bank credit is available to the Canada may bear interest at a negotiated chartered banks and one federally chartered rate above the discount rate. Advances are savings bank through rediscounts and col­ made and renewed for either two or three lateral advances, and to money market business days, at the option of the borrow­ dealers 16 under repurchase agreements. The ing bank.18 Bank of Canada has authority to make short-term advances to the Canadian Gov­ 17 Acceptable collateral, as defined in the Bank of ernment, but in practice such advances Canada Act, consists of Federal and provincial gov­ have been extremely rare. ernment securities; U.K. securities within 6 months of maturity; U.S. Government securities; most bills 15 As with the old Act, deposit liabilities in curren­ of exchange and promissory notes endorsed by a cies other than Canadian dollars are not subject to chartered bank; Canadian municipal securities; secur­ explicit reserve requirements. The new Bank Act (ar­ ities issued by a local school authority (corporation ticle 72) states that the banks must maintain “ade­ or parish trustee); mortgages; gold or silver coin or quate and appropriate assets against liabilities pay­ bullion, or documents of title relating thereto. able in foreign currencies.” 18 In addition, on the last day of any averaging pe­ 16 There are about 15 money market dealers that riod a bank may at its option take an advance for 1 have entered into arrangements giving them the right day provided it had on the previous day a cumula­ to obtain central bank accommodation at their initia­ tive cash ratio at least equal to its required cash tive. ratio for the period.

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Central bank credit to money market dealers. or influence market rates or as a means of Money market dealers may obtain central indicating the views of the central bank bank accommodation by selling Govern­ with regard to changes in economic condi­ ment securities with a maturity of 3 years tions or to a new posture in monetary or less to the Bank of Canada under an policy.19 The main reason for tying the agreement to repurchase the securities discount rate to the weekly bill tender rate within a maximum period of 15 days. The in 1956 was to assure its penalty character; price at which these securities are resold is the resulting gradual changes in the cost of such that the dealers incur a cost equal to central bank credit were thought to be pref­ the so-called money market rate (see next erable to frequent changes by discretionary paragraph) or the discount rate, whichever amounts. Use of the tying technique makes is lower. In contrast to the chartered banks, it possible for the central bank to raise the money market dealers are not required to cost of credit unobtrusively in situations pay interest for any minimum period of when it might be difficult to obtain support time, and the agreements are usually out­ for a discretionary rate increase. Indeed, standing for only a few days. The dealers the tying technique was introduced follow­ are given lines of credit on the basis of the ing a period in which six successive in­ volume of their business and inventories creases occurred within 14 months. and of alternative sources of financing. The However, use of the rigid linkage tech­ credit lines of dealers were designed in such nique amounts to giving up direct control a way as to assure liquidity of the day-to- over the discount rate and substituting there­ day loans through which the commercial for indirect control of the market (Treas­ banks finance the dealers. ury bill) rate to which the discount rate is Level of the discount rate. For the first 20 years of the Bank of Canada’s operations, 19 The Bank of Canada wanted no policy signifi­ cance attached to these adjustments in its discount the discount rate was of little significance; it rate and hoped to minimize any disruptions to the was changed only three times. However, economy that changes or expectations of changes might cause. According to a press release issued at after a short-term money market developed the time of the institution of tied rates: in 1954 and the use of advances rose sub­ . . . the bank rate is not changed arbitrarily or with a view to bringing about other interest rate changes. stantially under tightening credit conditions, On the contrary, it has been desired since the develop­ ment of the money market . . . that the bank rate the Bank of Canada raised the rate quite should be kept in line with other interest rates and should move when they do, but not usually otherwise. often in order to keep it above market The present technical change in the method of setting the bank rate from week to week is intended to rates. Then in 1956 the Bank of Canada clarify this relationship and remove what has evi­ shifted to an automatic technique for set­ dently been a source of some public misunderstanding. Four years later this opinion still prevailed. The ting the discount rate, which came to be Governor of the Bank of Canada wrote in the known as the “tied rate.” From then Bank’s Annual Report for 1960: It will be apparent that there is no past history in through mid-1962 the Bank of Canada’s Canada of having changes in the bank rate made with discount rate was fixed weekly at a margin a view to influencing other interest rates, or as a means of indicating the views of the central bank with of lA of a percentage point above the latest regard to changes in economic conditions or monetary policy. The Bank’s view has been that moving the weekly tender rate for 91-day Treasury bank rate would not be the best method of giving such indication, which if they were to be given at all, bills. This method of setting the discount would be the subject of public statements. rate is unique in the history of central By pegging the discount rate in this manner, the Bank of Canada appeared to avoid using the rate for banking. policy purposes. This impression was convenient at a The tying of the discount rate in Can­ time when monetary constraint was being aggres­ sively used for the first time, and when the Bank had ada reflected a central bank philosophy that come under strong criticism for causing the substan­ the discount rate should not be used to lead tial rise in Canadian interest rates.

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tied. Because the Bank of Canada could purchase agreements with money market substantially influence the bill rate (and thus dealers at the money market rate (which the entire structure of short-term rates) by is still set weekly by the central bank at lA affecting the bank’s cash reserves and by of a percentage point above the 91-day varying the amount of Treasury bills it pur­ Treasury bill rate) or at the official Bank chases at the weekly auction, it in effect rate, whichever is lower. Since the 91-day kept a good deal of indirect control over Treasury bill rate has always been kept the bill rate, which automatically deter­ below the official Bank rate, money market mined the discount rate. During the period dealers have had to pay what in fact was a in which the discount rate was tied, the penalty rate. Bank of Canada had a substantial portfolio The rationale behind the use of a dou­ of Treasury bills, and actually it did not ble-base discount rate is that such a rate follow a neutral policy with regard to the gives the central bank more operating flexi­ rate (as it would have by merely rolling bility. There may be times, for example, over its bill portfolio). when the central bank would like to have While indirect management of the dis­ short-term rates move down without having count rate proved effective in normal per­ to take an overt action that might be con­ iods, it became clear that an immediate, sub­ strued as signaling a shift in the basic direc­ stantial increase in the cost of money could tion of monetary policy. In these circum­ not be achieved through this device; such a stances the use of a separate money market need had developed in June 1962, when discount rate assures money market dealers the authorities had had to take steps to that they will obtain central bank credit at counteract a threat to the exchange value of rates close to current (and declining) the Canadian dollar. Hence indirect man­ money market rates rather than at the un­ agement was abandoned at that time as changed (and higher) discount rate, which part of a program to deal with a foreign ex­ would tend to counter the downward pres­ change crisis. sures on short-term rates. Obviously, if in The Bank of Canada has concluded times of rising interest rates the spread be­ since then that a discount rate that is set tween the official discount rate and the by the Bank provides an important element Treasury bill rate becomes less than V\ of 1 of stability in the structure of money mar­ percentage point, the dealers will opt to get ket rates that had been missing during the cheaper accommodation at the official rate, era of the tied discount rate. When changes and therefore the double-base discount rate in the rate are being contemplated, discus­ would in effect become a single rate. sions between the Bank of Canada and the The official discount rate was set at 6 per Government may bring consideration of cent in 1962, following a serious crisis in monetary policy into sharper focus. On foreign exchange markets, as part of a com­ some occasions, changes in the discount rate prehensive stabilization program designed merely confirm basic policy changes that to restore equilibrium in Canada’s balance have been affecting market interest rates for of payments. Subsequent changes in the a considerable period. Bank of Canada’s discount rate have been Since the return to a fixed discount rate made quite frequently, for both internal in June 1962, central bank credit has been and external reasons, including the interest available at two different rates. The Bank sensitivity of private capital flows between extends advances to the chartered banks at the United States and Canada. the official Bank rate, and it enters into re­ There is no direct link by law or custom,

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and therefore no fixed spread, between the rates was lifted to 7 'A per cent for the central bank’s discount rate and the loan balance of the year and was eliminated al­ and deposit rates of commercial banks. together after January 1, 1968. However, until May 1, 1967, commercial Quantitative role of central bank credit. Be­ bank rates were limited under the Bank Act tween 1958 and 1970, the yearly averages to a rate of interest or discount no higher of commercial bank borrowing from the than 6 per cent per annum on domestic central bank outstanding on weekly report­ loans.20 Thus, rates of more than 6 per cent ing dates ranged from 0.001 per cent to in the money and capital markets tended to 0.260 per cent of the chartered banks’ re­ cause pressures on the chartered banks, quired reserves. During the same period which on such occasions were faced with similar yearly averages of Government se­ difficult problems of nonprice rationing. curities held by the central bank under re­ Testifying at the hearings of the Royal purchase agreements with money market Commission on Banking and Finance in dealers ranged from $2.4 million to $15.3 1962-63, Governor Rasminsky pointed out million (Canadian); as a proportion of the disadvantage of interest rate rigidities in chartered banks’ required reserves, such financial markets and indicated his opposi­ holdings ranged from 0.24 to 1.38 per cent. tion to a direct statutory linkage between During the same period the ratio of com­ the central bank discount rate and commer­ mercial bank borrowing at the central bank cial bank lending or deposit rates. Under to their loans to the private sector averaged the new Bank Act, effective May 1, 1967, less than 0.03 per cent. For very short peri­ the ceiling on commercial bank lending ods central bank credit has of course been much more important in cash reserve and 20 To some extent the banks had avoided this limi­ money market adjustments than these an­ tation by using various service charges. nual average figures suggest.

FRANCE

Introduction largely by increases in official holdings of France, like most other continental Euro­ international assets. In the 7-year period pean countries in which international trans­ 1961—67, during which there was a reversal actions play a major role in domestic in France’s external payments position, monetary and credit conditions, has found official holdings of international assets tre­ that regulation of the cash base of the bled and accounted for nearly four-fifths of banking system is complicated by the effect the expansion in the cash base. During of external influences on bank liquidity. 1968 and most of 1969, official holdings Prior to accepting convertibility, the banks’ declined and thus had a restrictive rather cash base had been enlarged mainly by dis­ than an expansionary effect on the cash counting at the Bank of France, or by some base. Because it is difficult to reduce or very large loans by the Bank to the Gov­ offset bank liquidity brought about by sur­ ernment. pluses on international transactions, French During most of the time since 1958, the monetary authorities tend to rely heavily on expansion of the cash base of the banking direct controls over bank credit expansion system in France has been brought about to deal with inflationary pressures.

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In periods when curtailment of inflows of oped state of the money and capital mar­ foreign funds became a major policy objec­ kets. And (5) progress has been made to tive, the central bank tended to keep the simplify the discount rate structure of the banking system supplied with enough cash Bank of France. All of these changes affect to maintain money rates in Paris at low lev­ in some way the regulation of discounting els relative to those in major centers at the Bank of France, which is basic to the abroad. For this purpose, policy instruments French system of monetary controls. developed to control discounting were used Discounting at the Bank by the bank­ and refined in various ways; however, open ing system, which includes public and semi­ market operations of the kind employed in public financial institutions, is restricted by the United States have never been used to a system of ceilings and liquidity ratios and supply funds to the banks in France. Such by a prior authorization procedure. Since success as has been achieved in restraining discounting within ceilings is considered a inflows of foreign funds is attributable to right rather than a privilege, however, com­ employment of other monetary policy in­ mercial banks always have available what struments to minimize money market strin­ is, in effect, a line of credit at the central gencies that might attract funds from bank. However, there have been numerous abroad, rather than to regulation of the for­ changes since the early 1950’s in regula­ eign exchange position of banks or to pro­ tions designed specifically to achieve quan­ hibition of payment of interest on foreign- titative limitations on expansion of bank owned franc balances. credit. Because existing monetary policy In order to keep discounting within instruments were not well adapted to the bounds, all discounts above ceilings, un­ relatively new situation of large payments less they fall into an exempt category (see surpluses, and for other reasons, French p. 231), are made at a rate that at times is monetary authorities have made several im­ much higher than the ordinary discount portant changes in policy instruments and rate. Since 1968 the differential has been banking regulations in the last several 2V2 percentage points.21 In recent years the years: (1) Cash reserve requirements were Bank of France has supplied liquidity to introduced to supplement and eventually re­ banks with the objective of keeping market place required liquidity ratios. (2) The rates below this ultimate penalty rate and number of channels through which the cen­ —as indicated earlier—within a range that tral bank may funnel credit has been some­ is compatible with the objectives of reduc­ what reduced, and the related structure of ing inflows of speculative short-term foreign rates has been simplified. (3) Efforts have funds. been made to reduce the importance of For a long time flexible liquidity ratios, discounting commercial bills as a means of under which bank exemptions from dis­ obtaining credit at the Bank of France. (4) count ceilings were limited first to Treasury Efforts have also been made to develop an bills and later to a considerably wider vari­ active market for short-term Government 21 From 1951 through 1967 banks could discount securities so that the Bank of France can up to 10 per cent above their ceiling at an intermediate penalty rate called the “hell” rate. The engage in open market operations, which for highest levels at which the two penalty rates, “hell” years have been inhibited by long-standing (enfer) and “superhell” (super-enfer) , were set were 8 and 12 per cent, respectively, in 1958 when the taboos against central bank lending to the discount rate was 5 per cent. In December 1967 the Government as well as by the underdevel­ two rates were combined into a single penalty rate.

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ety of paper, were used as an important affect its own operations— mainly decisions tool to control access to the discount win­ related to rates and terms for discounts dow and to facilitate adjustment of the and advances. In these matters the NCC banks’ cash positions. Until recently, they may only advise the Bank. On the other were manipulated in conjunction with spe­ hand, matters that require action by the cial techniques at the discount window that banks— as for example, maintenance of li­ had been developed to avoid end-of-month quidity ratios— are technically the responsi­ stringencies. One such ratio is still in force, bility of the Council, which is concerned but it is scheduled to be gradually reduced with banking procedures. In practice, the and ultimately abolished. Council acts through the Bank of France as The discount mechanism has been used agent. also as a means of selective credit control In addition to being responsible for mon­ —in particular to support medium-term etary and banking control measures, the financing of expenditures for housing and NCC provides a medium for coordination industrial equipment and of exports. Quali­ of views on the objectives and techniques of tative credit controls in France make use of monetary policy. In this process the Bank moral suasion and of a procedure of prior of France provides leadership, but ultimate authorization by the Bank of France to responsibility rests with the Government. make certain credits automatically eligible The influence of the Bank of France de­ for discount. pends to a large extent on the personality of its Governor. Institutional structure A similar working relationship exists be­ Monetary authorities. Responsibility for tween the Bank of France and the Banking formulating monetary policy is shared by Control Commission, which was set up by the Bank of France and the National Credit the nationalization law primarily to admin­ Council (NCC), which was established by ister liquidity ratios of the banks. The the 1945 law that nationalized the Bank of members of the Banking Control Commis­ France and the four largest commercial sion are the Governor of the Bank of banks. The President of the Republic ap­ France, who is its ex officio president, two points the Governor (and two deputy gov­ representatives of the Government, one rep­ ernors) of the Bank of France. The presi­ resentative of the commercial banks, and dent of the NCC, which has 44 members, is one representative of bank employees. the Minister of Finance. However, the Structure of the banking system. The princi­ Governor of the Bank of France is the de pal types of credit institutions that are clas­ facto head of the Council and is generally sified as banks in France can be grouped the presiding officer at its meetings. In ad­ into three categories: (1) banques de dition to these two officers the NCC con­ depdts (deposit banks); (2) banques sists of representatives of several Govern­ d'affaires (investment banks); and (3) ment departments, of public and semipublic other financial institutions. Some of the lat­ financial institutions, and of various eco­ ter are organizations of a limited scope and nomic and social interests; it has its own of a specialized nature, and as such they small secretariat drawn from the staff of the are supervised by a ministry responsible for Bank of France. their particular area of activity. The most Technically, the Bank of France has pri­ important institutions in this category are mary responsibility only for decisions that the banques populaires (cooperative credit

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societies catering to the banking needs of medium-term credit banks are under the ju­ small manufacturers, traders, and artisans) risdiction of the Banking Control Commis­ and the caisses de credit agricole (agricul­ sion and are known as the “registered tural credit cooperatives). The cooperative banks.” Their assets comprise nearly 80 per banking societies and the agricultural credit cent of the assets of the banking system as cooperatives have their own central dis­ a whole.23 count institutions (the Caisse Centrale des The distinction established in 1945 be­ Banques Populaires and the Caisse Nation- tween deposit banks, which could not ac­ ale de Credit Agricole, respectively). The cept deposits with a maturity of more than Caisse Centrale de Credit Cooperatif is the 2 years, and investment banks, which could central institution of nonagricultural co­ not accept deposits with a maturity as short operative credit institutions. as 2 years, was virtually eliminated on Jan­ Several other public intermediate financ­ uary 1, 1966. (However, the two types of ing institutions that do not accept deposits banks remain subject to different regula­ play a very important role in the French tions with regard to investments in shares.) banking and credit system and have dis­ The deposit banks perform all, and the in­ count privileges at the Bank of France.22 vestment banks some, of the functions that They include the Credit National, which would be classified in the United States as provides long- and medium-term financing commercial banking. French investment to public and private enterprises from funds banks also engage in the same types of ac­ acquired primarily by the issuance of bonds tivities as do investment banks in the and which also endorses medium-term United States. The seven discount houses equipment paper, thus satisfying a require­ are classified as deposit banks. The four ment for making this paper discountable at largest deposit banks, as already noted, the Bank of France; the Caisse Nationale were nationalized in 1945, and two of them des Marches de I’Etat, which guarantees were merged in 1967. The three national­ credit granted for the purchase of equip­ ized banks, which together account for ment by public and private enterprises; the about one-half of total assets of all banks, Credit Fonder de France, with its subsidi­ are managed very much in the same way as ary, the Comptoir des Entrepreneurs, both privately owned banks, and they compete of which grant mortgage credit from funds among themselves for all types of business. derived primarily by the issuance of bonds; The nonnationalized deposit banks include and the Caisse Centrale de Credit Hotelier, establishments located in Paris (including a Industriel et Commercial. Another institu­ few with branches outside the city) and re­ tion that does not accept deposits is the gional and purely local banks, as well as Banque Frangaise du Commerce Exterieur, foreign banks. Practically all the investment which finances foreign trade on its own ac­ banks are located in Paris. count and also assists other banks in such financing. All deposit, investment, and long- and 23 At the end of 1969 the Banking Control Com­ mission was supervising 237 French banks in Metro­ politan France, with resources of 272 billion francs 22 Additional financial establishments that may ($49 billion), of which 191 were deposit banks, 18 make loans but that do not accept deposits from the were investment banks, and 28 were long- and medi- public include the following main categories: societes um-term credit banks. In addition, the Banking Con­ fnancieres (financial societies, which do mainly an trol Commission had under its jurisdiction 9 French investment management business), stock brokerage banks operating overseas, 51 foreign banks in houses, and instalment credit firms. France, and 9 banks in Monaco.

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Savings institutions (caisses d’epargne) principle open an account for discounting have no direct access to central bank credit. purposes at the Bank of France, and in However, nearly all of the funds collected practice many banks have additional ac­ by the savings institutions, which include counts for their main branches. The “autonomous” savings banks, many of Banque Franqaise du Commerce Exterieur which are sponsored by municipalities, and may also discount directly with the Bank of the nationwide Postal Savings System are France. A cooperative credit society may deposited with the Caisse des Depots et have an account for discounting purposes at Consignations, which reinvests them in ap­ the Bank of France, but individual agricul­ proved securities; hence, in the normal tural credit cooperatives may not.24 course of their business, savings banks have Types of liquid assets held. The types of no need to discount their assets. The short-term assets acquired by French banks Caisse also manages the liquid funds of the to meet their needs for liquidity depend to social security system and the reserves of some extent upon the kinds of business that pension funds. It has access to central the banks are permitted to conduct, upon bank credit. the standards of eligibility for discounting Among these institutions, only the or for obtaining advances from the Bank of Comptoir des Entrepreneurs (which sup­ France, and upon the kinds of paper the plies credit to contractors of major public Bank may purchase on the open market. works projects) is a substantial discounter Prior to the end of 1967, when they were with the Bank of France of paper that it abolished, two separate liquidity ratios were originates; the others merely rediscount imposed by the NCC to control the liquid­ paper that has been previously discounted ity of banks. The first prescribed minimum with them by banks or their member insti­ holdings of Treasury bills (planchers); the tutions. Thus, in effect, there is a two-tier other, minimum holdings of a broader discounting system—with specialized dis­ range of liquidity instruments (coefficient count institutions dealing with a large num­ de tresorerie). These ratios constituted an ber of primary credit institutions, mostly of additional and important tool of credit con­ local or regional significance, and discount­ trol (see below). ing credits with the Bank of France, as About 80 per cent of all commercial needed. In some cases, however, they dis­ bank credit in France is extended in the count their own short-term notes drawn form of discounted trade bills. Largely as a against a portfolio of discounted medium- result of the heavy reliance by banks upon term paper. the Bank of France as a source of loanable Indeed, an outstanding characteristic of funds, and the conditions imposed by the the French banking system is its heavy reli­ Bank for such accommodation, a major ance for liquidity upon discounting, either part of commercial banks’ business consists at the Bank of France or at the public fi­ of discounting short-term bills. These banks nancial institutions. This circumstance had extend credit to the private sector largely in its origins in the traditional willingness of the form of discounts of commercial bills, the Bank of France to discount freely and acceptances, warrants, and cross endorse­ in the high proportion of currency in the French money supply, which makes the 24 For many years the Bank has not accepted new banks quite sensitive to liquidity drains. All private customers, and for about 15 years it has dis­ couraged credit demands from its remaining private registered banks, as already noted, may in customers—mainly nonbank, nonfinancial enterprises.

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ments of promissory notes, all of which are has been to direct bank credit into ap­ described in French banking statistics as proved uses and to control its expansion. In “discount of bills.” At the end of 1968 mid-1964, keeping money market rates “private paper” (autres effets) constituted below the level that would attract inflows of almost half of the total assets of regis­ funds from abroad became another major tered banks. At the large deposit banks this objective. With the development of a cur- ratio was somewhat higher, and for invest­ rent-account deficit in 1966 the emphasis ment banks it was slightly more than 40 shifted to keeping capital from flowing out, per cent. and subsequently interest rate policy has A considerable part of private paper con­ been guided by balance of payments con­ sists, however, of loans to Government- siderations. owned enterprises, such as railroads, air­ At first French monetary authorities craft factories, and so forth. At the end of sought to control expansion of bank credit 1968, short-term Government securities by restricting its monetization through ceil­ made up less than 1 per cent of the total ings on central bank credit and by use of assets of registered banks; cash and deposits liquidity ratios designed to neutralize war­ with the Bank of France and the Treasury, generated liquidity. But in 1958 ceilings 3 per cent. Most of the nonliquid assets of were introduced and used intermittently to the deposit banks were advances and over­ control directly the expansion of bank drafts. Customers are expected to use over­ credit to the private sector.26 drafts only to meet marginal requirements Discount ceilings. The first step toward because such credits cannot be the basis for generalized credit control was the introduc­ obtaining central bank credit. tion in September 1948 of ceilings on dis­ Other than resorting to the central bank counting at the Bank of France at the basic directly, individual French banks can in­ discount rate. Originally the ceilings were crease their domestic short-term (under 1 placed on each bank’s account for discount­ year) borrowing only through the Paris ing purposes at the Bank of France, but as money market. The main suppliers of funds it turned out they were effectively restrictive to the money market are the commercial for small banks only. banks, stockbrokers, the various semipublic Discount ceilings for individual banks institutions that manage large amounts of were initially set at approximately the level funds, and the Bank of France (see of discounts outstanding on September above). The banks at times do discount at 30, 1948. But since then the global ceilings the Bank of France within discount ceilings have risen because of adjustments in the for the purpose of supplying the funds so ceilings of individual banks, and on a few acquired to the money market. French occasions the ceilings have been raised banks may also borrow abroad.23 across-the-board for reasons of over-all policy.27 Several years ago each bank’s dis­ Instruments of monetary policy count ceiling was fixed on the basis of a During most of the postwar period a princi­ complex formula that took into considera­ pal objective of monetary policy in France tion mainly a number of quantitative fac­

25 Until Jan. 31, 1967, they were required to main­ 26 Such ceilings were in effect for about a year, tain a balanced position in foreign exchange on spot and then again from February 1963 to June 1965. and forward combined. Their claims in a given for­ After being formally abolished in February 1967, eign currency, vis-a-vis both residents and non­ bank credit ceilings were reintroduced for the period residents, were required to be equal to their liabilities October 1968 to October 1970. in the same currency. 27 Most notably, the discount ceilings were raised

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tors such as deposits, assets, and capital ac­ of the medium-term credit instruments dis­ counts; these formulas are changed very counted by them. infrequently and do not reflect the relative Liquidity ratios. Prior to 1967, banks were growth of each bank. At first banks were not required to keep any particular cash re­ required to bring their discounts within serves, but they were subject to two related the ceilings only at the end of the month, liquidity ratios. These ratios had essentially but since 1951 they have been required to the same initial purpose: to force banks to keep within the ceilings at all times. hold assets that could otherwise be mone­ Several kinds of paper are exempt from tized to provide the basis for an excessive discount ceilings: in particular (1) bills expansion of credit— in the first case by representing medium-term credit to finance discounting such assets or by letting the housing, industrial equipment, and exports short-term Government securities run off, (approved through the prior authorization and in the second, by discounting at the procedure; see below), (2) grain storage Bank of France outside of ceilings.28 bills, and (3) short-term foreign trade bills. For nearly two decades the so-called Most types of paper representing medium- Treasury bill “floor” (plancher), instituted term credit must be discounted first with in 1948, was used to immobilize banks’ one of the intermediate financing agencies large holdings of Treasury bills, inherited in before becoming eligible for rediscounting the main from World War II and from at the Bank of France. The exemption from early postwar deficits. Banks were required discount ceilings of certain categories of to hold Treasury paper in an amount not credit serves to promote the flow of credit less than 95 per cent of their holdings of into such activities deemed to deserve pref­ such paper as of September 30, 1948, and erential treatment. The Bank of France re­ to place 20 per cent of the subsequent in­ quires as a condition for discounting that crease in their deposit liabilities in such se­ its prior authorization be obtained for bills curities. The liquidity ratio was fixed at a representing purely financial transactions uniform 25 per cent of deposit liabilities in and for certain types of medium-term 1956 and was reduced to 20 per cent in paper. 1961. Since this Treasury paper was of a When the system of making medium- type reserved solely for financial institutions term credit discountable at the Bank of 28 For purposes of safeguarding the solvency of France was introduced in the early postwar banks, a different agency, the Banking Control Com­ mission, prescribes a ratio of liquid assets to short­ years, it was expected that the intermediate term liabilities (rapport de liquidite). It defines liquid financing agencies, which are collectors of assets for this purpose as cash; deposits with the Bank of France and the Treasury; deposits with savings, would hold the bulk of this credit banks and correspondents (including call loans); to maturity. Claims upon the resources of Treasury bills and similar securities drawn on or guaranteed by certain Government agencies; bills and these agencies were so great in the 1950’s, acceptances discountable at the central bank; coupons however, that the agencies were constrained collectible and in suspense accounts; claims on for­ to pass on to the Bank of France the bulk eign exchange dealers and stockbrokers; subscrip­ tions to securities; securities that are eligible to guar­ antee advances from the Bank of France; and other by nearly 25 per cent in the inflationary period of securities that are traded on the public securities 1955-57 and then lowered by about 35 per cent in markets. The last item may comprise at most only 5 the second half of 1957 to offset the monetary effects per cent of short-term liabilities. This scheme was in­ of new advances granted by the Bank of France to tended to apply to all classes of banks, but a specific the Treasury at that time. From 1957 to the end of ratio (60 per cent) has been prescribed only for the 1959 the discount ceilings were stable at a level of deposit banks. It is expected that the investment about 4.3 billion francs. By the end of 1969, they banks will be made subject to the liquidity ratio had risen to 9.6 billion francs. later.

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and yielded considerably less than other In addition to exemption from discount Treasury bills, which were designed for sale ceilings, export credits have benefited from to the general public, the plancher pro­ a preferential discount rate of 3 per cent duced a rather important and cheap source since 1957. At the end of 1960, just before of funds for the French Treasury. An im­ the inauguration of the coefficient, banks provement in Government finances made it held nearly 5 billion francs of this paper possible to reduce gradually (between 1961 discountable at the Bank of France outside and 1966) the Treasury-bill-floor require­ of the ceilings; hence they were in a position ment, which French monetary authorities to almost double the volume of their dis­ had long regarded as providing the Treas­ counts without having to pay the “hell” ury with an inflationary source of financing. rate. The coefficient forced the banks to The floor was abolished effective September hold about 90 per cent of this otherwise 1, 1967. discountable paper in their portfolios, al­ In 1961 an additional liquidity ratio, the though the Bank of France, in exempting coefficient de tresorerie, was introduced.29 this paper from the ceilings, had given an It required the banks to hold a percentage implicit commitment to discount it. of their deposit liabilities in certain liquid The coefficient was a powerful tool for assets—including cash, Treasury paper held controlling access to the discount window; to meet the floor ratio, and those kinds indeed, when in use it was regarded as the of paper that could be discounted at the principal instrument for controlling the li­ Bank of France outside of the banks’ ceil­ quidity of banks. While the main purpose ings. The coefficient had an upper limit of was to prevent excessive use of Bank of 36 per cent, and its lower limit was the France credit, the ratio was frequently low­ floor ratio for Treasury bills, but in fact the ered by a few points in order to allow the coefficient was varied only between 30 and banks greater access to the central bank in 36 per cent. Thus, as the banks were al­ periods of tightness due to temporary fac­ lowed to reduce their holdings of Treasury tors, such as end-of-month cash drains. bills, they were required to hold larger Such temporary reductions served to keep amounts of medium-term or other paper ex­ money market rates from rising above a empt from discount ceilings. level that would attract inflows of funds The institution of the coefficient consti­ from abroad. While this liquidity ratio was tuted a technique for immobilizing desig­ originally intended to be both a credit- nated types of credit at the banks. In effect, rationing device (with preferential treatment this provision compelled banks to allocate a for Government securities) and a quantita­ certain percentage of their resources to tive credit-control device (since it limited loans or investments designated as eligible the discounting of medium-term paper), in for inclusion in the coefficient. Only paper 1965 and 1966 it was used primarily for held above the level required to satisfy the short-run quantitative control purposes. (In coefficient could be discounted at the Bank 1966 alone it was altered eight times.) of France; making it discountable outside Although formally abolished in January the ceiling was another way of giving such 1967, the coefficient de tresorerie was re­ credits preferential status. placed at that time by a similar liquidity ratio known variously as the coefficient de 29 Although the coefficient de tresorerie could have been fixed separately for each class of bank, the retenue or the portefeuille minimum and in­ same ratio was applied to all classes. itially set at 14 per cent. Since the abolition

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of the coefficient de tresorerie left banks twice—by 1 percentage point each time— with considerable holdings of medium-term against both demand and time deposits (to credits discountable at the Bank of France 7.5 and 2.5 per cent, respectively, as of outside their discount ceilings, the new July) in an effort to offset balance of pay­ ratio, which requires the banks to hold a ments surpluses. portfolio of such medium-term credits equal In February 1971, institution of an addi­ to a certain percentage of their liquid liabil­ tional reserve requirement against credits ities, was designed to prevent banks from granted was announced, but no immediate making immediate use of this excess liquid­ use was made of this new power. This re­ ity. It is the intention of the Government to serve requirement may be imposed on finan­ reduce, and ultimately abolish, the porte- cial institutions that do not accept deposits feuille minimum as increasing reliance is as well as on banks. placed on discount ceilings and cash re­ Open market operations. Prior to January serve requirements to control bank liquid­ 1967 the Bank of France used two kinds of ity. However, in 1969 and 1970 the Gov­ supplementary accommodations to cushion ernment twice increased the minimum in short-run fluctuations in bank liquidity. response to financial developments, and it While both were referred to as “open mar­ appears that final abolition is not contem­ ket operations,” neither involved a market plated for the foreseeable future. process that would allocate funds or set the Cash reserve requirements. Liquidity ratios rate. In both cases, credit was channeled were designed primarily to control pressures through discount houses, for very short pe­ at the discount window, and they have riods, at a cost set by the central bank. been fairly successful in doing that. As the Each bank used one specific discount house major means for such control, however, for its operations in the money market, in­ they were replaced in 1967 by legal reserve cluding interbank sales of funds and “open requirements, which became fully effective market” operations with the Bank of France. in October of that year, and the provisions One technique was used to meet the of portefeuille minimum were designed as a day-to-day needs for funds of about 50 transitional arrangement. Under the new leading banfer, which had been given an system the Bank of France may require open market “limit” (or quota) at the banks to maintain at the central bank cash Bank of France in addition to the dis­ balances of as much as 10 (later raised to counting quotas (or ceilings). Each such 15) per cent of their deposit liabilities. bank could obtain automatically additional In introducing the system of legal re­ Bank of France credit at the basic discount serves, the Finance Minister gave three rea­ rate up to a limit that in practice was set at sons for the change: (1) alignment of about 10 per cent of the bank’s discount French monetary control techniques with ceiling. Such drawings took the form of those in other major countries; (2) removal sales to the Bank under repurchase agree­ of major constraints on the kinds of assets ment of paper already in the Bank’s cus­ that banks may hold; and (3) desirability tody. These en pension sales, which were of developing a free market in Government negotiated through the discount houses on securities, a necessary precondition to mak­ behalf of individual banks, actually consti­ ing Paris a major European capital market. tuted an additional line of central bank In 1970 the central bank began to use this credit. tool more vigorously. It raised requirements The other kind of “open market opera­

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tion” was used solely to meet end-of-month from mainly facilitating the placement of strains in the money market when cash Treasury bonds and thereby providing more withdrawals for the payment of wages, sala­ flexibility to bank liquidity, to regulating ries, and rents tended to reduce the liquid­ bank liquidity on a day-to-day basis with ity of the banks. The technique was similar more precision than is possible with other to that described above, but only 10 to 12 monetary instruments. of the most important banks were involved; In the fall of 1968, the Bank of France the rate for such exceptional accommoda­ rationed the banks’ access to its open mar­ tion, which on occasion reached a substan­ ket window so as to moderate credit expan­ tial volume, was usually set by the Bank sion. This led to the establishment of a above the basic discount rate. Using esti­ parallel interbank market for short-term mates of sources and uses of funds, supple­ loans, a sort of Federal funds market, and mented by personal contact with the at that time the day-to-day rates in that discount houses and the banks involved market were considerably higher than the (which absorb 85 per cent of the funds Bank of France’s rate. The interbank mar­ made available), officials at the Bank of ket is still active, but the rates are identical France made projections of the volume of to those posted by the Bank of France. funds needed at the end of the month and As a result of its more active interven­ asked banks to deposit the necessary collat­ tion the Bank of France has begun to exer­ eral. cise considerable influence on money market Unlike the Bank’s rates for regular oper­ rates. The Bank most frequently acts as a ations, which are fixed in advance and re­ lender, but on occasion it also absorbs ex­ main unchanged for long periods, the rates cess liquidity. Since the suspension in 1967 charged for end-of-month repurchase oper­ of the banks’ right to negotiate certain bills ations were fixed by the Governor on a at the discount rate, the central bank has day-to-day basis. Although both kinds of intervened exclusively at the prevailing mar­ operations were always used to ease money ket rate. Until June 1968 it used a single market pressures and were ostensibly at the rate in all open market operations; since initiative of the banks, in the second kind then, separate rates have been set for private of operation the Bank of France took the paper and Treasury paper, with the rate initiative in estimating the amount of funds for the former usually Vs of 1 percentage needed to keep market rates within the de­ point higher than that for the latter. sired range. During the first few months of 1971, the The central bank’s right of intervention intervention rate was set below the basic was limited to short-term Government and discount rate, and as a result, banks began private bills admissible to discount. How­ to borrow from the money market before ever, in December 1966 a decree extended reaching their ceiling at the discount win­ its operations to bonds and medium-term dow. This has led the Bank of France to bills issued by credit institutions with a enlarge the list of paper eligible for the special legal status; subsequently, the list of money market. eligible bills was further expanded. Quantitative restrictions. Direct restrictions Starting in January 1967 a number of on certain kinds of credit were abolished other modifications were made in the Bank in February 1971. Until then such restric­ of France’s open market operations. The tions had also been an important instrument Bank’s objectives have gradually changed of monetary policy in France. Credits to the

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nationalized industries were restricted to the dure have been in directing credit into ap­ level of 1958 by the Caisse Nationale des proved channels. Marches de VEtat, whose endorsement is Discounts and advances required to make such credits negotiable. Residential construction credits were re­ Access to central bank credit. Bank of stricted by a 1964 agreement—signed by France credit for the purpose of financing the Minister of Finance, the Governor of the or refinancing the private sector may be ex­ Bank of France, and the Governor of the tended in various forms. The techniques Credit Fonder— according to which special used include (1) discounts of Treasury construction loans outstanding were to be securities and specified types of private progressively reduced and new authoriza­ short-term paper held by banks, other finan­ cial establishments, and public and semi­ tions for such loans were to be held within public financing institutions as well as by an annual ceiling.30 Direct restriction ap­ businesses; (2) purchases of short-term (up plied not only to certain categories of loans to 2 years) private and Treasury paper, but also to the volume of credit extended with or without the seller’s agreeing to re­ by the entire banking system to any individ­ purchase; and (3) advances to the public ual borrower (see p. 232, footnote 35). as well as to banks against collateral in the Moral suasion. Direct Government owner­ form of certain long-term securities of Gov­ ship of large segments of industry as well as ernment agencies or certain Government- of commercial banking and of the various sponsored borrowers. From 1935 until specialized institutions in the field of medi­ the end of 1967, banks could obtain ad­ um-term credit offers various opportunities vances for up to 30 days, against certain for implementation of official policies. To short-term public securities as collateral. As relate credit policy to over-all goals of Gov­ already described, discounting by the bank­ ernment economic policy, the Commissioner ing system, including the public finan­ General of the National Economic Plan is­ cial institutions, is subject to a system of sues credit guidelines on behalf of the ceilings and liquidity ratios and, in some NCC. For example, a directive issued on cases, to a procedure requiring prior au­ September 12, 1963, asked that credit not thorization. be extended for speculative purposes, in­ The Bank of France may not discount cluding land speculation, and that priority paper directly for the Treasury, and it is be given to export industries, to those in­ forbidden to operate in the market “for the dustries being exposed to new foreign com­ benefit of the Treasury.” Central bank petition by reduced tariffs, and to those credit to the Government must take the projects designed to increase efficiency. Such form of book-entry, nonnegotiable loans, directives have no force of law, and it is which require ratification by the legislature in the form of a convention, or treaty, be­ difficult to determine how effective moral tween the Bank and the Government. But suasion and the prior authorization proce­ outstanding Government bonds may be used as collateral for advances, and Treas­ 30 The original intention to reduce such loans from 10 billion francs at the end of 1964 to 8.4 billion ury bills may be purchased outright by the francs at the end of 1968 was later (August 1967) Bank of France. largely nullified by raising the ceiling to 9.5 billion francs; this ceiling was extended through December Many of the legal provisions governing 1970. the extension of credit by the Bank of

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France reflect the view, common at the be­ Eligibility requirements. To be eligible for ginning of the 19th century, that the bank discount at the Bank of France, commer­ of issue should also engage in regular com­ cial bills of exchange and other commer­ mercial banking. Thus it is still technically cial paper must have a remaining maturity possible for a member of the general public of 3 months or less and bear three good to discount commercial bills or securities at signatures (the third signature may be re­ the Bank or to obtain an advance from the placed by a pledge of securities or goods); Bank, provided the paper presented for the Bank also may require additional discount or as collateral meets eligibility re­ guarantees.3-' Bills corresponding to a loan quirements; however, as a practical matter, of money or a line of credit without any the Bank no longer accommodates private immediate connection with the transfer of customers. goods or services (“finance” bills) require Except for a few private customers of prior authorization of the Bank in addition long standing, the Bank of France grants to the same guarantees as commercial bills. credit only to banks, to certain public and Medium-term credits for specified pur­ semipublic financial institutions, and to a poses (housing, industrial equipment, and few registered financial establishments,31 of exports) become eligible by a process in which only the instalment credit establish­ which the originating bank obtains the re­ ments generate any appreciable amount of quired third signature from the appropriate discountable paper. Furthermore, the Bank intermediate financing agency. This proce­ may refuse any request to discount or dure involves depositing the original docu­ make advances— even when eligibility re­ ments with the intermediate financing quirements are met—except when grain agency and permitting the originating bank storage bills guaranteed by the National to draw short-term notes using the medi­ Cereals Office (Office National Interprofes­ um-term paper as collateral. These notes sional des Cereales) are presented for dis­ are then sold to the Bank of France under count or when Treasury bills are presented repurchase agreement. Effective January 1, by the nonbank public, even though banks 1966, the Bank of France extended to 7 consider access to the discount window, years from 5 years the maximum original within the ceiling, to be a right rather than maturity of certain kinds of medium-term a privilege. credit for equipment and construction that In addition to direct discounting for pri­ it would admit indirectly for discount, vate business accounts (this volume is provided the remaining maturity was only 3 small) and discounting for banks and other years. Repurchase agreements, on the other financial institutions, the Bank of France hand, are made on paper with periods to makes secured advances, but these are at a maturity ranging from 15 days to 2 years, rate higher than the discount rate. Until De­ and under present Bank policies they may cember 21, 1967, when the facility was be for as short a period as 2 days. Paper withdrawn, the Bank also made advances to 32 A decree issued in December 1966 authorizes the banks for 30 days at a rate that was often banks to make short-term nonguaranteed loans based below the discount rate; however, these ad­ on the general credit standing of the borrower rather than on individual commercial transactions. Subse­ vances were subject to very low ceilings. quently, legislation has been passed empowering the Bank of France to discount such two-name instru­ 31 For a list of the specialized credit agencies, see ments. (Previously, discounting was limited to paper the 19th Annual Report of the National Credit Coun­ bearing three names—those of the debtor, the credi­ cil for 1964, p. 190. tor, and the banker.)

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that is not eligible for discounting because be discounted at the basic rate. Medium- of maturity may be sold under a repurchase term export paper, however, still benefited (en pension) arrangement and repossessed from a much lower rate; namely, 4 per cent later by the borrowing bank and then dis­ (except that for exports to the countries in counted when it comes within the 90-day the European Economic Community the maturity range. basic rate applied). Ordinary commercial Cost of Bank of France credit. The cost of paper (within applicable ceilings), grain the marginal amount of central bank credit storage bills guaranteed by the Office Na­ in use is reflected in the money market rate tional Interprofessional des Cereales and for day-to-day money secured by private equipment credits to nationalized industry bills and, since the abolition of the plancher guaranteed by the Caisse Nationale des and the coefficient, Treasury bills. The hier­ Marches de VEtat were discounted at the archy of rates at the Bank of France deter­ basic rate. The preferential rate of 3 V2 per mines the order in which the banks present cent for special advances, which was in­ different kinds of paper to the Bank (or to tended to aid small and medium-sized enter­ the intermediate financing agencies) to ob­ prises, was abolished in October 1970. tain cash. Since the beginning of 1967, the Bank of The level of money market rates depends France has intervened in the money market upon the degree of utilization of central on the “buy” side to keep market rates bank credit facilities. At times when many from declining to levels that authorities banks have unused margins for discounting consider inappropriate. In times of boom within the ceilings, the rate for day-to-day conditions, with high and rising interest money secured by private bills tends to fluc­ rates, the Bank has raised the whole struc­ tuate close to the basic discount rate, since ture of its rates (except for export paper banks with surplus funds may employ them prior to the end of 1969) and has corre­ to reduce their discounts at the Bank of spondingly lowered these rates when infla­ France or to lend in the money market. As tionary pressures have eased. On 26 occa­ rates become firmer, banks with unused sions in the 14 years ending 1969 the Bank margins within the ceilings will discount of France changed one or more of its rates paper at the Bank of France to obtain funds for discounts or advances, but it changed to lend in the market. When all, or nearly the basic discount rate only 12 times during all, banks are up to their discount ceilings this period. Five of the seven increases were at the Bank, rates for day-to-day money will by 1 percentage point each, while four of tend to move up to the rate for discounting the five reductions were for Vi of 1 per­ medium-term paper at the intermediate centage point each. On several occasions financing agencies; if market conditions the size of the change and the timing were tighten still further, day-to-day money rates influenced by balance of payments consid­ will move toward the penalty rate. erations, which varied with the require­ During 1969 the Bank of France began ments of the domestic situation. to reduce the number of different rates it charges on discounts and advances. At the Bank of France credit practices. As a rule, end of 1969 short-term export paper, which routine discounting33 takes place at the is accepted without limit outside the dis­ 33 Local or regional banks normally discount with count ceilings, and which used to benefit their Paris correspondents; thus a good deal of the paper originating throughout France is submitted for from a preferential 3 per cent rate, began to discount or repurchase operations in Paris,

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Bank of France until 11 a.m. After that the right of each bank to discount up to hour the Bank of France intervenes in the its full quota is not questioned and because open market, either by selling or by buying the supply of eligible paper is more than eligible paper under en pension (repur­ ample to make up for paper rejected for chase) agreements, in order to achieve its any reason. rate objectives. The Bank of France requires that, in Early in the day banks inform the dis­ order to be eligible at the discount window, count house, through which they ordinarily all finance bills (provided they fulfill the operate in the money market, whether general requirement with regard to a 3- they will have excess funds or whether they month maximum maturity and provided will need to borrow. First, each discount they have at least three signatures) be sub­ house conducts an internal operation that is ject to the prior authorization procedure comparable to intermediation in Federal from which only short-term trade bills are funds in the United States. Then banks that exempt. are still short of funds will arrange through Prior to June 30, 1970, any extension of the discount houses to sell paper en pension credit by a bank that would increase the in­ to the Bank of France. If the market is debtedness of any single borrower above 10 firm, banks with margins under their dis­ million francs required a prior authorization count ceilings will also borrow from the of the Bank of France. This last requirement Bank in order to lend to other banks. made a considerable volume of ordinary At the end of 1966, the French banking commercial paper subject to the prior- system had on its books approximately 156 authorization procedure, which was quite billion francs ($36 billion) of short-term cumbersome.34 It has been replaced by a and discountable medium-term loans out­ procedure involving ex post control of all standing to businesses and individuals; loans of 25 million francs or more to the about 84 per cent ($25 billion) of this same borrower. total was backed by bills. The heavy re­ For each credit sought under this proce­ liance upon bill financing is due to the dure, the borrower must submit to its bank fact that Bank of France credit is available a file (dossier) that must include (1) bal­ most cheaply and most readily on the secu­ ance sheets of the firm for the last 3 years; rity of short-term bills. Since the abolition (2) an estimate of the value of trade cred­ of the plancher and the coefficient (see its, inventories, and investments; (3) a p. 226), credit operations of the Bank of statement of all bank accommodations al­ France have been based upon private paper ready obtained;35 and (4) plans for use as well as Treasury bills. The examining and repayment of the credit applied for, to­ and processing of private collateral to de­ gether with evidence showing that no alter­ termine whether it meets eligibility require­ native means are available for raising the ments, and for other reasons, require the 34 The Bank of France and its branches examine employment of a large staff. about 43,000 credit dossiers a year, and the entire The bulk of the paper discounted within procedure usually requires considerable time for each dossier. ceilings is related to normal sales transac­ 35 The Central Risks Office (Service Central des tions and is always acceptable, as long as it Risques), which is attached to the General Discount fulfills the applicable maturity and signa­ Department of the Bank of France, collects and col­ lates data on the total volume of credit furnished to ture conditions. Rejection of paper that any given borrower on the basis of monthly reports fails to meet these conditions can have no by banks and other financial institutions. The infor­ mation is available to the Discount Committee for effect upon monetary conditions because its decisions to grant central bank authorization. The

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required funds. This dossier is studied by system of minimum lending rates for these the Discount Department of the Bank of banks was abandoned at the beginning of France (or one of its branches if the credit 1966 after several years in which the is small and presents no complications) not connection with the Bank of France dis­ only to ascertain the quality of the loan but count rate was progressively loosened. Ex­ also to determine whether it conforms to cept for deposits of more than 500,000 current guidelines on the allocation of francs (which have been freed from ceil­ credit in accordance with the National Eco­ ings), the NCC does set maximum interest nomic Plan. rates payable by banks and financial institu­ Linkage of lending and deposit rates to cen­ tions on sight and time deposits and certifi­ tral bank rates. Since 1966 neither the lend­ cates of deposit (bons de caisse), but these ing nor the deposit rates of the commercial rates have no fixed relationship to move­ banks have been formally linked to the ments in the Bank’s discount rate. In gen­ eral, however, changes in maximum rates lending rates of the Bank of France. The payable on deposits have followed with some lag changes in money market condi­ over-all amount of credit outstanding to any bor­ tions. Similarly, the heavy reliance of the rower is also communicated each month to those banks and financial institutions that have reported a banks on Bank of France credit (at the end credit in the name of that borrower, although infor­ of 1969 the Bank financed about 25 per mation as to the source of the borrower’s other cred­ it is not divulged. The Central Risks Office also tab­ cent of all short- and medium-term credit to ulates the data according to the purpose of each the economy) makes it inevitable that bank credit in order to provide information on the extent to which the qualitative credit guidelines of the Na­ lending rates should reflect the cost of bor­ tional Economic Plan have been followed. rowing from the Bank of France.

FEDERAL REPUBLIC OF GERMANY

Introduction posted selling and repurchase rates, but it does not undertake open market operations In the Federal Republic of Germany (West on its own initiative, except for a modest Germany) the authorities have sought the amount of transactions in long-term securi­ means to maintain monetary control with­ ties initiated in 1967. out resorting to direct restriction of interna­ In periods of monetary restraint since tional capital movements. To this end, they World War II, the Federal Bank has found have modified the traditional monetary pol­ it necessary to discourage net borrowing icy instruments and have introduced other abroad. At such times variable reserve re­ tools. The principal monetary policy tools quirements have been employed; require­ used by the German Federal Bank are vari­ ments against net liabilities of German able reserve requirements and discount pol­ banks to nonresidents have been set at sub­ icy. Use of open market operations has not stantially higher levels than those against been feasible because the money market is gross domestic deposits.36 The discount narrow and because short-term securities (mobilization paper) can be easily con­ 36 In addition, there is a 25 per cent withholding tax on interest earned by foreign holders of West verted into cash at the German Federal German securities. In early 1970 a repeal of the tax Bank. The central bank does influence the was proposed in response to excessive net outflows of long-term capital, but no decision had been reached market for short-term paper by adjusting its by the end of that year.

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mechanism has been employed in a similar The Bank’s experience, especially in the fashion. The maximum amount that each last decade, indicates that by use of the pol­ bank is permitted to discount at the central icy tools available the best that can be bank may be reduced, at the authorities’ achieved is only a gradual, indirect, and de­ discretion, by an amount equal to the in­ layed effect on the lending activity of credit crease in a bank’s foreign borrowing above institutions. Consequently, since the early a specified level. And at various times the 1950’s, the Bank has placed considerable authorities have employed swaps between reliance on discount ceilings to control the central bank and commercial banks to bank lending to the nonbank sector, and encourage the latter to hold balances it has also used at times reductions of such abroad rather than to sell foreign exchange quotas as a means of achieving credit re­ to the Federal Bank. straint. Reserve requirements may be varied only The central bank has been among the within a specified range. Moreover, when strongest advocates of legislation under reserve requirements have been raised in which expenditures and revenues of the an effort to curb credit expansion, the re­ Federal, state (Land), and local govern­ strictive effects have sometimes been offset ments would be brought into a framework to a considerable extent by sales of open of coherent fiscal policy; considerable prog­ market paper to the Federal Bank—at ress in this direction was achieved by the the initiative of commercial banks— as well passage of the Stabilization Law of 1967. as by discounting. This has been true de­ On the whole, however, the German experi­ spite the fact that central bank purchases of ence since the shift to convertibility in the open market paper are subject to an over­ late 1950’s reveals the limitations on use of all ceiling, and that ceilings on the volume monetary policy during periods of substan­ of discounts apply to each credit institution. tial trade surplus and unrestricted interna­ Central bank credit is available through tional capital flows. three avenues—by discounting eligible Banking system paper within the rediscount quota, by ob­ The Government owns the German Federal taining collateralized advances (Lombard Bank (Deutsche Bundesbank) and appoints credit) at a higher rate, and by selling Gov­ its Council. The Bank is an autonomous in­ ernment securities at rates posted by the stitution, and it can pursue a policy Federal Bank (referred to as open market independent of the Federal Government. operations). The granting of advances de­ Nevertheless, it maintains a close relation­ pends not only on the availability of accept­ ship with the cabinet and, more specifically, able collateral but also on the would-be with the Ministers of Finance and Eco­ borrower’s financial condition, the purpose nomic Affairs. of the borrowing, and the general credit The German Federal Bank succeeded in policy of the Federal Bank. During most of 1958 the Bank Deutscher Laender, which the postwar period the rate on the advances operated along very similar lines but had a was 1 percentage point above the Bank’s more decentralized structure. It has a head discount rate, but more recently it has been office (in Frankfurt) and several regional 2 and even 3 percentage points higher. central banks (Landeszentralbanken) lo­ Both discounting within ceilings and ad­ cated throughout the individual states that vances are regarded as a privilege, not a constitute the Federal Republic.37 right, and both are permitted to remain 37 These regional banks serve as offices of the Fed­ outstanding for very short periods only. eral Bank in each Land and carry out the policy

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The Federal Bank is the fiscal agent of While the six big commercial banks play an the Federal Government, while the central important role in the economic life of the banks of the individual states hold the ac­ country, local and regional commercial counts of state governments, with minor ex­ banks are quite significant. ceptions. The Federal Bank is also in Of the total balances held with the Fed­ charge of all foreign exchange transactions eral Bank, commercial banks accounted for and other transactions with foreign coun­ only about one-third—an amount consider­ tries and organizations. ably smaller than reserve balances held by The banking system is very complex and the savings bank system. Industrial and ag­ extensive, with almost 40,000 banking ricultural credit cooperatives, as well as offices at the end of 1969, operated by al­ banks with special functions (such as the most 10,000 separate institutions, including Reconstruction Loan Corporation), are also 8,000 credit cooperatives. Three main sec­ important as sources of credit and in meet­ tors may be distinguished in this structure: ing other banking needs. All these institu­ (1) commercial banks, including private tions, and some less important categories of banks; the latter outnumber other commer­ financial institutions not specifically men­ cial banks but account for only about one- tioned above, are subject to reserve tenth of commercial bank lending to non­ requirements and are considered to be banks; (2) a three-tier savings bank system, banking institutions for the purpose of reg­ with regional “giro” institutions acting as in­ ulation. termediaries between local institutions (but also having a considerable volume of lend­ Discounts and advances ing to nonbanks) and the Girozentrale, Central bank credit is available to all im­ which is their central institution; and (3) co­ portant categories of credit institutions, but operative banks. commercial banks use it more extensively One significant characteristic of the than other eligible institutions. In more re­ banking system is the importance of savings cent years, savings and cooperative banks banks, which outnumber commercial banks have made considerable use of central bank and extend a considerably larger volume of credit. credit to nonbanks than do commercial The normal avenue for obtaining central banks, and of specialized institutions, such bank credit is to discount eligible paper. as mortgage banks, whose volume of lend­ Lombard credit is more expensive and is ing to nonbanks is about equal to that of more in the nature of “bridging credit” to commercial banks. Indeed, commercial be granted only for very short-term balanc­ banks account for only between one-fourth ing-out purposes, usually to cover month- and one-fifth of the total volume of bank end needs arising from day-to-day cash lending to nonbanks. The importance of flows. savings banks reflects the wide range of as­ In order to be eligible for rediscounting, sets that they can acquire, enabling them to commercial bills normally have to be en­ compete effectively with commercial banks. dorsed by three parties “known to be sol­ vent,” and the bills must mature within 3 decisions reached by the Central Bank Council. Each months of the central bank’s purchase date. Land central bank acts as the fiscal agent for its Land and carries out on its own responsibility central Discountable paper also includes bankers’ banking operations, such as establishing rediscount prime acceptances that serve to finance for­ quotas and providing central bank credit at the stated rates for rediscounts and advances with all credit in­ eign trade, promissory notes of import and stitutions within its geographical area. storage agencies, exporters’ bills endorsed

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by a bank and by the Export Credit Com­ is located. These quotas are determined flex­ pany, and bills used to finance certain cate­ ibly with consideration being given to the gories of instalment sales for business pur­ individual institution’s record of compliance poses, as well as for the purchase of with the rules and regulations of the central consumer durable goods, provided they ma­ bank and of the Federal Banking Supervi­ ture within 3 months.38 sory office.39 However, rediscount quotas Assets that may serve as collateral for that can be granted by the regional central Lombard loans include bills of exchange el­ banks (which currently number 11) are set igible for rediscount; Treasury bills; bonds directly by the directorate of the Federal of the Federal Government, state govern­ Bank. Each credit institution may be granted ments, or the Federal Special Funds that by the Central Bank Council, usually for a appear in the Debt Register; and equaliza­ 6 months’ period, supplementary quotas for tion claims (bank claims on the Federal amounts up to 25 per cent of its regular Government arising from the currency re­ quota to cover exceptional needs. form of 1948). Normally, securities are Since discount quotas increase automati­ used as collateral. cally with the growth of bank equity funds, Limitation on availability of central bank they have been reduced from time to time credit. West German credit institutions tend to avoid excessive credit expansion. The to accommodate their customers with loans most recent across-the-board reduction in as long as they are able to supplement their quotas was made effective in July 1969. resources by using central bank credit— Furthermore, since September 1964 the even if in the process they become increas­ German Federal Bank has, at times, been ingly sensitive to restrictive monetary pol­ using reductions in quotas to discourage icy. However, the access to the discount credit institutions from borrowing abroad. window is restricted by a quota system. Most recently— effective June 1970— the This system was introduced to protect the discount quota of each credit institution be­ central bank’s exposure, but since about came subject to reductions by the amount 1951 it has been increasingly used as an of its foreign borrowing in excess of the instrument of monetary control. The Cen­ amount outstanding at the end of March tral Bank Council has established “stand­ 1970. In effect, quotas of a considerable ard” quotas that are based on the credit number of banks are subject to reduction at institutions’ equity capital and has dif­ one time or another, with some reductions ferentiated these quotas according to types clearly amounting to sanctions. of institutions. Since credit institutions may not discount Within the framework of the “standard” in excess of their quotas under any circum­ quota guidelines, the rediscount quota of stances, there is a tendency among some in­ each credit institution is individually deter­ stitutions to maintain a substantial leeway. mined by the Land central bank in whose This is true principally of the larger institu­ area the head office of the credit institution tions, although under extremely tight credit conditions—such as in 1965 and 1966 and 38 Banks may also obtain funds by selling to the Privatdiskont, A.G. prime bankers’ acceptances or in­ again in 1970—they too tend to borrow struments arising from the extension of medium- and very heavily. Smaller institutions, on the long-term export credit; and the Privatdiskont, A.G. other hand, typically use their full quotas. in turn rediscounts the acceptances with the central bank. Holdings of such assets constitute secondary 39 The latter prepares, in cooperation with the Fed­ liquidity because they may be immediately converted eral Bank, draft banking legislation and establishes into cash. rules for bank operations.

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Credit institutions of the Federal Repub­ However, such a boost in domestic interest lic have relied heavily on the credit facili­ rates encouraged a massive inflow of capi­ ties of the central bank. In order to provide tal, which in turn forced the authorities to a continuously expanding amount of credit reverse their monetary policy. As a conse­ to the private sector, these institutions have quence, between November 1960 and May increased their rediscounting and other 1961 the discount rate was reduced in three borrowing at the Bank whenever the bal­ successive steps back to 3 per cent. ance of payments or the central bank’s for­ Balance of payments considerations eign exchange operations have restricted prevented the Federal Bank from making bank liquidity. This has occurred several any further changes in the discount rate times: for instance, in 1960 when the cen­ until January 1965. By that time rising in­ tral bank offset the accumulation of its for­ terest rates abroad had reduced the danger eign assets, in 1964 and 1965 when re­ of inducing a further large inflow of foreign strictive monetary policy was reinforced by capital and after that rate changes were a decline in official holdings of foreign as­ made more often. For example, during 4 sets, as well as in 1970 when the central months in 1967, the discount rate was low­ bank was striving to maintain the liquidity ered four times, each time by Vi percentage squeeze that had developed in the wake of point. More recently, between April 1969 the capital outflow following the revalua­ and March 1970, the central bank raised tion of the German mark in October 1969. the discount rate in four steps from 3 to The increasing importance of discounting IV2 per cent in response to both external in periods of reserve shortages is reflected and domestic factors. in several ways: (1) the volume of central The repercussions of frequent changes in bank credit; (2) the relation of such credit the discount rate on the capital market to credit institutions’ total reserves (which have complicated implementation of mone­ sometimes rises to one-fifth or possibly even tary policy. The effects of such changes are to one-third); and (3) the rising propor­ transmitted to the capital market through tions of such credit to loans granted to the commercial banks, most of which are active private sector and to the foreign assets port­ in the securities markets as underwriters, folio of the central bank. brokers and dealers, and buyers for their Rate policy. The German Federal Bank own account—using their securities portfo­ charges a uniform rate for all rediscounts, lios as buffers whenever changes in mone­ whereas on advances its rate has been set as tary policy occur. In order to offset the much as 3 percentage points above the dis­ effects on the capital market of policies that count rate. The two rates are not neces­ are aimed essentially at the money market, sarily changed simultaneously. The rate on the central bank has found it necessary from advances normally constitutes a ceiling on time to time to support the prices of bonds fluctuations in money market rates. issued by Government agencies. Until Au­ If credit conditions require it, the central gust 1967 the central bank undertook sup­ bank changes the discount rate frequently. port operations for the account of the var­ During 1959 and 1960, for instance, it ious agencies whose securities were raised the rate three times in a span of 9 involved rather than for its own account. months from 3 to 5 per cent. This was While such purchases did not add to the vol­ done to restrict the impact of a large for­ ume of central bank credit outstanding, but eign trade surplus on domestic liquidity. merely shifted balances at the central bank

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from the Government agencies to the bank­ limits for imiximum reserve ratios against ing system, such operations tended to ease sight, time, and savings deposits are 30, 20, commercial bank reserve positions and thus and 10 per cent, respectively. Actual reserve to offset restrictive monetary policy. Since ratios may vary not only with the type of August 1967, however, the central bank deposit but also with the type of depositor has engaged in open market operations in and the location and size of the credit insti­ long-term securities for its own account. tution, so the number of specific ratios ap­ Relationships between central bank rates and plicable at any given point in time is quite market rates. Practically all market rates are large. Any reserve deficiency is subject to linked, or were until recently, to the Ger­ a fine of 3 percentage points above the rate man Federal Bank’s discount rate. Also, on central bank advances.41 until April 1967 rates on loans and depos­ Reserve ratios are changed quite often. its of credit institutions were formally The changes that have been made in re­ linked to the discount rate. The Federal Banking Supervisory Office set the ceiling serve ratios since November 1959 have rates on loans made by credit institutions, been across-the-board, and the same per­ and these ceilings varied directly with the centage change (not the same number of discount rate. Rates on business loans were percentage points) has been applied each AVz percentage points above the discount time in order to maintain the same structure rate, and those on bills discountable at the of reserve ratios. At various times additional central bank were 3 percentage points minimum reserve requirements have been above the discount rate. The linkage of de­ imposed on marginal increases in bank lia­ posit rates to the discount rate was less di­ bilities above the level prevailing at a given rect, however, and changes in rates on de­ date or during a given period.42 Changes posits usually lagged behind changes in the in reserve ratios against nonresident de­ discount rate. On April 1, 1967, the legal posits, separate from those in reserve ratios ceiling rates on both loans and deposits against other deposits (and allowing, at were removed. times, for bank borrowing abroad to be Other instruments of monetary policy counted as an offset against such liabilites), have been used to regulate the liquidity of Minimum reserve ratios. The Federal Bank is authorized to set minimum reserve re­ prescribed net worth and liabilities. These ratios are quirements against all sight (demand), administered by the Federal Banking Supervisory time, and savings deposits. These ratios are Office and are not used as an instrument of mone­ variable, and they apply to all credit institu­ tary policy. 41 Reserve requirements are computed on the basis tions that accept such deposits. of the monthly average of deposit liabilities on four Reserve requirements can be satisfied statement days (the 23rd and the last business day of the preceding calendar month, and the 7th and 15th only by holding nonearning balances with of the current calendar month). The reserve period, the central bank. These balances may be which is the current calendar month, permits individ: ual credit institutions to average out sharp oscilla­ counted toward the liquid assets that must tions. This is especially important in Germany where be maintained under other laws.40 The upper there is no equivalent of the “tax and loan account” at the Federal Reserve Banks. 40 Credit institutions must also observe certain 42 For example, between December 1968 and No­ guidelines concerning their liquidity and solvency. vember 1969, additions to external liabilities were These are expressed as ratios of prescribed assets to subjected to 100 per cent reserve requirements.

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the banking system in periods of large somewhat more often than the discount capital inflows. Another technique, intro­ rate— is left to the credit institution. duced in 1970, was to subject to reserve Credit institutions as a whole have come requirements bank guarantees on certain to regard their holdings of open market types of direct business borrowing abroad. paper as secondary liquidity. Most such Open market operations. For several rea­ paper was created by issuing securities to sons, the principal of which are mentioned replace— “mobilize”— book claims of the in the introductory section, open market Federal Bank against the Federal Govern­ operations of the German Federal Bank are ment arising from the postwar currency re­ a passive element among the monetary pol­ form. The amount of “mobilization paper” icy tools. The level of bank reserves is af­ is limited to 8 billion German marks, which, fected only when the banks choose to buy once fully issued, was large enough to per­ securities from, or sell them to, the central mit credit institutions to counteract, at least bank. The Federal Bank does not initiate temporarily, the central bank’s policy aim­ market sales or purchases, but rather re­ ing at a specific level of free reserves. To stricts itself to making changes from time to put the central bank in a position to mop up time in the rates at which it will buy or sell additional bank liquidity once its holdings Federal Treasury bills and bonds as well as of mobilization paper were exhausted, the short- and medium-term securities (of up Federal Bank was authorized in 1967 to to 2-year maturity) of certain Government sell up to 8 billion marks of “liquidity agencies. The decision of how much to buy paper” issued to it by the Treasury in the or sell at the posted rates— these are changed form of bills and bonds.

ITALY

Introduction per cent as part of a policy to bring the do­ Discount policy plays an important role as mestic rate structure closer into line with a monetary policy tool of the Bank of interest rates abroad. Accommodation is Italy, even though there are no formal mostly in the form of advances rather than statements or regulations setting forth the rediscounts. Bank’s objectives in this area. The Bank The Bank has broad discretionary pow­ administers discount policy flexibly, and its ers in implementing its discount policy with day-to-day course depends to a large extent respect to both form of accommodation and on how Treasury operations and balance of type of asset accepted. These powers give payments developments affect the monetary the Bank considerable leverage in directly base. Moreover, until mid-1969, the em­ controlling the expansion of credit. The phasis appears to have been on changes in monetary authorities also maintain control credit availability affected through rationing over the volume of liquidity available to rather than on the discount rate, which had Italian banks from their foreign balances by remained unchanged since 1958. Since Au­ regulating the banks’ net foreign exchange gust 1969, however, the discount rate has positions vis-a-vis nonresidents and by mak­ been raised in two steps from 3 Vi to 5 Vi ing available, at their discretion, cost-free

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forward exchange cover facilities. Before tablished by a decree of the Minister of the May 1969, when the amount being offered Treasury acting upon recommendation of to the banks began to be limited to their the Governor of the Bank. Execution of actual required reserve needs, the Bank of monetary policy is entrusted to the Bank of Italy had substantial control over a third Italy, which has a network of regional source of bank liquidity-—the amount of branches. Treasury bills held in excess of the banks’ The outstanding stock of the Bank of compulsory reserve requirements. Italy is owned by various types of financial The central bank’s commitment to sup­ institutions, all of which are publicly owned port the Government’s budget constitutes a in whole or in part. Even though the Gov­ major loophole in its control over liquidity. ernment itself holds none of the central However, since World War II, successive bank’s capital stock and does not participate governments have not abused their power in the activities of any of its governing to obtain credits from the central bank. bodies, the Treasury in effect has control There has been no serious slippage in mone­ over the Bank of Italy. However, the stature tary control as a result of Treasury opera­ and prestige of the Bank’s governors have tions, especially since the Bank of Italy is given the Bank considerable autonomy and in a position to offset any disequilibrating great weight in policy decisions in the whole influences emanating from that source. area of Government financial policy. Reserve requirements, introduced origi­ In the international field the Bank of Ita­ nally in 1926 as liquidity ratios to protect ly’s functions are complemented by the Ex­ depositors, have been used as a tool of change Office ( Ufficio Italiano dei Cambi), monetary policy since World War II. The which—though nominally an independent use of this tool has proved cumbersome, public body— is in effect an affiliate of the however, because the reserve ratios are de­ central bank. The Exchange Office carries termined by a very complex formula (see out its domestic operations through the pp. 244 and 245). Moreover, the effective­ Bank of Italy’s branches, which act as its ness of this tool is limited by the fact that agents. The Exchange Office obtains the the reserve requirements can be satisfied lire it needs to acquire foreign exchange in a way that provides the banks with a through an unlimited line of credit from the return, which until mid-1969 was fairly Bank of Italy. close to market rates. The Italian banking system has grown over the years into a heterogeneous con­ Institutional framework glomerate of institutions (some of them Over-all monetary policy in Italy is formu­ nearly 500 years old and pioneers of bank­ lated by the Interministerial Committee for ing) that are not easily fitted into precise Credit and Savings. This Committee, which classifications according to type of activity. consists of the Minister of the Treasury (its All of these institutions engage to a greater chairman), seven other ministers, and the or lesser extent in short-, medium-, or Governor of the Bank of Italy as a nonvot­ long-term lending. By the Banking Law of ing member, meets seven or eight times a 1936, the Italian credit system was divided year. Its policy decisions are embodied in into two sectors. One consists of banking decrees signed by the Minister of the Treas­ institutions that take most of their deposits ury and in regulations issued by the Bank of as “short-term savings” (defined as demand Italy. For example, the discount rate is es­ deposits and savings and time deposits) and

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that are forbidden to accept deposits with about 80, of which 21 are engaged in mort­ more than 18 months’ maturity. The other gage credit, 12 in agricultural credit, and consists of institutions that accept medium- the rest in industrial credit and miscella­ term savings—with maturities of 18 to 60 neous activities. months—but that, with one exception, raise Discounts and advances most of their funds by issuing bonds in the Central bank credit is available to all the capital market. The former are called credit institutions and group institutes (all “credit institutions” (aziende di credito) and of which are generally referred to herein as the latter “special credit institutions” (istituti banks), and in principle also to private in­ speciali di credito). Both groups are subject dustry and individuals.45 In contrast to the to supervision by the Bank of Italy. central government, local governments do The credit institutions number about not have direct access to central bank 1,200 (with over 10,000 branches); about credit. No type of paper, other than Storage 350 larger institutions account for about Agency Bills (see footnote 46), is auto­ 98 per cent of total deposits. The leading matically eligible for rediscounting or as banking institutions include: (1) “public collateral for a loan. The Bank of Italy de­ law banks”; directors of these banks are ap­ termines how much credit it wishes to ex­ pointed by the Government (because they tend in the light of prevailing monetary pol­ have no share capital, or because the capi­ icy and then scrutinizes every credit tal is owned by the Government); and (2) appliction individually. “banks of national interest”; banks in this Accommodation to credit institutions and group have widespread networks of group institutes. Central bank accommoda­ branches and most of their capital is pub­ tion of credit institutions and group insti­ licly owned. tutes takes three forms: advances on collat­ The scope of business of some of the sav­ eral, rediscounts of commercial paper and ings banks is virtually indistinguishable Treasury bills, and “deferred payments” at from that of the commercial banks. Certain the clearing house.46 Commercial banks are categories of credit institutions—Coopera­ 45 In principle, special credit institutions, except tive People’s Banks, savings banks, and joint- those extending credit to agriculture, have no direct stock banks and private banks—belong to access to central bank credit. However, under unu­ sual circumstances they may obtain advances on col­ “group institutes” that hold part of their liq­ lateral on the same terms as nonbank borrowers; the uid reserves and provide a variety of serv­ volume of such advances has been insignificant—less than 0.5 per cent of the Bank of Italy’s total ad­ ices— such as issuing bank drafts (assegni vances in recent years. 46 A fourth type of central bank accommodation circolari) ,43 providing clearing facilities and consists of the rediscounting of bills issued through technical assistance, and representing the the crop year 1963-64 to finance the Government’s farm price-support program (particularly the price of members in dealings with the Treasury and wheat). These Storage Agency Bills are first dis­ other branches of the Government.44 counted with the credit institutions at rates ranging from 5 V2 to 6 V2 per cent per annum; all such bills The special credit institutions number are automatically eligible for rediscount at the Bank of Italy and for the most part are passed on to the 43 Assegno circolare is an instrument very widely latter. Such rediscounts rose from 383 billion lire at used by the public in Italy, where the practice of the end of 1958 to 905 billion lire at the end of De­ payment by check for general purposes is rather lim­ cember 1969. In this instance, the Bank of Italy acts ited. as agent for the Government, and discount policy is 44 On Dec. 31, 1969, total liabilities and net worth presumably adjusted to take account of the auto­ of the group institutes amounted to 2,132 billion lire matic rediscounting of Storage Agency Bills. Conse­ ($3.4 billion equivalent); most of this total presuma­ quently, the discussion in the text is confined to “or­ bly represented claims of the member institutions. dinary” rediscounting.

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the main users of central bank credit. Ital­ the banks’ borrowing from the central ian banks as a group borrow continuously bank. In case of tightness, banks will first from the central bank, which is usually pre­ use their credit lines for advances, and only pared to meet seasonal and local needs. when these lines are running short will Permanent financing of required reserves, banks resort to rediscounting.48 In normal however, is avoided. times, total central bank credit tends to be Accommodation by the Bank of Italy is very small in proportion to the banks’ lira mainly in the form of advances on collat­ loans to the private sector (less than 1 per eral. These advances are made on the basis cent) and relatively small in proportion to of lines of credit that the central bank the banks’ required reserves (3 to 6 per opens in favor of the individual banks cent). against securities deposited with it when the Collateralized advances as well as redis­ line of credit is established. The paper counting are available as a privilege, sub­ eligible as collateral consists of Govern­ ject to the discretion of the Bank of Italy. ment and Government-guaranteed securities, The Bank has established individual ceil­ mortgage bonds, and bonds of “equivalent ings for lines of credit for each bank as rating.” 47 The line remains open for 4 well as for local branches of institutions months and is renewable. The banks are with national networks of branches. As a not expected to draw the credit at once and rule of thumb, these ceilings are set at 5 to remain fully indebted for the duration of per cent of the individual bank’s total de­ the credit period; rather, it is expected that posits, but they are occasionally reviewed drawings and repayments will be continu­ and revised. Branch managers of the Bank ous. In 1967 the Bank of Italy introduced of Italy, who are intimately acquainted with advances on collateral with a fixed maturity the needs of the local banks, have some dis­ of 8, 15, or 22 days. Such advances, when cretion in increasing these ceilings, but they granted, must be drawn in full, but in every refer decisions concerning any substantial other respect they resemble the line-of- upward revisions to the main office. An in­ credit advances. dividual bank does not know what its ceil­ The second type of accommodation con­ ing is, and the Bank of Italy does not dis­ sists of rediscounting of commercial paper cuss the 5 per cent figure publicly. and Treasury bills. In practice, the bulk of Although there are no ceilings for redis­ the paper discounted consists of commercial counting and fixed-maturity advances, it is bills, since the banks prefer to keep Treas­ worth noting that aggregate advances and ury bills for other operations. Commercial rediscounts have seldom reached 5 per cent bills presented for rediscounting must have of the total deposits of all banks. At the end a maximum remaining maturity of not more of 1969, however, the ratio was 6.8 per than 4 months, and they must bear the cent, and the central bank provided about signature of at least two persons or firms one-fourth of bank reserves. known to be solvent. In normal times redis­ Large banks generally prefer to obtain counting is a marginal item in the total of central bank credit through collateralized

47 This category comprises bonds issued by impor­ 48 Excluding rediscounts of Storage Agency Bills, tant official financial institutions, such as Istituto per ordinary rediscounting is relatively insignificant com­ la Ricostruzione Industriale and Ente Nazionale Idro- pared with advances on collateral; however, in times carburi; special credit institutions, such as Istituto of liquidity pressures (for instance, during most of Mobiliare Italiano; and the nationalized enterprises, 1963 and in early 1964), the relative share of redis­ such as Ente Nazionale Elettricita. counting has tended to increase.

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advances rather than through rediscount­ per cent of the original ordinary budget ap­ ing, for the most part because the former propriations and of any supplementary ex­ method is more flexible and less costly but penditures approved by Parliament, was re­ also because the banks do not want their duced to 14 per cent in 1964. Moreover, customers to know that they use central the Bank of Italy is authorized to subscribe bank credit. The official rates for redis­ without limit to securities issued or guaran­ counts and advances have been identical teed by the Italian Government. It also re­ since 1950, but in the case of advances on discounts special paper issued in connection current account, interest is charged only on with the Government’s agricultural price- outstanding balances and banks may repay support programs (see p. 241, footnote 46). the loan at any time, whereas rediscounts Discounts by the Bank of Italy for and fixed-maturity advances, even though private individuals were forbidden by law repaid early, are considered as outstanding in 1936. However, the law does not prevent for the full period to maturity. Large banks the central bank from making advances to resort to rediscounting at the central bank private customers on the following types of chiefly to meet unusually heavy withdrawals collateral: Treasury bills; bonds issued or of funds and sharp increases in drawings guaranteed by the Government; bonds of under confirmed credit lines. The smaller mortgage credit institutions; Italian and for­ banks resort to rediscounting more often. eign legal tender gold coins; gold bonds; Finally, a minor avenue of central bank foreign government securities payable in credit open to banks has been a system of gold; and raw and processed silk. In 1958 “deferred payments” (prorogati pagamenti) advances to individuals represented 14 per for meeting adverse clearing balances at the cent of the total advances of the Bank; such local clearinghouses operated by the Bank advances have declined since then and in of Italy. Such accommodation is granted— the last 3 years were a little over 1 per cent normally for a single day but in exceptional of the total. There are indications that the instances for as many as 4 days—to clear­ Bank of Italy intends to eliminate the re­ inghouse members against collateral of the maining private accounts as quickly as fea­ kind accepted by the Bank of Italy for reg­ sible, but it wants to retain the legal author­ ular advances.49 Since the introduction of ity to make direct loans for emergency fixed-maturity advances, however, recourse purposes. to “deferred payments” as an additional Relationship of bank deposit and lending source of funds has been officially discour­ rates to the discount rate. The volume of aged, and since July 1967 an end-of-month commercial bank borrowing at the central balance outstanding has been a very rare bank is influenced by availability of funds phenomenon. rather than by cost. In principle, there are Accommodation to the central government no obstacles to large or frequent changes and private individuals. Since 1948 the Bank in the discount rate, but for several rea­ of Italy has been required by law to grant sons— chiefly the lack of an organized and the Treasury unsecured short-term over­ interest-sensitive money market—the central draft facilities. The initial limit, set at 15 bank has relied until recently almost exclu­ 49 In normal years these deferred-payment loans sively on tight controls of the volume of its (year-end basis) have not amounted to more than credit. However, during the last year, partly 0.5 per cent of the banks’ required reserves. During the 1963-64 “squeeze” they amounted to nearly 2 under pressure of external factors, the per cent. Bank’s emphasis on the cost of credit has

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greatly increased. After having remained the lending rates actually charged by indi­ unchanged at 3 Vi per cent since June vidual banks had exceeded the minimum 1958, between August 1969 and March “cartel” rates long before the lapse of the 1970 the discount rate was raised in two Agreement. Through most of the period steps to 5Y2 per cent. In March 1969, a since the 1964-65 recession, actual lending new rule concerning the interest rate on rates have, according to some reports, ex­ fixed-term advances was introduced: banks ceeded the cartel rates by as much as 3 to that borrow at the Bank of Italy more than 4 percentage points. On the other hand, once in a 6-month period have to pay a when Euro-dollar rates were still relatively penalty rate, which may exceed the official low, the Italian banks— to meet competi­ rate on advances by IV2 percentage points. tion of foreign banks—kept rates on for­ Moreover, since July 1, 1969, the Bank of eign currency loans to their prime custom­ Italy has been charging a penalty rate of ers below the cartel rates on lira loans. 1V2 percentage points to banks whose aver­ Although in late 1970—with the Euro­ age rediscounting in the preceding half year dollar market losing much of its attractive­ exceeded 5 per cent of their reserve re­ ness and the liquidity of the domestic money quirements. market easing rapidly—the major banks The structure of interest rates in Italy were able to negotiate a new agreement cov­ used to be regulated under a voluntary “In­ ering interest payable on deposits, no new terbank Agreement” that set minimum rates agreement concerning the lending rates was on loans and maximum rates on deposits.50 reached before the end of the year. However, the Agreement, which had pre­ viously been renewed every year since its Other instruments of monetary policy inception in 1954, was allowed to lapse at In recent years the most important of the the end of 1969 under pressure of very other instruments of monetary policy have tight conditions in the domestic money been controls over maximum expansion of market and sharp competition for deposits. bank credit and manipulation of commer­ After the lapse of the Agreement, banks cial banks’ net foreign assets positions. The began almost universally to pay interest monetary authorities also set and vary re­ well above the “cartel” rates.51 Moreover, serve requirements and engage in open mar­ ket operations; and they may impose ad 50 The Agreement linked the banks’ minimum lending rates to the official discount rate, but with hoc direct and selective controls, such as variations according to the type of lending. (In July those over securities issued by both the 1969 this link was abandoned.) Thus, the banks’ dis­ count rate for commercial paper was usually set IV2 banking and the nonbanking sectors. percentage points above the official discount rate; the Relatively little use is made of the re­ “cartel” minimum rate for overdrafts was ZVi per­ centage points above the Bank of Italy’s discount serve requirement tool in policy manage­ rate (and Lombard rate), plus a quarterly commis­ ment; changes in the rates are infrequent.52 sion of Vs of a percentage point on the highest bal­ ance outstanding. The enforcement of the Agreement lire), IV 4 per cent for normal savings deposits, and was entrusted to a special committee—chaired 33A per cent for tied savings deposits. Yet, holders by the president of the Italian Bankers Association of sizable current accounts were able to obtain in­ and including representatives of the major banking terest rates of 6 per cent or more. groups—that was able to impose penalties of up to a 52 Reserve requirements for credit institutions have hundred times the amount paid to a depositor (or been changed only once (in 1962) after having been charged to a borrower) above (or below) the maxi­ modified in 1947.. However, from time to time the mum (or minimum) agreed rate. Bank of Italy has used this instrument as a counter­ 51 The maximum rates payable under the Agree­ cyclical weapon by changing the types of financial ment were V2 per cent for current accounts (2 per assets that can be used to satisfy reserve require­ cent where the average balance exceeded 5 million ments.

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Different reserve requirements are applied and moral suasion. The latter is particularly to individual categories of credit institutions effective because of the wide discretionary and types of liabilities, and the reserve coef­ powers that the Bank of Italy has in reject­ ficients are to some extent progressive. In ing or accepting applications for redis­ general, the credit institutions must satisfy counts or advances and perhaps because of their reserve requirements by holding inter- the state ownership or control of many lead­ est-bearing deposits with the Bank of Italy ing banks. against the first 10 per cent of their total The Bank of Italy must give prior au­ deposit liabilities in excess of net capital re­ thorization to a commercial or savings bank sources, and they may satisfy the balance, before such a bank can provide credit ac­ at the option of the Bank, by holding addi­ commodation or renew a loan to any one tional cash balances, Treasury bills, or cer­ customer if such accommodation would tain types of long-term securities. raise the customer’s total liability to the Thus far, open market operations are bank above the so-called “legal limit on still only a potential instrument of monetary credit” (limite legale di fido), defined as management, inasmuch as an important in­ one-fifth of the paid-up capital and reserves stitutional reform in November 1962, of the lending bank. Introduced in 1926 to aimed at establishing an organized money safeguard depositors, the scope of this rule market, has been slow in producing signifi­ has been extended considerably in the post­ cant results. Recently, however, the Bank war period as inflation has greatly reduced of Italy has been dealing with banks in the capital/deposit ratio of banks.54 long-term securities on a fairly large scale. The exercise of this power has been use­ Moreover, the new Treasury bill issue sys­ ful, at least at certain times, as a tool of tem introduced in early 1969 has made it monetary policy. It enables the Bank of possible for the central bank ultimately to Italy to exert a selective and restrictive in­ include short-term Government securities in fluence on the quantity and quality of bank its open market operations.53 credit, and it enables commercial banks to Direct controls over private credit flows. resist local political pressures to provide Direct controls over the banks’ loan expan­ funds to support local government spend­ sion are implemented by both legal authority ing. For example, of all lira-denominated loans outstanding to the private sector at 53 Under the present system, two types of Treasury the end of 1962 and 1963, about 25 per bills are offered. One type, which remains eligible for the fulfillment of reserve requirements but is appar­ cent had been approved by the Bank of ently offered only in limited amounts, carries a fixed Italy, and more than 70 per cent of these interest rate of 3.75 per cent. If total bids exceed the had been granted by the big banks. This total amount offered, allotments to banks are made on a pro rata basis. The second type of bill (not eli­ control has been used to prevent speculative gible to fulfill reserve requirements and not qualify­ inventory building during boom periods ing for central bank support) is offered for invest­ ment purposes at a “market” rate of interest, strictly and to limit the use of short-term credits to meet the Treasury’s temporary need for cash. Any for long-term financing of fixed invest­ amount tendered and not purchased by commercial banks may or may not be taken up by the Bank of ment. Italy, at its discretion. Once the amount of the new The “legal limit on credit” varies greatly type of Treasury bill in the portfolios of both the in amount of course from one institution to commercial banks and the central bank reaches a sufficient volume, the latter should be able to engage 54 Whereas the capital/deposit ratio was about 12 in open market operations for monetary policy pur­ per cent in 1938, it dropped to less than 2 per cent poses and thus to contribute importantly to the de­ in 1947 and was still not much more than 3 per cent velopment of a broadly based money market. in September 1969.

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another and rises as a bank’s capital re­ tions subject to the Bank of Italy’s supervi­ sources increase. Therefore, while effective sion or to be listed on a stock exchange.55 for small and medium-sized banks, this in­ This requirement extends also to bonds is­ strument has only limited usefulness with sued (other than mortgage bonds) by regard to the few giant banks. Limitation of credit institutions. Authorizations may be lending by the large banks is achieved delayed or speeded up, depending on the mainly through moral suasion. As a result current objectives of monetary policy. of the close relationship of the central bank Manipulation of commercial banks’ net exter­ to these institutions—in most of which the nal position. Manipulation of the commercial Government owns a controlling interest, banks’ net foreign exchange position has either directly or through holding companies been used vigorously since August 1960 —the Bank of Italy has obtained the coop­ and, during times of large balance of pay­ eration of these institutions in applying more ments surpluses, had been one of the most stringent “qualitative” criteria and in other significant tools of monetary management. ways slowing down loan expansion. The authorities can affect this position by Finally, direct control over flows of instructing banks to adjust their net foreign credit in the economy is enhanced by the exchange holdings vis-a-vis nonresidents to authority of the Bank of Italy to approve specified levels and thus bring about desired (concurrently with the Ministry of the changes in the banks’ domestic liquidity Treasury and subject to approval by the In- through inflows or outflows of funds. terministerial Committee), or to withhold approval of, all issues of bonds and stocks 55 The power to authorize special credit institutions (see p. 241) to float bond issues is vested with the made through the intermediary of institu­ Governor of the Bank of Italy.

JAPAN

Introduction ments. In borrowing abroad, the Japanese The Japanese monetary authorities (the are “guided” by the central bank. Bank of Japan and the Ministry of Fi­ Discount policy plays a central role in nance) are well equipped to control exter­ Japanese monetary policy, although the nal sources of liquidity and to maintain Bank of Japan also employs to some extent monetary control through their power to open market operations and variable re­ regulate the cost and availability of central serve requirements to achieve its aims. Since bank credit. This is so in large part because November 1962, when the Bank of Japan the Japanese banking system, being chroni­ introduced discount ceilings after some cally in need of liquidity, is heavily depend­ lapse and began to buy and sell securities, ent on the central bank. Moreover, broad open market operations have provided a powers to control foreign exchange enable rising proportion of the banking system’s the authorities to exercise a significant in­ credit needs. Under the conditions that fluence over changes in the central bank’s have existed since World War II, however, holdings of international assets and thus there has been only a very limited scope for over changes in the cash base that result use of reserve requirements. Deposits with from movements in Japan’s balance of pay­ the Bank of Japan to meet legal reserve re-

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quirements—the present maximum being cific monetary controls are applied at pres­ W 2 per cent of deposit liabilities—are of ent to consumer and housing credit. minor importance. Until fairly recently, the traditional in­ Access to the discount window is consid­ struments of monetary policy appear to ered a privilege. A scale of rates is estab­ have been considered adequate to deal with lished that varies with the type of paper of­ both domestic and external disequilibria. fered. Ceilings are set on the amounts that Since 1964, however, the authorities have will be lent to individual banks at the basic placed increased reliance on fiscal measures discount rate, and penalty rates are applica­ for implementing over-all economic policy. ble to borrowing in excess of the ceiling. The structure of discount rates, the types of Institutional framework paper acceptable, and the ceilings on bor­ The Bank of Japan is operated as part of rowing are all subject to change—and in­ the Government’s economic administration deed are frequently changed—in accord­ in close liaison with the Ministry of Fi­ ance with the authorities’ monetary policy nance. Some 55 per cent of its capital is objectives. And these objectives in turn are owned by the Ministry of Finance; the re­ closely geared to over-all economic policy. mainder by local authorities, financial insti­ The authorities’ control is strengthened tutions, and other private corporations and by the close links that exist between the individuals. The Bank is managed by the structure of discount rates and the structure Governor, the Vice Governor, and the of market rates. Although rates on commer­ board of directors; the directors are usually cial bank loans are permitted to fluctuate, selected from the Bank’s senior staff. Over­ they may not exceed the maximum level set all policy is determined by a Policy Board by the Bank of Japan. Moreover, there is consisting of (1) the Governor, (2) four an indirect tie between the bank prime rate, outside members (required to be experi­ which is set by the Banking Association (a enced, respectively, in banking, industry, trade organization), and the discount rate. commerce, and agriculture) appointed by The bank prime rate, which is the mini­ the Cabinet and approved by both houses mum rate charged by commercial banks on of Parliament, and (3) two direct repre­ commercial paper eligible for discount at sentatives of the Government. The Policy the Bank of Japan, is at present set at a Board is not concerned with the Bank’s level no higher than the basic discount rate. management on a current basis. In addition to controls over market rates, The banking system is dominated by 15 the authorities control the rate that banks so-called “city banks,” which operate may offer in the market for short-term de­ branches throughout the country and ac­ posits. count for almost 60 per cent of the assets Other policy instruments include so- of the banking system. In addition, there called “window guidance,” under which the are some 60 local commercial banks and a authorities have, from time to time, used variety of other credit institutions, including moral suasion—which has developed into a trust banks, long-term credit and other spe­ system of close supervision of each bank’s cialized banks, mutual savings and loan day-to-day activities—to influence the com­ banks, credit associations, and agricultural mercial banks’ lending policies, and selec­ credit cooperatives. tive credit controls, such as those over the The outstanding features of Japan’s finan­ financing of securities and imports. No spe­ cial structure are the extremely low ratio of

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commercial banks’ liquid assets to total as­ though there are no formal liquidity ratios, sets and the heavy indebtedness of the window guidance includes guidelines on banks to the Bank of Japan. This “over­ liquidity. loaned” situation is the result of the infla­ The reintroduction of ceilings on com­ tionary aftermath of World War II, which mercial bank rediscounts and advances in led to high debt/equity ratios for Japanese November 1962 stimulated the city banks industry generally; virtually all industry to search aggressively for sources of invest- debt consists of short-term bank loans. able funds, and they turned mostly to the While correction of this weakness in the call-loan market. During the next 2 years, banking system and in business has been a when Japanese monetary policy was restric­ policy objective, the authorities have been tive, the proportion of the city banks’ re­ reluctant to permit long-term interest rates sources obtained in that market expanded to rise to a level that would promote devel­ significantly. opment of an adequate supply of long-term On the average, during the period capital and thus reduce the dependence on 1960-69, 53 per cent of the funds bor­ short-term bank loans; hence a large pro­ rowed by the city banks came from the portion of private investment continues to Bank of Japan, 32 per cent from the call- be financed through commercial bank loan market, and 13 per cent from other fi­ credit, and the banks in turn replenish their nancial institutions. The call-loan market is cash reserves through credits from the cen­ supplied almost entirely by local banks, tral bank. trust banks, and mutual savings and loan Liquid assets of the banking system as a banks. In the same period city banks sup­ whole consist of cash, deposits with the plied less than 2 per cent of the funds Bank of Japan and with other financial in­ placed in the call-loan market, but they stitutions, call loans, and credit extended to borrowed more than 70 per cent of the financial institutions. Treasury operations funds available in that market. greatly affect the banking system’s liquidity. The Japanese Government holds on deposit Discounts and advances in the Bank of Japan all of its funds, in­ Discounts and advances are the main cluding the proceeds of tax collections and source of central bank credit in Japan. In of all Government borrowings. When the accordance with Japanese monetary policy, Government receives taxes or when it bor­ the authorities make such changes as may rows, the liquidity of the commercial banks be necessary in the discount rate structure, is adversely affected. There are similar the types of instruments eligible for dis­ effects when the public, which likes to hold counting and as collateral for advances, currency, increases its demand for currency. and the ceilings on borrowing from the cen­ Commercial banks maintain such liquid tral bank at the regular rates. As a matter asset ratios as they deem suitable; there are of practice, the Bank of Japan has restricted no required ratios. In recent years liquid as­ discount facilities to commercial banks, sets, including deposits with the Bank of Japan to meet legal reserve requirements, while local banks’ holdings averaged 6.6 per cent. have ranged between 3.0 and 3.8 per cent The city banks hold only small amounts of claims on the Government that are readily convertible into of the banking system’s total assets, with cash. At the end of December 1969, the equivalent the bulk accounted for by vault cash.30 Al­ of $1,040 million, or less than 2 per cent of total as­ sets, was held in this form. However, since mid-1965 56 During the 1960-69 period, liquid assets of the banks’ holdings of long-term Government paper have city banks averaged 2.1 per cent of their total assets, increased.

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even though the law does not limit exten­ during that month the rate for commercial sion of such facilities to any specific cate­ bills was equalized with that for loans se­ gory of borrower. There has been a tend­ cured by Government securities and desig­ ency lately to expand the range of financial nated paper, as shown in the accompanying institutions that are welcome to use central table. bank credit. Private corporations and indi­ RECENT CHANGES IN RATES ON DISCOUNTS viduals have not in practice used the Bank AND ADVANCES of Japan’s facilities. Individual banks bor­ Per cent per annum row from the central bank on a continuous August September January basis. City banks are the main borrowers, Type 1968 1969 1971 in terms of both volume and duration of Commercial bills...... 5.84 1 Government securities and spe­ \ 6.25 5.75 borrowing; local banks borrow less and for cially designated securities. . . . 6.21 j Export trade bills: shorter periods. Usance bills in yen...... / 5.00 Advance bills...... | 4.02 4.25 \ 5.25 Commercial bills,57 including notes Advances, secured by — Export trade bills...... 4.38 4.50 drawn by specified marketing organizations, Export advance bills...... 5 . 50 and export trade bills are eligible for dis­ Other bills and securities...... 6. 57 6.75 6.00 count at the applicable rate. The following types of paper may be used as collateral Export financing is an important part of for advances: Government bonds and bank lending in Japan. About half of all bills, Government-guaranteed bonds, bank export financing is through commercial debentures, specified municipal and corpo­ bills, which are rediscountable provided the rate bonds, rediscountable commercial bills, remaining maturity does not exceed 3 export trade bills, and other general bills months and there is a supporting letter of considered suitable by the Bank of Japan. credit. Although much foreign trade is Rate structure. The rate structure is fairly financed abroad, goods for export are complex. The Bank of Japan presently financed domestically until they are actually maintains five “basic money rates,” depend­ shipped, and discounts of and advances ing on the type of paper discounted or on these bills have been substantial.50 Al­ pledged as collateral.58 Discounted commer­ though the rate structure makes the dis­ cial bills are charged the Bank of Japan’s counting of export bills the preferred means “basic discount rate,” which is subject to of obtaining central bank credit, the banks frequent change, usually in conjunction borrow from the central bank mainly with the whole range of rates. The rates ap­ through advances, presumably because plicable to export paper are lower than the there is a shortage of export bills. In May basic rate, whereas the rates on advances 1970 the Bank of Japan introduced a dif­ secured by specified Government securities ferential of Va of a percentage point be­ are higher. In September 1969 the Bank of tween the rates on “export usance bills in Japan discontinued the preferential treat­ yen” (postshipment bills) and “export ad­ ment of commercial bills, and on the occa­ vance bills” (preshipment bills), which pre­ sion of the official discount rate change viously had always been discounted at the same rate. 57 Two-name paper either drawn or accepted by a Penalty rates. The Bank of Japan has purchaser of goods for resale in settlement of the used a system of ceilings on discounts and purchase and payable by the buyer. 58 Prior to September 1967, when import trade 59 Until September 1967 commercial banks could bills and overdrafts ceased to be eligible for dis­ also obtain overdrafts at the Bank of Japan, but this counting, the structure consisted of seven basic facility was used little because the last rate was 1.09 money rates. percentage points above the basic rediscount rate.

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advances and of “penalty” rates on borrow­ level of total borrowing at that time from ing above the ceilings more or less continu­ the Bank of Japan by the 10 city banks ously since 1912. Since World War II, the subject to ceilings, and each bank’s ceiling system has involved three levels of rates: was fixed at the amount of its actual bor­ basic rates on discounts and advances, and rowing. After 1964, however, the ceilings two sets of higher rates on borrowing in ex­ of individual banks were determined as a cess of specified percentages of a (fre­ percentage of the total ceiling—the percent­ quently revised) ceiling for each bank. Be­ age for a particular city bank being calcu­ cause of the heavy reliance by commercial lated on the basis of the relation of the banks on central bank credit, particularly bank’s borrowing in the call-money market during the early postwar reconstruction pe­ to the total of its capital and deposits. riod, the maximum penalty rates, rather Finally, since August 1967 a more com­ than the relatively low basic rates, deter­ plex formula has been in effect, and at pres- mine the actual cost of borrowing. sent the ceiling for each bank is revised every The discount rate structure has been sub­ 3 months. Under this system a fixed factor ject to several major changes in recent is applied to capital funds (including surplus years. In March 1957 the complex penalty and undivided profits), and from the result­ rate system was replaced by a single set of ing figure the amount of borrowing in the penalty rates. This arrangement was contin­ call-money market and from the Bank of ued under the “New Monetary Adjustment Japan is subtracted. A certain percentage of Measures,” which were introduced in No­ this residual is assigned to the bank as its vember 1962. At that time the Bank of ceiling. The new method of calculating the Japan began more active operations in ceiling gives an advantage to banks with Government securities in order to facilitate large and increasing capital funds. the adjustment of commercial banks’ re­ In determining credit ceilings, the Bank serve positions (see p. 251). of Japan excludes export financing credits. Such open market operations, together It also excludes certain credits granted to with adjustments (so far, with one excep­ the city banks that made loans in 1964 and tion, downward) in the commercial banks’ 1965 to two companies for the purpose of ceilings on discounts and advances, have stabilizing the stock market (see p. 252). for all practical purposes eliminated com­ The proceeds of such loans by the Bank of mercial bank borrowing from the Bank of Japan were available to the borrowing Japan in excess of individual discount ceil­ banks to reduce their regular borrowing. ings. Since the end of 1962, therefore, a Thereafter, the ceilings of these banks and rising proportion of central bank credit to the total over-all ceiling were cut by ap­ the banking system has been provided proximately the amount of such special loans. through increases in the Bank of Japan’s Central bank discounts and advances holdings of securities. Although discounts are not formally limited in duration, nor and advances have continued to expand in are the rates charged by the central absolute terms, they have declined some­ bank changed with the term or the fre­ what in relative importance. quency of such borrowing. However, in Ceilings on discounts and advances. When practice, individual loan agreements often ceilings for central bank credit (discounts specify a maximum and a minimum time to and advances combined) were reintroduced maturity. These maturities, which are deter­ in 1962, the total ceiling was set at the mined by the central bank, vary from 2

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days to 3 months, depending on the author­ have been undertaken to offset the tighten­ ities’ assessment of the projected cash needs ing effects of seasonal inflows of funds to of the individual bank. the Treasury. In November 1962 the Bank of Japan Commercial bank interest rates became more active in buying and selling securities, but these operations were still of The Bank of Japan, in conjunction with the limited significance for several years be­ Ministry of Finance, has the authority cause of the shortage of Government (under the Temporary Rates Adjustment securities.60 However, large amounts of 7- Law of 1947) to set maximum rates on year Government bonds have been issued loans and deposits for all banks. since 1966, mainly to banks, and purchases Rates on loans are determined, within of such bonds by the Bank of Japan in the Bank of Japan’s maximum rates (which 1968 and 1969 equaled nearly two-thirds have not been changed since 1957), by in­ and one-fourth, respectively, of the increase terbank agreement through the Banking in note circulation in those years. Association. Effective rates are currently Although authority to impose flexible re­ lower than maximum rates; for instance, in serve requirements was granted to the Bank December 1969 the rate for discountable of Japan in 1957, it was not used until prime bills— lowest in the rate range— was 1959. The central bank has authority to the same as the central bank’s basic dis­ impose separate ratios on time deposits and count rate (6.25 per cent), while the maxi­ on all other deposits—for the latter cate­ mum rate was 9.50 per cent. Changes in gory up to a maximum of 10 per cent. the “prime” or “standard” rate on loans fol­ Since their introduction in 1959, reserve re­ low changes in the discount rate almost au­ quirements have been changed seven times, tomatically. mostly to reinforce the effects of changes in The rates payable by commercial banks the discount rate. In September 1969 (after on deposits are not linked to the discount the most recent change) the required ratios rate. They tend to change infrequently; in ranged between Va and 1 V-i percentage fact, only two changes have been made in points, the effective ratio for a particular the last 10 years. At present the prevailing commercial bank reflecting the amount of rates on deposits are at the ceiling set by deposit liabilities in each category. There is the authorities. a uniform penalty at a rate 3% percentage points above the basic discount rate on all Other instruments of monetary policy reserve deficiencies. An important change in implementing mon­ Moral suasion in the form of window etary policy in the postwar period has guidance is used by the Bank of Japan as been the expansion of open market opera­ tions by the Bank of Japan. Although open 60 In December 1965 the Bank of Japan, in addi­ market operations had been conducted for tion, introduced a repurchase system for foreign ex­ change bills (denominated in U.S. dollars) against some time on a small scale for strictly lim­ which previously the central bank had extended ited purposes, it was not until 1958 that the loans. Credit supplied to each bank under repurchase Bank of Japan began to sell bills from its agreement is subject to a separate ceiling determined by the central bank. Reportedly this arrangement has portfolio to banks in order to absorb sur­ so far not been used by the Bank of Japan, which plus funds. Since 1960 open market pur­ considers it as a safety valve to give commercial banks access to foreign exchange, mainly dollars, to chases of Government-guaranteed bonds meet their external commitments.

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a form of credit control, particularly in pe­ stances the lending activities of commercial riods of monetary restraint. Window guid­ banks ought to be left to the banks’ own ance may be applied to individual banks or judgment and discretion, and that the through general directives to all commercial banks’ knowledge of, and desire to cooper­ banks. The central bank advises the com­ ate with, over-all Government economic mercial banks regarding lending policies policies provides adequate guidance. that the banks should follow and also regard­ The banking system’s high degree of reli­ ing other uses of funds. The banks use this ance on central bank credit suggests that advice as a guide in dealing with their cus­ the importance of window guidance as a tomers. means of policy implementation should not Until May 1963 the formal system of be underestimated. Such guidance does not window guidance in use was based on a involve the use of formal penalties; it is car­ monthly review of commercial banks’ lend­ ried out on the basis of the traditionally ing, on which detailed reports were sub­ close relationship between the central bank mitted to the central bank, and on projec­ and individual commercial banks, and the tions of sources and uses of funds. Monetary success of the system depends on the latter’s policy was easy throughout the remainder of cooperation and desire to avoid expression 1963, but was tightened in January 1964. of official criticism, which in Japan is a Thereafter, window guidance was based on major factor shaping business behavior. a 3-month—and after 1965 on a 6-month Under the Securities Transactions Law, —review of commercial banks’ lending and the Ministry of Finance has the power to on guidelines that limited all banks to ex­ impose margin requirements on securities plicit and uniform rates of credit expansion. transactions, and the Bank of Japan is au­ In June 1965 the formal system of win­ thorized to control the conditions of lending dow guidance was discontinued, because at by financial institutions to securities compa­ that point the Bank of Japan believed that nies. The Ministry has acted under this au­ the commercial banks’ cautious attitude thority, but the Bank of Japan has not. under conditions of domestic sluggishness Other credit control instruments, such as would be adequate to curtail lending. But pre-deposits for imports (suspended since in September 1967 the Bank reinstated the May 1970), are administered by the Minis­ system it had abandoned in 1965. try of International Trade and Industry Then in October 1968 the Bank of Japan with the agreement of the Ministry of Fi­ changed the nature of its window guidance. nance. Almost uniform controls on the rates of in­ Toward the end of 1964 the persistent crease of loans of all city banks were re­ weakness in the stock market prompted the placed by a procedure that determines indi­ Bank of Japan, together with other finan­ vidual banks’ lending quotas on the basis of cial institutions, to undertake extensive sup­ their liquidity positions as well as total loan port operations. This support took the form volumes. of central bank credit—on an unspecified The authorities regard window guidance emergency basis and reportedly amounting as a temporary and supplementary mone­ to about $1 billion equivalent—to quasi- tary tool to be applied especially when mon­ governmental stock-buying and stock-hold- etary restraint is indicated. The Bank of ing agencies. The portfolios of these agen­ Japan believes that in ordinary circum­ cies have now been liquidated.

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Quantitative role of central bank cent of all bank loans to the private sector. credit policy However, open market operations have be­ The private sector’s heavy reliance on cen­ come gradually more important since No­ tral bank credit is a main feature of Japan’s vember 1962; indeed, in the 4 years ended financial structure. In individual years since September 1966, the Bank of Japan’s hold­ 1958 central bank loans and discounts have ings of securities increased substantially accounted for between 4.1 and 11.7 per more than its discounts and advances.

NETHERLANDS

Introduction The discount mechanism performs essen­ In its conduct of monetary policy the Neth­ tially as a safety value. It serves to accom­ erlands has relied heavily in recent years on modate the banks in meeting seasonal direct control of credit and on management swings in their cash needs caused by of liquidity of external origin. The discount changes in circulation of bank notes, in the mechanism, as well as all other indirect in­ balance of payments, or in Government fi­ struments of monetary policy, has played a nancial operations. Changes in the discount secondary role because until recently most rate serve in the main to signal changes in of the banks had ample liquidity. The main the economic situation. In general, the focus of monetary policy in the Netherlands Bank’s discount rate is a ceiling for the has been on the availability of credit rather rates on short-term Treasury bills and call than on interest rates. money.

In its efforts to achieve internal monetary Structure of the banking system stability, the Netherlands Bank has been The accompanying tabulation shows the hindered by the conflicting requirements of number and total assets, as of the end of external policy. It is this conflict between 1969, of the registered credit institutions domestic and external policy objectives that has caused the Bank to subordinate indirect supervised directly or indirectly by the Netherlands Bank. means of monetary control in favor of di­ rect controls over bank credit expansion. Total assets (millions of Variation of the cash reserve ratio was dis­ Type of institution Number guilders) continued because, in the words of the Commercial banks 80 40,549 Bank, if the ratio were raised “the resulting Central institutions of the agricultural credit banks 1 2 16,576 sterilization of liquidity would have led to Unaffiliated agricultural credit sales of foreign exchange to it (the Bank) banks 11 336 Security credit institutions 45 166 without effectively reducing the liquidity of General savings banks 205 8,370 the banks.” 61 On the same grounds, open 1 With 1,251 member credit banks and 1,272 member sav- market operations have not been used re- ings banks. S o u r c e .— Netherlands Bank, Report for the year 1969. strictively to any significant degree. Although the Netherlands has many commercial banks, a very large proportion 61 Netherlands Bank, Report for the year 1964, p. 104. of commercial banking business is done by

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a relatively few banks, and the concentra­ Instruments of monetary policy. The instru­ tion of banking has been considerably in­ ments of monetary policy available to the creased by mergers that have taken place Bank are: (1) control over the volume of since 1964. Branch banking is highly devel­ central bank credit, both in the form of oped. In the spring of 1968 the three larg­ borrowing by the credit institutions and in est commercial banks in the Netherlands the form of open market operations; (2) controlled about three-fourths of the assets operations in the foreign exchange market; of all commercial banks. (3) control over borrowing from or lending The money market in the Netherlands is to foreigners; (4) variation of cash reserve probably less important, in terms of total requirements; and (5) direct limitation of volume relative to the size of the country, the volume of credit extended by banks and than the money markets of the United other credit institutions. States and the United Kingdom. Commer­ The Netherlands Bank uses discount pol­ cial banks, the bill brokers (discount icy mainly to signal a change in, or rein­ houses), and the two central institutions for forcement of, its monetary policy and at agricultural banks participate on both sides times to influence the lending rates of com­ of the market. The central government and mercial banks. Although there is no formal the local authorities appear mainly as bor­ linkage between central bank and commer­ rowers, and the two giro transfer services, cial bank rates, changes in the former tend institutional investors, savings banks, and to be reflected in the latter. large business firms appear mainly as lend­ In its use of discount policy and in its ers in the market. In the past the Nether­ open market and foreign exchange opera­ lands Bank has intervened occasionally on tions, the Bank is empowered to act with­ one side of the money market or the other, out consulting either the Government or the but since the spring of 1964 it has not en­ credit institutions. Two other principal in­ gaged in any open market operations. struments of monetary policy—variation of Commercial banks may obtain funds cash reserve requirements and credit guide­ from the money market, which is concen­ lines—may be employed only by securing trated in Amsterdam, either by borrowing the voluntary cooperation of the credit in­ on call loans or by selling Treasury bills; in stitutions. Although the Act for the Super­ terms of quantity, borrowing is the more vision of the Credit System (as amended in usual means. Since 1958, when the guilder 1956) empowers the Bank to issue general was made fully convertible and the banks directives to the credit institutions on cash began to invest abroad on a large scale be­ reserve requirements and on lending poli­ cause of the interest incentive, repatriation cies for the purpose of regulating the value of funds has been an important means by of the guilder, the Bank may issue such which the banks adjust their cash positions. directives only after failing to secure volun­ tary cooperation. And in such case the Mechanism through which monetary policy Bank’s directives must be approved by the operates Finance Minister and ratified by the legisla­ The Netherlands Bank is charged (by an ture within 3 months, after which they may Act of 1948) with responsibility for regu­ have a maximum validity of 2 years. How­ lating the value of the guilder in such a ever, the Bank has never found it necessary way as to promote the welfare of the coun­ to exercise this authority. try and (by an Act amended in 1956) for Although the Netherlands Bank is au­ supervising the credit system. thorized to undertake open market opera­

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tions and to impose cash reserve require­ repatriation of funds from abroad rather ments, it currently makes no use of these than to an effective reduction in the domes­ policy instruments. And whereas formerly tic liquidity of the banks. the Bank eased temporary pressures in The higher levels of interest rates abroad the money market by purchasing Treasury have been the main factor inducing com­ bills from bill brokers under repurchase mercial banks to keep a substantial propor­ agreement, its present policy is to employ tion of their liquid assets in foreign invest­ operations in the foreign exchange market ments. During the early 1960’s the for that purpose. Netherlands Bank discouraged the banks The Bank is also empowered to issue from repatriating funds to meet temporary general directives of unlimited duration to tightness in the money market. In 1965, the banks and to other credit institutions however, the Bank ceased to buy Treasury for the purpose of ensuring their liquidity bills from the bill brokers under repurchase and solvency. These directives sometimes agreement and instead offered to sell dollars have an effect on the credit situation as, for forward—often without charging a prem­ example, in 1964. At that time the Nether­ ium—while simultaneously making spot lands Bank issued a directive increasing re­ purchases. As explained in the 1965 annual serve requirements for savings banks. Ac­ report of the Netherlands Bank, “The cording to this directive, savings banks were banks were thus enabled to acquire guilders required to hold in the form of primary by temporarily repatriating funds from liquid assets—that is, cash and sight depos­ abroad instead of by temporarily parting its in other banks—10 per cent of all de­ with Treasury paper.” posits that have a high rate of turnover. Under the Foreign Exchange Control An agreement between the credit institu­ Decree of 1945, the Netherlands Bank may tions and the Netherlands Bank concerning also order the commercial banks to restrict maintenance of minimum cash reserves is their foreign borrowings. In 1964, for in­ still formally in effect although it is not in stance, it directed each bank authorized to use. The agreement, concluded in 1954, deal in foreign exchange markets not to provides that the commercial banks and the permit its foreign liabilities to exceed its central institutions of the agricultural credit foreign assets by more than 5 million guild­ banks may be required to maintain reserves ers ($1.4 million). Under the same decree at the Netherlands Bank that may range as foreign capital issues and loans to nonresi­ high as 15 per cent of their deposit liabili­ dents also require a license from the Neth­ ties, with the first 15 million guilders of de­ erlands Bank. The Bank thus regulates for­ posits being exempt. eign issues in accordance with the This required cash ratio has been zero requirements of domestic monetary policy since September 1963. At that time the —at times withholding approval for a long Netherlands Bank established direct and time or refusing it altogether. specific limits on credit expansion and re­ The Netherlands Bank also uses adminis­ quired the deposit of interest-free compen­ tration of foreign exchange controls and its sating balances at the Bank for noncompli­ authority to operate in the foreign exchange ance with these guidelines. The required markets to influence domestic monetary cash reserve ratio was reduced to zero be­ conditions. From time to time the Bank in­ cause, given the tightening effect of the in­ tervenes in the forward exchange market to crease in bank note circulation, mainte­ encourage commercial banks to increase or nance of the ratio would have led to decrease their holdings of foreign exchange

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in order to influence the domestic liquidity excessive reliance of local government au­ of the banking system and conditions in the thorities on short-term bank credit, how­ money market. The Netherlands Bank has ever, the monetary authorities in 1967 ex­ also relied on direct control of commercial tended the credit guidelines to cover bank banks’ net foreign asset positions. For ex­ loans to local authorities as well. ample, when attractive rates in the Euro­ Moreover, the Netherlands Bank acted to dollar market in 1969 induced commercial close the loophole for long-term lending on banks to increase substantially their net for­ May 1, 1965. At that time, after consulting eign asset positions and the banks financed with the representative organizations, it re­ this build-up largely through reliance on the quested that the banks not allow the in­ discount window, the Netherlands Bank re­ crease in their long-term assets to exceed the quested that commercial banks halt the increase in their long-term liabilities. The growth of their net foreign assets and cut restriction on long-term lending was allowed such assets back by 10 per cent during the to lapse in 1967 in line with a more expan­ second half of the year. sionary monetary policy, but was invoked Control over credit expansion. Direct con­ again in late 1968 (and was maintained trol over the rate of credit expansion was throughout 1969) as the monetary author­ the principal instrument of monetary policy ities effected another policy reversal. In between 1960 and 1970. Agreement with March 1969 the Netherlands Bank, recog­ the organizations representing the banks nizing a trend toward an increased turnover and agricultural credit institutions on a gen­ in savings deposits, extended the applica­ eral formula for restricting credit expansion tion of restrictions on long-term credit to was reached by the Netherlands Bank in include savings banks. 1960. This formula was to be applied when Each bank that exceeded its total credit necessary and the permitted rates of expan­ ceiling was requested to hold at the Nether­ sion altered as required. lands Bank for 1 month an interest-free de­ The Netherlands Bank relied strongly on posit in the amount by which the ceiling voluntary credit ceiling agreements in the was exceeded. The criterion for compliance 1960’s: it allowed the agreements to lapse with credit guidelines was determined on only briefly, once in 1963 and again in the basis of the bank’s level of loans out­ 1967 and 1968. Central bank consultations standing at the end of the month; if the every 4 months with the bankers’ organiza­ average of the last three end-of-the-month tions helped to make the system a flexible positions was in excess of the credit one. The permissible expansion of lending guidelines, a penalty deposit was required. was expressed in terms of a formula re­ Each bank is penalized only if the aggregate stricting the growth of short-term credit to of all types of bank lending has exceeded the a certain percentage of the average credit credit ceiling. The enforcement of penalties outstanding in a previous base period. Vari­ was also modified on occasion to support ations in the permissible rates of credit ex­ pansion were made to allow for seasonal policy goals. For example, in June 1966 variation in lending. the Bank required that under certain cir­ Credit ceilings in the early 1960’s ap­ cumstances penalty deposits be maintained plied only to short-term lending to the pri­ at the prescribed level at all times instead of vate sector, defined as loans with a maturity allowing the banks to take the average of of less than 2 years. Due to frequent and their positions over the period.

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Discounts and advances within bounds. Banks and other credit insti­ The Netherlands Bank establishes its rate of tutions have traditionally resorted to central discount, the rates on certain other types of bank credit only to a small extent. loans and advances, and the maturity of the Credit is made available through dis­ paper it will accept. The types of borrowers counting of eligible paper as well as in the to be accommodated and the types of col­ form of advances at a higher rate. The lateral acceptable, however, are stipulated Bank may refuse credit to prospective bor­ by law. rowers, and at times it has made access to Eligible borrowers. All “registered” credit its resources dependent upon the conduct of institutions, including savings banks as well the borrowers. As a general rule, banks try as bill brokers, have access to central bank to manage their cash positions in such a credit. However, the Bank accommodates way that they have no need to borrow from savings banks only on the condition that the Netherlands Bank. However, the tradi­ they refrain from making new investments tion against such borrowing tends to break while they are indebted to the Bank. The down when the banks are subject to very Bank also has a small number of private strong liquidity pressures. Except for the customers, who occasionally take a secured local authorities, there are no formal quotas advance from the Bank at a rate of 1 per­ or ceilings, nor is there an official maxi­ centage point above the rate charged credit mum duration for advances. However, the institutions for similar advances. Netherlands Bank does exert moral suasion Local authorities have access to the dis­ on banks making excessive use of its credit count window, but their access is subject to facilities. formal quantitative restrictions.62 These re­ Eligible paper and collateral. The Nether­ strictions appear to be directed more at re­ lands Bank may discount (1) bills of ex­ straining short-term borrowing by local change and promissory notes having two authorities than at reducing the amount of signatures and having a maturity in accord­ such paper actually discounted or used as ance with the customs of trade; (2) bills collateral for advances from the Bank.63 and notes of the Netherlands Treasury; and The Netherlands Bank regards access to (3) debenture bonds redeemable within 6 its credit as a privilege, not a right, and months. By contrast, the range of assets credit institutions are expected not to use that the Bank may accept as collateral for its facilities on a continuous basis. The advances is quite broad, since it includes all Bank has no formal guidelines governing discountable assets, plus other securities, the amount of credit that the banks and bill merchandise, warehouse receipts, and coin brokers may take up; rather it relies upon and bullion. moral suasion to keep use of its credit The Bank has set a limit of 105 days on the maturity of short-term securities (Treas­ 62 Only those local authorities whose floating debt does not exceed 25 per cent of their current revenues ury paper, commercial bills, and bank ac­ are allowed access to the Bank’s credit facilities. ceptances) that it will accept for discount. 63 The National Government has in general no di­ rect access to the discount window. However, the Subsequent to an agreement in 1967, how­ Netherlands Bank may, on its own initiative, buy ever, it has allowed export credits with ma­ Treasury bills directly from the National Govern­ turities of 5 years or more to be considered ment, as it did for instance in the summer of 1968, to avoid seasonal pressures in the money market. The discountable and eligible as collateral for Bank is also authorized by statute to grant the Na­ loans. The purpose of this exception was to tional Government an interest-free line of credit up to 150 million guilders ($41 million). lower the interest rate for these bills.

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Rates. In addition to the discount rate— Banks having debit balances resulting its rate for discounting bills of exchange— from check clearings obtain almost auto­ the Bank specifies rates for three other matic advances from the Bank to cover kinds of transactions: discounts of promis­ such balances; normally the banks repay sory notes; loans and advances to private within the same day, and there is no customers; and loans and advances to oth­ charge. Banks obtain funds for repaying ers. The principal effective rate is the rate advances from the Bank by borrowing in, on advances to others, the category that in­ or recalling funds from, the call-money cludes banks and bill brokers. This rate is market; by selling Treasury bills; or by con­ regularly the same as the rate for discount verting foreign exchange. of promissory notes, and both rates are gen­ Netherlands Bank credit in the form of erally 50 basis points higher than the dis­ open market transactions has been used in­ count rate. The rate for advances to private frequently in recent years. One reason for customers is regularly 1 percentage point the negligible recourse to the Netherlands higher than the rate for advances to banks Bank through the mid-1960’s was that and bill brokers. whenever tightness in the money market Actual practices with respect to central bank threatened to induce banks to repatriate credit. Borrowing from the Netherlands funds held abroad, the Netherlands Bank Bank by banks, bill brokers, and local au­ would temporarily lower the required cash thorities often takes the form of secured ratio. Another deterrent was the fact that overdrafts (advances on current account). banks could average their balances at the These advances are obtained mainly against Netherlands Bank over a reserve period in the security of Treasury bills and notes that order to conform to the required cash ratio; the banks have in safekeeping at the Nether­ in other words, they could draw down their lands Bank. Such overdrafts accounted for large balances at the Netherlands Bank to 62 per cent of the 273 million guilders of meet temporary liquidity drains provided loans outstanding on the average to the their balances met the required average Bank’s nongovernmental customers in 1967; over the reserve period as a whole. In 1963 the remainder represented discounts of the required reserve ratio was reduced in Treasury paper and bank acceptances. three steps to zero, and as of July 1970 it Although commercial bills are legally eli­ was still zero. gible, in practice the Bank rarely discounts After the cash ratio became inoperative, such bills or accepts them as collateral for banks were required to keep deposits at the advances as long as the borrower has Netherlands Bank only if they exceeded the short-term Treasury paper in its portfolio. prescribed limits on credit expansion. On The preference of banks for advances, de­ the other hand, as a result of the decline in the banks’ foreign assets and of the increase spite the fact that the rate is 50 basis points in bank note circulation, the average higher than the Bank’s discount rate, stems amount of borrowing from the Netherlands largely from the fact that an advance can Bank has increased in the past few years; be for as short a period as 1 day. The hence the ratio of bank borrowing to cash banks normally need recourse to the central balances has risen sharply. bank only for short periods, and discounts Because the major factors influencing the at the Bank must be for a minimum of 10 money market—such as the foreign bal­ days. ance, Treasury receipts and expenditures,

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and seasonal cash drains—tend to affect the the 3 per cent level have little effect upon liquidity of banks and bill brokers in the commercial bank lending rates. However, same direction and at the same time, the the discount rate of the Netherlands Bank volume of central bank credit often fluc­ has not been below this level since No­ tuates sharply from week to week, and even vember 1959. from day to day. Similarly, no formal regulations govern Linkage of commercial bank rates to central rates paid on deposits. As a consequence of bank rates. In setting the rates they charge sharp competition in this field among the on loans, banks are not restricted by either banks, especially in recent years, rates on regulations or formal conventions. Neither deposits are relatively high. are the banks required to inform anyone Changes in the rates of the Netherlands except their customers of these rates. Ac­ Bank are often made in concert with cording to unofficial reports, lending rates changes in other monetary policy measures. appear to run from 2 to 2Vi percentage The fact that commercial bank lending points higher than the discount rate of the rates tend to follow changes in the Bank’s Netherlands Bank. It is also reported that discount rate reflects not a direct causal the banks usually do not lend at rates of link between these rates, but rather the less than 5 per cent; therefore, changes in economic climate in which monetary policy the Netherlands Bank’s discount rate below is made.

SWEDEN

Introduction commercial banks, (2) by open market op­ Monetary policy in Sweden is the responsi­ erations and debt management policy (im­ bility of the Bank of Sweden (Riksbank), plemented in part through the borrowing but in implementing that policy the Bank is and lending operations of the National assisted considerably by the operation of Debt Office), (3) by required liquidity ra­ the National Debt Office, which is responsi­ tios (which are designed as much to secure ble for management of the Government a supply of bank credit to the Government debt. Both are official agencies responsible and the housing sector as to control over-all to Parliament. bank credit), (4) by penalty rates for con­ The Swedish discount mechanism, sup­ tinued or excessive rediscounts, and (5) by ported by a variety of other policy tools, is bond-issue control. Cash ratios for, and an effective instrument for influencing the ceilings on advances to, commercial banks cash base of the banking system. Further­ and required portfolio ratios for other finan­ more, the Bank of Sweden has broad pow­ cial institutions have also been applied from ers to restrict borrowing abroad by Swedish time to time. residents—although not commercial bor­ The discount mechanism in Sweden is rowing associated with the conduct of used primarily to meet the extreme bi­ trade. monthly squeeze on bank liquidity caused The central bank influences the over-all by the pattern of Government tax receipts volume of bank credit in several ways: (1) and expenditures. Changes in the central by modifying the terms of its advances to bank’s holdings of Government securities—

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which reflect mainly transactions with the deposits of this system have accounted for National Debt Office—are used to cushion the bulk of the movement in the funds of swings in the bank’s holdings of foreign all depositors at the Bank of Sweden. currencies and in deposits of the Invest­ The Bank of Sweden works closely with ment Reserve System. (See footnotes 64 and the National Debt Office with a view to in­ 65.) The results of the net change in all of tegrating debt management and general the Bank’s assets and liabilities (including monetary policy. On the other hand, it advances and Government current-account maintains no direct working relationship deposits) affecting bank liquidity and of the with the administering board of the Invest­ operations of the other two accounts have ment Reserve System, and its role with re­ been to expand the banking system’s re­ spect to management of the funds of that serves each year. In general, the amount of system is passive. funds supplied by all such Bank transactions The banking system in Sweden is highly has varied roughly with the posture of concentrated. It consists of five large banks*16 monetary policy. —four with branches throughout the coun­ On the whole, it appears that in recent try and one that is active only in the Stock­ years commercial bank credit has responded holm and Goteborg areas—and nine re­ to monetary policy with considerable sensi­ gional banks. In addition, two specialized tivity, which suggests that the Swedish mon­ central institutions serve as lenders of last etary authorities possess adequate tools to resort, one for savings banks and the other control the liquidity of commercial banks in for agricultural credit associations. the face of fairly wide fluctuations in Swe­ The banks adjust their liquidity first by den’s external positions. buying and selling Government securities and foreign exchange and, if further adjust­ Institutional framework ments are necessary on any day, by borrow­ The Bank of Sweden is expected to imple­ ing in the day-to-day market. The banks, ment the Government’s economic policy as the National Debt Office, and some other enunciated in the budget message and ac­ financial and nonfinancial institutions par­ cepted by Parliament. It administers foreign ticipate in that market. Borrowing against exchange control and performs a number of collateral at the central bank is used only banking and other functions for the Gov­ as a last resort. ernment. As the Government’s banker, it makes funds available to the National Debt Discounts and advances Office64 and receives deposits from that Central bank credit to the commercial office and from the central government— banks is in the form of advances against but not from business enterprises of the collateral. This collateral may be Treasury central government (which deal with a bills, Government bonds, or other bonds Government-owned commercial bank) or quoted on the stock exchange, but the pre­ from local governments. It acts also as de­ dominant part is in the form of Treasury positary for the Investment Reserve Sys­ bills and Government bonds.67 The basic tem.65 In recent years fluctuations in the 1930’s and expanded in 1955 as a means by which to foster, through the establishment of tax-favored 64 The National Debt Office administers the public reserves, countercyclical capital spending. debt and is responsible for managing the funding and 66 One of the large banks is Government-owned. borrowing operations of the central government. 67 The central bank also grants discounts to non­ 65 The Investment Reserve System, administered by financial business concerns, but the amount of such the Labor Market Board, was established in the direct lending is not significant.

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rate that the central bank charges on ad­ ods of tightness the conditions were made vances is a key determinant of the interest still more rigorous; under these circum­ rate structure in Sweden. Until 1970, rates stances a bank that failed to follow the li­ on loans and deposits of commercial banks quidity recommendations of the central bank customarily were geared to the discount rate. paid a penalty rate on all borrowing in ex­ Advances by the central bank to com­ cess of 25 per cent of its own funds. mercial banks are normally made at the However, after 1964 the penalty rate was discount rate, or at a rate that is 1 percent­ set uniformly at 3 percentage points above age point above the discount rate if the the discount rate. To make the penalty-rate banking system, collectively, has been in system fully effective, borrowing for the debt for more than 5 days. An even higher purpose of re-lending to other banks is pro­ penalty rate is imposed on banks that bor­ hibited. row excessively in relation to their capital Funds may also be supplied to the bank­ accounts or that do not meet the liquidity ing system by the National Debt Office. ratio. The penalty rate is particularly effec­ This office, which as noted above has au­ tive in controlling the amounts that banks thority to borrow at the central bank, has borrow to cover the large swings in liquid­ been empowered since 1964 to lend in the ity that are associated with bimonthly day-to-day market. Such lending, under­ swings in Government receipts and expend­ taken after consultations with the central itures. (See below.) bank, has helped to even out the swings in Advances are normally made by the cen­ reserves associated with the bimonthly tax tral bank only to meet temporary needs of collections. The National Debt Office also the banking system. Such borrowing by the borrows extensively in the short-term mar­ commercial banks is for a minimum period ket every other month between the 10th— of 3 days. The borrowing bank pays the when the central government makes large basic rate on funds borrowed for that expenditures to the local governments, period and for the next 2 days; for addi­ which deposit the funds with the banks— tional days the bank pays an additional 1 and the 20th—when the central govern­ percentage point.68 ment recei¥es-tax payments.* The effect of In periods of tight monetary policy, how­ these borrowings is to smooth out money ever, the effective rates on advances are market conditions because the banks have a higher than the discount rate. Penalty rates surplus of funds during that period. were applied intermittently between 1961 After the 20th of the month, tax collec­ and 1964. Such rates are usually levied tions cause a squeeze on the banks; this against commercial banks whose borrow­ squeeze tightens until the end of the month ings from the central bank are high relative and then gradually weakens. It is during to their capital and/or against banks not this bimonthly squeeze that the banks are observing recommended liquidity ratios (see usually forced to seek advances from the below). At first, a rate double the dis­ Bank of Sweden, thus providing the central count rate was charged on borrowings that bank with its best opportunity to restrain exceeded 50 per cent of a bank’s share cap­ commercial bank lending through the use ital and reserves. Subsequently, during peri- of the penalty rate. 68 An additional condition is that in order to be During the period 1959-69 average net able to borrow at the basic rate, a bank must have borrowings (indebtedness minus sight de­ been free from debt to the central bank for at least 3 days. posits) of commercial banks from the Bank

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of Sweden generally increased as monetary have been designed to assure priority for policy tightened (except in 1964, when Government borrowing and for the financ­ there was a large external surplus) and de­ ing of residential construction. They have creased as policy eased. Nevertheless, for not been used as a flexible tool of monetary the period as a whole there was a strong policy, but they do influence the cost of upward trend in average gross borrowing central bank credit because banks that do by the banks. not observe the ratios are charged penalty rates on their borrowing from the central Other instruments of monetary policy bank. Also, liquidity ratios reinforce the Lending by the Bank of Sweden to com­ pressure on banks to curb any lending that mercial banks is integrated with other mon­ is financed by open market sales of long­ etary policy tools, especially minimum li­ term securities. Although the central bank quidity ratios, open market operations, and was given powers in 1962 to impose com­ control of bond issues. The central bank pulsory liquidity ratios on commercial also operates in the foreign exchange mar­ banks and other credit institutions, it pre­ ket to maintain the external stability of the ferred to continue the voluntary approach krona. To facilitate achieving the goals of until March 1969. At that time, the pre­ domestic monetary policy, the Bank admin­ vious “recommendations” observed volun­ isters foreign exchange controls in such a tarily by the banks became mandatory. way as to insulate the Swedish credit mar­ The liquidity ratio to be maintained var­ ket to some degree from international influ­ ies with the size of the bank; the number of ences. size groups has been reduced gradually Controls over the distribution of credit- The over the years from five in 1952 (with ra­ Bank of Sweden exercises considerable con­ tios ranging from 15 to 33 per cent) to two trol over the distribution of long- and (with ratios of 24 and 30 per cent, respec­ short-term credits—by setting liquidity ra­ tively). tios for commercial banks and by mak­ The liquidity ratio for each bank—ex­ ing recommendations to other financial in­ pressed as a percentage—relates total liquid stitutions (such as insurance companies and assets to total liabilities. The numerator in­ savings banks) concerning the composition cludes not only vault cash and the bank’s of their assets and the pattern of their lend­ net position with the central bank, with ing (especially to the central government other Swedish banks, and with the National and the housing sectors). Moreover, the Debt Office, but also net foreign exchange central bank exercises general control over holdings, Government securities, mortgage issuance of bonds. The control of capital bonds, and certain other commercial bank issues does not involve the choice of individ­ assets. The denominator consists primarily ual companies or qualitative examination of deposits, including bank drafts and ac­ of the issues offered. It assumes rather a ceptances. form of rationing among the major cate­ Specification for the ratio remained vir­ gories of borrowers for which commercial tually unchanged from 1952 until 1968. In banks act as underwriters. The participation 1968 the central bank stipulated (mainly as of commercial banks in any issue—includ­ an incentive to the banks to keep funds in ing timing, amount, interest, and repayment Sweden) that only one-half of the banks’ conditions—must be approved by the cen­ net foreign assets were to be regarded as tral bank. liquid in calculating the ratio. In 1969, the Liquidity and cash ratios. Liquidity ratios liquidity requirements were stiffened further

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by the provision that bonds should be val­ ject to a penalty on any deficiency in its ued at current rather than at face value. required reserves. Furthermore, the maximum amount of net Operations in Government securities. Opera­ foreign exchange assets that might be in­ tions in Government securities are con­ cluded in the liquid assets total was limited ducted by the Bank of Sweden and, more to IV2 per cent of a bank’s liabilities. importantly, by the National Debt Office in In certain circumstances the liquidity consultation with the central bank. Sales ratio offers a partial substitute for reserve of Treasury bills and of Government bonds requirements; that is, under certain condi­ are conducted primarily by the National tions the central bank may charge the pen­ Debt Office. Such transactions are an im­ alty rate on advances if the borrower fails portant instrument used to reinforce the to observe the required liquidity ratio. On impact of changes in the official discount the other hand, use of the liquidity ratio as rate. Nevertheless, the effectiveness of such a tool is limited because the ratio is also de­ operations as a restrictive device is limited signed to influence the distribution of cred­ because the market for short-term Govern­ its in favor of securities of the Government ment securities outside the banking sector is and specified mortgage institutions. insignificant, and because in periods of very In order to sterilize increases in bank large demands for credit the banks would liquidity, the central bank moved for the probably not be interested in buying secu­ first time in December 1967 to implement rities unless yields were high. the cash-ratio law of 1962. During the first Increases in the discount rate are often 6 weeks of 1968 the five biggest banks were also accompanied by a refinancing of Treas­ required to hold at least 2 per cent—and ury debt into longer-term Government other banks to hold at least 1 per cent—of bonds by the National Debt Office in order their liabilities, defined in the same way as to put the banks’ cash and liquidity posi­ those included in the denominator of the tions under pressure. Changes in interest liquidity ratio, with the Bank of Sweden. rates offered by the National Debt Office on The cash-ratio provisions were activated new long-term Government security issues again effective August 1, 1969, with the complement and reinforce the effect of ratios fixed at 1 per cent. A bank failing to changes in the discount rate on market rates fulfill the cash reserve requirements is sub­ of interest.

SWITZERLAND

Introduction trality, has made Switzerland a major re­ In Switzerland, perhaps more than in any fuge for flight capital. Consequently, the other country surveyed, the inflow of inter­ Swiss banking system has become highly national capital has vitiated monetary con­ liquid. As a matter of fact, the banks’ hold­ trol through traditional instruments gener­ ings of cash and liquid assets far exceed the ally, particularly through the discount minimum required ratios, which in any mechanism, and has led the authorities to event are not employed for monetary policy rely mainly on direct controls over bank purposes. credit. The stability of the currency, com­ The Swiss National Bank has limited bined with the country’s international neu­ powers to conduct open market operations.

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Such operations have been confined thus expansionary in recent years, the Federal far largely to the placement of Treasury budget accounts have continued in general bills (rescriptions) with the banks. Practi­ to show surpluses. cally no use has been made of medium- The Swiss monetary authorities—having and long-term paper for purposes of open found that reliance on voluntary agree­ market policy, because the Bank’s portfolio ments with the banks (see p. 265) was of marketable securities is tiny relative to not fully satisfactory—have been concerned the cash balances and other liquid assets of about the insufficiency of the available in­ the banking system. In part because the struments of monetary policy and have banks are so liquid, but also for domestic been pressing since at least 1964 for a sub­ political reasons, and above all to discour­ stantial enlargement of the National Bank’s age further capital inflows, the Swiss Na­ powers. The procedure for the adoption of tional Bank has held its discount rate new monetary legislation is cumbersome: among the lowest in the world and has thus legislation must be submitted to the vot­ fostered an interest rate structure that is ers for ratification if a referendum is re­ low relative to those of other money cen­ quested. After much delay, new legislation ters. was proposed in September 1968 that Hence, the major Swiss banks hold a sought the following: (1) imposition of substantial proportion of their assets abroad minimum reserve requirements on the in­ and adjust their cash positions mainly crease in deposits; (2) quantitative restric­ through exchange operations. Access to tions on credit expansion; (3) widening of central bank discounts and advances is re­ the scope of open market operations; and garded as a privilege, and the authorities (4) authorization to engage in foreign ex­ encourage the large banks, at least, to rely change operations. However, the proposed on their own resources rather than to resort bill was shelved by Parliament in May to central bank credit. In practice, banks 1969. This decision was made in anticipa­ rely on such borrowing only to a minor ex­ tion of a basic agreement, concluded on tent for adjusting their cash positions. Of September 1, 1969, between the National late, however, they have repeatedly had re­ Bank and the banks on the imposition of course to central bank credit for quarter- minimum reserve requirements and restric­ end reporting purposes. This is related to tions on credit expansion (see p. 265). the fact that, in view of the favorable inter­ est rates prevailing on the Euro-dollar Banking structure market, the banks have generally abstained The Swiss banking system is still considera­ from increasing their domestic liquidity in bly less centralized than those of other Eu­ step with the rise in their liabilities, but ropean countries surveyed, even though nevertheless have been anxious to restore there has been some trend toward concen­ temporarily the traditional relationship be­ tration in recent years. At the end of 1969, tween liabilities and cash resources in pre­ about one-half of the total assets of the paring their quarter-end balance sheets and banking system were held by the five big­ have borrowed for this purpose. gest banks, with the other half being dis­ Monetary policy in Switzerland has been tributed among approximately 400 can­ strongly reinforced by Federal Government tonal, local, mortgage, and savings banks, budget surpluses that were partly sterilized. and loan associations, as well as about 90 Although fiscal activities have been largely banks engaged in international business.

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The “big five” and certain “other” banks foreign funds. The liquidity of the market hold the bulk of the banking system’s for­ has prevented the National Bank from eign assets. At the end of 1969 the total of building up an open market portfolio and these foreign assets was officially estimated also has made it unnecessary for the banks at about $10 billion equivalent, an amount to make much use of the discount window. more than twice as large as the entire cash Consequently, monetary policy in the post­ base (bank balances at the central bank war period has been put into effect primar­ plus currency in circulation) at the time. ily by means of voluntary “gentlemen’s The power to regulate Swiss monetary agreements” between the banks and the Na­ affairs is diffused, reflecting the country’s tional Bank. constitutional arrangements. Although the In 1955 and 1956, for instance, gentle­ Swiss National Bank has certain of the men’s agreements provided that the banks powers normally vested in the central bank, would hold minimum balances at the Na­ the Federal Government retains important tional Bank. Other gentlemen’s agreements regulatory powers. have aimed at checking the inflow of for­ The central bank is owned to the extent eign funds by prohibiting payment of inter­ of 40 per cent by private stockholders; the est on foreign deposits and by providing rest is owned by the cantons, the cantonal that several months’ notice be given for banks, and other public law corporations. withdrawal. In the spring of 1962 the Na­ The influence of the stockholders is very tional Bank concluded an agreement with limited because all senior officers of the the banks restricting the growth of bank Bank are appointed by the Federal Council. credit. This agreement was renewed on a The National Bank advises the Federal au­ voluntary basis in 1963, but it became thorities on monetary policy. mandatory for a period of 3 years under emergency legislation approved by the Fed­ instruments of monetary policy eral Assembly in 1964 and ratified by a ref­ Since many of the tools of monetary policy erendum in 1965. In 1965 the banks also that are used to influence credit conditions agreed not to assist the investment of for­ indirectly are not available to the Swiss Na­ eign capital in Swiss real estate or mort­ tional Bank, chief reliance has been placed gages, and they agreed to sell Swiss securi­ on direct controls on credit expansion and ties to foreigners only to the extent that foreign capital flows. Swiss securities had been sold by foreigners The Swiss National Bank has the power to the bank concerned. Following the re­ to grant or deny access to its credit facili­ fusal by Parliament in early 1969 to en­ ties, to set its rates, to buy and to sell for­ large the National Bank’s regulatory powers eign exchange spot and short-term securi­ on a permanent basis—and by virtue of the ties, and to veto credits of 1 year or more basic agreement of September 1, 1969—an to foreign borrowers in amounts of more agreement restricting the growth of credit than 10 million Swiss francs ($2.3 mil­ was concluded in September of that year lion). Except for the last one mentioned, and strengthened in February 1970. these powers of the National Bank have Banks are required to maintain certain been rendered ineffectual by a persistently cash and liquidity ratios. These ratios, how­ high degree of money market liquidity, ever, are intended primarily to set uniform which results largely from Switzerland’s po­ standards of liquidity and to safeguard the sition as a haven and as an intermediary for individual bank’s solvency. They are not

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used as an instrument of monetary policy. repatriate several hundred million dollars The ratios are prescribed by a separate just before these reporting dates. agency, the Banking Commission, which But this process of window dressing and may waive the requirements for individual other end-of-the-year transactions had an banks in appropriate circumstances.69 unsettling effect on the foreign exchange The Swiss domestic money market is ex­ markets that it seemed desirable to avoid. tremely narrow. Other than borrowing from In the past few years, therefore, the Swiss the National Bank, the principal source of National Bank has arranged short-term short-term borrowing open to Swiss banks swap transactions with the banks and in is the interbank market for call money. turn has swapped the dollars it received Usually, the large banks are lenders in this from these banks with the Bank for Inter­ market, and the cantonal banks and other national Settlements or foreign banks. Fur­ categories of banks are borrowers; the mar­ thermore, in circumstances where foreigners ket is small. Until several years ago the (nonresidents) were shifting funds into large banks tended to adjust their cash po­ Switzerland on their own initiative, the sitions mainly by liquidating short-term National Bank passed on to the banks for foreign investments in the foreign exchange investment purposes, on a swap basis, rate- markets. Because of seasonal patterns in secured balances of foreign exchange that it cash payments—and also a desire on the had taken over from foreign central banks part of both banks and other institutions to within the framework of the swap system. show a good cash position on their balance The Swiss National Bank does not con­ sheets at the end of June and December, duct open market operations in the sense of and to a lesser extent at the end of the first buying and selling securities in the market. and third quarters—the Swiss banks would In its endeavor to offset certain foreign flows, however, the National Bank has placed Treasury bills (rescriptions) of 69 The prescribed ratios are not very meaningful the Federal Government directly with the because the banks do not report the ratios on a con­ tinuous basis and, moreover, there are no penalties banks and has sterilized the proceeds— for noncompliance. Since most banks, however, tend charging interest costs to its own account. to do a considerable amount of “window dressing” for balance sheet purposes, the actual ratios (based To relieve itself of part of the cost of these on year-end balance figures) tend to be significantly sterilization transactions, the National Bank larger than the prescribed ratios, irrespective of ac­ tual liquidity conditions during the period. Thus, at had purchased in 1962 franc-denominated the end of 1966, when Swiss banking conditions were U.S. Treasury securities. Rescriptions can characterized by a high degree of liquidity, the pre­ scribed ratio of cash assets to total deposit liabilities, be used as collateral for loans by the Na­ including medium-term bank bonds, averaged 2.4 per tional Bank to tide the banks over short pe­ cent for all banks, whereas the actual ratio shown by riods of stress, especially at the end of the the banks averaged 6.6 per cent. Similarly, the pre­ scribed ratio of cash assets to short-term liabilities month, the quarter, or the year; alterna­ averaged 7.4 per cent, whereas the actual ratio was tively, when the maturities are within the 20 per cent, and the prescribed ratio of cash and liq­ uid assets combined to short-term liabilities was 44 range of 90 days, the National Bank may per cent, and the actual ratio was 73 per cent. At rediscount rescriptions for the same pur­ the end of 1969 the actual ratios were still around 7.5, 20, and 78 per cent, respectively, even though, pose. These open market operations have through most of the year, the banks tended to keep had the effect of smoothing money market their domestic liquidity at the bare minimum while shifting the bulk of their liquid resources into more rates, but they do not seem to have re­ attractive Euro-currency assets. stricted bank liquidity significantly.

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Discounts and advances six times—the first of these changes came Eligibility requirements. Paper eligible for in 1957. In general, the changes in rates rediscount by the Swiss National Bank in­ followed trends in money market rates. Of­ cludes Swiss commercial bills and checks ficials of the National Bank consider that bearing at least two independent signatures the role of the discount rate is to “sanc­ of known solvency, Federal Treasury bills, tion” changes in market rates. Only in ex­ Swiss bonds, and Federal Debt Register ceptional instances has the Bank changed claims. All discountable paper must have a the discount rate to lead the market. The maturity of not more than 3 months. Vir­ National Bank’s lending rates are always tually the same items are acceptable as col­ well below commercial bank rates for loans lateral for advances. and advances, which constitute the bulk of Access to central bank credit. According to the business of the average Swiss commercial the law, the Swiss National Bank may grant bank.70 Advances by the Bank are subject credit to any resident customer—whether to call at 10 days’ notice or less. The Na­ business firm, bank, or government. Ad­ tional Bank’s rate for advances always ex­ vances to the Federal Government are de­ ceeds the discount rate by at least one-half termined by fluctuations in the Treasury’s of a percentage point and generally by a cash position. As a carryover from earlier full point. times, some business firms other than banks Use of central bank credit.. All banks have have accounts at the National Bank; and accounts at the National Bank, but except within individual limits, they may discount at month-end, only the smaller banks bor­ their bills with that Bank. The National row in the form of discounts. The National Bank does not open new credit lines for Bank has fostered a tradition that the large business firms, except in special circum­ banks should rely on their own funds and stances, and it is gradually reducing the list that they should not borrow from the cen­ of the firms that have access to direct dis­ tral bank. However, in the face of a growing counting. liquidity squeeze, the amount of total cen­ About 20 agricultural cooperative orga­ tral bank credit has recently increased con­ nizations also have accounts at the Bank siderably. and can discount with it the paper of their The maximum level of National Bank members. Direct lending to these organiza­ discounts, although still quite moderate in tions is in line with the general Swiss policy relation to total bank credit, has increased of aiding agriculture. about threefold in recent years from around In general, the National Bank is not Vi of 1 per cent to about IV2 per cent.71 obliged to grant credit to any customer. However, in response to a request from the 70 In addition to the official discount rate, the Na­ tional Bank sets special rates for two kinds of com­ Government, the Bank has undertaken to pulsory stock bills—those financing storage of food discount automatically bills financing the and fodder and those financing the storage of other essential materials. The commercial banks discount “compulsory stocks” of essential raw mate­ the compulsory stock bills at the same rates as does rials, foodstuffs, and fodder, which are held the National Bank, which endeavors to set the rates for emergency purposes. at the lowest level that will still induce the banks to hold the bills. Since 1957, when compulsory stock Official rates. In the postwar period in­ bills were introduced, the rates for discounting these terest rates of the Swiss National Bank for bills have sometimes been above, but most of the time have been below, the official discount rate. discounts and advances have been changed 71 The amount of bills held by the Swiss National

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Central bank credit tends to rise at the end Commercial bank lending and borrowing of each calendar quarter because of win­ rates. Minimum lending rates of commercial dow dressing, and the range of fluctuation banks are set by interbank agreement and is fairly large.72 This, despite the fact that are not published. Although there is no for­ the banks have, especially in recent years, mal link between deposit rates and central met their needs for cash assets for end-of- bank lending rates, in any decision to quarter purposes to a great extent through change the discount rate the National Bank foreign currency swaps with the National considers the trend and levels of rates on Bank.73 bank bonds and time deposits along with call-money rates. The rates that banks pay Bank (monthly-statement-date basis) increased from on time deposits, other than savings depos­ 252 million Swiss francs on June 30, 1965, to 1,137 its, respond to market forces. Medium-term million francs on June 30, 1969. 72 In 1969, for instance, end-of-month figures for bank bonds, however, are sold at a given National Bank discounts and advances outstanding rate, and this rate may be changed only averaged 665 million Swiss francs compared with a peak of 1,392 million francs in June 1969. after 2 weeks’ notice to the National Bank. 73 These swaps, under which the National Bank Rates on these bonds therefore fluctuate less buys foreign currency assets from the banks spot and sells such assets forward, lead to a temporary rise in than those on time deposits, but they con­ foreign exchange holdings of the Bank. form to the general trend of deposit rates.

UNITED KINGDOM

Introduction sharp fluctuations in rates on U.K. Treasury In the United Kingdom monetary policy has bills because wide swings in such rates been implemented traditionally by control would be communicated to the bond mar­ of interest rates but, in more recent years, ket and would adversely affect endeavors also by credit ceilings. The British author­ to refund longer-term debt. The discount ities (a term used in the United Kingdom mechanism, which links the large commer­ to convey the notion that the Bank of Eng­ cial banks to the central bank through the land acts as an agency of the Government) discount houses, also provides a means for use the discount mechanism primarily to influencing the employment of short-term control interest rates in the London money banking funds. This aspect of the discount market. Such control is regarded as neces­ mechanism too is a matter of considerable sary to achieve the broad objectives of na­ concern to the authorities. tional policy and to protect the international The authorities have powerful tools that position of sterling. Since the British Treas­ they can use to influence the interest rate ury, in contrast to the U.S. Treasury, does structure. Conventions that have grown not maintain large working balances, one over the years and are now well established link many bank lending and money market important objective of monetary policy is rates to the central bank discount rate— to meet the day-to-day financing require­ thus providing the authorities with a lever ments of the Government. for raising or lowering the entire spectrum Ordinarily, the discount mechanism is of short-term money rates, as well as bank administered with a view to preventing lending rates.

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General background tensified pressure by the central bank and Control of money market rates in Britain further costly borrowing at the central bank involves strict limitation on access to the can be expected. Clearly the central bank Bank of England’s discount window. Ac­ discount rate is a penalty rate when com­ cess is granted only to specialized interme­ pared with the rate on call loans that com­ diaries—11 recognized discount houses.74 In mercial banks normally charge to the dis­ return for this privilege, the discount houses count houses. submit a syndicated bid for, and undertake Open market operations of the Bank of to cover, the weekly tender of U.K. Treas­ England are designed to reinforce the effec­ ury bills, thus assuring the central govern­ tiveness of rate policy rather than to influ­ ment that its short-term financing require­ ence the cash position of banks and, ments will be met. For its part, the Bank of thereby, the volume of credit outstanding. England’s strategy at the weekly Treasury Through such operations the pressures on bill tender is designed—by manipulation of the banks’ cash positions are passed on to the amount of bills offered and by means of the discount houses, whose liabilities consist open market operations—to keep the dis­ largely of secured call loans from the count market initially “short” of cash. banks. When the banks call these loans, the Under such circumstances the authorities discount houses obtain relief by borrowing have the option of providing assistance at the discount window—an accommoda­ through open market purchases or through tion that the central bank may not refuse— more costly rediscounts or loans from the on terms established by the Bank. Thus, Bank, on which the Bank may charge a pressures on banks’ cash positions tend to rate above the discount rate, generally re­ be offset by the provision of funds through ferred to as “Bank rate.” (See p. 271.) the discount window, with the result that Enforced borrowing at the discount win­ the Bank’s interest rate policy is reinforced. dow is thus a device by which the Bank of If used boldly, interest rate policy could England can, when necessary, make clear exert a significant influence on credit flows. to the market that it would like to see that However, for a number of domestic and in­ rates are firm or rising. To such signals, ternational reasons, the range within which which are supplemented by frequent per­ the discount rate can be moved is limited. sonal contacts of discount houses with repre­ Therefore, since the end of World War II, sentatives of the Bank of England, the dis­ the traditional modus operandi of British count houses normally respond by main­ monetary policy has been supplemented by taining or raising the interest rate at which direct quantitative and qualitative controls. they will bid at the next tender. If its proce­ These controls, which have been operated dures achieve the desired result, the Bank in a very informal fashion, derive their of England can permit borrowing to disap­ pear, because the amount of borrowing is main strength from the authority that the not by itself an indicator of market condi­ Bank of England and its Governor enjoy tions. On the other hand, if the expected re­ and from the willingness of banks and other sponse does not materialize, sustained or in­ financial institutions to cooperate—in part, to avoid formalization of the controls, with 74 Except for London clearing banks seeking to re­ the attending rigidities and overt sanctions. discount export and shipbuilding paper, as discussed on p. 273. To supplement rate control, the authori­

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ties have used various means to regulate the with its policies by issuing directives to the total liquidity of banks and nonbank insti­ Governor of the Bank of England, after tutions and ultimately the amount of credit due consultation with him—this despite the supplied by the banking community. For fact that long before the 1946 legislation it example, to backstop their interest rate pol­ had been established that the Bank would icy, the authorities require that the London make no change in the discount rate with­ clearing banks maintain specific liquid as­ out prior approval of the Government. The sets ratios and that both the London clear­ Bank of England Act of 1946 also gave the ing and Scottish banks hold “special depos­ central bank the power to issue general its” at the Bank of England. By requiring directives to any banker; the Bank has an increase in special deposits (or con­ never found it necessary, however, to issue versely by releasing such deposits) and by a formal directive in order to obtain com­ making purchases (or sales) of Treasury pliance by the financial community. bills in the open market, the Bank of Eng­ In addition to official accounts and those land forces the impact of a change in spe­ for foreign central banks, the Bank of Eng­ cial deposits to spread to other categories of land maintains accounts for various types liquid assets. of banking institutions, among which the London clearing banks are the most impor­ Institutional framework tant. The Bank also keeps a few accounts The Bank of England is the chief adviser to for employees, other individuals, and busi­ the Government on all domestic and inter­ ness firms; this practice, a holdover from the national monetary matters, but at the same time when the Bank was engaged in com­ time the Government has considerable di­ mercial banking business, gives the Bank rect influence on the Bank’s policies. This direct exposure to present-day banking central bank is more deeply involved per­ problems. haps than most others in assuring day-to- The commercial banking structure of the day financing of Treasury operations and in United Kingdom is quite complex. It was the management of the public debt. formed when Great Britain was the most Until the end of World War II the link­ advanced industrial country of the world, ages that made it possible to express official the center of world trade, the leading finan­ Government policy action through the cial power, and the center of the British central bank were largely informal. But in Empire and when London was the most 1946 legislation was passed that transferred important and active financial market in the capital stock of the Bank of England to the world. While the banking structure is still Treasury and formalized the basic relation­ characterized by many traditional influ­ ship linking the Bank with the Government. ences, it has been quite responsive to new Since then the Governor, Deputy Governor, challenges, and there have been numerous and the Court (equivalent to a board of innovations since World War II. directors), which consists of 16 members, The London clearing banks form the have been appointed by the Crown. Some core of the commercial banking system. As of the directors are full-time officers of the recently as 1968 there were 11 such banks, Bank (“executive directors”). but by 1970 a series of mergers had re­ Most importantly, the 1946 legislation duced their number to six. All of them have gave the central government the statutory extensive networks of domestic branches; power to obtain central bank compliance and most of them have foreign branches,

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agencies, or subsidiaries, as well as domes­ spectrum of the money market rates. The tic financial affiliates. The clearing banks rate is established by the Court of the Bank also have substantial equity holdings in the of England with approval of the Chancellor overseas banks, described below, and in of the Exchequer. Changes in the discount consumer finance houses. The clearing rate, if any, are traditionally announced on banks, which held about 80 per cent of all a Thursday, shortly before noon; departure domestically owned deposits in 1969 and from this tradition has occurred only in cri­ 1970 (but no significant amount of foreign sis situations. Changes are made either to currency deposits), extend about two-thirds increase the authorities’ room to maneuver of all domestic loans. Banks in Scotland and in their day-to-day management of the in Northern Ireland serve local needs for the money market or to give a lead to the finan­ most part, although they do place signifi­ cial community on general economic pol­ cant amounts of call money in the London icy, or both. money market. Only the 11 houses that make up the Lon­ In London there are also about 200 don Discount Market Association have other “nonclearing” banks. Such banks are regular access to the Bank of England’s dis­ included in the following important cate­ count window and thus are a key element in gories: (1) merchant banks, (2) overseas the rediscount mechanism. As specialists banks (domestic banks whose main activ­ dealing in short-term money, they do busi­ ities are in the Commonwealth and in for­ ness mainly with banks but they also do eign countries), and (3) foreign banks. All some with nonbank institutions; they have of these banks are active in taking foreign practically no business at all with the gen­ currency deposits (mainly dollars, but other eral public. The principal activities of these convertible currencies also) and re-lending 11 houses are summarized as follows: them abroad or swapping them into sterling 1. The discount houses undertake to assets. The nonclearing banks have grown underwrite the weekly tender of U.K. very much more rapidly than the clearing Treasury bills. With the concurrence of the banks in recent years and since 1968 their authorities, they submit a syndicated bid total deposits have exceeded those of the that puts a floor under the market price at clearing banks. This greater growth is the auction. The price quoted in this bid largely because London’s rapidly increasing must be calculated very carefully. The dis­ Euro-dollar business is virtually all concen­ count houses cannot afford to go without trated in the nonclearing banks, but also Treasury bills; and at the same time they because liquidity ratio restraints and inter­ must meet the competition from the out­ est rate conventions do not apply to either side. Such competition stems particularly the foreign currency or sterling operations from the nonclearing banks and bill brokers of those banks. In mid-1970 nonclearing outside the Discount Market Association banks accounted for about 15 per cent of that bid for their own accounts and from the total banking sector’s sterling deposit the banks that offer bids for insurance com­ liabilities. panies, nonfinancial corporations, and over­ seas and other customers. Clearing banks Discounts and advances do not submit bids for Treasury bills for The discount rate establishes the pattern of their own account. rates for bank loans and deposits of London 2. When the discount houses need clearing banks and influences the entire funds, they borrow on a secured basis any

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excess cash that the clearing banks may When the discount houses seek central have; such loans provide the banks with a bank credit, they may either rediscount bills highly liquid asset in the form of call or borrow on collateral, normally at the money. The discount houses obtain about discount rate. In either case rediscountable two-thirds of their liquid resources in this paper or acceptable loan collateral consists manner. The remainder comes largely from of Treasury bills, Government securities other banks operating in the London maturing within 5 years, bills issued by money market; such “outside money” is local authorities that comply with the Bank borrowed at rates that fluctuate with money of England’s requirements, and commer­ market conditions but that are slightly cial bills carrying two established names; higher in general than the cost of funds ob­ such names usually include a British bank tained from the clearing banks. The clear­ and a discount house, one of which must be ing banks never borrow funds from each the primary acceptor. other but normally recall from the discount To reinforce the penal nature of borrow­ houses each day sufficient cash to meet ing, Bank of England regulations require their cash reserve requirements.75 that rediscounts have an average maturity 3. The discount houses invest in Treas­ of at least 21 days; and until 1966, ad­ ury bills, prime commercial bills, negotiable vances had normally been made for a mini­ sterling certificates of deposit, other Gov­ mum of 7 days but now some are shorter, ernment securities with maturities of up to as noted below. When bills are offered 5 years, and local authority bonds and bills. for rediscount, the Bank of England insists Treasury bills are held by the discount that no bill in the parcel have less than 15 houses primarily to meet anticipated pur­ days to maturity; and as noted above, it re­ chases by the clearing banks, but also be­ quires an average life of 21 days for the ag­ cause they are immediately discountable at gregation of the bills involved in each the Bank of England (although discount transaction. Rediscounts are treated by the houses normally seek central bank assist­ discount houses in their balance sheets as ance through advances against suitable col­ sales of assets; there is no counterpart of re­ lateral (see below)). purchase agreements as practiced in the The discount houses make a market for United States. Treasury bills, bank bills, and trade bills, as As a general rule, discount houses re­ well as for Government bonds of up to 5 quire assistance for much shorter periods years to maturity, and they use these instru­ than 21 days, and they try to obtain loans ments as collateral when they borrow from with the shortest possible maturity in order the clearing banks or from the rest of the to minimize the total interest cost. There­ money market. In recent years the discount fore, they prefer to borrow not by means of houses’ holdings of commercial bills have rediscounts but rather by advances, usually grown relatively faster than their other as­ secured by “short” Government securities sets—reversing a long-term trend. (bonds within 5 years of maturity), because the interest rate is uniform (usually the 75 Nonclearing banks similarly may recall needed cash balances; in the last few years, however, an ac­ Bank of England discount rate) regardless tive interbank market has developed among the non­ of the maturity. clearing banks. These banks, which keep accounts with and make settlements through the clearing On June 30, 1966, the Bank of England banks, can adjust their cash positions by borrowing informed the discount houses that it was or lending sterling deposits among themselves on an unsecured basis, in addition to using the discount prepared on occasions of its own choosing, market. and for purely technical money market pur­

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poses, to assist them with overnight loans occurred, and the total time that loans —thus reducing the actual cost of borrow­ were outstanding has lengthened. This use ing. Overnight lending has sometimes taken of central bank credit reflected the pres­ place when a large surplus was expected to sures imposed on the discount market by follow an acute shortage of money. With the Bank of England through its day-to-day the new accommodation, the Bank does not open market operations. have to buy bills one day and sell the next. The discount houses, however, seldom Overnight lending has also been used to borrow or rediscount in excess of their push forward a shortage from day to day short-term needs, for they cannot profitably and thereby ensure the opportunity for tak­ finance investments in prime short-term as­ ing penal action the following day, if de­ sets on funds borrowed at a penalty rate. sired. Excessive acquisitions of high-yield paper So far, overnight lending has been at a with considerable risk exposure would rate below the Bank’s discount rate, and surely incur the disapproval of the Bank of usually at the highest effective market rate. England. Moreover, the clearing banks However, the authorities have reserved the would not accept such assets as collateral right to charge for overnight accommoda­ for money market loans because such col­ tion whatever rate seems appropriate in the lateral in turn must be eligible as security at light of policy objectives at the particular the Bank of England. Still, some leeway ex­ time. ists for “speculative” operations in short­ The authorities’ signals may be rein­ term Government securities. For instance, if forced by charging on discounts or ad­ the discount houses anticipate that over the vances a rate above the regular discount near term interest rates will decline (as for rate if it seems inadvisable to raise that rate. example, after a stringent official credit pol­ But as of the middle of 1970, the super­ icy has been in force for some time and the penalty rate had been used only once—in market has reason to expect an easing of March 1963. policy), they will increase their holdings of Technically, there is no ceiling on the these types of assets. amount that a discount house may borrow, Another refinancing device, but one that provided the house can present enough ac­ is not part of the mechanism whereby the ceptable collateral and is willing to pay the Bank of England seeks to influence mone­ rate set by the central bank. Nor are there tary conditions, relates to export and ship­ limits on the total amount of commercial building paper. Since 1969, the Bank has bills that may be rediscounted, although for been prepared to refinance directly Govern- business reasons the Bank of England does ment-guaranteed export and shipbuilding observe internal limits on the amounts rep­ loans held by the London clearing and resenting individual acceptors and drawers. Scottish banks to the extent that such loans In periods of relative stringency, the Bank are not eligible to be counted as liquid makes no attempt to hold new borrowing assets 76 and are in excess of 5 per cent of by any individual house to maturities that gross deposits. The purpose of this facility are shorter than the average for outstanding is to relieve the clearing banks of the neces­ discounts. In fact, during such periods—as for example during the early part of 1965 when total borrowings were exceptionally 76 The Bank also stands ready, subject to certain limits, to refinance fixed-rate loans that do count as large—there have been increases in the liquid assets. This facility has apparently not been number of days on which such borrowing used.

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sity of holding unduly large amounts of rela­ even though this involved some sacrifice of tively low-yield paper. Until October 1970 short-term interest rate stability. To facili­ the rate chargeable on such refinancing was tate the new approach the authorities an­ 5Vi per cent; at that time the rate was nounced: (1) that they would no longer raised to 7 per cent. specify the price at which they were pre­ pared to sell “tap stocks” (leaving it up to Other instruments of monetary policy the market to bid for them instead); and In addition to the discount mechanism, (2) that the official buying price for Gov­ other instruments employed by the Bank in ernment securities within 3 months of ma­ its management of monetary policy are turity would no longer be tied to the Treas­ open market operations, debt management ury bill rate. operations, and credit ceilings. Also there In implementing debt management are the customary minimum cash and policies, the authorities automatically offset liquidity ratios which, in fact, have become the effects of flows of foreign-currency-based mandatory. More recently, such ratios have liquidity. In fact, official purchases or sales been supplemented by a “special deposit” of sterling through the Exchange Equaliza­ requirement and also by a cash deposit tion Account are reflected in smaller or scheme, but as of the end of 1970, the latter larger issues of Treasury bills, respectively, had not been implemented. which are integrated into the Bank of Eng­ Open market and debt management opera­ land’s daily management of the money mar­ tions. Open market operations in the money ket—thus returning to, or absorbing from, market are designed to keep short-term the market the cash equivalent of flows of rates within the desired range. In the long­ foreign exchange. term market—given the existing debt man­ Bank reserves and liquidity ratios. Require­ agement arrangements—the authorities have ments concerning cash reserves and liquid considerable influence on interest rates, assets vary from one type of British finan­ apart from the secondary effects that such cial institution to another, depending in operations may have on short-term rates. large part on the type of institution and its The Bank of England has control over both function in the financial system. the supply and the terms of sale of medium- The London clearing banks, by long-es­ and long-term Government securities, some tablished tradition, maintain minimum cash of which are almost always available to the as well as liquidity ratios. These ratios were public from the Issue Department’s hold­ originally adopted, and still are maintained, ings. Moreover, debt management opera­ to protect the banks’ customers, but they tions are continuous; the Bank usually pur­ also have become a means of implementing chases large maturing issues in advance of monetary policy. maturity and sells long-term issues whenever Indeed, the Bank of England expects possible. The authorities’ desire to avoid the clearing banks to maintain ratios that sharp swings in long-term interest rates has have evolved as a matter of custom. As been an important factor affecting the vol­ nearly as possible on a day-to-day basis, ume of open market operations during any the clearing banks keep 8 per cent of their given period. total deposits in the form of cash—that At times since 1969 debt management is, coin, notes, and balances with the operations have been undertaken with a central bank. In addition to their required view to influencing the monetary aggregates cash reserves, the clearing banks currently

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must keep an additional 20 per cent of from 1 to P/4 per cent for the Scottish their total deposits in the form of specified banks.) A cash deposit scheme for non­ types of liquid assets—that is, call loans clearing banks was developed in 1967. The and money available on short notice (loans authorities plan to apply it at times when to the money market and loans to others credit ceilings have been lifted or as a form with maturities up to 28 days), U.K. Treas­ of penalty when ceilings or other guidance ury bills, commercial bills, or specified refi- “requests” of the Bank of England are nanceable export credits. The Bank of breached. England has varied the liquidity ratio only In recent years, it may be noted, several once—in 1963—and the banks themselves developments have tended to reduce the po­ determine in what proportion to hold each tency of liquidity controls over the banking type of asset, depending on the type of busi­ system. One, the clearing banks themselves ness in which they are engaged. have often been able to adjust their portfo­ Cash and liquidity ratios are applicable lios by selling Government securities to ob­ not only to the London clearing banks but tain needed liquid assets. The central also to the Scottish banks and the banks in bank’s support of Government bond prices Northern Ireland, whose balance sheets are limited its ability to squeeze the cash posi­ broadly similar to those of the clearing tion of the banks. Another development has banks. However, the standards of liquidity been a resurgence of financing through issu­ that the Bank of England expects these ance of commercial bills; this has provided banks to maintain are somewhat more flexi­ the banks with a means of extending credit ble and less explicit than those that apply while at the same time improving their to the clearing banks. This distinction re­ liquidity positions, because many commer­ flects in part the greater emphasis on time cial bills qualify as liquid assets. This deposits by the banks in those areas. growth in the banks’ holdings of commercial The Bank of England expects other bills has been the result of a number of fac­ banking institutions to maintain liquidity tors. To some extent it reflects the growth standards suitable to their particular pattern of consumer instalment credit extended of business. It applies no formal liquidity largely by finance houses, which rely on ratios to the discount houses, the merchant commercial paper to obtain funds. banks, or the overseas and foreign banks. Credit ceilings. To cope with the tendency However, most of these institutions (espe­ of the clearing banks to augment their liq­ cially those whose bills are bought by the uid asset holdings through transactions with Bank) submit to central bank judgment as the nonbank public, and with the tendency to the adequacy of their capital resources, for peripheral institutions to expand into liquidity, and general standing. any credit gap left by curbs on the major The Bank of England has supplemented banks, the authorities have issued credit cash and liquidity ratios by intermittently ceiling requests to the clearing banks and to requiring the London clearing and Scottish a gradually increasing list of other financial banks to make special deposits that ordinar­ institutions. These requests have been used ily bear interest at the Treasury bill rate but to impose both quantitative restrictions and are not included in liquidity ratios. (For ex­ to a certain extent qualitative guidance on ample, in April 1970 these ratios were lending (including financing through com­ raised from 2 to 2 ^ per cent of gross de­ mercial bills) by almost all banking institu­ posits for the London clearing banks and tions.

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Relationship of other interest rates to the this rate is normally l s/s points below the discount rate discount rate. It also establishes a ceiling The pattern of interest rates and the rela­ for the Treasury bill rate and, by conven­ tionships among the various rates are imple­ tion, a lower limit to the price that discount mented in part through formal agreements. houses may bid for Treasury bills at the For example, the London clearing banks, weekly tender and at the same time expect by agreement, currently pay 2 percentage that official operations in the open market points less than “Bank rate” on their will keep the money market on an even deposit accounts,77 and they generally keel. In the recent past, for instance, the charge rates from Vi to 1 percentage point authorities have usually been willing to above that rate on prime loans, but no allow the rate on Treasury bills to range less than 5 per cent. Nonclearing banks, from lA to 3A of a percentage point below finance houses, and local authorities nor­ the discount rate. At the same time, such a mally pay a rate close to Bank rate for spread has given the discount houses suffi­ 3-month time deposits, although in re­ cient maneuvering room at the weekly cent years when the official discount rate tender to garner enough bills to meet the has not always fully reflected market strin­ liquid asset needs of their main customers, gency, the rate on such deposits has some­ the clearing banks.78 times exceeded Bank rate by 1 percentage point, or even more. 78 At least once in the recent past the Bank of England has acted to move the Treasury bill rate un- The central bank rate establishes the precedentedly close to the current central bank dis­ minimum rate that clearing banks may count rate in order to keep short-term interest rates charge the discount houses for call loans; internationally competitive. On one other occasion it used the exceptional technique of lending above the central bank discount rate to produce this result. 77 Accounts not directly subject to check, but calla­ Earlier, the Bank of England had used similar de­ ble on 7 days’ notice. The clearing banks do not offer vices in its discount procedures in order to achieve longer maturities. specific objectives.

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