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FEDERAL RESERVE BANK OF'1 PHILADELPHIA Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis A commercial bank will make a loan to an Law books are haunted by ghosts from the past, individual without security even though the by laws that were adopted in response to the bank knows relatively little about the bor­ real or imagined needs of yesterday, but that rower. A Federal Reserve bank cannot le­ serve no apparent function in the contemporary gally make a loan to a member bank without security even though the Fed knows a great environment. Discussion of these laws can be deal about the borrower. Why this double fascinating and fruitful. It can be fascinating standard? The reason is that law sometimes because the laws are often living fossils of once- responds very slowly to changing condi­ powerful social forces. It can be fruitful because tions and views. legislative inertia often works against repeal of these laws despite their current irrelevance and not infrequent propensity for harm. Continued Why Collateral discussion of outdated laws keeps the spotlight on potential dangers in our legislative structure Requirements? and encourages useful changes. by Ira Kaminow One legal anachronism that merits discussion on both these counts concerns an aspect of the nation’s financial system. When commercial banks borrow from the Federal Reserve, they are required to place on deposit with the Fed some kind of collateral. This requirement can be costly for both the borrowing bank and the Fed because the relevant laws are quite complex. Compliance can require a good deal of work at both professional and clerical levels. Even ignor­ ing the costs of legal interpretations and form­ filling, the physical effort of as mundane an activity as locating, transporting, and storing collateral can be great. Once, collateral requirements were thought to be integral parts of the operation of the Federal Reserve System. Today, the environ­ ment that precipitated this belief is gone. Like the human appendix, the requirements outlived their original contex, and are redundant at best, downright harmful at worst. BUSINESS REVIEW is produced in the Department of Research. Evan B. Alderfer is Editorial Consultant; Ronald B. Williams is Art Director. The authors will be glad to receive comments on their articles. Requests for additional copies should be addressed to Public Information, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylvania 19101. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis BUSINESS REVIEW Why isn’t something done about the situa­ aster, “ and it seemed likely that, unless the tion? Since 1963, the Federal Reserve System, hysterical rush for liquidity could be stopped, with the support of leading experts has been economic transactions would return to the bar­ trying to get one relatively minor liberalization ter state.” 1 The public was getting fed up; the built into the law. Although the reform has cry for an elastic currency supply, responsive to been passed by the Senate on several occasions, demand, grew louder. From 1907 to 1912, a it has never gotten out of committee in the major economic reform was planned. It culmi­ House. It seems likely, therefore, that a com­ nated in the Federal Reserve Act— “ An Act . plete overhaul of the law will require a good to furnish an elastic currency. .” 12 deal of work. The elastic currency was to be provided by HISTORICAL BACKGROUND allowing banks to sell promissory notes they Laws almost always stem from compromise held against loans to the Federal Reserve Banks. and, so, rarely reflect the views of any particu­ (The sale was made at a discount from the face lar group. Moreover, even when compromise is value; hence, the process was called discount­ unnecessary or minimal, support may come ing. ) When banks needed currency to meet from many diverse groups, each of which favors increased withdrawals, they could go to the the legislation for quite different reasons. Be­ Fed to swap notes for currency. cause of space limitations, we will try to capture The Federal Reserve Act, however, attempted only the “ main currents of thought” that pre­ to do more than provide an elastic currency vailed. We will ignore all the subtle (and some supply. An elastic currency required only that not so subtle) points of disagreement about banks have an opportunity to convert their non­ both content and emphasis. currency assets into currency; it really didn’t Panic, Currency Elasticity, and Eligibility Re­ matter what assets were sold to the Fed. With quirements. The post-Civil War National Bank­ an eye toward influencing banks’ portfolios and ing Act had provided the Nation with a highly contributing to economic and financial stability, restrictive monetary system and a currency sup­ however, the framers of the Act limited assets ply that was unresponsive to the demands of eligible for discount to so-called real bills— in the public. To most observers of the day, the the words of the Act, to short-term “ bills of ex­ periodic financial crises following the Civil War change issued or drawn for agricultural, indus­ stemmed from this monetary system. Sharp in­ trial, or commercial purposes.” By limiting the creases in the demand for currency led to de­ class of eligible assets, legislators made the posit withdrawals. Banks, finding their fixed eligible assets more attractive to banks. Banks currency reserves depleted, suspended with­ were encouraged to hold real bills for two rea­ drawal privileges, and the panic was on. Each sons. First, because real bills mature quickly, suspension resulted in a further decline in con­ 1 Paul Studenski and Herman Kroos, Financial His­ tory of the United States, (N ew York: McGraw-Hill fidence until credit dried up and the economy Book Company, Inc., 1963), p. 253. succumbed. 2 This quotation comes from the title of the Act. The In the winter of 1907, the Nation was facing full title reads “An Act to provide for the establishment of Federal reserve banks to furnish an elastic currency, its fourth severe panic since the end of the Civil to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the War. The situation bordered on national dis­ United States, and for other purposes.” Digitized for FRASER 3 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis NOVEMBER 1969 banks that hold them experience a rapid turn­ There is currently less than complete agree­ over. Every day some loans are maturing and ment on why linking bank ownership of eligible providing the bank with an inflow of funds. paper to business activity was considered sta­ This rapid turnover was considered a highly bilizing. Most of the earlier arguments, how­ desirable property in bank-held assets because ever, seemed to consider this relationship as the the majority of bank liabilities were payable on first link in a rather round-about connection demand; unexpectedly large withdrawals could between business activity and the volume of be met by the inflow of funds from a constant currency, or reserves, or money, or credit (de­ stream of maturing real bills. Second, real bills pending on the version of the theory— these were created to finance “ productive” activities. four magnitudes were not always clearly dis­ The Act, consequently, was believed to encour­ tinguished). The proposed linkage went some­ age “ productive” loans at the expense of “ non­ thing like this (see the accompanying diagram): productive” loans, particularly loans to finance The level of business activity would control the speculative activities.3 * quantity of real bills in bank portfolios, the Eligibility requirements were supposed to do quantity of real bills in bank portfolios would more than merely encourage prudent banking control the volume of discounting, the volume practices and contribute to a socially desirable of discounting would determine the quantity of allocation of credit. In 1913, there was consider­ currency and/or reserves in the system, and able sympathy for the view that eligibility require­ finally the quantity of currency and reserves ments would contribute to economic stability. would control the volume of credit and/or It was believed that sharp economic fluctuations money. Through this complicated mechanism, could be avoided if bank holdings of eligible eligibility requirements were supposed to serve paper grew and shrank with business activity a crucial role in fostering a semi-automatic con­ and that the volume of real bills in bank port­ nection between business activity and currency, folios would fluctuate in the desired fashion. reserves, credit, or money. 3 It is not clear whether speculative loans were to be discouraged because speculative activities were to be dis­ The Fed and the War. Clearly, much was ex­ couraged, or because the issuance of credit and/or money to finance speculation and other “non-productive” activ­ pected of eligibility requirements. They turned ities would lead to an over-supply of money and/or out to be incapable of handling the burden they credit. 4 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis BUSINESS REVIEW were designed to bear. Renunciation of eligi­ enormous bank borrowing that followed con­ bility requirements as a bulwark of financial tributed to the inflation that lasted until 1920. stability was hastened by the onset of World It was this experience with large-scale bank War I. borrowing that prompted both the Fed’s atti­ The war broke out only months before the tude of discouraging member-bank borrowing Federal Reserve Banks opened their doors. In except on a temporary basis, and a reluctance 1915 and 1916, it was becoming increasingly on the part of banks to borrow. By 1929, the evident that the United States would not remain tradition against member-bank borrowing had neutral.

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