CQRNELJ. UNf^BKlSrff LIBRARY BOUGHT WITH THE INCOME OF THE SAGE ENDOWMENT FUND GIVEN IN 1 89 1 BY HENRY WILLIAMS SAGE Cornell University Library arV12728 The federal reserve 3 1924 031 493 517 olin.anx Cornell University Library The original of tinis bool< is in the Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924031493517 THE AMERICAN BOOKS A LIBRARY OF GOOD CITIZENSHIP "The American Books" are designed as a series of authoritative manuals, discussing problems of interest in America to-day. THE AMERICAN BOOKS THE AMERICAN COLLEGE THE INDIAN TO-DAY COST OF LIVING THE AMERICAN NAVY MUNICIPAL FREEDOM AMERICAN LITERATURE BY ISAAC SHARFLESS BY CHARLES A. EASTMAN BY FABIAN FRANKLIN BY REAR-ADMIRAL FRENCH E. CHADWICK, U. 8. N. BY OSWALD RYAN BY LEON KELLNER (translated FaOH THB GERMAN BY JULIA FRANKLIN) SOCIALISM IN AMERICA BY JOHN MACY AMERICAN IDEALS BY CLAYTON SEDGWICK COOPER THE AMERICAN SCHOOL BY WALTER S. HINCHMAN THE FEDERAL RESERVE BY HENRY PARKER WILLIS (for more extended notice of the series, see the last pages of this book.)] The American Books THE FEDERAL RESERVE A Study of the Banking System of the United States BY HENRY PARKER WILLIS Secretary of the Federal Reserve Board WITH AN INTRODUCTION BY CHARLES S. HAMLIN, Governor of the Federal Reserve Board GARDEN CITY NEW YORK DOUBLEDAY, PAGE & COMPANY 1915 Copyright, igis, by DOUBLEDAY, PaGE & CoMPANY All rights resened, including that of translation into foreign languages, including the Scandinavian PUBLISHED NOVEMBER, I9I5 SECOND EDITION DECEMBER, I915 c- INTRODUCTION- o It is of great importance that the American people should understand fully not only the text of the Federal Reserve Act, but, as well, its history during the process of enactment, and I am sure that this book will be read with the deepest pleasure by all who are interested in the subject of banking. The Federal Reserve Act has already been, and will be in the future, of the greatest advantage, not alone to the bankers, but to all our people who are the customers of the banks, and who are engaged in agriculture, commerce, and industrial pursuits. The author points out that so far as expressions of opinion are to be found in the book, they are expressions merely of his personal views, but such expressions are surely entitled to have great weight. I feel confident that this book, both as a history and a searching analysis of the Act, will be an invaluable help to every student of banking and finance. Charles S. Hamlin. BIOGRAPHICAL NOTE Henry Parker Willis was born in 1874 of New England parents, who moved to Racine, Wisconsin, when he was four years of age. He lived in Racine until seventeen years old when he entered Western Reserve University at Cleveland. He entered the University of Chicago a year later and received the degree of B. A. in 1894. The University of Chicago appointed Mr. Willis graduate scholar; then Fellow; and then Armour-Crane Travelling Fellow in Political Economy. He studied at Berlin and Vienna, then returned to this country and received the degree of Ph.D. from the University of Chicago in 1898. From 1897 to 1898 Mr. Willis served as special assistant to the Indianapolis Monetary Com- mission; 1898-1901 he was adjunct professor and professor of Economics and Politics at Washington and Lee University. In 1901 he went to New York as editorial writer for the New York Evening Post; then was sent to Wash- viii Biographical Note ington as correspondent for the New York Journal of Commerce and the Springfield Repub- lican. He returned to Washington and Lee University to organize the School of Commerce there. In 1906 he resumed work as Washing- ton correspondent of the Journal of Commerce, and at the same time joined the staff of George Washington University as Professor of Finance, and (in 1910) became Dean of the College of Political Science in that institution. In 191 2 he moved to New York as Associate Editor of the Journal of Commerce, being at the same time a member of the staff of Columbia Uni- versity. Mr. Willis was appointed as expert by the House Ways and Means Committee in 191 2 and 191 3 during the preparation of the Under- wood Tariff. He became expert to the House Banking and Currency Committee when work was begun on the Federal Reserve Act and continued as such until the passage of the Act. In 1 91 4 he was expert to the Joint Committee of Senate and House on Rural Credits, and was appointed Secretary of the Federal Reserve Board in September, 1914. Mr. Willis was for some years American correspondent for the London Economist. He Biographical Note ix is the author of books on "Principles and Prob- lems of Banking," " Principles of Accounting," etc., and monographs on tariff and financial questions. PREFACE In this book I have, in accordance with the invitation of the editor of the series in which it appears, attempted to furnish a brief outline of the Federal Reserve Act and the operation of its principal provisions. That such an out- line might be intelligible, it was necessary to include a brief introductory discussion of banking conditions in the United States, and a short sketch of the history of the demand for banking legislation, as well as of the reasons which ultimately dictated action. Within the space at my disposal it is not possible to afford more than the barest outline of either of these topics, or, in the later chapters of the book, to offer anything save general descriptions and analyses of the principal points involved in the Act. In thus outlining the main aspects of the subject, I have, however, sought to provide a connected account which could be easily followed by a reader without technical bank- ing knowledge, and who desired only so much xii Preface information regarding the subject as would put him in touch with the principal aspects of the banking situation as changed by the Federal Reserve Act. Deeply appreciating the limitations upon the treatment imposed by the conditions of space and methods of analy- sis, I have nevertheless endeavored to present the facts dealt with as accurately and in as suc- cinct and connected a manner as possible. The Federal Reserve System is in its early stages of development. There is still a wide- spread failure to understand its real nature, and some tendency to make banking questions a subject of political controversy. In the hope that a comprehensible account of a great con- structive statute may enable the general reader to form a correct opinion of it, and so to deter- mine his attitude toward it in the future, as well as to furnish him with a true idea of the system of banking under which his business affairs are carried on, the following pages have been written. H. P. W. CONTENTS Introduction by Mr. Hamlin v Preface xi CBAFTBR PAGE I. Banking in the United States . . 3 II. History of Banking Reform Movement 25 ■~— III. The Federal Reserve Act . . . /\JS~ ""■^IV. Putting the Act into Effect . . 85 V. Opening the Banks 100 "" VI. The Federal Reserve "System" . 124 ~^VII. The Federal Reserve Board . . 140 VIII. The Federal Reserve Bank- . . . 159 IX. Types of Commercial Paper . . . 176 X. The New Banks, Their Members AND THE Public 192 XI. Clearing and Collecting Checks . 218 XII. The New Currency Issue . . . 239> XIII. Unifying the Banking System . . 256 XIV. Financing Foreign Trade . . . 27^ XV. The Government and the Reserve "^ System 297 Appendix 313 Index 333 xiii THE FEDERAL RESERVE CHAPTER I BANKING IN THE UNITED STATES In the United States to-day three distinct systems of banking may be distinguished: (i) The national banking system organized under Federal law. (2) The commercial banking system organ- ized under the laws of the several States. (3) The system of special institutions organ- ized under State laws, and including trust com- panies, savings banks, building loan associations, and various others. It will be noted that the foregoing classifica- tion is based upon the legal foundation un- derlying the banking situation. A different classification which might be employed would recognize merely the following: (i) Commercial banking, including both na- tional and State institutions, and among the latter, in certain cases, trust companies which have specialized along commercial lines. (2) Non-commercial or investment institu- 3 4 The Federal Reserve tions, including some State banks, many trust companies, practically all savings banks and building loan associations. There are other classifications and sub-classi- fications that might be adopted for various purposes, but the two thus sketched are the most important to the present treatment, and are those which will chiefly figure in the follow- ing discussions. Of all the banks in the United States, the earliest are the State banks organized in the older commonwealths — those on the Atlantic seaboard. In some of these commonwealths^ there are institutions enjoying special charters which run back to the colonial period. In most of the States, however, there now exist general banking laws under which any person who com- plies with specified requirements can organize a bank. Wherever special charters prevail it is often found that many broad powers are granted in them, some dating from a time when the business of banking was not clearly differ- entiated from other occupations. Wherever general banking laws exist, as they do to-day in most of the States, it will be found that care- ful descriptions, limitations, and requirements enter into the several banking acts, the object Banking in the United States 5 being to define the classes of business in which the various institutions whose incorporation is^ permitted may legally engage. In all Statey^ where such statutes exist there is some pro- vision for very careful public oversight and inspection of the accounts, books, cash, and se- curities of the several banks. Banking, then, under whatever laws conducted, and in what- ever way it may be specialized, is everywhere regarded] as a quasi-public occupation, and as demanding the general oversight and partici- pation of the public authorities. But what is banking? Many writers define a bank as an institution which exercises the functions of discount, deposit, and issue — a classification which yields very little insight because of the fact that such a grouping of functions is merely a way of describing bank- ing as an operation from different points of view. What the bank does is the same under' each of these heads — there is no difference in its essen- tial performance. Reduced to its lowest terms, thi s essenti al function is that of guaranteeing the credit of individuals. The basic banking trans- action may be described as follows: A has purchased goods from B, and has given B a document or "note," in which he promises 6 The Federal Reserve to pay B the sum of i5l,ooo with interest at the end of ninety days. We may assume that this payment is absolutely certain, and that there is no risk of loss. B, however, wishes to get means of payment immediately in order to meet his own obligations. In order to do this, he resorts to some one who has immediate funds, and asks him to extend "accommoda- tion." If the man who aids him, thus called in, is simply a money lender, he purchases the note of B either with or without B's guarantee or endorsement; that is, he gives B the amount agreed upon, and takes the note. Thus B gets the funds he needs, and the money lender, C, gets an investment for ninety days. If the agency called on is not a money lender but a "bank," the banker takes the note from B, and B gets in exchange the right to draw upon the bank at sight up to an amount agreed upon. This process is called discount, and the differ- ence between the amount that B can draw at sight, and the face of the note, is the discount for this transaction. The banker seldom, if ever, enters into such a transaction without having B's endorsement or guarantee on the note, but it is plain that what has been done is to substitute the credit of the bank for the Banking in the United States 7 credit of A and B. The banker counts upon not being asked to pay money for the drafts drawn on him by B. That is to say, he expects that not every one to whom B gives a draft or check on him will want to cash it, or, if such cashing should be demanded, that other checks and drafts will come into his possession sufficient to offset those which he is thus asked to make good. This hope is founded upon the fact that the banker accepts the funds on deposit. He al- lows persons who want to have their money safely kept to leave it with him, and this aflFords them a convenience because they can now pay by means of checks. When he makes a dis- count he may, and usually does, in the United States, make it by merely crediting the person to whom it is granted with a fixed sum, allow- ing that person to draw on it to the amount indicated. It is clear that this "deposit" function is the same as the discount function, except insofar as the deposits with the banker consist of money. Where they are created simply through crediting a customer with a specified amount, the deposit function is merely another aspect of the discount function. Neither function could be carried on without the other. 8 The Federal Reserve It may be that the customer of the bank would rather not receive the credit on the books of the institution because the persons with whom he deals do not understand the check system, or have no facilities for cashing checks. Should that be true, the customer will probably ask to receive his discount in currency. If the banker is allowed to exercise the issue function, he will then merely hand the person to whom he has granted the discount a quantity of "bank notes." They are notes which he agrees to pay at sight if presented. In this phase of the oper- ation the banker has merely taken the note from B and given in exchange a quantity of his (the banker's own) notes in small denomina- tions. The banker now has A's note endorsed by B for ^i,ooo for ninety days, while B, having paid, say $io for the service, has, say, ninety- nine of the banker's notes of ten-dollar denomi- nation payable to bearer. The question may be asked why B did not simply issue his own notes, numbering one hundred, of denominations of ^lo, and pay them to any one who desired him to settle his obligation. There is no reason why he might not have done so except that the banker's credit is better known than his, and that the banker specifically undertakes to pay Banking in the United States 9 his own notes in money when they are pre- sented. It is quite true that in most cases the holder of such a note will not present it for payment; but one principal reason why he does not do so is that he knows he can, if he chooses, liquidate in that way at any time. Performance of the operation just referred to over and over again, and proper protection of the bank's notes and deposits issued or granted so that the holder may get cash at sight, is commercial banking. The banker may modify the plan of his business by entering into an agreement with his customers to pay them not at sight, but on time; and in that case he is able to use such funds as come to him for long-time investments. The basic idea is the same in the one case as in the other, but the method of procedure is different. The national banking system is a system of commercial banks, and the same is true of many of the State systems. Trust companies are institutions which frequently do a large com- mercial banking business, but which under- take a variety of additional functions that have nothing to do with banking, such as those of serving as executor, trustee, and the like, act- ing as administrator, registering stocks and lo The Federal Reserve bonds, and otherwise performing fiduciary duties. Shortly after the Constitution of the United States was adopted, Alexander Hamilton, who was then Secretary of the Treasury, secured the adoption by Congress of a plan for the establishment of a Bank of the United States. This was the so-called " First Bank of the United States," which was granted a charter for twenty years. That charter was allowed to lapse shortly before the War of 1812. There was then no sub-treasury system, and the closing of the First Bank of the United States, which held the funds of the national Government, necessitated the redepositing of these funds in State banks. Most of the State banks were small and unsatisfactory; many failed. The United States Government was not able to get good accommodation from the State banks during the War of 1812. When peace returned a plan for another Bank of the United States was put forward, and the institution was finally chartered in 1816, with a twenty-year life period. The Second Bank of the United States held the Government deposits and acted as Fis- cal Agent. It was an efficient institution, but it incurred the enmity of those in charge of the Banking in the United States ii general Government about the year 1830, and ultimately a renewal of its charter was refused. After it ceased to exist, funds were again de- posited with State banks, and that plan once more proved unsatisfactory. In 1846 the inde- pendent or sub-treasury system of the United States was established, and the funds of the Government were deposited in it in hard cash. When the Civil War broke out there were sixteen hundred State banks in existence. All had the power to issue currency — a function which had also been exercised by the First and Second Banks of the United States. Con- sequently there were sixteen hundred different kinds of currency in the United States. After the opening of the Civil War it was again found that the State banks were not able to extend much aid to the national Government, while the confusion of currency was rendered worse by the fact that the Government had been obliged to issue legal tender notes or green- backs. Consequently the national banking sys- tem was planned, its fundamental idea being to establish a uniform currency, each bank be- ing obliged, when chartered, to purchase a specified amount of Government bonds, re- ceiving a specified percentage of the face thereof 12 The Federal Reserve in the form of national currency. This was be- lieved likely to have the double advantage of creating a demand for Government bonds, and of unifying the currency. The State banks accepted national charters so slowly, however, and so few new national banks were organized, that Congress, shortly after the close of the Civil War, imposed a tax of lo per cent, upon State bank notes. This practically limited the issue of currency to national banks, and the system expanded rapidly. State banks were still able to go on exercising banking functions through the deposit side of their activities, crediting borrowers with the loans they re- ceived in the form of deposits, and allowing them to draw checks thereon. The national banks, of course, could do business in this way, but in addition they could also issue notes, as just seen. There was a steady regular growth of the national banking system, until to-day it numbers 7,600 institutions with a combined capital and surplus of $1,800,000,000. The State banks, however, have had an even more rapid growth, and trust companies have of recent years also increased in numbers. The savings banks have always had a moderate ex- tension. Grouping all such State banking in- Banking in the United States 13 stitutions together, the number is probably not less than 20,000, while the combined capital of all is over $1,100,000,000, capital and surplus being over $2,400,000,000. It is thus seen that the national banks are neither numerically nor in point of capital in the majority; but they have always had a disproportionate importance by reason of the fact that they were united under Federal oversight, uniform in their methods for the most part, commercial in their type of business, relatively strong in their re- serve requirements, and better protected than most other institutions. This does not imply that there are not many State institutions fully the equal of national banks, but is a general remark applying to the different systems taken in the aggregate. Under the national system, and in most of the States, entrance to the bank- ing business is free — that is to say, a specified number of persons complying with certain requirements can take out a charter and begin business. They do not need a special act of the legislature or of Coligress, If the insti- tution thus organized is a national bank, it can, by depositing national bonds with the Govern- ment, unquestionably issue currency. In other words, access to the privilege of currency issue 14 The Federal Reserve is open to all who are willing to comply with the necessary requirements. The banking system whose main outline has thus been drawn is practically unique. In most foreign countries banks have been much more highly centraUzed. Two types of banking may be noted outside the United States. In the one there is a large central institution which usually has a close connection with the Govern- ment, holds Government funds, and issues cur- rency on a monopoly basis. Such banks ordi- narily have branches varying in number. Around them are developed subordinate insti- tutions which engage- in a more varied type of banking operations. These usually keep a sub- stantial part of their funds with the central bank, and the latter is thus able, by reason of its control of note issue and its holdings of re- serves, to regulate the flow of money into and out of the country, and to affect the prevailing rate of interest to a certain extent. With divers variations this is the type of banking that is found in England, France, and Germany. The other of the two types of banking is seen in Canada, where twenty-seven different insti- tutions, many of them of large resources, exist side by side, and operate under special charter. Banking in the United States 15 Several of them possess many hundreds of branches, each and all exercising the functions of note issue, while all protect the notes of each by contributing to a joint guaranty fund, upon which the notes of any failed bank become at once allien. It will be observed that, both under the Canadian and European systems of banking, the branch system is widely employed, which accounts for the centralization of the system of banking. In the United States branch banking has been practically prohibited ever since the inauguration of the national banking system, either as a result of law or of conditions and cus- toms equivalent thereto. Upon the banking system thus organized has now been superimposed the Federal reserve banking system; or, rather, it is perhaps more accurate to say that the banking units thus described are in process of being reorganized into a coherent whole through the operation of the Federal reserve system. Exactly how this proc- ess is being carried out must now be described in some detail. We have seen that some 25,000 different banks are scattered over the United States, none of them having any open or overt connection with any other. The Federal reserve system endeav- 1 6 The Federal Reserve ors to organize these banks into a single sys- tem, and, at the same time, to localize the con- trol of that system. In order to accomplish this did, it divides the country into a certain number of districts, each of which is supposed to be self-controlling and democratic in its methods. In each of these districts every na- tional bank is required to become a member of a corporation known as a Federal reserve bank. It is obliged to take out stock in this Federal reserve bank to an amount equal to 6 per cent, of its capital and surplus, one half being paid up, and the other constituting a Hability of the bank taking stock. While every national bank must thus become a member of and stock- holder in the Federal reserve bank of its own district, the State, private, and savings banks of the district are permitted to become members if they choose. Since they are organized under State and local laws, the Government of the United States has no direct jurisdiction over them; it can merely permit them to do certain things, encouraging or discouraging given lines of banking policy on their part. These banks, if they choose, may take out stock in Federal re- serve banks, and may thereupon place themselves upon an exact equality with the national banks Banking in the United States 17 which are required, by law to become members and stockholders of the Federal reserve banks. If the banksy both national and State, in any given district, should take out stock in the Federal reserve bank, it is evident that there would thus be established a joint or cooperative institution practically uniting the banks of the community or region. If not all should join, or if the membership in the institution should be confined to the national banks, the Federal re- serve bank would still possess the same general cooperative qualities, although it would not be be so inclusive as would otherwise be the case. Whether more or less inclusive, the Federal reserve bank acts as a medium of communica- tion and joint means of assistance to the banks that are members of it. It holds the reserve* deposits of the member banks up to a specified amount, and it deals only with such banks. That is to say, it takes the funds of its member banks and uses them wherever circumstances demand for the purpose of accommodating other member banks who may stand in need of relief or additional funds. The Federal reserve bank may go out into the open market and purchase paper from indi- viduals or corporations in the event that it 1 8 The Federal Reserve does not obtain from its own members sufficient discount business to enable it to pay its expenses and to make its own rates effective when neces- sary. Whatever line of policy it may pursue, however, it, under the terms of the Federal ' Reserve Act, as 'vill later be shown, must keep its cash invested in very short-time paper — that is to F''y, it makes no long investments, and endeavors to discount and liquidate only that paper which is of exceptional quality and responsibility, and which grows out of commer- cial, agricultural, and industrial transactions. This restriction of the business of Federal re- serve banks is not due to a belief that no other kind of paper can be considered "good," but is due to the recognition that only those classes of paper will liquidate themselves — ^that is t^- say, will automatically afford a settlement means in the course of the natural processes of trade. The Federal reserve bank of the district rep- resents not only the interests of banks that are stockholders in it, but also those of the pubHc as represented by three Government directors designated by the Federal Reserve Board, and of the business community as represented by three business men chosen by the member banks Banking in the United States 19 in the same way that they select their own bank- ing representatives. The Federal reserve banks as a whole are under the oversight and direction of the Fed- eral Reserve Board in Washington, a body ap- pointed by the President, and whose duty it is to oversee the operations of the reserve banks, harmonize them, and generally operate the system as a unit. The Federal Reserve Act does not describe the functions of the Federal Reserve Board in this way, but gives a lengthy and detailed account of its powers and duties. In effect, these, when reduced to simple form, amount merely to what has just been stated. Every Federal reserve bank is presumed to be self-goverriing or autonomous, and independent of any other; but the Board is given power to call upon any Federal reserve bank to rediscount ' the paper of another whenever circumstances seem to require it. In cases where no such in- tervention is necessary, but where one Federal reserve bank desires to get funds from another which stands ready to advance them, the Board simply exercises the function of fixing the rate at which such inter-bank accommodation shall be extended. From this brief sketch of the Federal reserve 20 The Federal Reserve system it will be seen that it is an association of banks to which all national institutions must ad- here, and in which all, whether national or State, may be members, for the purpose of uniting the reserves of the multitudinous small banks of the country into a very small number of combined reserves, such reserves to be used primarily for the purpose of equalizing the strength of the banking community by aiding those members of It which are weak or which require aid in the ex- tension of their business along legitimate and desirable lines. To this it should be added that the Federal reserve banks are by law vested with what 'would ultimately amount to a monopoly of the power of issuing notes. At present national banks exercise this function, while State banks, trust companies, etc., do not. But under the Federal Reserve Act national banks will grad- ually find it to their interest to surrender the note-issue power, and that function will conse- quently pass into the hands of the Federal reserve banks, to be by them exercised as they deem best in response to the request of the mem- ber banks, which, in turn, will be controlled and actuated by the applications of the public for note currency. Banking in the United States 21 The Federal Reserve Act has in many ways modified the National Bank Act, in some re- spects profoundly, but it has not changed its structure, or altered the basis of banking in the United States. It leaves that as it was before, and seeks simply to organize the existing banks into units eflFective for regular work in quiet times and for relief in times of emergency. It is not a change in the banking system in the broad and true sense of that word, but is an evolution and further development of it. It applies the teachings and experience of foreign countries to American conditions by introducing the principles of centralization or combination of reserves, and of joint control and protection of the issue function. At the same time it maintains free banking, the essentially American element in bank operation, so that any group or individual possessed of a limited amount of capital and holdings, by meeting certain easily attained requirements, can organize a bank, gaiii admission to the Federal reserve system, and thereby become party to and sharer in the operations of the joint organization already described. It is a notable fact that the Federal Reserve Act, in making provision for the elec- tion of directors of Federal reserve banks, gives 22 The Federal Reserve to each and every bank, whether small or large, equality of voting power with every other, so that the institution of $25,000 capital has ex- actly as much influence in the selection of direc- tors to represent its interests in the Federal reserve bank of the district as does the city institution possessed of many millions of capital. In times past one of the greatest difficulties of the national banking system has been in its inadequacy at moments of panic or disaster. Banks which had funds on deposit with others under such conditions would invariably with- draw them, thus weakening the reserves of the larger banks, and oftentimes piling up funds to no purpose in the vaults of the sriialler. Individuals doubtful of the solvency of the institution with which they were dealing, al- though without good grounds for such doubts, have acted likewise, withdrawing their deposits from the institution where they were being kept. The consequence has been weakness at the very time when strength was needed, and . lack of cooperation at the moment when co- operation was a necessity. From this system it has developed that bank loans were usually contracted in times of panic, notwithstanding that at that very moment they should have been Banking in the United States 23 enlarged, and in European countries were ac- tually enlarged in that way. The Federal Re- serve Act provides against such a condition by permitting large issues of notes, and also by requiring each member bank to keep a speci- fied amount of deposits with its Federal reserve bank, whether it chooses to do so or not. The Federal Reserve Board is given qualified power to suspend reserve requirements, and by these means the law endeavors to make the whole banking chain as strong as its strongest link — always assuming, of course, that each bank's assets are sound and good, and that the strain upon it is merely a strain due to desire for liquidation. No banking mechanism can pro- tect banks whose assets are rotten; neither is it possible for any mechanism wholly to over- come panic. All it can do is to eliminate un- necessarybasis for panic, and to so organize and consolidate the strength of the financial com- munity as to enable it to meet panic conditions firmly and without loss. All this the Federal reserve system enables its member banks to accomplish, and thus it is in position to extend indirect aid even to non-member banks, be- cause the latter are affected by the general con- ditions of the financial community precisely as 24 The Federal Reserve member banks are. The Federal reserve sys- tem is, however, not simply an insurance against panic, but a regular working part of the banking mechanism of the country with given functions to be steadily and continuously performed, and a definite part to play in the continuous devel- opment of banking. CHAPTER II HISTORY OF BANKING REFORM MOVEMENT Deficiencies in the national banking system were perceived comparatively early in its his- tory, but did not make themselves felt in a way so serious as to enlist active effort for their correction until about twenty-five years after the system had first become operative. More- over, during this period of twenty-five years, the difficulties which were most seriously felt were not those that afterward caused most an- noyance and led to most active effort for im- provement. Probably the first inconvenience that was experienced in the management of the national circulation after the national banking system had been definitely created and the Act had been amended to meet the earlier require- ments of the conditions then existing, was the prospect that the supply of Government bonds, available at prices that would enable the banks to put out circulation based thereon, would be 25 26 The Federal Reserve insufficient. In 1880-83 this problem had become acute, due to the fact that the twenty- year bonds which had been issued by the Fed- eral Government during the Civil War at 5 and 6 per cent, interest were expiring, and the ques- tion what should be done in connection with them was unsettled. This problem was dis- posed of by refunding the bonds for another twenty years, and thus enabling the national banks to get the securities they needed as a basis for their circulation. With the growth of the great surpluses of revenue during the dec- ade 1880-90, a new type of problem appeared; for the purchases of bonds made by the Treasury Department, in order thus to use up the surplus, had again brought the bonds to a premium and made it questionable whether the maintenance of the circulation on a satisfactory basis pro- viding for the issue of enough of the notes would be feasible. Discussion of the question was, however, only sporadic. The national sys- tem was proving itself in so many ways bet- ter adapted to the needs of the country than the system of banking which had preceded it, that comparatively few persons were disposed to at- tack it seriously. A new situation developed after 1890. The History of Banking Reform Movement 27 difficulty in getting an adequate supply of cir- culating notes had been making itself more and more felt prior to that time, and when the panic of 1893 came on, this phase of the prob- lem became suddenly very acute. During the panic of 1893 there was a tremendous shortage of currency, and many expedients had to be resorted to for the purpose of supplying even the bare necessities of the country for a circulat- ing medium. Not only clearing-house certifi- cates, but a great variety of forms of local obligations which served as currency substitutes, were injected into the circulation from time to time, and served as a means of relieving the strain upon national bank notes. As for the national bank notes themselves, it was almost out of the question to obtain sufficient amounts of them. Even when a national bank had de- posited its bonds with the Treasury and had made application for notes, fully three weeks were necessary in order to get delivery of the final completed currency. This delay was necessary in order that the notes might be printed, dried, and shipped to their destination. The process of signing them and putting them out required more time. Altogether, the delay involved in making the currency available was 28 The Federal Reserve so great that the experience of the panic con- vinced practically all observers of the unsatis- factory nature of the prevailing system for issuing notes as a practical matter, entirely independent of the question whether the method of note issue provided in the National Act was or was not theoretically satisfactory or desirable. The result of these events was to draw the attention of American bankers toward the practice of other countries. Many persons be- heved that the past experience of the United States with so-called central banking as exem- pUfied in the history of the First and Second Banks of the United States had been such as practically to put resort to such expedients out of the question. This belief directed attention most strongly to the Canadian banking system which had been lately revised, and in which the most striking feature, from the standpoint of American bankers, was an issue of currency protected by a joint guaranty fund contributed by all of the banks. At a meeting of the Ameri- can Bankers' Association in 1893, at Baltimore, a plan of a somewhat similar sort was advo- cated. This was designated as the "Baltimore Plan," and became to many minds synonymous with what has long been called "Currency Re- History of Banking Reform Movement 29 form." Unsatisfactory conditions in the cur- rency situation had their share in contributing to the growth of the silver agitation, but the presidential campaign of 1896 turned almost entirely about the question of remonetizing silver. Discussion of banking and currency, as distinct from that relating to the standard of vklue for money, practically disappeared in the struggle over silver. Immediately after the election of President McKinley, however, an effort was made by business men and bankers throughout the country to direct attention once more toward ' the question of an appropriate note issue. Legislative leaders, nevertheless, showed almost complete indifference to the whole subject, and the "currency reform" movement after 1896, therefore, naturally became an effort to secure definite gold-standard legislation and only incidentally improvement of the banking situation. The most notable movement of the four years from 1896 to 1900 was that embodied in what was called the IndianapoHs Currency Commission. This was a body appointed by a convention of boards of trade and commercial organizations generally, which had met at Indianapolis, Indiana. The Commission did 30 The Federal Reserve its work largely in Washington, and ultimately issued a report which called for three principal changes in existing legislation: (i) The definite establishment of the gold standard; (2) the separation of the gold fund protecting green- backs or United States notes in the Treasury Department from the other funds of the Treas- ury, with provision for reconstituting this fund by the issue of bonds; and (3) the issue of bank notes based upon commercial paper and duly protected in various ways. It is probable that this report would have evoked immediate action by Congress to some effect had not the Spanish-American War intervened. The close of the war found the United States approach- ing another presidential election. Congressional leaders then hastily framed a measure known as the Gold Standard Law of 1900, which be- came a statute on March 14th of that year. In this Gold Standard Law provision was made for the segregation of the funds of the Treasury, so that ^150,000,000 should always be available behind the greenbacks, and authority was given to the Secretary of the Treasury to sell bonds for the purpose of reestablishing this fund if at any time it should fall below the level thus arbitrarily fixed for it. The Act declared the History of Banking Reform Movement 31 standard of money in the United States to be the gold dollar, although it was defective in making no provision for the redemption of the silver dollar in gold or for the issue of bonds to maintain parity. Outstanding bonds were to be refunded into 2 per cent, consols, and these 2 per cent, bonds were made available to protect national bank currency. Prior to 1900, $50,000 had been the minimum capitalization of a national bank, but the new Act reduced this sum to $25,000 in towns of 3,000 inhabitants. This reduction and the issue of the 2 per cent, bonds were expected to enable country com- munities to organize national banks and take out the currency they needed. The fact that prior to 1900 the outstanding bonds had brought a large premium, while banks could obtain only 90 per cent, of the par value of their bonds in currency, had made it unprofitable for the banks to issue. For example, if a bank had to pay for $100,000 of, Government bonds, say, 112, while it could get only $90,000 in currency, there would be a gap of $22,000 between the currency and the amount invested in bonds, on which the bank was Hkely to suffer loss. Shrinkage in bond premiums and the fact that this amount of money was not definitely employed in any 32 The Federal Reserve way, except for the interest on the face of the bonds, made the issue unsatisfactory to the banks. Therefore, the new law allowed the banks to get loo per cent, of the face of their bonds in notes. The Act of 1900 made, how- ever, no provision whatever for notes based on commercial paper, nor did it render the prompt issue of the notes any easier than before. It was, nevertheless, successful in stimulating the organization of national banks, and the number in existence rapidly increased, especially in the group with $25,000 capital. The outstanding bonds were rapidly converted into the new 2 per cent, bonds, and these were taken up by the new banks. The small banks, especially, were disposed to take out circulation up to the level allowed by law, and became strong buyers of 2 per cent, bonds. Under the Act of 1900 the needs of the coun- try for currency were more or less fully met. Business was prosperous, and there was a gen- eral expansion of operations and of prices. The Act of 1900 had not, however, met any of the real requirements of banking and currency reform. Although the previous prosperity and the apparent remoteness of panic had led to a slackening of interest on the part of many com- History of Banking Reform Movement 33 mercial and business interests which had pre- viously urged banking reform, scientific students of the situation did not reduce their efforts, and nearly every year a succession of new bills made their appearance in Congress. The striking feature of this second period of agitation may be said to be the recognition of the fact that a mere reform in note currency issue methods would not meet the needs of the case. Both the experience of foreign countries and of the United States, as well as closer analysis of the contemporary experience of Canada, showed that such was the fact, and emphasized the necessity for a more thorough and far-reaching type of legislation than had yet been afforded. Charles N. Fowler, who had become Chair- man of the Banking and Currency Committee in the House of Representatives in the year 1901, was a strong advocate of a genuine elastic currency provision. He introduced a succession of bills dealing with the subject, and in the course of his investigation was speedily led to the conviction that what was needed most was cooperation among the banks, not only for note issues, but also for the control of credit in such a way as to prevent hasty expansion that would occur were reserves lowered to a 34 The Federal Reserve danger point. Working toward this thought through a succession of later measures, Mr. Fowler ultimately framed in the year 1910 a measure entitled "A Bill to EstabHsh a Com- plete Financial and Banking System." The measure provided in general terms for an insti- tution formed through the cooperation of exist- ing national banks, and designed to hold the reserves of the country as well as issue its cur- rency. Some other students of the subject had been working along somewhat dissimilar, although parallel, hues. Among them was Hon. Isidor Straus of New York City, whose measure pro- vided for the permanent organization of the clearing houses of the United States, with the purpose of permitting them regularly to issue supplies of currency as the gold reserve fund of the community was advanced, the thought in that plan being that, inasmuch as aid had been obtained through clearing-house coopera- tion in times of panic, the type of cooperation to be furthered by any new law should be some- thing modeled on this clearing-house system. Ideas of a similar kind were strongly urged not only by Mr. Straus, who was for some time a member of Congress and a well-known mer- History of Banking Reform Movement 35 chant of New York City, but likewise by other able students of the problem. Another group of thinkers was more and more drawn toward the idea of a central bank modeled upon Euro- pean institutions and designed to hold the funds of the country. Conspicuous among these was Hon. M. L. Muhleman. There was a multitude of bills and drafts of many kinds, some intro- duced in Congress, some circulated throughout the country by private publications, some rec- ommended by commercial organizations, and others merely put forward as the work of in- dividual students. Notwithstanding the apparent prosperity of the country, there were signs of danger in the inflation and unsound finance that prevailed during the period, and these, at about the be- ginning of the year 1907, had developed into a state of affairs which portended immediate disaster. Banks were greatly inflated with large lines of credit which they could not liqui- date. Business men were unable to pay their obligations. In the late summer of 1907 it ap- peared inevitable that there should be a collapse, and this, in fact, occurred in October. The first open symptom of difficulty was noticed in New York, and from there the trouble steadily 36 The Federal Reserve spread throughout the country. As usual, specie payments were suspended, and clearing-house certificates were issued. There was a general shortage of currency accompanied by many bank failures. In order to relieve the situation. Secretary of the Treasury Cortelyou and Comp- troller of the Currency Ridgely did all in their power to enlarge the volume of bonds available for the purpose of carrying the new national bank notes. At the opening of the panic it seemed as if all the available bonds had already been deposited with the Treasury to secure national bank notes or else to protect public deposits. As public deposits with banks were then very large, the amount of bonds thus ren- dered unavailable as a basis for bank-note issue was likewise considerable. The Treasury De- partment ruled that other securities might be substituted for national bonds behind public deposits, and this released a good many national bonds which were then transferred to circulation account, thereby providing for the issue of an additional supply of notes. In this way con- siderable enlargement of the circulation was obtained, but, as on former occasions, the as- sistance came too late to do very much good. It was strongly felt that Congress ought History of Banking Reform Movement 37 to do something by way of relief, particularly as another presidential election was in sight. Consequently, in the spring of 1908 a bill was reported by the House Banking and Currency Committee and another by the Senate Commit- tee on Finance. The House bill was a measure calling for the issue of currency based on com- mercial paper, while the Senate plan, speedily known as the Aldrich bill, sought to meet the difficulty by allowing banks to deposit with the Treasury other kinds of bonds in protecting their circulation. The philosophy of the House bill was more complex, being based on the view that what the country needed was a thorough re- vision of its banking methods, particularly as related to the issue of currency, with a flexible note issue backed by commercial paper. By a * legislative manoeuvre there was now substituted for the Fowler bill a plan which became known as the Vreeland bill, and called for the issue of currency by associations of banks, called at first clearing-house associations, on the basis of commercial paper deposited with such associa- tions. The bill was originally incredibly crude, and was changed almost daily for a long period of time. It finally assumed greater feasibility and was passed by the House of Representatives. 38 The Federal Reserve The Aldrich bill had meanwhile been passed in the Senate, and efforts were now made to ad- just and combine the two. Ultimately this attempt resulted in the so-called Aldrich-Vree^^ land Act of May 30, 1908, which permitted the issue of currency based on commercial paper by associations of banks known as "National^ Cur-_ rency Associntions," while it also permitted national banks to deposit bonds of specified classes with the Treasury Department, and to receive direct issues of currency based thereon. In every case the new currency was made the subject of a very high rate of tajcatipn, it being supposed that this would force the notes to retire rapidly. One feature of the Act was a provision for a "N ation al Monetary Commission" to con- sist of senators and representatives only. The Commission was given almost unlimited power of spending money in furtherance of its inquiry, and was directed to investigate currency and banking conditions wherever it saw fit, and report to Congress what further action was needed. The control of Congress changed in 1910, a Democratic majority appearing in the House of Representatives, while dissatisfaction with the expenditures of the Commission for travelling History of Banking Reform Movement 39 and publishing began to be expressed. Late in the summer of 1910 Senator Cummins of Iowa succeeded in securing the adoption of a resolu- tion calling for some report by the Monetary Commission within a specified period. In De- cember following the outlines of a bill drafted for Senator Aldrich became known to the public, and shortly thereafter the measure was adopted by the National Monetary Commission. This later became known as the Aldrich bill. The Aldrich or Monetary Commission bill was a lengthy and detailed legislative proposal which had been worked out with the aid of banking authorities, and which presented a plan for the complete reorganization of the bank- ing system of the country. In order to under- stand the Aldrich bill thoroughly it must be remembered that, as already suggested, it was merely the outcome of a long period of discussion and controversy. The brief treatment to which we are necessarily limited prevents us from con- sidering more than a very few of the antecedents of the bill; but it is important to note that the measure had been preceded by two other pro- posals of similar character, which had been worked out independently of those who had the Aldrich bill in hand. These were the Fowler 40 The Federal Reserve and the Muhleman bills. A true understand- ing of the Aldrich bill, and what was done in the way of legislation subsequently, can best be attained, therefore, by a brief sketch of these three measures. The object of the plans presented in these three proposed measures was that of arranging a cooperative organization of the banks of the United States which should serve to afford these banks the means of rediscounting their paper at times when they required assistance or accom- modation in order to continue extending loans to their customers, and in order to avoid the ■ curtailment of credit which in the past has fre- quently resulted in precipitating commercial panics and stringency. The fundamental idea running through the proposals was that of cen- tralizing the control of discounts as well as that of applying a more rigorous method of oversight to the operations of the several banks expected to participate in the new scheme. It was sup- posed by the authors of these plans that the institution which they aimed to create would ac- complish at least the following financial results: (i) Establishment of a more or less uniform rate of discount throughout the United States, and thereby the furnishing of a certain kind of History of Banking Reform Movement 41 control over bank operations which should be similar in all parts of the country. (2) General strengthening of reserves in or- der that such reserves might be held ready for use in protecting the banks of any section of the country and so enabling them to go on meeting their obligations instead of suspending pay- ments, as has so often been necessary in the past. (3) Furnishing of an elastic currency by the abolition of the existing bond-secured note issue in whole or in part, and the substitution of a freely issued and adequately protected system of bank notes which should be available to all institutions which had the proper class of paper for presentation. (4) Management and commercial use of the funds of the Government which are now isolated in the Treasury and sub-treasuries in large amounts. (5) General supervision of the banking busi- ness and furnishing of more stringent and care- ful oversight. Other objects were sought, incidentally, in these plans, but they were not as fundamental as the chief purposes just enumerated. The plans presented a general community of 42 The Federal Reserve design and similarity of arrangement which was not necessarily the outgrowth of plagiarism or imitation, but had resulted from the facts that some proposition of the same general kind had been under consideration for many years past, and had commended itself to leading bankers and business experts, and that the idea of com- bined action had also the support of Euro- pean experience, nearly every European country being equipped to-day with a central banking mechanism of some kind. This notion of a central banking mechanism which should econo- mize resources and sustain the several banking units was thus admittedly desirable, provided that various diificulties connected with it could be overcome. It was in overcoming these diifi- culties and avoiding the embarrassments that necessarily arise from such a proposition, that the three plans under consideration, as well as numerous others of the same general descrip- tion, varied from one another. These variations were of great significance when it is sought to adopt a piece of practical legislation for the purpose of remedying existing conditions; but they are not fundamentally important from the general theoretical standpoint. The particulars in which the various plans History of Banking Reform Movement 43 differed one from another are numerous, but the principal points upon which those who had framed these plans concentrated their attention may be enumerated as follows: (i) Methods of providing capital for the suggested central organization. (2) Relationship between the central organ- ization and branches of the same. (3) Details of the relationship between the institution and its branches on the one hand and existing banks on the other. (4) Relations between the proposed insti- tution and its branches on the one hand and the pubHc on the other. (5) Relations between existing institutions on the one hand and the Government on the other. (6) Methods of controlling the proposed mechanism. (7) Details of the lines of business to be transacted by the proposed institution. Although the Aldrich bill was in a general way in line with what had been often urged and widely talked about both in Congress and out of it, and although it could have been amended in such a way as to eliminate many of the ob- jectionable ideas which had been veneered upon 44 The Federal Reserve the fundamental basis of banking theory and practice which constituted its substructure, the measure never commended itself to the public. As a matter of fact, it never received consider- ation at the hands of a committee in either house of Congress, and within a few months after it was introduced the control of both houses had largely slipped from the hands of the political group which was responsible for it. The Demo- cratic party had succeeded the Republican in full charge of the House of Representatives, and a combination of party groups had practically deprived the conservative Republicans in the upper chamber of Congress of the majority control which they had long exercised there. Consequently it became necessary for the Demo- cratic party to consider carefully what should be its attitude with reference to the subject of banking legislation. Should it accept the Al- drich plan as a scientifically developed, perhaps almost perfect, proposal, to be treated, therefore, as an entirely non-partisan and non-political matter, or should it approach the subject from a fresh standpoint with a view of determining upon its own measure of legislation ? The latter course was the one determined upon ; and upon the Banking and Currency Committee of the History of Banking Reform Movement 45 House of Representatives fell the duty of exam- ining the great mass of information already col- lected with reference to currency and banking, of analyzing the data at hand, of simplifying the results thus obtained, and of selecting those which were deemed most worthy to be incor- porated into a measure for the reorganization of the banking and currency system of the nation. CHAPTER III THE FEDERAL RESERVE ACT We may now present a orief outline sketch of the legislative history of the Federal Reserve Act. Without at present entering into the early history of the process by which the measure it- self was framed, between April, 191 2, and June, 1913, it may be generally said that during the period referred to a preliminary draft of what later became the Federal Reserve Act was shaped under the auspices, first of a sub-com- mittee of the House Banking and Currency Committee as organized in the Sixty-second Con- gress, Hon. Carter Glass of Virginia being chair- man of the sub-committee in question, and then under the auspices of Mr. Glass himself as the ranking Democratic member and prospective chairman of the Banking and Currency Com- mittee to be organized in the House of Repre- sentatives of the Sixty-third Congress. Upon the basis of careful investigation, con- ducted under direction and supervision of the 46 The Federal Reserve Act 47 committee, partly at public hearings during the winter of 1912-1913, partly by private inves- tigations, it had been determined what features should and what points should not be embodied in the proposed measure. The bill thus drafted had been submitted to and had received the approval of President Wood row Wilson, and was thus, when introduced in the House of Representatives on June i8th, an administration bill in the sense that it had received the ap- proval of those charged with administrative responsibility, while it had been developed by the authorized legislative agencies of Congress. As thus drafted for presentation, the banking bill covered certain main points, which were subjected to no serious change and which have been succinctly reviewed in a report, submitted to the House on September 9, 191 3, by Chairman Glass on behalf of the Banking and Currency Committee, as follows: "After looking over the whole ground, and after examining the various suggestions for leg- islation, some of which have just been out- lined, the Committee on Banking and Currency is firmly- of the opinion that any effective legis- lation on banking must include the following fundamental elements, which it considers indis- 48 The Federal Reserve pensable in any measure likely to prove satis- factory to the country: "i. Creation of a joint mechanism for the ex- tension of credit to banks which possess sound assets and which desire to liquidate them for the purpose of meeting legitimate, commer- cial, agricultural, and industrial demands on the part of their clientele. "2. Ultimate retirement of the present bond- secured currency, with suitable provision for the fulfilment of Government obligations to bond- holders, coupled with the creation of a satis- factory flexible currency to take its place. "3. Provision for better extension of American banking facilities in foreign countries to the end that our trade abroad may be enlarged and that American business men in foreign countries may obtain the accommodations they require in the conduct of their operations." Beyond these cardinal and simple proposi- tions the committee has not deemed it wise at this time to make any recommendations, save that in a few particulars it has suggested the amendment of existing provisions in the Na- tional Bank Act, with a view to strengthening that measure at points where experience has shown the necessity of alteration. The Federal Reserve Act 49 In order to meet the requirements thus sketched, the committee proposes a plan for the organization of reserve or rediscount institu- tions to which it assigns the name "Federal reserve banks." It recommends that these be established in suitable places throughout the country to the number of twelve as a beginning, and that they be assigned the function of bankers' banks. Under the committee's plan these banks would be organized by existing banks, both national and State, as stock- holders. It believes that banking institutions which desire to be known by the name "Na- tional " should be required, and can well afford, to take upon themselves the responsibilities involved in joint or federated organization. It recommends that these bankers' banks shall be given a definite capital, to be subscribed and paid by their constituent member banks which hold their shares, and that they shall do busi- ness only with the banks aforesaid, and with the Government. Public funds, it recommends, shall be deposited in these new banks which shall thus acquire an essentially pubHc char- acter, and shall be subject to the control and oversight which is a necessary concomitant of such a character. In order that these banks 50 The Federal Reserve may be effectively inspected, and in order that they may pursue a banking policy which shall be uniform and harmonious for the country as a whole, the committee proposes a general board of management entrusted with the power to overlook and direct the general functions of the banks referred to. To this it assigns the title of "The Federal Reserve Board." It further recommends that the present national, banks shall have their bonds now held as se- curity for circulation paid at the end of twenty years, and that in the meantime they may turn in these bonds by a gradual process, receivirig in exchange 3 per cent, bonds without the cir- culation privilege. In Heu of the notes now secured by national bonds and issued by national banks, and, so far as necessary in addition to them, the committee recommends that there shall be an issue of "Federal reserve treasury notes," to be the obligations of the United States, but to be paid out solely through Federal reserve banks upon the application of the latter, protected by com- mercial paper; and with redemption assured through the holding of a reserve of gold amount- ing to 33I per cent, of the notes outstanding at any one time. In order to meet the require- The Federal Reserve Act. 51 ments of foreign trade, the committee recotp- mends that the power to establish foreign branch banks shall be bestowed upon existing national banks under carefully prescribed con- ditions and that Federal reserve banks shall also be authorized to establish oflEces abroad for the conduct of their own business and for the purpose of facilitating the fiscal operations of the United States Government. Finally and lastly, the committee suggests the amendment of the National Bank Act in respect to two or three essential particulars, the chief of which are bank examinations, the present conditions under which loans are made to farming inter- ests, and the liability of stockholders of failed banks. It believes that these recommenda- tions, if carried out, will afford the basis for the complete reconstruction and the very great strengthening and improvement of the present banking and credit system of the United States. The chief evils of which complaint has been made will be rectified, while others will at least be palliated and put in the way of later elimina- tion. The Federal reserve banks suggested by the committee as just indicated would be in effect cooperative institutions carried on for the 52 - The Federal Reserve benefit of the community and of the banks themselves by the banks actirig as stockholders therein. It is proposed that they shall have an active capital equal to lo per cent, of the capital of existing banks which may take stock in the new enterprises. This would result in a capital of something over ^100,000,000 for the reserve banks taken together if practically all existing banks should enter the system. It is supposed, for a number of reasons, that the banks would so enter the system. More will be said on this point later in the discussion. How many State banks would apply for and be granted admission to the new system as stockholders in the reserve banks cannot be confidently predicted. It may, however, be fair to assume at this point that the total capital of the reserve banks will be in the neighborhood of ^100,000,000. The bill recommended by the committee provides for the transfer of the present funds of the Government included in what is known as the general fund to the new Federal reserve banks, which are thereafter to act as fiscal agents of the Government. The total amount of funds which would thus be transferred cannot now be predicted with absolute accuracy, but the released balance in the general fund of the The Federal Reserve Act 53 Treasury is not far from $135,000,000. Cer- tain other funds now held in the department would in the course of time be transferred to the banks in this same way, and that would re- sult In placing, according to the estimates of good authorities, an ultimate sum of from $200,000,000 to $250,000,000 in the hands of the reserve banks. If the former amount be assumed to be correct, it is seen that the reserve banks would start shortly after their organiza- tion with a cash resource of at least $300,000,000. As will presently be seen in greater detail, it is proposed to- give to the reserve banks reserves now held by individual banks as reserve holders under the National Banking Act for other banks. Confining attention to the national system, it is probable that the transfer of funds thus to be made by the end of a year from the date at which the new system would be organized would be in the neighborhood of $350,000,000. If State banks entered the system and conformed to the same reserve requirements they would proportionately in- crease this amount,. but for the sake of conser- vatism the discussion may be properly confined to the national banks. For reasons which will be stated at a later point, it seems likely that 54 The Federal Reserve at least $250,000,000 of the reserves just re- ferred to would be transferred to the reserve banks in cash; and if this were done the total amount of funds which they would have in hand would be at least $550,000,000. This would create a reservoir of liquid funds far surpassing anything of similar kind ever availa- ble in this country heretofore. It would com- pare favorably with the resources possessed by government banking institutions abroad. It will be observed that in what has just been said the reserve banks have been spoken of as if they were a unit. The committee, however, recommends that they shall be individually or- ganized and individually controlled, each hold- ing the fluid funds of the region in which it is organized and each ordinarily dependent upon no other part of the country for assistance. The only factor of centralization which has been pro- vided in the committee's plan is found in the Federal Reserve Board, which is to be a strictly Government organization created for the pur- pose of inspecting existing banking institutions and of regulating relationships between Federal reserve banks and between them and the Gov- ernment itself. Careful study of the elements of the problem has convinced the committee that The Federal Reserve Act 55 every element of advantage found to exist in co- operative or central banks abroad can be realized by thedegree of cooperation which will besecured through the reserve bank plan recommended, while many dangers and possibilities of undue control of the resources of one section by another will be avoided. Local control of banking, local application of resources to necessities, combined with Federal supervision, and limited by Federal authority to compel the joint ap- plication of bank resources to the relief of dangerous or stringent conditions in any locality are the characteristic features of the plan as now put forward. The limitation of business which is proposed in the sections governing! j fgdiscounts, and the maintenance of all opera- ■ tions upon a footing of relatively short time will ! keep the assets of the proposed institutions in a strictly fluid and available condition, and will in- sure the presence of the meansof accommodation when banks apply for loans to enable them to extend to their clients larger degrees of assistance in business. ; It is proposed that the Government shall retain a sufficient power over the reserve banks to enable it to exercise a directing au- thority when necessary to do so, but that it shall in no way attempt to carry on through its 56 The Federal Reserve own mechanism the routine operations of bank- ing which require detailed knowledge of local and individual credit and which determine the actual use of the funds of the community in any- given instance. In other words, the reserve bank plan retains to the Government power over the exercise of the broader banking functions, While it leaves to individuals and privately owned 'institutions the actual direction of routine. As first presented, the bill was taken in hand by the House Committee on Banking and Cur- rency, which, however, had not been named until a few days previous to the introduction of the measure. The committee held its first meeting June 6th; then began the active work of considering the bill on July 7th; and continued regular sessions several hours each day until the beginning of September. The bill was then reported to a Democratic caucus, and after about two weeks of discussion behind closed doors was ratified, and was thereupon formally reported, on September 9th, to the House of Representatives, where it was taken under de- bate on September loth and ultimately forced to a passage in the House on September i8th. It was then sent to the upper chamber and was taken under advisement in the Senate Banking Com- The Federal Reserve Act 57 mittee where extensive hearings were promptly begun and were continued until October 25th. Thereafter, a month of consideration in commit- tee ensued, and subsequently three days of cau- cus consideration in the Senate, a final report to the Senate as such being rendered on Decem- ber 1st. Debate then began and was contin- ued, first in the intervals of business already scheduled, then at practically continuous ses- sions until December 19th when a final vote was secured and the measure within twenty-fjJur hours sent to conference, from which it emerged on December zzd, receiving, as already stated, the President's signature on the following day. When reported by the Senate Banking Com- mittee, after its own consideration and that of the caucus, the banking bill contained no im- portant changes in theory, as compared with the House draft, save only in the section which related to the method of retiring existing national bank circulation and of providing for the re- funding of United States 2 per cent, bonds. The bill, however, differed essentially from the House measure in many details, some of them of great importance, others of minor significance. The framework of the bill had been changed in no fundamental particular, but remained as it 58 The Federal Reserve had been originally constructed. The detailed changes, taken in the aggregate, would, however, have altered in a considerable degree its scope and effect. A sketch of these changes must, therefore, be presented at this point. As reported by the Senate Committee, the bill, instead of providing for a series of reserve banks not less than twelve in number, whose stock was to be owned exclusively by existing I national and State banks, provided for not less \th%n eight nor more than twelve of such banks, and permitted the stock, if not taken up by existing banks through subscription, to be sold to the public, or, if not subscribed for by the pubHc, to be allotted to the United States Gov- ernment. It slightly altered the method of voting for directors of reserve banks froin the plan prescribed in the House bill. It relieved the national banks entering the system of the necessity of rechartering. The Federal Re- serve Board was somewhat changed in compo- sition through the elimination of one ex-officio member drawn from the administration, and was given broader and less restricted powers than had been conferred by the House bill, al- though none of a new or fundamental nature was added. The Senate Committee, moreover, The Federal Reserve Act 59 instead of making the deposit of pubhc funds in reserve banks mandatory, left it to the dis- cretion of the Secretary of the Treasury to deposit such funds or not as he might see fit, al- though the tenor of the provision on this subject was such as to indicate that the declared policy of the United States would in the future be that\ of making the deposits with the reserve banks rather than with national banks as in the past. As a method of retiring United States bonds and national bank circulation, the Senate bill provided that these securities might be annually assigned to Federal reserve banks in a sum not to exceed $25,ocx),ocx), the banks to be required to purchase the bonds at par from their existing owners and to issue upon them, as security, notes exactly similar to existing national bank notes and subject to the same requirements, limitations, and obligations. In dealing with the reserve question, it was provided that Federal reserve banks should maintain 35 to 40 per cent, instead of 33I per cent, as in the House bill, and that national banks should maintain in central reserve cities 18 per cent., in reserve cities 15 per cent., and in the country 12 per cent., of demand deposits. 6o The Federal Reserve with 5 per cent, against time deposits, both the proportion to be kept in the reserve banks and the rate of transfer being altered, as compared with the House bill, in such a way as to make the process of transfer easier for the contributing banks. Byway of still further lightening the bur- den, which, it was supposed, would be imposed upon the banks in this process of transfer, it was provided that one half of the credits to be estab- lished with the reserve banks created under the bill might be paper eligible for rediscount, while the notes issued by the reserve banks were also allowed to be counted in the reserves of these member banks. The Senate bill, moreover, extended the provisions of the so-called Aldrich- Vreeland law of 1908, and inserted in the meas- ure a provision authorizing the Secretary of the Treasury to sell bonds for gold, should such a measure be necessary at any time to maintain the redeemableness of Federal reserve notes. Lastly, the Senate bill largely altered the pro- vision which had been made in the House for the collection of checks and drafts at par through- out the country. While under debate in the Senate, the bill underwent some further al- terations, none of which, however, materially changed its more important aspects, as already The Federal Reserve Act 61 described. Such clauses as were inserted were intended mainly to clarify the language or to add further safeguards which had been found or thought to be necessary here and there as the work proceeded. Little needs to be said of the debate in the Senate. It is doubtful whether any important provision was altered on the floor as the result of discussion, although a few points at which the measure was weak were subsequently rectified; probably as a result of the repeated attacks to which they had been subjected during the weeks before the measure was finally adopted. As the bill ultimately passed the Senate, it differed from the plan of the House in no respect that was of theoretical importance. It retained the pro- vision for sales of stock to private holders and for the voting of the stock by trustees represent- ing these holders, as well as for the purchase of stock by the United States itself, in case of necessity for so doing. It moreover introduced | a change in the method of distributing the earnings of Federal reserve banks whereby a portion of those earnings was to be employed, for establishing a fund for guaranteeing the deposits of member banks which had taken stock/ in the Federal reserve banks of their district. 62 The Federal Reserve It altered the number of banks by cutting it to no less than eight and not more than twelve, in place of the "at least 12" of the House bill. While many minor changes and alterations of wording were made throughout, they did not alter the essential structure of the plan, but in some cases carried it further than the framers of the House measure had been able to d», embody- ing ideas that had been urged by them while the measure was under discussion, but for which they had not succeeded in obtaining endorse- ment. Perhaps the most injurious features which were added during the Senate stage of the measure were the provision cutting reserves of member banks and that permitting the intro- duction of bank notes into reserves as a con- stituent element therein. The substance of the work done in confer- ence committee may be summarized somewhat further in order to bring out the points that had been accepted as innovations upon the House bill and those that had been rejected because the changes proposed in them were not deemed wise. Turning first to the alterations in the House bill that secured acceptance, the principal features may be enumerated as fol- lows: The Federal Reserve Act 63 (i^ Introduction of provision for sale of stock in Federal reserve banks to the public in the event that not enough banks subscribe for the stock to furnish an adequate capital in any given district. (2^ Provision for alternative voting in the choice of directors of Federal reserve banks so as to insure prompt election. (3) Reduction of number of Federal reserve banks to not more than twelve, as against the "at least twelve" of the House bill. (4J) Elimination of requirement that all na- tional banks recharter. (5.) Broadening of powers of Federal Re- serve Board and modification of language re- lating to rediscounts between Federal reserve banks, so as to render such rediscounts easier than was intended by the House bill. ^ Provision that the Secretary of the Treas- ury might, not must, deposit public funds in re- serve banks. (7) Reduction of reserve requirements placed upon member banks under House bill. On the other hand, the following important points were yielded by the Senate in the con- ference : (i) Omission of provision that holders of 64 The Federal Reserve stock sold to private individuals (if any) should have voting power in directorates of Federal reserve banks and elsewhere. (2) Elimination of guarantee of banfc de- posits by use of surplus earnings. (3) Elimination of provision that Federal reserve bank notes might be counted in re- serves of stockholding banks. (4) Restoration of provision that many classes of checks should be collected at par throughout the country, and that where such par collection was not enforced the charge for making collec- tion should be fixed by the Federal Reserve Board. (5) Elimination of domestic acceptances, thereby excluding them from use by stock- holding banks and from rediscount by Federal reserve banks. (6) Modification of reserve requirements as formulated by the Senate so as to require actual cash reserves in the vaults of country banks (the Senate having entirely dispensed with such reserves after twenty-four months after date of the passage of the Act) and general stiffening of reserve requirements made by the Senate, although the final language still constituted a reduction below the House provision. The Federal Reserve Act 65 (7) Reduction of period of maturity for which discountable paper might run. While many other points of modification and concession on either side might, of course, be enumerated, it is believed that the foregoing presentation is representative and shows suffi- ciently well the nature of the conference work and the character of the points conceded on either side. Assuming that such a fair or rep- resentative selection has been made, it is evi- dent that the work of the conference resulted in the establishment of the House contentions at nearly every essential point, the exceptions to such a remark being found in two main particulars: (i) the reduction in the number of reserve banks and their limitation to not more than twelve at any time, and (2) the pro- vision that public deposits might or might not be made in the reserve banks at the discretion of the Secretary of the Treasury. While other points were significant and important in their way, it can certainly be fairly concluded that on those matters involving important issues of theory the House virtually held its own in most respects. In fact, it is an accurate generaliza- tion that the final bill as completed in con- ference committee and as passed by both 66 The Federal Reserve Houses was a closer approach to the original House draft of the measure than anything that had intervened during the time the bill was going through the various permutations to which it was subjected in its slow progress from one stage to another of the legislative process. At one other point there was marked and vital departure from the original House meas- ure — the provision with reference to the re- funding of United States 2 per cent, bonds and the treatment of the currency based upon such bonds. On this subject the final action of the conference was nearly equivalent to the accept- ance of a plan formulated by the administra- tion and designed to take the place of all of the various other schemes that had been recom- mended from diflFerent sources in either House. As has already been seen in Chapter 11, the Federal Reserve Act is the product of a lengthy course of development and has grown gradually out of the discussion and analysis of the past twenty years. It was not drawn, even largely, from any single source, but is the product of comparison, selection, and refinement upon the various material, ideas, and data rendered available throughout a long course of study and agitation Many bills embodying the same The Federal Reserve Act 6^ general line of thought that now finds expres- sion in the new act have been offered in Con- gress; some have been suggested outside that body. The most fundamental concept of all — that of uniting the banks of the country into organized groups — is found in the clearing- house organizations, which in time of stress have pooled their resources and converted bank assets into the equivalent of reserve money. The bills prepared by or under the direction of Hon. Isidor Straus, Hon. J. H. Walker, Hon. Charles A. Fowler, and Hon. Maurice L. Muhle- man, already described, have suppHed at least the basis for many of the detailed analyses and methods of treatment that are found in the Federal Reserve Act. Earlier than any of these was the bill recommended by the Indian- apolis Monetary Commission, which did not provide for cooperative unions of banks, but upon which the framers of the present Act have evidently drawn for some of their ideas. The latest bill in the long series which was available for study to the framers of the Federal Reserve Act was that prepared for the National Mone- tary Commission and called in popular lan- guage the "Aldrich bill." By many the new law is regarded as a partial copy of, or plagiarism 68 The Federal Reserve from, the Aldrich bill; and that view has been widely expressed both in and out of Congress. The Aldrich bill provided for a single central "reserve association" with scanty public over- sight, with control vested practically wholly in the banks, and with the preponderance of power in the hands of the larger institutions which owned stock. It so arranged things as to keep this "reserve association" relatively inactive except upon special occasions of panic or dis- turbance. It made no direct provision for the shifting of reserves in part from existing banks to the proposed associations, but it relied upon inflation due to the placing of bank notes issued by the central association in the reserves of the stockholding banks for protection in time of danger. The new Act provides for twelve reserve banks, introduces the principle of local ; control, calls for strict government oversight, shifts reserves from present correspondent banks to the new institutions, minimizes the influence of the larger banks in directorates, and generally diffuses control instead of centralizing it. It leaves banking as such to be practised by bankers; it vests the control of banking in I the hands of government officers. The theory and purpose of the new Act are widely The Federal Reserve Act 69. different from those of the Aldrich bill. Where the Aldrich proposal veers widely away from the tendencies that have been developed during the preceding ten years of American banking discussion, the Federal Reserve Act closely fol- lows them. Indeed, the Act of 191 3 is closer to any one of half a dozen bills of former years than to the Aldrich proposal. From the standpoint of technique, as already noted, the case is quite different. With regard to stock issues, kinds of paper eligible for redis- counts, and not a few other particulars, the Fed- eral Reserve Act follows lines laid down in the measure which bore the name of Senator Al- drich. In fact, the original House bill, for strategic purposes, retained, wherever it could safely do so, the language of the Aldrich bill as regards banking technique, its framers recogniz- ing that by so doing they enormously reduced the hold of the opposition and immensely con- tracted the field within which the famihar charges of " unsoundness " could find scope. Perhaps the most notable and beneficial changes made by the Federal Reserve Act — the transfer of reserves from reserve and central reserve city banks and the provisions for par collection of checks whenever possible — ^were 70 The Federal Reserve not mentioned either in the Aldrich bill or in those of its predecessors already referred to. They were not only new elements in the move- ment, but were undoubtedly among the ele- ments in the measure which proved hardest to enact into law. From the beginning, the most strenuous opposition was offered to them, not- withstanding that both features were admitted to be sound in principle. It was, therefore, only after a sharp contest that they succeeded in gaining a definite foothold, inasmuch as they constituted a new and distinctly distasteful element in the whole legislative proposal. A reviewof the detailed provisions of the meas- ure shows, therefore, that, while the conception of banking reform upon which it is founded is the same that has constituted the staple of the banking reform movement of recent years, and while the conception of a union of banks is di- rectly borrowed, as in other bills of the past decade, from the actual practice of the banks themselves as developed under the stress of circumstances in the form of clearing-house organizations; while, moreover, certain phases of the technique of the legislation itself followed the lines of the Aldrich or Monetary Commission bill, and while other portions of the Act have The Federal Reserve Act 71 been adapted from well-known legislative pro- posals that have figured within the past few years of banking discussion, the Act as a whole is based upon a conception and plan entirely its own, applies in many fundamental respects methods of control and administration that have been given at least a new form, and includes several important innovations not heretofore conspicuous in banking discussion, although ad- mittedly significant, not to say necessary, to any thorough reorganization upon sound principles. It is now necessary to devote some attention to the new legislation from the broad general standpoint and to note the significance of the measure as it finally became law. To the student of banking it need hardly be said that the strik- ing aspects of the legislation are these three: (i) the creation of a general discount market for | commercial paper; (2) the systematic pooling of reserves of existing banks; and (3) the provision' of an elastic currency. In the multitude of de- tails provided by the legislation, and in the va- rious adjustments rendered necessary by it with respect to Government deposits, bank reserves, examinations, and other more or less important matters, it is noticeable throughout that every- thing done has been for the purpose of promoting 72 The Federal Reserve the objects already enumerated, and of insuring the transformation of American banking from its present basis of organization to its new proposed type of effort. If these chief objects shall be ac- complished in actual practice, the legislation will have been amply warranted, and, it need hardly be said to a professional reader, will completely revolutionize the banking and credit situation, to the great profit not only of the banks them- selves but of their customers. That the banks will greatly profit under the bill is susceptible of easy mathematical demonstration. That the business public will profit in a far higher de- gree than the banks is less obvious, but is a fact which constitutes the chief basis for the legislation. Were it not true, the time and effort expended in securing the present result would scarcely have been warranted. In its real essence the new law is in fact and in the best sense of the term a "business man's meas- ure." Heretofore American banking has been too largely an agency in the service of speculation. This statement is borne out by the following considerations: (i) the rates controlling the flow of gold out of the United States have been those dictated by the call loan market, not The Federal Reserve Act 73 those prevailing in the commercial discount market; (2) the funds which the banks desired to have ready to hand have been customarily in- vested in demand loans on stock rather than in quick commercial paper or short-term foreign exchange; (3) in times of crisis or pressure the banks have shortened loans in this country in- stead of, as in foreign countries, enlarging them to accommodate legitimate borrowers. If they have undergone sacrifice, it has been for the primary purpose of upholding and safeguard- ing the stock market. The new Act changes this condition in the following ways: (i) it transfers a small but necessary fraction of the ultimate reserve money of the country to Government-inspected institu- tions, located in various parts of the country, where they will be quickly responsive to, and in sympathy with, business necessities, and prescribes by rigid rules that these funds shall be applied solely to commercial needs and to nothing else, since the loans that may be made by these new banks are narrowly restricted in term and in character; (2) it broadens the methods of doing business allowed to national banks, so far as relates to investments in legiti- mate commercial paper, and narrows them cor- 74 The Federal Reserve respondingly, so far as relates to investment in stocks and bonds; (3) it increases the loan- ing power of the banks of a given community, and promises to such banks, when in need of assistance, the support which will be derived from the combined resources of their fellow banks in the same community or region. Its effort is thus to promote the growth of commer- cial credit and to protect that credit when brought into existence. It differs from the pres- ent law in that it refuses longer to look upon the business man as one who "borrows money" at a bank, and regards him as one who manu- factures a commodity — commercial credit and the papjx. representing it — ^which he sells to banks, and which it is the function of the latter to insure and to keep liquid. It regards the duty of the bank as being, above all things else, that of maintaining specie payments and sustaining the solvency of the community; and it declines to consider the banker ^s one whose duty it is to promote enterprises, float issues of securities, or aid in stock speculation. That all these phases of financial effort have their place — a desirable place when properly defined and recognized — the Act fully concedes, but it holds in principle that that place is not The Federal Reserve Act 75 found in connection with the work of commer- cial banks. If the business community contents itself with simply continuing its present methods of operation, it will derive great advantage from the law. It will find: (i.) that local banks will be able, by rediscounting the paper of local enterprises, to provide the funds needed by such enterprises in their operations; (2) that there will be no such wide fluctuations of inter- est rates either geographically or from season to season as now exist; (3) that there will be no necessity of emergency measures to safeguard -the-Gouatry from the possible results of finan- cial panic or stringency. Credit will be more simply available, cheaper, and more equitably open to all. Not the least advantage to the business man will be found in the provisions with respect to bank examinations, __since through these, it may be hoped, many opera- tions which have been the disgrace of American banking in the past will be early detected and corrected before they have had time to eat out the heart of institutions which might otherwise have continued sound and solvent. This is equivalent to saying that, under the new law, credit, even if there be no change in business "](> The Federal Reserve methods, will be cheaper and more evenly diffused, as well as more steady and more cer- tainly to be counted upon by those who do business by acceptable methods. But the com- munity will not gain the greatest advantage from the measure if it adheres merely to estab- lished types of operation. The new act pro- "^vides for the creation of a true discount market, such as has existed for man^years in every European country. This means that every merchant of established local credit may in the future count upon a free sale for his paper throughout the reserve district in which he is situated, and to a somewhat lesser degree gen- erally throughout the country. The redis- count principle, when fully worked out, taken in connection with the use of the acceptance system, will enable the sound, even though small, manufacturer or trader to get the advan- tage of the best rates of commercial credit that prevail anywhere within his region of the coun- try. If there is capital to spare — unemployed and seeking occupation — he may expect that, through the general sale of bills under the new system, such capital will be available for the purchase of his paper and will be so employedi By the judicious use of the acceptance, the The Federal Reserve Act 77 local bank will be enabled to facilitate the move- ment of goods into and out of the country, and will at once make the utmost of its own capital and at the same time enable its clients to gain the widest employment for their own resources. The net result of these various influences should be: (i) considerable reduction in average rates of interest on commercial paper throughout the United States; (2) very great reductions in the rates in certain sections remote from com- mercial centres; (3) stability and certainty in distribution of credit; (4) creation of new and more convenient types of paper. Not the least important of the provisions of the new measure is that which assures to the business man the cheaper collection and trans- mission of his funds. The Act provides for the deposit of many classes of checks and drafts at par with Federal reserve banks, and thereby aims to establish a parity of exchange among banks within every Federal reserve dis- trict and then between the Federal reserve banks themselves. It permits charges to be made by member banks that correspond to the actual cost to them of collecting funds for their clients, but it places these charges under Fed- eral control and specifically authorizes the 78 The Federal Reserve Federal Reserve Board to restrict them by rule. This is as it should be. In years past American commerce has suffered severely from the inflic- tion of high, not to say excessive, charges for check collection upon business men throughout the country. Much of this evil may, however,' be expected now to disappear. The banks will be restricted, when the system is fully in opera- tion, to moderate rates; and thereby a great burden will be lifted from the backs of the com- naercial^ community. In the opinion of some, this burden will in part be removed by the process of clearing checks instead of collecting them, which is to be inaugurated under the new system. But whether it does so disappear or not, the merchants of the country will be relieved of the excess charges made by the banks in the way already indicated. In many [instances this will save thousands of dollars annually to indijddual firais. A less direct, although most important, aspect of the new law in its relation to business is seen in the economy of gold that will be effected under it. The original bill provided for main- taining reserves at about their present height, in the belief that ultimately the governing board would let them all down to the level pre- The Federal Reserve Act 79 scribed for country banks. The final Act made a very great reduction in reserve requirements and thus released a great volume of money after all new needs for the reserves of the Federal reserve banks had been complied with. That this will produce some danger of inflation during the transition period — a danger that will need to be carefully guarded against by the best sense of the banking community — is evident. After that period has been passed, the reduction in the amount of gold that must be carried constantly in bank vaults will really be far- reaching. The United States has for many years been obliged by its antiquated banking methods to use much larger gold reserves than any other country in the world in proportion to business done. This was as much a waste as any other unnecessary employment of capital. It meant that the actual cost of operating a bank, which had to be recovered from borrowers in interest charges, was necessarily greater in proportion to the enlarged expense of carrying an unnecessarily high reserve. This cost in turn was heightened in times of panic by the very great expense that had to be incurred for the sake of getting more gold with which to build up the reserves when the latter had been 8o The Federal Reserve depleted. By lessening this important item of cost in banking, and by reducing the exceptional and sporadic elements of cost growing out of panic conditions from time to time, reductions of interest rates will be rendered feasible and will ultimately transfer their effect to the com- mercial world. In this same connection it de- serves to be noted that the new system will also render the control of the country's gold supply much easier and simpler. It provides the machinery for dictating, upon occasion, changes in rediscount rates intended to prevent exporta- tion, and upon other changes intended to aid importation. The mechanism will be auto- matic and effective and will replace the anti- quated, costly, and not very effective methods that have had to be followed in the past. This will directly aid the man engaged in foreign trade and will immensely assist in the manage- ment of foreign exchange operations. Ex- change will be furnished at much less cost to the community and our rates of exchange will be much more closely harmonious with those of the rest of the world. In times past there has been constant and well-founded complaint that American busi- ness men engaged in foreign trade or operating The Federal Reserve Act 8i branches of their houses abroad were obliged to depend upon foreign banks for their accommoda- tion or else finance themselves practically un- aided. Where, as in the South American trade, it has been necessary for the American business man to resort to branches of European banks established in the various countries, it has been asserted that such banks, working as they did in close harmony with merchants of their own nationality, were often unfaithful to their Amer- ican clientele, allowing competitors to know their business operations, and, when disposed to do so, cutting off their credit in favor of such rivals. These charges have had more or less foundation, and it has certainly been true that the banking accommodation of Americans engaged in foreign operations has been poor even at the best. Un- der the new law, banks of suitable capitahza- tion may, under the supervision of the Reserve Boatd, estabhsh branches in foreign countries, and operate them subject to very broad and liberal terms of business management. This should end the constant complaint about lack of banking accommodations and should place Americans in the foreign trade upon a footing of equality with foreign competitors. It is true that, as has recently been noted, the United 82 The Federal Reserve States lacks a supply of well-trained bank man- agers acquainted with foreign practice and ready to expatriate themselves for the time necessary to carry on a branch office elsewhere. Such shortage of trained men will, however, be overcome as soon as opportunity of a real sort is offered, just as the lack of well-prepared con- suls has already been overcome in a very large degree since the consular service was placed, at least partially, upon a footing of efficiency, and promotions made in a measure according to merit. It may be confidently expected that American foreign trade will within a short time be afforded all the assistance that it can reason- ably call for under the very liberal provisions now made for foreign branch banking. The general management of the new system has wisely been taken, in part, out of the hands of bankers, and has been placed, in a measure, in those of men representing commerce, indus- try, and agriculture. This is not because of distrust of bankers or because of a feeling that special discrimination should be shown in favor of given classes in the community. It is due to a feehng, eversrwhere recognized, that the in- dustrial portion of the community should be given a voice in the management of the commer- The Federal Reserve Act 83 cial credit of the nation, and that banking is, ' in its highest and best sense, a semi-pubhc function, carried on, not merely as a means of profit, but for the sake of providing for social wants in the creation of credit and the main- tenance of redemption. The business man, in the best sense of the word, is expected to take a living and direct part in the work of carrying on the new system, no matter whether he owns stock in any bank or not — and perhaps the more freely if he does not own such stock. He will thus be drafted into service because of the signifi- cance of banking to every class and section of the country, and because of the perception that it, like transportation, is no longer to be considered solely a private money-making industry. To get the full advantage of the system, the business man needs to arouse himself to a new conception of his functions and duties. He needs to bring his methods of borrowing and his view of commercial paper into harmony with Eu- ropean practice, to accustom himself to prompt payment of notes and bills without extended renewals, and to the putting of his business upon a short-term cash basis. He needs further to familiarize himself with the idea of banking in the larger sense as distinct from a mere note- 84 The Federal Reserve shaving and stock-manipulating occupation, and to prepare to share actively in the management of "the new reserve banks and their branches, in which important places have been reserved for him. When he has fully developed him- self along these lines he will find the new legis- lation perhaps the most important step in the progressive development of business, in the broader sense of the word, that has for many years been taken by the Federal Government. It has the distinction, almost unique among re- cent acts of legislation, of being not a restric- tive or hampering but a constructive measure in its purposes and methods. CHAPTER IV PUTTING THE ACT INTO EFFECT In the foregoing pages describing the Federal Reserve Act it has been noted that the law was based upon the idea of organization in from eight to twelve districts. The first step toward making the measure effective was, therefore, manifestly that of creating the new reserve bank districts, and of bringing about an election in each of these districts for directors of the banks there to be organized. This duty, by the terms of Section i of the law, had been as- signed to a board consisting of the Secretary of the Treasury, the Secretary of Agriculture, and the Comptroller of the Currency, known as "The Reserve Bank Organization Commit- tee." The new board automatically came into existence as soon as the law was passed, and found itself in control of the sum of $100,000 which Congress had assigned to it for the purpose of bearing the expense of organizing the new system. Secretary of the Treasury 8s 86 The Federal Reserve McAdoo projected a journey through the coun- try for the purpose of hearing arguments of various cities with reference to their claims for designation as headquarters, in each case, of a Federal reserve bank. Such a trip was actually undertaken immediately after the opening of the new year (1914), and two members of the committee with a corps of aids and assistants visited many of the most important points thought eligible for designation as reserve bank headquarters. It was not possible to visit all the cities desiring such designation, for the number of these steadily increased to about thirty-six; but in those cases where a visit to a given city was out of the question, representa- tives of that city presented themselves at a specified point and their arguments were heard. Most of them filed through representatives briefs in which they stated arguments and fur- nished statistics designed to show reasons for designating them as the headquarters of reserve banks. All this placed in the hands of the Organization Committee an immense mass of material, some of it good, some bad, and much that was irrelevant. Upon its return to Washington, at the end of February, the committee set to work to digest and examine Putting the Act into Effect 87 the data of which it had thus become pos- sessed. In the meantime, another important phase of the process of organization had been carried through to completion.. The Federal Reserve Act had provided that every national bank in the country must either join the new system or else hquidate and surrender its charter within a year of the adoption of the Federal Reserve Act; but it had also provided that within sixty days after the adoption of the Act each such national bank must indicate whether or not it intended to join the system and, by the require- ments thereof, in the event that the reply was in the negative, it was understood that such bank would, in accordance with the terms of the Act, cease to be a reserve agent^that is to say, would no longer be authorized to hold the re- serves of other banks that might be deposited with it in accordance with the terms of the National Bank Act. The carrying out of this phase of the law had naturally been entrusted to the Comptroller of the Currency, who had communicated with each national bank for the purpose of getting its response. There had been abundant predictions before the Federal Reserve Act was adopted that many national 88 The Federal Reserve banks would withdraw because they did not sympathize, it was said, with the methods em- ployed in securing the adoption of the Act, or for some other reason. The final outcome showed that these statements were without basis, for, of the more than 7,600 banks hold- ing national charters, all except fifteen — these being chiefly small institutions — signified with- in the sixty days allowed subsequent to the passage of the Act their intention of becoming members and stockholders of the Federal re- serve bank of the district in which they were situated. Roundly speaking, therefore, it may be said that the acceptance of the system was practically unanimous, and that at the begin- ning of March, 1914, the Reserve Bank Organ- ization Committee was in position to proceed with the next step in the establishment of a system which would have at least 7,600 mem- bers. Some State banks, too, recognizing the power given to them under the terms of the law to join the system, had, in a few instances, in- dicated their desire to do so. Perhaps a dozen State bank members had pledged themselves at the opening of April, 1914. Meanwhile, the Reserve Bank Organization Committee had not been neglecting the scientific side of its duty. Putting the Act into Effect 89 It had recognized that the formulation of ad- ministrative rules designed to carry into effect the mechanism provided by the law would be a task of almost as much difficulty as the original preparation of the law itself. The committee had, therefore, retained the services of a corps of experts who were to be known as the " Pre- liminary Organization Committee," and who originally acted as a sub-committee, preparing plans and outlining business methods to be pursued by the new system. When finally pre- pared, the report of this committee covered a great variety of technical subjects, including the forms and methods of subscription for capital stock, the accounting system to be followed by the Federal reserve banks, the interpretation of commercial paper, the establishment of by-laws both for the board, the banks, and any branches the latter might establish, the method to be followed in issuing Federal reserve notes, and the details of the system by which the clearance provisions of the law were to be put into effect. Recommendations on all these points were em- bodied in a lengthy report which was filed with the Organization Committee early in June,i9i4. The Organization Committee had meanwhile reached a conclusion with reference to the first 90 The Federal Reserve phase of the work — the division of the country into districts for the establishment of Federal reserve banks. An examination of the wording of Sec. 2 of the Act shows that general instructions had been given with reference to the performance of this task. The committee could not create less than eight nor more than twelve districts, and it was obliged to establish them as nearly as possible in accordance with the convenience and customary course of business. In selecting the total number of districts to be established many factors necessarily had to be taken into account, some of a theoretical and others of a purely practical nature. In general, it was decided to bring about a certain measure of equality or strength between the several dis- tricts. This was not altogether feasible, for, owing to the one-sided development of the bank- ing business under the old banking system. New York was far in advance of all other cities in the amount of its bank capital and deposits. This situation was not due wholly to the natural importance of NewYork as a financial centre, but was in part the result of the artificial reserve system of the National Bank Act, shortly to bp described at greater length, which had led to the placing of the surplus reserves of the banks Putting the Act into Effect 91 quite generally in the hands of New York in- stitutions, where they were employed in loans on Stock Exchange collateral to a very consider- able extent. In the hearings before the Organ- ization Committee it had been urged that the committee practically recognize this financial preeminence of New York by assigning to it as large a territory as possible, thereby giving it as great a capitalization as circumstances would at all permit. The other districts to be estabhshed under the law would then have been dependent on New York, and the banks in them would have had only a limited amount of capital. They would have been microscopic in- stitutions, as much dependent upon the reserve institution in New York as if they had been regularly organized branches of it. This pro- posal the committee naturally rejected. Simi- lar to it was a suggestion, emanating from much the same source, that the banks be arranged in three, or, perhaps, four, general groups, in each of which there should be one large institution with two or three subordinate institutions practically dependent upon it. Thus if there had been four dominant institutions at, say. New York, Chicago, St. Louis, and San Fran- cisco, each would have had two subordinate 92 The Federal Reserve institutions. These might have been for New York the banks of Boston and Philadelphia or Cleveland; while a similar arrangement would have been made in the other parts of the country. The Organization Committee naturally rejected this proposal also, at least in so far as it could, recognizing that it was out of harmony with the spirit and purpose of the law. The final effort was to establish twelve institutions of somewhat similar size in so far as capitalization was concerned, situated in districts that were geographically united, and yet that would per- mit of subdivision at a later date should Congress determine upon enlarging the number of banks. On the Eastern seaboard the districts were natu- rally laid out upon lines believed likely to prove final, while in the Middle West and particu- larly on the Pacific Coast it was recognized that the growth of population and the development of business would be likely to create new align- ments which would call for additional banking headquarters either in the shape of branches — for which the Act made provision — or, more probably, in that of new Federal reserve banks. The decision to estabHsh immediately the total permitted number of twelve Federal reserve banks was undoubtedly the result of a number Putting the Act into Effect 93 of conflicting influences. The Organization Committee evidently recognized that those who were responsible for the law had been looking confidently to the development of a system of local bank control, and doubtless wished to comply with the wishes thus indicated in so far as practicable. The pressure of a great number of cities for action in their behalf naturally tended to confirm and strengthen the disposition to fix the number of banks at twelve. There was at least a reasonable doubt whether it might not have been well to fix the number as low as nine or ten, thereby reserving two or three banks for subsequent placement by the Federal Reserve Board. Not knowing the com- position to be given to the Board, or the probable trend of subsequent developments, and recog- nizing the power of the influences which were opposed to the creation of more than a very small number of reserve banks, the committee inclined toward the largest number, indepen- dent of all other considerations. The arrangement finally determined upon is represented in the accompanying map, which shows in a rough, general way the divisions between the several Federal reserve districts. Accompanying the map is a table showing the 94 The Federal Reserve capitalization and number of banks Included in each district. It is convenient to note at this point that after the Federal Reserve Board was established there were several appeals from the decisions of the Organization Committee as to districting, and that of these three have thus far been granted, each, however, affecting only a relatively small territory. The accompany- ing map is drawn to show the division lines established after the decision in the redistricting appeals had been decided by the Federal Re- serve Board, and, therefore, differs slightly from the map showing the original outline of the system. With the districts definitely outlined, it was now possible to proceed with the organization of the several boards of directors. Examina- tion of the law showed that these boards were in each case to have three constituent elements : (i) A group of three members representing the bankers of the district and elected by them; (2) A group of three members representing the business men of the district, also elected by the bankers; and (3) A group of three members presumably representative of the public and designated by the Federal Reserve Board. ^i o or more capital for the estab- lishment of branches in foreign countries, or reject or accept such applications and to prescribe conditions under which such branches may be opened. To require examinations of foreign branches as it may deem best. The Federal Reserve Board has been in ex- istence at this writing for less than a year. A part of that time has been consumed in the per- formance of emergency duties growing out of the critical situation resulting from the Euro- pean war. These have been reviewed in Chap- ter V, foregoing. Such duties have, however, no necessary relationship to the regular func- tions of the Board as the central mechanism of the Federal reserve system, and must be re- garded as merely a type of public service inci- dental to the organization and inauguration of The Federal Reserve Board 145 the new reserve institutions, and not a regular feature of administration. Under it, it is to be hoped, and with the Federal reserve system in full operation, emergency measures of the kind that were necessary after the outbreak of the European war will no longer be found requisite. The permanent and regular duties of the Federal Reserve Board outlined above may be considered under three general divisions: (i) Administrative. (2) Constructive. (3) Educative. We may first address ourselves to the admin- istrative functions of the Federal Reserve Board. These administrative functions are es- sentially of two kinds : {a) The regular and recurring duties neces- sary to the operation of the system, and (b) The sporadic or occasional duties which grow out of the operation of the Act, but which do not occur at any definite time or times. Of the regular and stated duties of adminis- tration, probably the most conspicuous is that of regularly approving discount rates when sub- mitted by the several banks. To do this work intelligently involves careful study and consider- 146 The Federal Reserve ation of the general business conditions through- out the nation, of the situation in each of the reserve districts themselves, and of the broad general outlook for the future. An incidental consideration is necessarily that of the earnings of Federal reserve banks, and the degree in which it is necessary or desirable to enlarge those earnings through the taking on of more business. Another administrative function, practically continuous in its operation, is that of granting to banks power to enlarge their acceptances of paper up to 100 per cent, of their capital and surplus, and of extending to them the right to exercise the functions of trustee, executor, administrator, and the Uke. Under the terms of the Federal Reserve Act these powers cannot be conveyed except by special permit, and any member bank which de- sires to make use of them must, therefore, ob- tain the consent of the Board. Under the system which has been laid down by the Board this involves an application first of all to a local Federal reserve bank, and when such an appli- cation has been approved, the Board is in po- sition to take action, either confirming or dis- approving the findings of the Federal reserve bank which had passed upon it. So also, under The Federal Reserve Board 147 the terms of the law, it is required that each Federal reserve bank shall submit to the Federal Reserve Board statements of compensation paid to officers and directors that they may be approved by the Board. This naturally im- plies a study of proper rates of compensation, and the taking of action designed to fix such rates when occasion demands. Once estab- lished, the salary lists of the Federal reserve banks are not likely to show extensive changes, but such alterations as there are will recur and require attention from time to time. Other administrative duties must likewise be performed, among them the passing upon and approval of applications for and surrender of capital stock in Federal reserve banks, the hold- ings of the member banks varying according as their own capitals and surpluses increase and decrease. These, however, are for the most part technical, and no further enumeration is necessary. The constructive duties of the Board pre- scribed by law are seen to best advantage in the provision which calls for the development and application of regulations designed to control methods of business. Since the Board was or- ganized it has issued regulations defining com- 148 The Federal Reserve mercial paper eligible for discount, regulations relating to the definition of savings accounts, rules for the issue and retirement of capital stock, for the purchase of warrants and bankers' acceptances in the open market, and a variety of others. These regulations govern the prac- tice of the Federal reserve banks, and have substantially the force of law inasmuch as the Federal Reserve Act itself calls for the exercise of these functions subject to the rules made by the Board. Inasmuch as the character of the rules and regulations thus made may gradually alter the scope and methods of business done by the banks, it is clear that the work of the Board in this regard is in the highest degree constructive in its nature. At times it is almost equal to the extensive limitation or modifica- tion of the provisions of the law itself. It is difiicult to say how far, when the system is fully perfected, it will be necessary for the Board to work out such regulations. A reasonable expectation would seem to be that, after the lapse of a moderate period of time, the banks would become fully possessed of their reserve holdings, while their experience would also have demonstrated the lines along which they must work in the performance of their business. The Federal Reserve Board 149 When such experience has been accumulated, and the system has definitely been set in working order, it may be expected that the regulations of the Board will be changed but little, and that any modifications will be the outcome of obser- vation and experience of banking and business conditions throughout the nation. By changes in the discount rate the volume of business will be controlled; but the methods of business at the banks, which are dependent upon the regu- lations aforesaid, will not be altered greatly. At present the Federal reserve system is still in process of development, and its business prac- tices are being analyzed. This has necessitated more or less frequent changes in regulations, but such changes, as already indicated, will diminish in number as time goes on. The Act has also placed in the hands of the Federal Re- serve Board the power of changing and read- justing the reserve districts, subject to the broad general requirement that there should not be less than eight nor more than twelve. How ex- tensive such readjustments of the districts will be experience must show; and when the time comes to make them, an important con- structive function of the Board will be that of determining when and how they shall be intro- 150 The Federal Reserve duced. Already the Board has granted three petitions for readjustment of boundary Hnes between districts. Of the same general char- acter is the provision of the Act which calls for the estabhshment of branches, and which prac- tically vests the Board with the authority to oversee the establishment of such branches of Federal reserve banks. Plainly the operation of the law in this particular will mean that the broadest use and development of the system and its branches, the establishment of agencies abroad, and other functions of the same general description, will be entrusted to the Board, and will constitute one of its most important duties of a constructive nature. Among the implied or educative duties of the Board is undoubtedly that of bringing about general and harmonious action among the sev- eral districts and the welding of the different parts into a consistent united whole. In order to do its work well the Board must necessarily be in close touch with the several districts and what is going on in them, and with this purpose in view, direct communication with the differ- ent districts has been entrusted to the several members of the Board in order that they may keep themselves and their colleagues advised The Federal Reserve Board 151 of any developments in these districts which call for special attention. An annual report to Congress was required by law and must be formulated by the Board, but it is also entrusted with the duty of keeping the country advised of the condition of the system. It has under- taken to carry out this duty in part by the establishment of a publication known as the Federal Reserve Bulletin, in which are collected notices and statements about the work under- taken and the results accomplished in the opera- tion of the system. Much more might be said of the detailed work of the Board in educating the public to a knowledge of its operations and of standardizing banking practices, but the statements already made practically cover the ground in its most essential aspects. The Federal Reserve Act imposes practically no limitations upon the methods by which the Board performs its own work. In accordance with the provision of the law which authorizes the Secretary of the Treasury to provide quar- ters for the Board in his department, the main offices at Washington have been located in the Treasury building. While there is no rigid practice, it has been customary to hold meet- ings from three to five times a week, usually 152 The Federal Reserve each day, although during the period of organi- zation two meetings a day were not uncommon. A set of by-laws defining the organization of the Board was early adopted, and these provide for an Executive Committee whose function it is to transact all necessary business not involving any new departures of policy. When the mem- bers of the Board are practically all present in Washington, stated meetings on Monday, Wednesday, and Friday, with Executive Com- mittee meetings on Tuesday and Thursday, are the rule, while other committees may meet occasionally as convenience dictates. Sessions of the Board are held in private, and thus far no public sessions, with the exception of the hearings on appeals from decisions of the Re- serve Bank Organization Committee, have been appointed. When a decision has been arrived at with reference to a proposed change in the discount rate, or the adoption of any new policy or method of business, the Federal reserve agents are at once advised by telegraph or letter, and then the decision is communicated to the various Federal reserve banks. The Federal Reserve Agent is regarded by the Board as its representative on the ground, and, as such, to be the official medium of communication be- The Federal Reserve Board 153 tween it and the bank to which he is accredited, although the Board may, and frequently does, hold direct communication with the Governor of the Federal reserve bank as being the active operating officer. As already stated, the Comptroller of the Currency is a member of the Federal Reserve Board. The Federal Reserve Act did not change his function as chief of the national banking system, or his responsibility to the Secretary of the Treasury and to Congress. These relationships, therefore, continue, and his presence on the Board simply serves to establish a connecting link between the supervision of the national banking system as such, and the gen- eral supervision of the Federal reserve system, including Federal reserve banks and such non- national banks as may have become members. In the same way the Secretary of the Treasury's membership in the Board in no way alters his other relationships or duties. The fact that he presides over the Board enables him to com- municate to it necessary information with ref- erence to the policies of the department on financial and banking questions, and to receive from it advice and information concerning the work of the reserve system. Under the Federal 154 The Federal Reserve Reserve Act the placing of pubHc deposits in the reserve banks is left entirely in the hands of the Secretary of the Treasury, although the Act distinctly contemplates that such deposits shall be made and that the reserve banks shall ulti- mately assume that place as agents of the Government. When that step shall have been taken, the membership of the Secretary of the Treasury on the Federal Reserve Board will have an additionally distinct and direct prac- tical importance by creating an effective com- munication between the revenue department of the United States Government and the banks as holders of the funds. The membership of the Secretary of the Treasury in the Federal Reserve Board will, under those conditions, be of increasing significance, and will include much more than the mere rendering of advice and suggestions. It will of necessity be a con- stant working participation on the part of the Secretary of the Treasury in the affairs of the Board, and, conversely, a participation on the part of the Board, as a conservator of the banking resources of the country, in the operation of the Treasury Department. In organizing its staff at Washington for the performance of the duties already enumerated, The Federal Reserve Board 155 and others incidental to them, the Federal Re- serve Board found it desirable to recognize several distinct divisions. The task of examin- ing member banks (not national) and of making periodic examinations of Federal reserve banks has been committed to a distinct bureau or divi- sion known as the Division of Audit and Exami- nation, headed by a chief underwhom is organized a small corps of examiners and assistant examin- ers. The task of examining the twelve Fed- eral reserve banks would not in itself be a heavy one, but as State banks enter the system, the duty of ascertaining whether they are in suitable condition for admission, and of making sure that they continue to be so, will involve a con- siderable amount of labor. Another of the main divisions into which the Board's work is divided is that of Reports and Statistics. When the Federal Reserve Act was drawn provision was made for a weekly report of the condition of all Federal reserve banks and of each bank, showing the main items in their accounts. This is prepared in the Division of Reports and Statistics from data which are weekly telegraphed to the Board and are combined to make up the final statements. Provision was also made when the Federal re- 156 The Federal Reserve serve banks were organized for regular reports by the several banks of paper purchased, with name of purchaser, maturity, rate, etc. Com- plete Hsts, showing all these items of information and giving data as to the daily condition of the several banks, are daily forwarded to Washing- ton by each one of the institutions; and it is the duty of the Division of Reports and Statis- tics to combine and analyze them and to pre- pare the result of the study in such form for examination by members of the Board as will aid them in forming conclusions regarding the business of member banks, as indicating neces- sary changes in rates of discount, and as other- wise determining the policy to be pursued in the general conduct of the banking system. In the Federal Reserve Act it was specified that each Federal reserve bank might act as a clearing-house for its members, but that the Federal Reserve Board itself might act as a clearing-house for the Federal reserve banks, or might designate one of the Federal reserve banks thus to act. In pursuance of this author- ity, the Board has established a Division of Clearing in Washington for the purpose of set- tling balances between Federal reserve banks without the actual shipment of coin. This di- The Federal Reserve Board 157 vision is in charge of a fund of about ^50,000,000 in gold, and conducts a set of books on which are recorded from week to week credits and debits between Federal reserve banks arising out of their operations during the week. As given banks are credited or debited on these books the amount of their ownership in the Gold Fund changes. No gold is shipped unless a Federal reserve bank has exhausted its balance in the Gold Fund, and even under those conditions no such shipment need occur if the bank which has become indebted to one or more of the others chooses to obtain from them loans or redis- counts sufficient to cancel its obUgations for the time being and afford it an opportunity to recover its ownership in the Gold Fund through the coming in of more claims in its favor upon other Federal reserve banks. A Correspondence Division has charge of the general clerical work required in com- municating with Federal reserve banks and the pubHc; while a Division of Issue — in charge of the issue of Federal reserve notes — was at first organized under the direction of the Comptroller of the Currency, but is supported and conixolled bytheBoard,its function being that of receiving, counting, packing, and shipping iiotes; the detail IS8 The Federal Reserve of this work so far as relates to new notes being later transferred to the Bureau of Engraving and Printing, which disposes of it as with all other shipments of Government currency. CHAPTER VIII . THE FEDERAL RESERVE BANK In its outline of organization, its methods, and the theory upon which it is based, the Federal reserve bank is in no respect diflFerent from the ordinary bank. In a general way, the or- ganization of the ordinary commercial bank consists of three divisions — one for receiving de- posits of funds from the public, one for passing upon commercial paper and extending loans of such funds to the public, and one for keeping records and accounts of the resources and lia- bilities of the institution. Naturally there are many variations upon this small type of organ- ization. In the large bank of to-day a great variety of so-called "departments" is found. The task of receiving deposits and of paying out cash is greatly subdivided. Foreign exchange is usually a quite separate and distinct depart- ment of banking with its own organization and personnel. In some large banks especially trained men are placed in charge of different i6o The Federal Reserve geographical divisions of the bank's work. "Out of town" and "in town" accounts are segregated, both as to bookkeeping and manage- ment, and in many other ways the organization Is refined upon in the interests of efficiency and economy. All this does not alter in any way the fundamental fact that the three primary divisions of bank organization are as indicated. They are found in the Federal reserve bank just as in the ordinary commercial bank. In two important respects, however, the Federal reserve bank organization is peculiar. These are as follows: (i) Owing to its close relation with the Gov- ernment each Federal reserve bank has a special officer representing the Government, who is chairman of its Board of Directors and who is designated as "Federal Reserve Agent." (2) Every Federal reserve bank confines its discount business to other banks, a fact which at once alters the type of organization of the institution in some important particulars. We may now survey the outline of organiza- tion of the Federal reserve bank as such. The fundamental control of the institution is in the hands of the Board of Directors, consisting of nine members. This Board of Directors con- The Federal Reserve Bank i6i sists of three classes, each containing three mem- bers and each class being designated by a letter, as A, B, and C. Class C directors are nomi- nated by and represent the Government. Class B directors are business men not engaged in banking, who are presumed to represent in a general way the industrial, commercial, and agricultural interests of the district in which the bank is situated. Class A directors are directly representative of the banks. Both Class A and Class B directors are chosen by the banks, and for the purpose of this selection the banks in each district are divided into three groups: group one chooses one Class A and one Class B director, group two the same number, and group three the same. In group ^ the voters or electors are the banks of large capitalization, group two those of medium capitalization, and group three the small banks. The chairman of each Board of Directors divides the banks of the district into these three groups in such a way as to place an approximately equal number of banks in each. Each bank has one vote, irrespective of its size. The group division, however, prevents the small banks from electing men who represent them exclu- sively and insures approximately equal repre- 1 62 The Federal Reserve sentation to banks of somewhat greater size. The directors in question are appointed for equal terms of three years each, but these terms are so arranged that three directors go out of office each year, thus insuring opportunity for rotation. The chairman of the Board of Direc- tors is designated by the Government and is the Federal Reserve Agent of the bank. A vice- chairman, with the title of Deputy Federal Re- serve Agent, is also designated by the Govern- ment. These two officers are of the number of Class C directors. The remaining Class C di- rector, sometimes described as the "unattached" director, has no specific functions other than those assigned to any director of the bank. Reference has already been made to the Fed- eral Reserve Agent. As chairman of the Board of Directors, his function is to preside over meetings of the Board, and in general perform all those functions of organization which ordi- narily fall to the chairman of any deliberative body. As representative of the Government in his capacity of Federal Reserve Agent as such, he communicates with the Federal Reserve Board and transmits communications from that body to the bank. He also acts in a fi- duciary capacity, receiving from the Board at The Federal Reserve Bank 163 Washington the notes ready for circulation in such amounts as the bank deems to be neces- sary, and issues or transfers these to the bank whenever the institution has placed with him, for the special protection of such notes, com- mercial paperof the kinds specified in theFederal Reserve Act as eligible for rediscount. It is his duty to report regularly to the Federal Reserve Board upon prevailing banking and commercial conditions in his district and to inform the Board of any special or unusual con- ditions demanding attention from the govern- ing body. An important function which falls to the Federal Reserve Agent is that of advising the Board, whenever necessary, that the bank desires to change the rate of discount on com- mercial paper. If such application for change is approved, the reserve agent notifies his bank and announces the rates thus newly fixed to the pubHc. Beyond these definite and well- recognized functions, the duties of Federal Re- serve Agent vary somewhat from bank to bank, according to the personality of the agent him- self, as will be presently set forth. In each Federal reserve bank the Board of Directors, acting upon a suggestion originally sent out by the Federal Reserve Board, has 164 The Federal Reserve named an officer of somewhat coordinate power with the chairman of the Board, giving to such officer the title of Governor. The Governor of a Federal reserve bank is the active operat- ing officer of the bank itself as thus organized. It is his duty to attend to all of the details re- lating to actual banking, supervising the loans, controlling the personnel, and in general carry- ing out the instructions of the Board of Direc- tors, whatever they may be. In some cases governors of Federal reserve banks have been more highly paid than Federal reserve agents, and the impression has gained ground on that ac- count that they were of superior rank. There is no basis for any such supposition. The Federal Reserve Agent, as chairman of the Board of Directors of his respective bank, and as a Government representative, has a distinctive status of his own and acts in an advisory and representative capacity. The governors of the banks are executives dealing with the daily operations of lending and collecting funds. Their functions are different from those of the reserve agent, and in no way conflict with them. One reason why they have frequently been given higher salaries than Federal reserve agents is that the Federal Reserve Agent being a The Federal Reserve Bank 165 Government appointee, was naturally subject to all those restrictions and limitations which surround the compensation of Government officers. The governors of the banks, on the other hand, were employed on a commercial basis for the most part, and their salaries were fixed upon somewhat the same terms as would have been the case had they been entering the employ of an ordinary commercial bank. The internal organization of the typical Fed- eral reserve bank may be conveniently set forth in the accompanying chart, which was recom- mended by the Federal Reserve Board at the time the new banks were opened as a general outline which might be followed in estabhshing them. Every bank has or may have, under the direction of its board and governor, a subordinate officer known as a vice-governor or deputy governor, whose function is that of taking the place of the governor when the latter is absent, or assisting him in prescribed duties. Most banks have appointed a cashier and a secretary. The latter keeps the minutes of the Board of Directors and assists in executive duties. In some cases he is also counsel of the bank, an individual in such cases having been selected who was known to be sufficiently well trained in i66 The Federal Reserve the law to act as counsel. The cashier has charge of the tellers, bookkeepers, and other ofiicers, whoever they may be, that are employed by the bank. The number of these officers and em- ployees varies considerably according to the size and volume of business of the institution. In some cases the work of the bank is sufficient to call for the maintenance of a relatively large staff of accountants, clerks, and other subor- dinates; in others, only a skeleton staff is needed. The principal point which dictates an organ- ization different from that of the ordinary com- mercial bank is that relatively little cash is deposited or drawn out over the counter. In most districts the greater number of members are outside the city in which the bank is situated, and in many the bulk of the transactions of the bank are with out-of-town members. Demands for cash and direct deposits of the same over the counter are naturally much less frequent then with the member bank.^Details of bookkeep- ing are also much simpler than with the ordinary bank, because the number of customers is limited to the number of member or stockholder banks, Federal reserve banks being prohibited from doing a deposit or loan or discount busi- ness with any except their members and the The Federal Reserve Bank 167 Government of the United States. As yet the Government of the United States has not be- come a depositor in Federal reserve banks, but the expectation is that it will before long trans- fer the bulk of its funds to Federal reserve insti- tutions and then pay its obligations by drawing checks and drafts upon them, thus giving them the use of its current funds and receiving from them the service involved in making transfers and settling obligations. While the internal organization of the typical Federal reserve bank is thus in its outline sub- stantially similar to that of the commercial bank, there are certain phases of the work of the re- serve banks that differentiate them quite sharply from commercial institutions. In the ordi- nary bank a great deal of the hazard or risk resulting from the operations of the institution is due to uncertainty as to the goodness of the loans that are made and doubt as to the charac- ter of the paper. The shrewdness and acumen of the ordinary bank president and his immedi- ate aides is exerted in determining whether given individuals who want to borrow are "good," and, when satisfied that they are "good," in ascertaining whether they will be able to pay at the time they say they will, or whether they 1 68 The Federal Reserve will have to be "carried" beyond that date, by extending their loans, in order to enable them to gather their strength and get in the cash needed to pay off the bank. The Federal reserve bank must meet a problem which in this respect is different from that presented to the ordinary bank. It discounts no paper without the en- dorsement of a member bank, which means that the paper thus offered for rediscount by the Federal reserve bank has passed under the scrutiny of the officers of the member bank and is endorsed or guaranteed by them. This means that if the maker of the paper does not pay at maturity the member bank must make good the shortage. The commercial side of the bank's work is thus considerably simplified. It can dele- gate to the member bank a large part of the task of passing upon the value of the signatures of the borrowers, the examination of their statements, their business condition, and the like. Only in those cases where a borrower has so large a vol- ume of paper outstanding in the hands of so many different banks as to make the problem of his responsibihty greater than can be dealt with by any individual bank or group of banks, does this question of testing his liability become really a problem for the Federal reserve bank The Federal Reserve Bank 169 itself to deal with. In another way, however, the Federal reserve bank has a highly special function which is not performed by the commer- cial bank. This is the duty of testing the valid- ity of the total volume of bank credit and of ascertaining whether in the aggregate the banks of the community are going too far in extending their loans to their customers. Such an over- extension may make itself evident in either of two ways: it may be seen in the presentation to the Federal reserve bank of a great deal of paper originating with the same makers which has found its way into the portfolios of various banks and has by them been offered for redis- count in the ordinary course of business, or it may be seen in the fact that given member banks, although not necessarily becoming burdened with too great a volume of paper coming from an identical source, are obtaining from Federal reserve banks accommodations which consti- tute too large a percentage of their capital, i. e., which involve a contingent liabiHty bearing too great a proportion to such capital. To reach this determination accurately requires a general survey of the banking field, knowledge of the general business conditions to which the various member banks are subject, and broad 170 The Federal Reserve . analysis of the bank credit situation generally. This is the primary "central banking" function — the determination whether in a given district or country bank credit as a whole is being too largely extended as compared with the avail- able means for liquidation, without an undue amount of renewal. The commercial bank does not concern itself primarily with questions of this class, but is chiefly interested in its own profits and is disposed to go as far as it feels that it can in making loans without bringing its own solvency into jeopardy. No doubt there are large and public-spirited institutions, more or less international in the scope of their opera- tions, which take a broader view of their relation to the community than this, but it is not unfair to say that the rank and file of the bankers hardly feel called upon to look beyond the im- mediate welfare and solvency of the institutions in which they are immediately interested. The Federal reserve bank must, however, take the broader view, since the primary purpose of its organization is that of supplying the elements of cooperation and conservation of resources. In studying the typical Federal reserve bank the question naturally arises whether a Federal reserve bank is an isolated or independent insti- The Federal Reserve Bank 171 tution or whether it is a branch of a great central institution. Closely connected with this point is the other question, whether a Federal re- serve bank is "autonomous" or whether it is subject to control. We may get at a clear no- tion of the practical answer to both of these questions by looking analytically at the facts concerning the Federal reserve system that have already been set forth. The Federal re- serve system consists of twelve distinct dis- tricts which are separately capitalized and separately organized, in each of which there is a separate Federal reserve bank. This at once shows what the framers of the Federal Reserve Act intended — that there should be a number of independent reserve institutions locally operated. While this was the manifest intention of the framers, however, it is occasion- ally stated that none of these banks can work without the other, or that all are parts of a general whole. Herbert Spencer has stated that the different individuals in human society are more closely connected with one another than the cells of the human brain, and in this sense the Federal reserve banks are undoubtedly closely united. There is no reason to question the closeness of the relationship in this sense 172 The Federal Reserve between Federal reserve banks. The same, it may be added in passing, is true of the relations between member banks and between the banks of one country and those of another. In an- other sense, there is no necessary connection between two reserve banks. It is not requisite that there should be a "financial centre" either for the United States or for any other country, nor is there any inherent reason why the ex- istence of such a centre should give to that cen- tre controlling power or authority over other points. Where "financial centres" have been built up in the past this has been the result of the depositing of funds from outside. The re- moval of such funds when convenience dictates merely transfers the centre elsewhere. It is quite true that some parts of the country are so-called "borrowing areas" and others are "lending areas," just as some nations are to-day borrowers and others lenders. The fact that some parts of the country have funds which they are in position to lend to others does not necessitate their exerting any control over the banking machinery in the borrowing sections of the country, but simply means that there is need of a reliable method of regulating the quan- tity of capital to be taken by these parts of the The Federal Reserve Bank 173 country and by them used in carrying on busi- ness. Such a regulator is furnished by the Federal reserve banks, and their function is that of determining jointly how great an ad- vance of capital in this way is needed and how much can safely be used. The Federal Reserve Act expressly provides that the several banks are to be independent of one another. It pro- hibits their keeping deposits with one another except in so far as may be necessary for exchange purposes — the collection and cashing of items between districts. It may be said in summary, therefore, that the reserve banks are entirely independent of one another, so far as actual con- trol or influence is concerned, so far as relates to the mechanism for electing ofiicers, and in every other particular except in so far as they may choose to do business with one another as two in- dependent business concerns of the same kind might. The Federal Reserve Act is very precise in its definition of the relations between Federal re- serve banks and the Federal Reserve Board. In a general way the Board is vested, as is else- where seen, with the power to oversee general banking policies, while the work of banking — its professional side, its technique, and its man- 174 The Federal Reserve agement — ^is placed in the hands of the officers and directors of each bank itself. The banks are protected against undue control by the Board by reason of the fact that the Board's powers are precisely and carefully defined, and while they are large, there can be no reasonable doubt as to their definite limits. The banks, in short, have all those banking powers that are not expressly mentioned in the Federal Reserve Act or directly implied as having been vested in the Federal Reserve Board. What the latter are have been fully discussed else- where. Except in so far as limited by this ex- pressed authority, each Federal reserve bank is an autonomous institution, responsible for its own acts and conducting its business in its own way. It is neither a branch of a central organi- zation nor of any other Federal reserve bank. There is nothing, either in the Federal Reserve Act or in the regulations of the Federal Re- serve Board, to indicate that the reserve banks are to be operated in groups or through com- munications with one another, resulting in the establishment of a single policy as to detail. Neither is there anything to prevent officers of Federal reserve banks from communicating with one another, getting such information as can The Federal Reserve Bank 175 be exchanged by that means, or adapting their own poUcies as the circumstances and business needs of each district or of all appear to require. As the system itself becomes better established and as the underlying thoughts of the Federal Reserve Act become better understood, it may reasonably be expected that the member banks in each district will more and more appreciate the advantages of being able to control their own affairs and will direct them with greater intelligence and independence. The Federal Reserve Board supplies the necessary link be- tween the several banks, insuring joint coopera- tion when necessary and uniformity of practice and procedure so far as that is at all requisite, while in no respect withholding or limiting the opportunity of adapting the various regulations to special local conditions. CHAPTER IX TYPES OF COMMERCIAL PAPER In the course of recent banking discussion a good deal has been said about what is called "commercial paper," and frequent references to the subject are found in the circulars and regu- lations published by the Federal Reserve Board. The Federal Reserve Act gives to the Federal Reserve Board the right to define the meaning of commercial paper. This is of the utmost importance, inasmuch as the terms of the law make the Federal reserve notes rest upon com- mercial paper, which is the type of security ' eligible for deposit with Federal reserve agents in order to protect Federal reserve notes. In defining such paper, therefore, the Federal Re- serve Board practically settles the volume of paper eligible for use as a backing for notes, and so, in a sense, determines the upper limit of the volume of notes which may be put out. In order to understand the precise effect of the provisions of the Act in this regard, it is 176 Types of Commercial Paper 177 necessary, therefore, to consider the principal types of commercial paper and their relation to the operations of banking. This, in turn, necessitates a preliminary consideration of the bank loan. The simplest type of bank loan is seen in the case where an individual who desires to get funds requests accommodation from his bank, and, being favorably received, gives the bank his own note, signed by himself alone, running, say, for ninety days. If the discount rate is 6 per cent, per annum, this would mean that the individual paid i| per cent, for the accommodation, or for a thousand-dollar note he would get roughly ^985 subject to his imme- diate draft. This would be a direct loan. It might or\ might not be for a "commercial pur- pose." In many cases the bank making the loan would inquire whether it was intended for such an object or not, and the answer might influence it as to the granting of the loan. Under ordinary conditions the note might be spoken of as commercial paper, but there would be nothing in the nature of the case to indicate whether it was so or not. A diflFerent situation arises when the borrower at the bank has sold goods to another and draws on him at, say, ninety days' sight. The purchaser of the goods 178 The Federal Reserve accepts the draft by writing the word "ac- cepted" and his signature across the face. In this case it was evident on the face of the trans- action that there have been deahngs between the two men which have resulted in the necessity on the part of one to make a payment to the other. This is a commercial transaction, and it may be assumed in most cases that the reason for it is that the buyer of the goods has pur- chased them for the purpose of reselling them. The individual who draws (seller of the goods) has, however, agreed to wait ninety days, and he desires his bank to accommodate him in the meantime. He consequently gets the bank to discount the accepted draft, and it undertakes to do so. The draft is then held by the bank during its life and is finally presented to the buyer of the goods who pays it. Meantime, the seller has had accommodation just as in the earlier case. This is true commercial paper, i. e., paper which has grown out of a commercial transaction. Such paper is often referred to as double-name paper, while paper of the kind first described is referred to as single-name paper. There may be variations of these operations. For example, the single-name paper may be fortified by the endorsements of friends of the Types of Commercial Paper 179 maker who have placed their names to it in order to satisfy the bank that the paper was good. It is still single-name paper, however, in the technical sense of the term. So also, in the second type of transaction, the double-name paper may be further protected by documents covering the shipment of the goods which were sold, such as bills of lading, insurance policies, and the like. These do not make it any more truly commercial than it otherwise was, but merely give the bank some additional protec- tion in collecting its money when the time comes. Again, either kind of paper may be further pro- tected by the deposit of collateral. For ex- ample, the maker of the note in the first case, being unable to secure the endorsement of others, may have left with the bank certificates of stock or bonds which may be sold in the event that payment is not made when the note falls due. In that case the note may be a collateral note and the bank is protected by the fact that it has custody of a certificate of stock or some bonds which have a known value and can be sold in the event of default by the maker. All such variations are variations in practice merely; the two broad types of accommodation remain the same as just described. i8o The Federal Reserve A third type of transaction may now be briefly described. B, who buys the goods from A in the second of the preceding illustrations, may find it to his advantage to induce his own bank to accept for him. That is to say, instead of accepting the draft on himself for one thou- sand dollars, he may have arranged with A, the seller, that a bank shall accept the draft presented. This means that the bank agrees to pay the claim when it falls due. Of course, it will then collect from the buyer of the goods who has induced it thus to stand in his place, or, what amounts to the same thing, it has arranged with the buyer that he shall pay in the amount of the claim to it on the date when it is due, so the transaction merely amounts to the buyer's meeting the claim at his bank on the specified date. This is a bankers' acceptance. The bank in this case has substituted its name for that of the buyer of the goods. He may have left with it securities sufficient to indemnify it in case of his failure to pay, or may otherwise have protected the institution. It is clear, how- ever, that A, the seller of the goods, will find it much easier to dispose of this bankers' ac- ceptance than he would to discount or sell that of the buyer individually. Indeed, the Types of Commercial Paper i8i bankers' acceptance may be so good that it can be sold without any endorsement or under- taking. It is equivalent to a time draft on the bank which has accepted it so that A, the seller, may not need to go through the process of dis- counting with his bank, protecting or guarantee- ing the amount of the loan, or otherwise obligat- ing himself. This is commercial paper of the purest type. It grows out of a commercial transaction and it is liquid in the highest sense because it is the obligation of a bank. On the face of any such transaction it is probable that the operation is a commercial one. It may, of course, have been undertaken for some purely financial purpose, but in this case, as in others, it is possible to make sure that the transaction is commercial by specifying or iden- tifying the goods on which the acceptance is based. [The Federal Reserve Act provides for the discount of notes, drafts, and bills of exchange growing out of commercial, industrial, or agri- cultural transactions, and also bankers' ac- ceptances. ^It, however, hmits the bankers' acceptances, which_can be discounted, to those based_upon the importation or exportation of joods. This limitation is imposed in order to 1 82 The Federal Reserve avoid an undue development of the acceptance business on the part of banks which perhaps would not be of the highest degree of solvency, or might have embarked upon an acceptance business to too great an extent in proportion to their resources. TheJFederaL Reserve Act also provides that there may be bought inJihe. open market, subject to the regulations of the Board, bills of exchange and bankers' accept- ances. In framing the bill it was originally intended to include notes, so that the open- market transactions would have been upon the same basis as the discount transactions, the difference between the two being that in the lat- ter case the paper would have been protected by the endorsement of a member bank, while in the former case such endorsement would not have been required. Before the bill finally came to passage, however, it was determined to omit notes on the ground that the purchase of single-name paper of this kind in the open mar- ket might expose the banks to some hazard, inasmuch as they would not be in as good posi- tion to judge the paper as the member banks themselves, so that they might from time to time take the paper which was not thoroughly satisfactory. Types of Commercial Paper 183 What has been said makes it plain that only a part of the paper held by banks is eligible for rediscount with Federal reserve banks, and that only a part of the paper currently sold in the open market is available for purchase by such banks. The member bank may have loaned funds to a merchant in order to enable him to extend his business. It may be well aware at the time that the loan is made that the merchant intends to enlarge his building or to construct a new building, or it may have made the loan for the purpose of enabling an individual to purchase stocks and bonds and hold them in the expectation of advance in their value; or it may have advanced funds for the purpose of enabling the borrower to invest in real estate and await an advance in the value of land. Good banking practice does not per- mit the making of any loans of this sort on long term. Stock loans are usually made on call — that is to say, payment may be demanded when- ever the bank desires. Other loans of the kinds referred to may be made for periods of four or six months, with the understanding that they will be renewed for another four or six months. In some parts of the country there is a good deal of such paper in banks. The Federal Reserve 184 The Federal Reserve Act expressly permits certain classes of na^ tional banks to loan^ percent, of their capital and surplus upon notes running not to exceed five years in all, secured by farm lands. The purpose of this provision is to enable banks to lend to farmers who can offer land as security, but who are practically unable to offer any other security and who need funds to carry on their operations for a long period. Such loans, however desirable and sound they may be, nevertheless are not of a commercial type. They are non-Kquid in the sense that they run for relatively long periods. Moreover, in those parts of the country where such loans are common it is likely to be true that the maturities of the loans cannot be distrib- uted, i. e., that many loans will fall due at about the same time. The effort of the bank which is lending on short term in ordinary commercial business is to distribute the matur- ities as much as it can, so that there will be a steady stream of notes maturing throughout each month. This gives the bank a regular flow of funds back into its vaults, and it can use its own judgment about letting them out again. The other classes of loans are of an entirely different type. There is no way of distributing them well, and consequently no way of collect' Types of Commercial Paper 185 tng steadily and readily. Banks which make such loans must, therefore, count upon having to carry them until maturity. They will not find it easy to rediscount them, at least until they approach maturity. Neither will they always be able to induce the borrower to pay at maturity, because in such long loans his ability to liquidate probably depends upon the success of some enterprise in which he has been engaged in the meantime. In order to protect itself, the bank may be practically driven to renew such loans, or even to increase them. In every bank which does a commercial banking business, however, there will be found a large element of paper which is of pure commercial type. If this were not true, the bank would not be a bank in the proper sense of the term. Every bank, therefore, may be said to have two dis- tinct classes of paper, one commercial and the other non-commercial — the former available for rediscount with Federal reserve banks, the latter practically requiring to be carried until maturity and constituting an investment of longer or shorter duration. It has already been stated that in those cases where the borrower goes direct to his bank and secures accommodation upon his own note, 1 86 The Federal Reserve whether protected or unprotected, there is nothing in the transaction itself to show whether the purpose of the loan was commercial or not. For this reason it has sometimes been suggested that it was the intention of the Federal Reserve Act to confine the discountable and eligible paper to that which bore two names: those of the buyer and seller. Such a proposal was considered at one time, while the Act was in process of preparation, but the plan was re- jected, as is shown by the language of the law which describes the eligible paper as that whose proceeds have been used or "are to be used" for the purposes specified in the Act. This, however, necessitates some investigation on the part of the bank which originally discounts the paper as to the genuineness of the com- mercial purpose which is alleged by the bor- rower at the time he gets the loan. How can the bank inform itself on this point? In small communities, or where the borrower and all of his operations are absolutely known to the bank, it may be sufficient for the borrower simply to state his purpose. The bank, after placing the funds to his credit, can tell in a general way by the character of the checks that he draws what the funds are being used for. In most cases, Types of Commercial Paper 187 however, particularly where loans are large, the bank gets its information by obtaining from the would-be borrower a statement of his con- dition. This statement shows the value of his business, the amount of short-term assets it holds, the quantity of goods ready for market, the long-term obligations it has outstanding, such as bonds, and the amount of bills pay- able, or short-term obligations which must be met within a specified period. The question whether the business is liquid or not is deter- mined by making comparison of its short-term or immediate resources with its short-term or immediate liabilities. If there is a sub- stantial surplus of the former over the latter it is in a liquid condition. It will be noted that this liquid character is only indirectly related to the solvency of the business. A business might conceivably be in a very liquid condition and yet insolvent, in the sense that its total assets were less than its total liabilities. On the other hand, the business may be highly sol- vent but very far from liquid. Its funds may have been allowed to become "tied up" in long-term operations, so that it is in want of immediate funds for actual current necessities. From the banker's standpoint the question 1 88 The Federal Reserve whether a loan to a commercial firm on the single-name paper of that firm is desired for a commercial purpose depends largely upon the degree in which the assets of the concern are liquid. If they are not very liquid it is fair to assume that the loan is practically equivalent to supplying the concern with more capital, which is to be steadily required in the business until it can put itself upon a more liquid basis. The point at issue can be understood by considering one or two illustrations. A bor- rower, for example, may give absolute evidence to the bank that a sum of a thousand dollars which he is borrowing is to be used in a strictly commercial transaction, and yet this knowledge may show nothing whatever of the borrower's general policy, because it may be necessary for him to use a similar amount of his own cur- rent receipts for purposes which are practically equivalent to the investment of more funds in his business. The real test is whether the aggregate of the loans and receipts of the con- cern are intended to be used for, and are in fact used to anticipate, income from the claims that will mature within a short time. If such is the case, the concern is in a liquid condition, and its paper may fairly be discounted as commercial Types of Commercial Paper i8g paper. Of course this test is a somewhat general and uncertain one, and in applying it the judg- ment of the bank which makes the loan must be the predominating guide. In foreign coun- tries relatively little such single-name paper exists. The course of banking in the United States has, however, been such as to develop single-name paper to an unprecedented extent, the makers dividing their obligations among a great number of banks of relatively small capi- talization. This is the case with some of the great borrowers of the country. Their paper is made in notes of standard size, as five hun- dred dollars, one thousand, five thousand, etc., and this is then sold to any banker who has spare funds. In many cases it is practically an advance of capital for further extension of the business. In foreign countries the paper held by banks is more largely two-name, and the banker buys or discounts it with reasonable assurance that it will be self-liquidating, i. e., that the sale of goods or the consummation of the transactions for which the money has been borrowed will result in providing the means to settle the account when the time comes. Many persons who have not examined the subject closely are incUned to inquire why the I go The Federal Reserve Federal Reserve Act should have limited the operations of Federal reserve banks so closely to commercial paper. In some parts of the country farmers, for example, who desire long- term loans in order to enable them to buy or pay for land, suggest that a banking system which is limited to the field covered by the Federal Reserve Act is not very useful. Else- where the suggestion is from time to time made that the restrictions are so great as to prevent the system from serving a general popular pur- pose. Criticisms like these ignore the primary pur- pose for which a commercial banking system exists, and particularly the purposes for which a reserve system exists. They overlook the fact that a main function of banking is to enable per- sons who have debts to pay to get the funds with which to meet them, and that banking is a process of equalizing the supply of fluid funds among those who require them. The Federal reserve system is intended to provide just this means of liquefying and equalizing resources. It is not a method of supplying capital to borrowers for investment. Such investments as it makes are made for the pur- pose of affecting the rate of interest in the mar- Types of Commercial Paper 191 ket, and of enabling banks to meet their own maturing obligations without difficulty. While this service appears to be directly and primarily for the benefit of the commercial world, it is beneficial indirectly to every member of the community. A bank's suspension affects the whole community, and the same is true of the failure of any commercial enterprise. Impor- tant as is the function of supplying capital to those who need it for long-term investment, this is the field of finance and not of banking. Pre- venting suspension of payment and insuring constant convertibility of demand obligations into cash is quite as great a service to the public at large as it is to those bankers,, merchants, and traders generally for whom the service is immediately performed. CHAPTER X THE NEW BANKS, THEIR MEMBERS AND THE PUBLIC The fundamental idea of the Federal Reserve Act was that of cooperation and union between the various banks of the country which might be members of the system. In some quarters this idea of cooperation has been referred to as "central" banking. In so far as the object aimed at is that of combination of effort and joint use of resources for the purpose of at- taining a single general object, the new Act provides for a form of central banking. The - plan, however, is not central in the sense of. being centralized. It is a plan in which the power of control is very widely diffused, but which makes an effort to combine all the exist- ing elements of strength so as to attain a defi- nite object. The foregoing discussion has already made it plain what this object is. It is simply the use of liquid bank funds by all banks, for the purpose of assuring that any 192 The New Banks 193 given bank may, at a given time, when such assistance is desired, hquidate its own assets and thereby obtain the means for paying its creditors.! It is evident that, in order to estab- lish strong institutions able to accomplish this result in an effective way, it is necessary that the institutions should be equipped with abun- dant resources. It is also evident that the funds of the country which have, by banking practice, been set apart for this purpose are those which are known as "reserves," and which, prior to the passage of the Federal Reserve Act, had been held either in the vaults of the individ- ual banks themselves or by so-called "reserve agents" in reserve and central reserve cities. One most fundamental provision of the Federal Reserve Act is, therefore, that which requires the transfer of reserves from the banks which have them now to the new Federal reserve banks. The old reserve system in the United States classified national banks in three groups: those in central reserve cities, those in reserve cities, and those in the "country." This classi- fication was somewhat artificial, inasmuch as it was left to the volition of the banks in a given place to apply for the designation of that place as a reserve city or not, as they pleased. It 194 The Federal Reserve consequently happened that the banks in many cities of the United States were technically country banks, while those in many smaller places had secured the status of reserve city banks. Bearing in mind this artificial quality of the grouping, however, the classification was perfectly distinct. It was founded upon a dif- ference in reserve requirements. Banks in central reserve cities were required to keep 25 per cent, of their outstanding demand liabili- ties; banks in reserve cities 25 per cent., and banks in the country 15 per cent. The reserve city banks, however, might keep one half of their 25 per cent, reserve in the form of "bal- lances" with banks in central reserve cities, while country banks might keep three fifths of their 15 per cent, reserve with banks in re- serve cities or in central reserve cities, and might distribute it among such banks as they saw fit. This classification of banks, with the accompanying permission to the reserve city and country banks to redeposit their reserves in the way just discussed, did not arise on a purely haphazard basis, but grew out of the system of providing for domestic exchange, which existed at the time of the Civil War, when the National Bank Act was passed. Under The New Banks 195 the system of highly diffused banking which then existed it had been found necessary for banks throughout the country to keep balances with banks at certain important commercial points in order to provide remittances for mer- chants. The proportions in which the reserves of country and reserve-city banks were allowed to be redeposited in this way are said to have been computed as the result of an investigation . of the average amount of such balances which had to be continuously kept with other banks by outlying institutions that were regularly called upon to provide exchange. The theory involved was that, inasmuch as a balance with another bank was presumably payable on de- mand, it was equivalent to cash in the vaults of the creditor bank, and should, therefore, be classified as "reserves." There may have been some basis for this view so long as the accounts referred to were used merely for providing exchange. While that was the case the redeposit of reserves merely amounted to a temporary transfer and the whole basis of the banking assets of the nation con- sisted of fluid funds. A change in the situation was shortly introduced. Competition among central reserve city banks set in, the effort of the 196 The Federal Reserve different banks being to obtain as large "out- of-town" balances as they could, in order that they might get whatever benefit arose from the holding of the funds and in order that they might draw to themselves the incidental business likely to result from the maintenance of relations with country banks and others which might have funds to spare or business to transact in the cities. The great growth of stock-market oper- ations after the Civil War increased this com- petition, because it shortly appeared that by developing the call-loan system it was, in ordi- nary times, safe for banks in central reserve cities, particularly in New York, to make large loans to stock-exchange operators, with the ex- pectation of promptly caUing these in if there should be a sudden drain upon them from their country correspondents. In other words, the country bank placed its funds with the New York (or other reserve city) bank; this New York bank built up a large "line" of demand loans to stock exchange operators; the opera- tors traded on the strength of the cash, and when called upon by banks to liquidate, did so by selHng their stocks and paying their loans, whereupon the banks found themselves in funds with which to meet the demands of their cor- The New Banks 197 respondents. There is no difference of opinion among practical bankers and students of the theory of banking that this system was unsatis- factory. In ordinary times, when conditions were prosperous, there was no serious shock to general business as a result of it, but the effect was to produce temporary superabundance and temporary shortage of loans in the stock market, the result being that a demand for money in the interior of the country meant high rates of interest on the stock exchange, and vice versa. The worst evil in the situation lay in the fact that there was a constant tendency to inflate stock op- erations and to raise prices thereby, the result being that as the maintenance of the market be- came more and more difficult, the strain on the banks was increasingly severe and their indisposi- tion to part with funds correspondingly marked. Moreover, in times of panic when shrinkage was imminent the banks found it impossible to get their "reserve" funds out of the stock-market se- curities in which they were practically invested through the call-loan operation, without produc- ing so severe a shrinkage of values as to cause widespread bankruptcy. They were, therefore, obliged to resort to suspension of specie payments, .and often did so. Furthermore, the interior in- 198 The Federal Reserve stitutions in times of stock-market activity fre- quently invested large quantities of funds which ought to have been kept by them in their own vaults, in direct loans to speculators on the ex- changes, their desire being to get the advantage of the high rates of interest which were prevail- ing there at the time. Undue stimulation to speculative operations and undue shortage of cash throughout the country, with a highly un- stable reserve system, was the result of this method of operating. In the Federal Reserve Act it was recognized that the essential remedy was the transfer of all reserve funds from institutions which were in danger of using them in investments that might become non-liquid and to put them in the hands of institutions which would keep them in a liquid form, using them only for the objects of strictly commercial banking. The Federal Reserve Act, therefore, provided that after three years nothing should be counted as re- serves by any member bank except either cash in its own vault or a deposit with the Federal reserve bank of its district. While there was no express provision prohibiting the Federal reserve bank of each district from paying in- terest on balances, it was the evident intent of the The New Banks 199 Act that no such interest should be paid but that the balances with Federal reserve banks should be carried there without any inducement or stimulus to member banks. Pursuant to this thought, the Act provided that immediately upon the organization of the Federal reserve banks a specified amount of reserve should be transferred to these banks, another specified amount at the end of a year, and later instal- ments half yearly. At the end of three years the whole transfer would have been effected. Believing that by massing reserves in this way and making them really available for the pur- pose for which they were intended the total amount of money actually required to be held for the purpose of safety would be much smaller than heretofore, the Federal Reserve Act ma- terially cut down the percentage required by law to be held by member banks, reducing it to 18 per cent, of demand deposits in central reserve cities, 1 5 per cent, in reserve cities, and 1 2 per cent, in country banks. The Act further provided that where banks held time deposits upon which thirty days' notice could be exacted by the member banks, only 15 per cent, of the outstanding Hability need be kept. The fol- lowing table will summarize the statements 200 The Federal Reserve that have been made in the foregoing pages by showing in comparative form the percentage requirements for bank reserves before and after the passage of the Federal Reserve Act: Requisites of Reserves — ^Amount and Where Kept: 1. Banks in Central Reserve Cities (New York, Chicago, St. Louis). l8% of demand deposits and 5% of time, (i) In its own vaults: (a) 6-18 thereof. (2) In Reserve Bank for its district: (a) 7-18 thereof. (3) Balance, at its option in its own vaults or Reserve Bank. 2. Banks in Reserve Cities. 15% of demand deposits and S% of time. (1) In its own vaults: (a) 6-15 for 3 years, (b) 5-15 thereafter. (2) In Reserve Bank: (a) 3-15 for one year, then increasing 1-15 for each of 3 succeeding half years. (b) 6-15 thereafter. (3) Balances (a) For first three years: 1. In its own vaults, or 2. In Reserve Bank, or 3. In National Banks in Reserve or Central Reserve Cities. (b) After three years: 1. In its own vaults, or 2. In Reserve Bank, or 3. In both. The New Banks 201 3. Banks not in a Reserve or Central Reserve City. 12% of demand deposits and 5% of time. (1) In its own vaults: (a) 5-12 for three years, then (b) 4-12 thereafter. (2) In Reserve Bank: (a) 2-12 for one year then increasing 1-12 for each of three succeeding half years. (b) 5-12 thereafter. (3) Balance: (a) For first three years: 1. In its own vaults, or 2. In Reserve Bank, or , 3. In National Banks in Reserve or Central Reserve Cities. (b) After three years: 1. In its own vaults, or 2. In Reserve Bank, or 3. In both. Summing this whole matter up, it will be seen that the effect of the Federal Reserve Act upon the reserves of the country, when the system has been fully worked out, will be merely that of (i) reducing the percentage of required reserve; (2) rendering this reserve really liquid by requiring that it be either cash in vault or funds with the Federal reserve bank, the latter to be either cash or investments in short-term commercial paper, and (3) eliminating the per- mission to count balances with other commer- cial banks as reserve. There has been a great 202 The Federal Reserve deal of misunderstanding and misapprehension regarding the operation of these provisions. It is believed in some quarters that the provisions of the Act prevent banks from keeping balances with other banks or prevent them from obtaining their usual interest on deposits with such banks, or in some way interfering with their operations. Nothing of the kind appears in the Federal Reserve Act or can be inferred from it. The Act merely repeals the older provisions of law which allow balances carried with other banks to count as reserve. There is no reason whatever why any bank which wishes to do so should not carry any balance it chooses with another bank at any rate of interest it can obtain. Others hold that, while the requirements of the Federal Reserve Act are not open to any direct criticism for the reason just stated, it is in effect a hardship upon the member banks be- cause it results in imposing upon them an ad- ditional reserve requirement, i. e., a requirement over and above what they have had to comply with in the past, the apparent reduction in reserves not being real, because in practice (to take care of their necessary exchange and col- lection operations) the member banks are obliged to go on keeping funds in New York and The New Banks 203 other cities. There would be force in this state- ment if there were not, as will shortly be shown, provision in the Federal Reserve Act for carry- ing on the collection and exchange business of the member banks through the Federal reserve bank. Since, however, that has been fully provided for, the necessity of keeping balances with commercial banks in other cities is elimi- nated and there is no reason why a member bank should not, if it chooses to do so, dispense with practically all collection and exchange accounts kept elsewhere, merely retaining its account with its own Federal reserve bank and expect- ing that bank to perform all necessary transac- tions for it. Pending the time that the State banks either enter the Federal reserve system or that provision is made for collecting items drawn on them through Federal reserve banks, there may be some basis for the statement that the maintenance of certain accounts with other banks for collection purposes is necessary. This, however, will disappear, probably rapidly, as time goes on. The effect of the Federal Reserve Act upon the profits and the prosperity of the member bank deserves careful consideration. As is well known, an important item in the cost of operat- 204 The Federal Reserve ing a bank is the fact that it must keep a satis- factory reserve on hand and is unable to realize anything from the amount of money thus "tied up." For example, if a bank finds from ex- perience that it must always have on hand $100,000 in its vaults, that means that it loses, at 5 per cent, interest, $5,000 a year, or that $5,000 a year is the expense to it of maintaining its reserve. The effect of the reserve require- ments of the Federal Reserve Act upon this as- pect of banking expense is, therefore, important. Let us take the case of the country bank under the older conditions. Such a bank may be sup- posed to have had outstanding $100,000 of demand deposit accounts. Against this it had to hold 15 per cent, reserve, or $15,000. Of this $15,000, three fifths, or $g,ooo, might be car- ried as a "balance" with a bank in some reserve city. The reserve city bank would usually al- low 2 per cent, interest on this balance, or, in this case, $180 per annum. Under the new sys- tem the bank has to hold a reserve of 12 per cent., or $12,000 instead of $15,000. This 12 per cent, is all cash, or balance with Federal re- serve banks which is non-interest bearing. The bank would, therefore, lose the $180 interest which it earned on its reserve balance under the The New Banks 205 old system. On the other hand, there would be set free for other uses $3,000 (the difference between $15,000 and $12,000). If the prevail- ing rate of interest in the community were 6 per cent., this $3,000 would yield $180, leaving the bank exactly where it was before as to income, or if the $3,000 were used as a reserve to sustain outstanding deposit to credits or loans, it would sustain presumably one fourth as much as the $12,000 held as a reserve against $100,000 of deposit accounts. This would mean that de- posit loarts to the extent of $25,000 could be added to those already outstanding, provided the bank could find borrowers. If it did find them its income would be 6 per cent, on $25,000, or $1,500, so that it would be a very large gainer by the change. Attention may now be given to the way in which the Federal reserve system is intended to assist and relieve banks which are included among its members. The essential and pri- mary purpose of the system is that of performing what is known as the operation of rediscount. It will be understood that by discount is meant the transaction in which a bank accepts an ob- ligation from a customer running for a specified length of time, and advances to this customer 2o6 The Federal Reserve the amount of the obhgation, minus the interest for the period for which the funds are advanced. This preHminary deduction of interest is termed discount, and the note has been discounted when it is left with the bank by one who wishes to obtain the immediate use of funds. When a bank possessed of such notes, and itself desir- ing funds, presents these notes to another bank in order to get an advance, the operation is called a rediscount. The notes in that case are rediscounted by the bank which presents them and they are discounted by the bank which takes them and advances funds in exchange. This process of rediscount is usually accompanied by that of endorsement. That is to say, the bank which presents the note for rediscount endorses it, thereby guaranteeing that it will be paid at maturity, or that, if not so paid, the bank obtaining the rediscount will make it good. In Europe, generally, the process of redis- counting is a common one and banks resort to it as a customary incident in their operation. In the United States there has long been a prejudice against rediscounting, it being felt that the situation in which a bank was obliged to resort to another in this way was not one The New Banks 207 which reflected credit upon it. It has been fre- quently the custom, therefore, that banks which needed funds borrowed them upon their own direct obligation or that of members of its Board of Directors, and secured such obli- gation by the deposit of collateral. Thus, for example, if a bank in Utica, New York, de- sired to borrow of a New York City bank, it might do so by simply giving its own note for the amount, or its directors might obtain loans at the New York City bank with the understanding that such loans were for the use of the Utica institution. The Federal Re- serve Act is intended to make rediscounting a natural, customary, and safe method of liquidat- ing paper and equalizing the stock of reserve money of the community among the different banks. The primary function open to the Fed- eral reserve banks, as already stated, is that of rediscount, but they are limited in the perform- ance of this function to their own members. They are, in other words, authorized to redis- count the paper of their member banks, thereby enabling the various members to obtain reserve credits in place of the obligations of their cus- tomers whenever they desire. It should be noted that the effect of this process is quite dif- 2o8 The Federal Reserve ferent from that of extending a "line" of credit in the way already described as being customary among the banks of the United States. Where such a general line of credit is established there is no genuine date of maturity for the loans. The bank which extends it may have taken the precaution to grant the credit with a definite maturity, and may demand payment at such maturity. This, however, does not necessarily mean that the bank thus called upon to pay has any automatic means of providing itself with resources. In the case where the bank which needs funds rediscounts a piece of com- mercial paper, it entirely parts with that paper, and the payment of the obligation when due falls upon the person who originally made the paper. The discounting bank has merely guaranteed that there will be no default. If the maker of the paper is practically certain to be in possession of funds at the maturity of the paper, liquidation at the time named is as- sured. The question, then, in carrying on a system of rediscount, is that of making certain that the paper thus presented is of a kind that will liquidate itself. Consequently, the Federal Reserve Act provides that only such paper shall be eligible for rediscount as grows out of com- The New Banks 209 mercial, agricultural, or industrial transactions, and the regulations of the Federal Reserve Board have interpreted this to mean that the only paper eligible for rediscount is that which grows out of an actual, live transaction involving. a'sale of goods in commerce, industry, or agriculture. Assuming this definition to be literally lived up to, the necessary consequence is that the paper is certain to be liquidated at maturity if the maker himself is solvent. In other words, the great mass of such rediscounted paper is as liquid as the general business of the community itself. If the community has suffered some gen- eral disaster there may be a condition of sus- pension of payments, in which case no paper would be liquid. If this is not the case, then it may be assumed that the function of the Fed- eral reserve bank has been merely to take from banks which had extended their credit too far, and which needed funds, a certain part of the commercial paper they had discounted and to give them the funds in exchange. It is worth while to note how the Federal re- serve bank is affected in this type of transaction. In the first place, a member bank has made loans to customers and has presumably employed all of the usual safeguards that are resorted to in 210 The Federal Reserve such cases to make sure that the loan is good. The Federal reserve bank has, 'in addition to this general investigation made by the member bank, the member bank's own endorsement or warranty that the note is good. In addition, as elsewhere seen, the Federal reserve bank has on deposit a certain amount of reserve funds belonging to the member bank, while it has, of course, the capital stock contribution made by the member bank in order to become a member. There is thus a triple additional protection against loss over and above what the ordinary or member bank has — namely, the member bank's own endorsement, the reserve, and the capital contribution of the member bank, which may be regarded as a kind of insurance margin in the event of failure, inasmuch as the reserve bank is not obliged to return to a member bank any- thing except the balance, whatever that may be, due it after all liabilities have been liquidated. Precisely because the protection to the Fed- eral reserve bank is thus so much greater than to the member bank, it is possible for the Federal reserve bank to make its rate low. All interest rates are essentially composed of three elements: the "pure" interest on money, or about what is necessary to pay in order to induce a man who The New Banks 211 possesses capital to forego the use of it for a time, although assured that it will be returned at a specified date; the provision for expense involved in the mechanism of making loans, and the item of insurance against risk. It is probable that in most loans currently made the latter is by far greater than any other. The Federal reserve bank, therefore, by reducing it to its lowest terms, makes a corresponding cut in the rate. Since the Federal reserve banks were organized they have been able to make rates as low as 3 per cent, for ten-day paper and 4 per cent, for thirty-day paper, or, in other words, at the rate of 4 per cent, per annum where paper matured within a period not ex- ceeding thirty days. Sixty and ninety day paper have borne higher rates of interest, and the question may be asked why there should be this discrimination if the security is practically as good in the one case as in the other. The answer is that the security cannot be called so good in the case of the longer maturities as in that of the shorter date. The real reason for making a lower rate for thirty-day paper is that the shorter the period for which notes run the less the probability that the funds obtained will be used for the purpose of financing a trans- 212 The Federal Reserve action which may become non-liquid. As has already been seen, the less the degree of liquid- ity, the less the probability that paper will be paid at maturity. The lack of abiUty to liqui- date does not necessarily mean inability to make ultimate payment, but merely temporary post- ponement. While the Federal Reserve Act was based upon the theory that the fundamental function of Federal reserve banks was to discount paper for their member banks, and thereby to enable these institutions to liquidate, the Act also made provision for what are called "open-market operations." These operations were of several kinds. The banks were permitted to deal in the securities of the United States Government to any extent they saw fit. They were also authorized to purchase and sell short-term obli- gations of States and municipalities running not more than six months. Bankers' accept- ances might be bought in the open market, and finally provision was made for the open- market purchase of bills of exchange. It is thus seen that if Federal reserve banks were authorized to exercise all of the provisions of the Act, and chose to do so, they would have a very wide field of activity apart from member The New Banks 213 banks. They could not only deal in long- term Government bonds and short-term war- rants of municipalities and States, but they could also invest in live commercial paper of designated varieties. At first sight it may seem as if the extension of these powers was at vari- ance with the idea that the resources of the re- serve banks were intended solely for the benefit of the member banks through the hquidation of paper in which their funds might have been invested. There are two reasons why this view is not sound: in the first place, it may frequently happen that member banks are not in need of discounts, while non-member banks would gladly get funds. The member banks may, for reasons of their own, not be presenting paper to Federal reserve banks for discount, while Federal reserve banks may be largely supplied with resources. In such a case as this the open-market power gives the Federal reserve bank the ability to relieve a noii-mem- ber bank directly should there be good reason for so doing, and at the same time it has the opportunity of keeping its own funds invested to some extent, thereby earning a revenue for itself at times when its resources would other- wise be idle. The second reason referred to 214 The Federal Reserve above is, however, more important. It is that the Federal reserve bank owes an obligation not only to its member banks as individual in- stitutions, but also to its member banks as a group or community of institutions. This duty is that of preventing undue fluctuations in rates of interest and in maintaining, so far as possible, a reasonable, stable, and even rate. There may easily be times when such a re- sult cannot be obtained simply through redis- count operations. In order to make a redis- count rate effective in the market, i. e., to influence the commercial rate of interest and to insure that that rate or something approxi- mating it shall be the prevailing rate in the market, it may be necessary at times for a Fed- eral reserve bank, or for any other institution exercising the same powers, to become an active factor in the open market and to buy and sell at the rate which it has itself established. Clearly, if this function were not thus to be exer- cised, the making of the rate of discount effec- tive would be entirely dependent upon the extent to which member banks chose to obtain rediscounts from Federal reserve banks. With the power on the part of Federal reserve banks to go into the open market, the control of the he Federal reserve banks if they have a sub- tantial amount of loan funds at their disposal, f they do not choose to employ these loan funds 1 open-market operations it is because they do ot consider that the facts in the case warrant bem in doing so. One other point needs to be particularly ob- ;rved in studying the functions of Federal 5serve banks and in diiFerentiating clearly be- Neen them. It will have been noted that 'hen funds were advanced to a member bank ich action was spoken of as a discount or re- iscount, while in the open-market operation le placing of funds was spoken of as a purchase f paper. The question is often asked how a urchase of paper differs from a discount, i^hen a discount is made it is understood that le person or institution obtaining the funds laves them on deposit with the bank which ex- ;nds the credit, i. e., uses them simply to draw pen and does not demand payment in actual loney. If he needs currency he takes it in le notes of the bank which extends him the an. Where a purchase is made it is expected ) be paid for in actual money, thereby reducing le reserves of the bank which makes the pur- 2i6 The Federal Reserve chase in a corresponding degree. The effect in the latter case is to limit the lending power of the institution which advances the funds, and a purchase consequently operates to re- strict the aggregate power of the bank in a much greater degree than does a discount in which the funds are left on deposit and are simply transferred by check. The question is frequently asked whether the public obtains any benefit from the redis- count and purchase operations of Federal re- serve banks, in view of the fact that it cannot discount with reserve banks, cannot keep its own resources on deposit with them, and proba- bly only in a minority of cases can expect to deal with the reserve banks through open-market operations. The answer to this question is simply that whatever lowers the rate of interest to banks in general, in a country where banking competition exists, helps the borrower at banks in a like degree. Any five persons of good standing, who have twenty-five thousand dollars capital, can charter a national b clearing functions of, 156; relation to re- reserve banks, 173; relation to clearance system, 231; voluntary clearance system at, 237; relation to refunding, 248ff; policy as to note issue, 252; attitude toward state banks, 265; requirements as to state bank admission, 268; acceptance circular of, 289; 'feffect of circular, 291 Federal Reserve Bulletin, purpose of, IJI Federal Reserve Districts, map of, facing p. 94; organiza- tion of, 134; readjustment of, 150 Federal reserve notes, how issued, 157; provision for, 244; reserve against, 247; amount needed, 251 ; amount issued, 251; not a substitute for gold, 253 ; amount ordered, 255 Federal reserve system, purpose, 15; started, 114; signifi- cance of, 124; basis of attack on, 127; relation to in- dividual, 130; relation to state banks, 258; relation to non-member banks, 272; unifies banking, 277 Index 339 Fiduciary powers, how granted, 147; First bank of the U. S., history, 10 Fiscal agents, Federal Reserve Banks as, 310 Foreign trade, financing of under Federal Reserve Act, 80; course of in 1914, 113; effect of reserve system on, 278; old method of financing, 285; new method, 288ff; basis of, 292; future of, 294 Fowler, C. N., work of, 33 Fowler bill (1908), provisions, 39 Glass, Carter, work of, 46 Gold, export movement, how controlled, 73; economy of under Federal Reserve Act, 79; drain from U. S. in 1914, 108; reappearance of, after war, 122 Gold certificates, place of, 239 Gold settlement fund described, 233 Gold Standard Law (1900), provisions of, 30; operation of, 32 Government, relation to reserve banks, 18; relation to reserve system, 297ff Government deposits, history of, 298 Governors of Reserve Banks,hownamed,98; their duties, 1 64 Greenbacks, place of, 239 Guaranty fund, in Canada, 28 House Banking Committee, begins work on measure, 45; reports Reserve Act, 47; work of, 56 Indianapolis Monetary Commission, work of, 29 Independent Treasury system, origin of, 298; found wanting in 1907, 3CX)ff; inadequacy of, 305 Inelasticity explained, 240 Issue as phase of banking, 5; how related to loans, 8; of Federal reserve notes, 157 Kansas City, clearing system at, 231 340 Index "Liquidity" of commercial paper defined, 185 Maturity of paper, reason for varying rate, 210 McAdoo, Secretary of the Treasury, work in organizing banks, 86; names date for opening new banks, 99 Monetary Commission, origin, 38; results, 39 Muhleman, M. N., work of, 33 National Currency Associations, work of in 1914, 104 National bank, effect of reserve system on, 275; growth in numbers of, 226 National Bank Act, provisions regarding reserves, I97ff; National bank notes, delay in issue, 27; place of, 240; how retired, 249 National banking system, its place, 9; origin, 4; defects of, 22; history of, 25ff National banks, how organized, 13; will lose note function, 20; join Federal reserve system, 87 New Orleans, branch bank at, 136 New York, position as reserve centre, 90 Notes, place in lending, 81 Non-member bank, relation to reserve system, 23; relation to clearance system, 223 Organization Committee, work of, 85; preliminary work of, 89; devises gold settlement plan, 233 Organization, executive and clerical of Reserve Banks, chart facing p. 165 Panic of 1907, origin of, 36 Panics, relation to banking, 23 "Par points," nature of, 227 Public, benefit of from reserve banks, 216 Index 341 Public deposits, relation to panic of 1907, 36 {See Deposits.) "Purchased paper" described, 215 Reserve agents described, 194 Real estate loans by state banks, 271 Redemption of notes, 247 Rediscount, operation analyzed, 206; paper eligible for, 209 Refunding, provision for, 242-3 ; operation of Reserve Act on, 244-s Reserve banks, number of, determined, 91; capitalization, 93-4; opened, 99; assets, 99 Reserve city bank, how affected by Reserve Act, 204 Reserves, held by reserve banks, 17; treatment of in Re- serve Act, 69; provisions of circular No. 10, 116; re- leased by reserve system, 118; defined, 193; old system of, 19s; relation to reserve system, 197; theory of, in Reserve Act, 198; provisions of Act regarding, 199; against notes, 247; provisions as to state member banks, 269 Reserve surplus, relation to public deposits, 311 Reserve system, relation to exchange charges, 227 Savings deposits, under Federal Reserve Act, 260; use of by national banks, 262 Second Bank of U. S., history, 10 Secretary of Treasury, power to sell bonds, 30; relations to Board, 141; control of public deposits, 154, 311 Senate Banking Committee, work of, 57 Special charter systems, character of, 126 Specie payments, suspended in 1914, 104 State banks, date of origin, 4; number and capital, 12; join new system, 88; relation to reserve system, 133; original Glass bill as to, 256; admission of, 257; control 342 Index of, 258; provision for membership in reserve system, 264; application of, 266; withdrawal of, 267; require- ments as to, 268; postpone application, 273 St. Louis, clearing system at, 23 1 Statistics, of Federal Reserve Board, 155; of Federal Re- serve districts, see chart facing p. 165 Stock exchanges, closed in 1914, 102 Stock market, relation to reserve system, 197 Stocks, sales of in 1914, 103 Straus, Isidor, work of, 34 Sub-treasury system, origin, 11 Surplus (Treasury), relation to bonds, 26; effect of, 299?; amount of, 303 Suspension, effect of bank, 191 Trust companies, their banking functions, 9; number and origin, 12 "Trust company powers" described, 260; demand for, 263 ; laws of states regarding, 263 Unification of banking system, 256 United States, systems of banking in, 3 U. S. notes, origin, 11 {See Greenbacks.) U. S. bonds, relation to currency inelasticity, 241; how affected by Reserve Act, 242fF; purchase of by reserve banks, 248 Vreeland bill (1908), provisions, 37 War, effect on reserve banks, lOl Wilson, President, endorses Federal Reserve Act, 47; names Reserve Board, 96 The American Books A Library of Good Citizenship TO vote regularly and conscientiously and never to have been arrested for disorder, is not the be-all and end-all of good citi- zenship. The good citizen is he or she who bears an active hand in cleansing and making merry the black spots of the neighborhood; who cher- ishes a home however small; who takes an increasingly intelligent interest in all that con- tributes to the country's welfare, and feels a keenly patriotic hope for the future of the nation. For such citizens the American books are designed — a series of small volumes on current American problems. 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