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RELATIVE TO THE .anmT comm PROBLEM THESIS HHH THE DEGREE OH H H Daryl V Mmms 193:2 32 PROPOSED CHANGES IN THE FEDERAL RESERVE LAW ANDHADMINISTRATION RELATIVE TO THE CREDIT CONTROL PROBLEM THESIS SUBMITTED TO THE FACULTY OF MICHIGAN STATE COLLEGE IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE 0F MASTER OF ARTS BY __ H” \ DARYL VT IHINNIS TABLE OF CONTENTS Page INTRODUCTION ‘ 1 Expected Benefits of Credit Control from the Federal Reserve Law and Subsequent Disappointments 1 Congressional Investigation of Banking System-1950 3 Purpose and Scepe of this Study 5 CHAPTER I 7 Federal Reserve Policy Relative to the Credit Control Problem 7 The Preliminary Period 1914-1919 8 Period of Constructive DeveloPment 1920-1929 11 Open-Market Investment Committee 17 Gold Imports 1921-1929 19 Effect of Open-Market Operations 1924 and 1927 23 Summary 55 Justification of Federal Reserve Credit Policy 54 The 1924 Credit Policy 54 The 1927 Credit Policy ' 56 Criticisms of Federal Reserve Credit Policy 1924-1929 37 Proposed Recommendations 43 The Open-Market Policy Conference 48 Conclusion 50 102943 TABLE OF CONTENTS Page CHAPTER II 52 Credit Going into the Stock Market 52 Federal Reserve Credit 53 How Federal Reserve Credit Flows into the Stock Market 54 Pr0posed Amendment to the Federal Reserve Act 57 Is it Possible to 'Earmark' Federal Reserve Credit? 59 Should the Federal Reserve Board Control Speculation? 61 Iember Bank Credit 67 The Problem of Time Deposits 68 Pr0posed Amendment to Federal Reserve Act 71 Loans for Account of "Others" 73 Business Corporations Supply Large Sums 75 Position of Loans for "Others" in the Credit Structure 76 The Part Loans for "Others" Played in October 1929 77 Position of the New York Banks 78 Should Loans for "Others" be Controlled? 79 How Corporations may be Prevented from Loaning Funds to the Stock Market 81 Conclusion 81 TABLE OF CONTENTS Page CHAPTER III 85 Security Affiliates 85 Brief History of Security Affiliates 85 Definition 87 Functions 87 Justifications 89 Indictment of Security Affiliates by the Comptroller of the Currency 92 Reasons lhy Security Affiliates Should be Abolished 94 Provisions of Glass Bill 97 Conclusion 103 CHAPTER IV 105 Bank Examinations 105 Three Kinds of Bank Examinations 105 Suggested Proposal to Improve Bank Examinations 107 Views of Mr. Melvin W. Traylor 109 Conclusion , 110 BIBLIOGRAPHY 115 TABLES United States Securities Held by Federal Reserve Banks, 1915-1922 Money in Circulation on July 1. 1922 and August 1, 1924 Loans and Investments - All Member Banks, 1921-1929 Demand and Time Deposits, 1919-1929 Sources of Loans for Account of "Others" Decline in Brokers' Loans - New York City Member Banks - Oct. 16-Dec. 4, 1929 Total Loans of New York City Member Banks on October 16' and October 30, 1929 Security Originations and Participations of Security Affiliates 1927-1929 CHART Reserve Bank Credit Outstanding and Principal Factors in Changes - New York Rediscount Rate Page 14 22 27 69 75 77 78 94 115 INTRODUCTION There is among some of the foremost friends of Athe Federal Reserve System keen disappointment at the manner in which it has functioned during the past four or five years. In order to appreciate the reasons for this disappointment. it is necessary to inquire into the nature of the Federal Reserve Act and see what it was expected to accomplish. If one goes back to the philosophy of the framers of the Reserve Act. one finds certain simple. definite ideas which are not stated definitely in the preamble to the Act itself.* EXPECTED BENEFITS OF CREDIT CONTROL FROM THE FEDERAL RE- SERVE LAW AND SUBSEQUENT DISAPPOINTMENTS It was asserted that the stock market tended to absorb too much of the country's money and it was ex- pected the the establishment of twelve Federal Reserve Banks would decentralize money supply. Subsequent hist- ory has destroyed this original conception. *"An Act to provide for the establishment of Fed- eral reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper. to es- tablish a more effective supervision of banking in the United States. and for other purposes."IUnderscoring mine) In addition it was believed that with the ex- ceedingly narrow limits of the district in which New York was placed. that city would be shorn of its great finan- cial pre-eminence. but instead it has been largely in- creased. It was further claimed that the Federal Re- serve System would not furnish credit for speculative purposes. Wild speculation in stocks was known long be- fore the enactment of the Federal Reserve law. It was formerly the fashion to ascribe this Speculation to our inelastic currency and banking system. This view held that at certain periods there was a dearth of demand for currency and credit for the ordinary purpose of industry and trade and a consequent accumulation of each in New York City to be used for Speculation. But. in those times, when a reversal of condition took place. and there was an active and insistent call for funds from the coun- try at large, the call money rate in New York went up to a high point, and Speculation was checked. The Reserve System has put an end to the ab- normal rates for money. and in that way has removed one of the former barriers to inordinate stock Speculation. Messing of bank reserves and easier methods of note issue have brought this about. These changes. however. which were designed to avoid currency panics and to afford better credit facilities to the legitimate trade and industry of the country. have also tended to foster stock Speculation. The laudable objects have been achieved, but not without at the same time furnishing the means to facilitate Speculation. Recent experience indicates that in accompishing what all concede was desirable. the Re- serve Act was not able to avoid what is generally re- garded as undesirable. Instead of hindering Speculation the Reserve Act has tended to encourage it. Lastly. it was confidently believed that the Reserve Act would reduce bank failures, but the experience of the last ten years indicates that they have been more numerous than ever. The excessive use of bank credit in making loans for the purpose of stock Speculation. or. more gen- erally stated, for the excessive carrying of securities with borrowed money. was generally admitted before the panic of October. 1929. Soon after the stock market crash many prominent authorities. including Reserve of- ficials. emphasized the fact that the 1927-1929 Specula- tive orgy was caused primarily by an overextension of bank credit. CONGRESSIONAL INVESTIGATION OF BANKING SYSTEM-1930 Under such circumstances it was to be SXpected that a Congressional investigation would be made with a view of making recommendations to modify the Federal Reserve Act. Accordingly. in December,1930, the Senate unanimously passed a resolution in which it resolved that: "In order to provide for a more effective Oper- ation of the national and Federal reserve banking systems of the country. the Committee on Banking and Currency of the Senate or a duly authorized subcommittee thereof be and hereby is empowered and directed to make a complete survey of the systems, and a full compilation of the essential facts and to report the result of its findings as soon as practicable, together with such recommendations for legislation as the committee deems advisable." we desire to invite particular attention to this sentence of the resolution: "The inquiry thus authorized and directed is to comprehend Specifically the administration of These banking systems in reapect to the use of their facil- ities for trading in and carrying Speculative securities. the extent of call loans to brokers by member banks for such purposes, the effect on the system of the formation of investment and security trusts. the desirability of chain banking. the development of branch banking as a part of the national system. together with any related problems which the committee may think it important to investigate." In obedience to the unanimous action of the Senate. the Committee on Banking and Currency set up a subcommittee of five members with Jurisdiction of all the questions propounded in the above resolution. (Senate Resolution 71) The subcommittee in January and February of 1931 instituted extensive hearings on every phase of the banking problem as comprehended in the resolution. The committee called before it banking experts and econ- omists and heard. in addition to the persons summoned. all responsible bankers or technicians who expressed a desire to be heard. The committee covered the entire field of existing banking. and made a searching inquiry into prOposals for modifications of the banking laws. In the words of the committee's chairman. Senator Glass, "The committee thus acquired perhaps the most extensive information on banking problems of any theretofore assembled by any committee of the Congress." PURPOSE AND SCOPE OF THIS STUDY The purpose of this study is to consider the recommendations dealing with the problem of bank-credit control which were suggested at the hearings before the subcommittee of the Senate Banking and Currency Com- mittee, and which are embodied in the so-called Glass Bill now before Congress. The Glass Bill is an attempt to remedy the evils which exist. as the previous dis- cussion indicates. in our banking system today. It is impossible in a study of this nature to discuss all the proposals in the Bill. We have therefore limited the scope of this study to the problem of bank credit con- trol because in both the hearings before the subcommittee and in the debates fefore the Senate on the Glass Bill, this problem received by far the most serious attention. The proposals to be considered will be dis- cussed under four main headings, namely: 1. Federal Reserve Policy relative to the Credit Control Problem 2. Credit going into the stock market 3. Security affiliates 4. Bank examinations It is believed that the evils of bank credit control which are present in the Federal Reserve banking system and which require legislation. fall under one of more of the above headings. CHAPTER I FEDERAL RESERVE POLICY RELATIVE TO THE CREDIT CONTROL PROBLEM The Federal Reserve System was originally planned and organized as a system for the accomodation of business through the discounting of paper of fixed maturity grow- ing out of industrial. commercial, and agricultural aper- ations. The scattered banking reserves of the country were consolidated into twelve Federal Reserve Banks. whose chief function, as the name implies, was to manage the reserves with a view to protect, support. and stabilize the entire banking and business situation. The use which these banks could make of the funds in their care was clearly and sharply restricted. They were to be used only for short loans to aid in financing the seasonal turn- over of trade. and not at all for financing investments or Speculations. The Reserve Act was drawn with the in- tent of Setting apart a fund devoted to Reserve purposes. and so safeguarded that it never could be drawn upon and possibly exhausted by a great Speculative movement. We may accept the statement, therefore. that "broadly Speaking. the aim of Federal Reserve credit policy is to help bring about such an adaptation of the volume of credit to the volume of business that every legitimate need for credit will be met, but that the volume of credit will not be SXpanded beyond the legiti- mate need".* The present section will be devoted to a des- criptive analysis of Federal Reserve credit policy for the period 1914-1929. We shall see how the Reserve authorities attempted to prevent an excessive use of Fed- eral Reserve credit and the extent to which they succeeded or failed. Four principal "weapons" which the Reserve authorities utilized to carry out their credit policies will be discussed. namely: 1. Discount rate 2. Open-market operations 3. Direct dealing with member banks 4. Publicity After considering the Justifications and crit- icisms of the Reserve credit policy. we shall conclude this section with a discussion of the legislative pro- posals. THE PRELIHINARY PERIOD 1914-1919 In order that the problems and difficulties of credit control may be thoroughly understood as undertaken by the Federal Reserve authorities. it seems advisable to * Burgess.W.R.. The Reserve Banks and the Money Market. page 179 present an historical background of Federal Reserve credit policy with particular reference to the period 1920-1929. Throughout this whole evolutionary period of Re- serve credit policy. it will be seen that the major issue has been concerned with the kind of credit instrument or "weapon" best suited to control effectively the flow of bank credit in and out of the prOper channels. During most of the period the movement of gold to and from the United States has played an important part in the form- ulation of Reserve credit policies. The credit policy of the Federal Reserve System did not assume any definite form until the year 1920. We may Summarize the period 1914-1919 as follows: In the first years of the Reserve System the credit policy was only of theoretical importance. Easy credit conditions in the United States. because of the re- duction of member bank reserve requirements and the large influx of gold.* made reserve bank credit policy and dis- count rates of little actual consequence until the late autumn of 1916. Then. for the first time. a credit situa- tion deve10ped which gave to the rates of some of the East- ern Federal Reserve Banks a degree of effectiveness. The * Between December. 1914 and December 1916. the gold stock in the United States increased 81.029.000.000. See Annual Report of Federal Reserve Board for 1930. 1O increasing pressure for credit funds. which would certainly have deve10ped in the year 1917 even if the United States had not entered the war. would undoubtedly have led to the development of an effective discount policy by the Federal Reserve System. With the entry of the United States into the war the outlook was changed. and the Reserve System was confronted with large and difficult problems of credit control growing out of the loan policy and loan Operations of the Treasury. From that time forth. to the beginning of the year 1920. the discount policy of the Federal Re- serve System was shaped not in accordance with money mar- ket conditions and the needs of business? but with the primary purpose or assisting the Treasury in the flotation of its great bond issues and its short term certificate issues. In brief. the discount policy of the Reserve System was treated as an element of the Treasury's loan policy. the Reserve System virtually ceasing to exercise. for the time being. its normal function of regulating credit. * Section 14 of the Reserve Act states that. "each Federal Reserve Bank shall have the power to establish. from time to time. subject to review and determination of the Federal Reserve Board. rates of discount to be charged by the Federal Reserve Bank for each class of paper. which shall be fixed with a view of accomodating commerce and business". PERIOD OF CONSTRUCTIVE DEVELOPMENT 1920-1929 With the year 1920 the Federal Reserve Banks entered upon the exercise of their function of regulating credit in accordance with business and economic indi- cations.* and for the first time since the outbreak of the war. under circumstances of extraordinary difficulty. undertook to deve10p a policy of credit control by means of discount rates. 'The attitude of the Federal Reserve Board is clearly indicated in its annual report for 1919: "The expansion of credit set in motion by the war must be checked. Credit must be brought under effec- tive control and its flow be once more regulated and governed with careful regard to the economic welfare of the country and the needs of its producing industries".** The reserve ratio (the ratio of the total re- serves of the Reserve Banks to their liability for de- posits and notes in actual circulation) for the Federal Reserve System as a whole on January 2.1920. was 43.7 per cent as compared with 50.8 per cent on July 3.1919. It *"Fortunately the condition of the Treasury is such that the Board can now feel free to inaugurate discount policies adjusted to peace time conditions and needs." Annual report. Federal Reserve Board. 1919 page 69 ** Ibid. page 71 11 12 declined to 42.8 per cent on July 2.1920.* The Board's action in raising rates** was therefore clearly supported by the reserve position of the banks. But the above statement of the Federal Reserve Board indicates that the action taken by the Federal Reserve Banks in 1920 was not taken primarily to protect their reserves but to control the rate of expansion of credit. It should be noted in reviewing the situation of the Reserve Banks during the years 1919 and 1920 that the reserve ratio was declining. not because reserves were being depleted through loss of gold. but primarily because the credit facilities of the system were being drawn upon too freely by the banks of the country. The attached chart shows the enormous amount of Federal ReServe credit outstanding during 1920. It was not until May. 1920. that the inevitable reaction in business began. and it was about six months * The legal minimum. as defined by the Reserve Act. is 40 per cent.against Federal Reserve notes and 35 per cent against deposits. ** The rediscount rate was advanced in January. 1920 from 4 3/4 per cent at ten banks and 5 per cent at two banks to 6 per cent at all banks. Further advances were made in the early summer. the rediscount rate at the largest Reserve Banks was advanced from 6 per cent to 7 per cent. Similar advances were made in other interest rates. 13 later that liquidation of loans both at member banks and at Federal Reserve Banks got under way. Between that time and the summer of 1922. the volume of member bank accom- odation at the Reserve Banks declined by about 85 per cent. (See Chart) Up to this point we have been considering the use and effect of the rediscount rate as a means of credit control in the hands of the Reserve authorities. From now on we shall give much attention to a second instrument Of credit control. namely. Open-market Operations.* This "weapon" was officially adOpted. as we shall see. by the Federal Reserve Board in the Spring of 1923. but it was used by the Reserve Banks. for a definite purpose. in the early part of 1922. We shall first inquire into the reason for this innovation of credit control and consider what. if any. were the results. From the organization of the Federal Reserve System to the early part of 1922. government securities. except for the periodical brief appearance of overdraft * Section 14 of the Federal Reserve Act provides that Reserve Banks may purchase and sell in the open mar- ket government securities and bankers' acceptances. The purchase and sale of government securities constitute by far the largest amount of Open-market Operations of the Reserve Banks. certificates. were a fairly constant item in the earning assets of the Reserve Banks. and did not fluctuate in re- Sponse to credit conditions. The following table illus- trates this conclusion: UNITED STATES SECURITIES HELD BY FEDERAL RESERVE BANKS* 1915-1922 (In millions of dollars) 1915 1916 1917 1918 1919 1920 1921 Jan. $15.1 $21.5 $ 55.7 $125.1 $294.7 $505.5 $287.1 April 25.4 49.6 117.8 78.8 218.6 295.5 267.0 July 7.9 56.5 76.9 57.0 259.4 525.5 244.5 Oct. 10.5 51.9 110.0 550.5‘ 301.2 296.3 192.5 Dec. 15.7 55.4 107.2 511.5 500.4 288.1 255.5 1922 Jan. $293.0 Feb. 407.9 Mar. 455.5 Apr. 587.0 May 603.4 As the table indicates. it was not until Feb- ruary. 1922 that government securities began to Show a considerable increase in volume. During the first five * Source: Federal Reserve Bulletins 15 months of 1922 the Reserve Banks purchased nearly 2370. 000.000 of these securities. The reason for this policy may be ascertained by referring to the appended chart. Member banks during 1921 were rapidly repaying their borrowings from the Reserve Banks and the latter's total earning assets.* as the attached chart indicates. (see curve Federal Reserve Bank credit) were rapidly declining. In comparsion with the years 1920 and 1921. the total earn- ing assets of the Reserve Banks in the early part of 1922 were at a relatively low level. Under these circumstances the Reserve Banks invested in government securities large- ly for the purpose of assuring to themselves sufficient earnings to meet their expenses and dividends.** Experience in 1922. however. indicated that 1. earning assets cannot always be increased through the purchase of securities in the Open market and * The nomenclature of this item was changed in 1925 from "Total earning assets" to "Total bills and securities". Either item indicates the amount of Federal Reserve bank credit outstanding at any one time. ** See testimoney of Governor Benjamin Strong before the House Committee on Banking and Currency. April 1926 - quoted in "Interpretations of Federal Reserve Policy". Edited by W. R. Burgess. pages 235-236 16 2. Open-market purchases by the Reserve Banks do “not always result in an equivalent increase in the volume of Reserve Bank credit in use. since the additional funds not infrequently find their way back. at least in part. to the Reserve Banks through the repayments of rediscounts. Similarly. sales of securities by Reserve Banks do not at all times result in a reduction of the volume of credit in use. since the shortage created by the sales is in many cases made up by additional borrowing by the member banks. as was the case in the early part of 1923.* (See Chart) There appeared. in 1922. to be a definite re- lationship between Reserve Bank purchases in the open market and the volume of rediscounts. As the volume of securities purchased increased there was a correSponding decline in rediscounts and total earning assets remained relatively constant. This scissor relationship is clear- ly brought out in the chart. In order that we may fully appreciate the great importance which open-market Operations played in * These limitations upon the power of the Reserve Banks to influence the volume of their credit in use through Open-market Operations does not. however. diminish the importance of Open-market purchases and sales as will be brought out later on. 17 the Reserve credit policy during the recession years of 1924 and 1927. we shall give a brief survey of the evolu- tion of the Open-market investment committee. All open- market Operations of the Reserve System are now conducted by this committee. OPEN-MARKET INVESTEENT COMMITTEE Prior to 1922 there was no thorough geing attempt to coordinate the Open-market operations of the twelve Federal Reserve Banks. Each Reserve Bank pur- chased and sold bankers' acceptances and government secur- ities in accordance with the decision of its own direct- ors. and executed these orders through whatever channels it chose. One consequence of this procedure was the con- stant danger that the Reserve Banks would be competing with one another in the Open market. In addition. it was found that in the actual execution of the orders. and in the effect upon the price of government securities in the market. there seemed to be some cause for complaint on the part of the Treasury. 0n different occasions the financial policy of the Treasury was seriously embarrassed as a result of the disorganized practice of Open-market operations. As the Reserve Banks are the fiscal agents of the Treasury. it was highly important that they should not complicate the existing relationship. A Because of the dangers discussed above. the 18 governors of the Reserve Banks in May. 1922. appointed a committee to deal with the matter. The first committee consisted of the governors of the Boston. New York. Phil- adelphia and Chicago Reserve Banks.* It was understood that all Open-market transactions not purely local in character should be executed through this committee at the request of the different Reserve Banks. In the early part of 1923 the Federal Reserve Board passed a resolution determining that Open-market Operations should be conducted with primary regard to their effect upon the credit conditions of the country. Also. that the work of the Open Market Committee should be under the general supervision of the Reserve Board and under such regulations as it should promulgate. The machinery for handling Open-market Oper- ations was changed in the fall of 1923. At that time arrangements were made for the creation of a System Open- market investment account to be increased or decreased by the committee. with the approval of the Federal Reserve Board and the directors of the Federal Reserve Banks. The holdings in the Special investment account were to be prorated among the several Reserve Banks with due regard to the size of the different banks. their holdings of * The governor of the Cleveland Reserve Bank was appointed to the committee shortly afterwards. 19 other earning assets. et cetera.* Purchases and sales for the Special investment account are generally executed through New York. but they are also made in other Federal Reserve Districts where markets exist and where the Reserve Banks can effect pur- chases and sales satisfactorily. But. of course. the principal market is in New York City. The special investment account offered a more effective means for carrying out Federal Reserve credit policy than any Operation which involved dealing with securities held by the twelve different banks in their own vaults. Before proceeding with our analysis of the System's Open-market Operations during the years 1924 and 1927. it will be worth while to review the important part that gold imports played in the exercise of Federal Reserve credit policy during the period 1921-1929. It will be seen that gold imports on several occasions had a direct influence in the determination of Reserve credit policy. GOLD IMPORTS 1921-1929 Turning to the chart again. the curve "Gold Stock" represents what happened to our gold supply in these years. In the year 1921 we gained over $660,000,000 * See Burgess. W.R.. 0p. cit. pages 215-220. for a more complete description of the Open market organization. 20 of gold and in 1922. 1923. and 1924. the amount each year ‘was Approximately $300,000,000. That isdnmhat period of four years we took in.a billion and a half dollars of gold. What effect did these gold imports have on the banking and credit situation in the United States? There are a number of reasons why general prices did not rise in this country in.accordanee with the quan- tity theory of money. But the main reason was that at the beginning of 1921. as the Chart shows. the member banks owed the Federal Reserve System.near1y 53.000.000.000 end 'when.the gold was received by the member banks. they used most of it to pay their debts to the Federal Reserve Banks.* Reserve Bank discounts declined between their peak on Nov- ember 5. 1920, and their trough on July. 26. 1922 by $2,400. 000,000. It was due to this enormous liquidation. as we have seen. that the Reserve Banks were induced to purchase a large volume of government securities. After mid-summer. 1922. the gold coming to the United States played a different part in our credit devel- cpments. By July. 1922. after a period of business and * Importations of gold come first to the member banks and are turned over to the Reserve Banks as Reserve Deposits. As one additional dollar of reserve will support about $10 of credit. we can realize the extent of the inflation which might have developed had the member banks been out of debt to the Reserve System. 21 credit contraction running through 1921 and the first half of 1922. business activity had revived. The demand for bank credit and for currency was growing and member banks were increasing their borrowings from the Reserve Banks. The gold coming from abroad during this period was no longer used to retire obligations at the Reserve Banks. Thus between 1922 and 1924. as in 1915 and 1916. the growth of member bank credit was based on the use of gold imported from abroad. Are we justified in concluding that gold imports were the fundamental cause of the credit inflation which resulted in Speculation in the security markets beginning in the early part of 1925 and continuing to the fall of 1929? One prominent banker argues in the affirmative. He states that "in the five years from June 30,1922 to June 30,1927, with an increase of $800,000,000 in our gold stock. total loans and investments of member banks in- creased by about $8,000,000.000. "This gold influx was the basis of the great expansion of credit that followed. It furnished the bank reserves without which the expansion of credit could not have occured. It was coming continuously from 1920 to 1927. Here is the fundamental cause of credit inflation".* * Roberts. George E.. Vice-President of the National City Bank of New York City. Quoted in the Proceedings of the Academy of Political Science. Vol. 13 January 1930. 22 We do not subscribe to this view. That there was credit inflation is admitted. But, in 1923. member bank credit expansion was not nearly as great as the gold imports of that year would be eXpected to have induced. What occurred was that the imported gold went largely into general circulation and not in full measure into the re- serves of the Reserve Banks. It is not difficult to establish the fact that it was the general circulation which absorbed most of the imported gold. Between Dec- ember 30.1922 and December 31,1923. total cash reserves of the Reserve Banks actually declined by $10,000,000. This decline took place during a period in which the country's total monetary stock of gold increased about $245,000,000. (See Chart) The table below indicates the amount of gold that was paid into circulation to take the place of Federal Reserve notes: MONEY IN CIRCULATION* (In millions of dollars) Kind of Money gElyngggghAug.l.l924 Increase Decrease Gold & gold certificates S 590 3 1.198 S 608 3 - Silver & silver certificates 555 680 125 - United States notes 292 502 10 - Federal Reserve notes 2.139 1.746 -- 393 Federal Reserve bank notes 72 10 -- 62 Nationalbank notes ' 728 729 l - Total -- $4.575 H 4.665 H 289 * Source: Goldenweiser. "Federal Reserve System in Operation". page 69 25 Gold imports for the period 1920-1926 reached their peak in September. 1924. (See Chart) For the next several months gold was being exported. By April. 1925 we had lost approximately p200,000.000 of the metal. Again in the summer of 1927. after reaching a new high. the "Gold Stock" curve began a rather precipitate fall un- til by the middle of 1928. we had suffered a net loss of $500.000.000. It seems clear that bank reserves. upon which all credit is based. during these two periods must have been supplied from some other source. It is our belief that this source originated within the Federal Re- serve System by means of its Open-market operations. Having seen the important influence that gold imports exercised on Reserve credit policy especially during the period 1921-1924. we are ready to proceed with the discussion of Open-market Operations during the years 1924 and 1927. EFFECT OF OPEN-MARKET OPERATIONS 1924 and 1927 In 1924 the System went into the market and bought $510,000,000 of government securities.* At this time we were in a period of mild business depression. * In June. 1924, the rediscount rate of the New York Reserve Bank was lowered to 3 per cent. which was the low- est rate in effect since the inception of the Federal Re- serve System. 24 The world situation was disturbed because England was not yet back on a gold basis. and most of the other countries of the world were in great uncertainty. Under these circumstances. the Reserve System began to formulate a credit policy which. it was hOped. would help not only the United States. but the world at large. The general confusion which existed at that time among different . officials in the Reserve System is seen in the following words of Dr. A. C. Miller. one of the two original members of the Federal Reserve Board to appear before the Hearings of the subcommittee: "I think it is fair to say that the Federal Reserve System. as a system. was not fully conscious at that time (1924) of just what its objective was. There was some drifting. The policy was not entered upon with a clear lconception of what was the goal to be attained. There was some thought on the part of the Reserve System at that time. as there has been since. (1927) that it could alter the psychology of business. as is said. and thus arrest the recession or lift business out of the depression. by the adOption of an avowed easy money policy, the policy SXpressing itself most effectively through increased purchases of United States government obligations. "I think there also filtered into the minds of the Federal Reserve officials at that time the thought that perhaps the System could do something. or ought to try to do something. to improve the international credit 25 situation at least to the extent of not allowing the heavy imports of gold than coming into this country to become. as it was expressed. 'sterilized'. by being used to take down rediscounts at the Reserve Banks. "I think there was also more or less of the illusion (that became more pronounced in 1927) that the Reserve System could do something to correct what was then des- cribed. as the maldistribution of gold in the world."* The remarks of Governor Strong before a House Committee on banking and currency are likewise instructive: "There'has been criticism of that very period (1924). ' We continued to buy securities until August. 1924. I think. myself. if it were to be done over again. we might have stOpped a month earlier or even 60 days earlier. We might have bought $50,000,000 or even $100,000,000 less. but there is no mathematical formula that will tell you where to stop or to begin. It is a matter of judgement --- We continued to buy after the New York banks had com- pletely liquidated their borrowings from us. It may have been an error in carrying it as far as we did." Such straightforward and sincere remarks coming from two important Federal Reserve officials indicate the perplexing problems which confronted the Reserve System in deciding upon a credit policy in 1924. * Hearings before the Subcommittee of the Committee of Banking and Currency. United States Senate, 71st Congress. pages 131-132 Hereafter referred to as Hearings. 26 Turning now to 1927, we see the Federal Re- serve System undertaking its greatest Operation by means of Open-market purchases. As the volume of these se- curities voluntarily purchased by the Reserve Banks in— creased, their followed immediately an increase in the; reserve balances of the member banks. The 1924 experience was being repeated on a slightly larger scale. (See Chart) One may logically ask. "What was the use made of the reserves which . so to Speak. were handed to the banks by the Reserve Banks"? The table on the next page will serve to answer this question. The table shows that during the period 1921- 1929 "all other loans". largely commercial. remained pract- ically constant. We see a considerable increase in loans on urban real estate; a large increase in the volume of in- vestments. and a still larger increase in loans on secur- ities. The latter include the so-called brokers' loans; in other words. the call loans made by the banks. We have already stated that for the period 1922- 1924. gold imports served as a basis for member bank credit. Total loans and investments of member banks for this period increased $5,000,000.000. It is significant. however. that total loans and investments of member banks increased $8.500. 000.000 from.June 30. 1924 to June 30. 1929.* In.other wards, * Loans and.investments of all banks during this period increased 813.294.000.000. LOANS AND INVESTMENTS - ALL MEMBER BANKS (In millions of dollars) Invest June 30 ments 19 21 6.002 19 22 7.017 1923 7. 757 1924 7.965 1925 8.865 1925 9.125 1927 9.818 19 28 10.758 19 29 10.052 Amrtual increase 4.050 1921-1929 Percentage increase 67% 1921-19 29 * Decrease Source: Federal Reserve Bulletins 4.500 4.950 5.550 H.713 7.521 8.156 9.068 14222 5.695 129% Loans on Urban Real Estate All Other 12.450 12.279 12.062 12.579 12.555 12.611 12. 814 50* Total Loans and Invest mente 24.121 24.182 26.507 27.167 29.518 51.184 52.756 55.061 man; 11.590 48% 27 28 durtng this latter period. when.the Federal Reserve Banks purchased government securities and bankers' acceptances. they forced the member banks of the country to buy or loan against securities or make loans on real estate. Since commercial loans during this period showed but a slight increase. due to the fact that corporations were relying largely on the security markets for their capital require- ments. it was to be expected that the additional funds created by open-market purchases should flow into Spec- uletive channels. When.more credit is available than bus- iness can use profitably. credit tends to go to the high- est bidders, who may be dealing in commodities. or secur- ities or real estate. The table on the proceeding page indicates that the additional credit went into the secur- ity and real estate markets. We shall now consider the steps which the Reserve System undertook to prevent credit inflation in the second half of 1927.* Late in 1927. Federal Reserve credit having reached new high levels for the period since the 1921 de- flation. the Reserve System.began to go into reverse with its open-merket policy.(See Chart) The System.began to sell securities with the advent of the year 1928. and not * It was in 1927 that brokers' loans began their rapid increase. 29 getting the expected reaction of the two previous periods.* it began to reinforce its sales of government Securities by a gradual increase in the rediscount rate. It began the year 1928 with a rate of 3% per cent. which Mr. Owen D. Young. a director of the New York Federal Reserve Bank. justified in his statement before the subcommittee in the following words: "Let me say at once that I think the low rates of 1927 were justified under the circumstances then existing. At that time. the gold standard was being reestablished throughout the world. and it was of major consequence to this country that it should be made to work. We had such an undue amount of the world's gold that it was most im- portant that some be exported--- I'It was realized at the time that such rates would. if continued. not only induce Speculation. but that if they were too long continued. Speculation would get out of hand."** * During the two periods. June. l922--July, 1925 and November, 1924--‘March. 1925. the System sold $525,000,000 and $260,000.000 of securities reapectively. This direct action. together with rate changes. undoubtedly aided in preventing periods of over-expansion and credit inflation. ** Hearings p-306 50 The 3% per cent rediscount rate was moved up, in three steps. to a rate of 5 per cent by July 1,1928. At this time the Reserve officials were attempting to supplement the operation of the discount rate with that of open-market operations. as they had previously done. with success. in 1923 and 1925. As money grew dearer the bond market became depressed* and ended a four-year "bull" movement: but rising business kept stocks forging ahead. In the late summer of 1928 Reserve credit policy was mod- ified in order to provide for the usual seasonal demands for currency. An additional amount of money was put into the market through purchases of securities and acceptances. By the end of 1928. the volume of Reserve credit outstand- ing had risen to a new high level since the post-war de- flation. (See Chart) Entering the year 1929 the Federal Reserve System again seemed to lack a definite credit policy. The New York rediscount rate was still at 5 per cent and brokers' loans. over a period of a few months, had in- creased approximately $1.000.000.000. The System began to sell securities in January 1929. but firming money rates had little effect on the upward course of the stock market. This particular phase of the credit control * Since bonds are bought and sold on a "yield" basis. their prices move inversely with money rates. 51 problem will be considered more in detail in the next section of this study in connection with the discussion of loans for "others". That history was repeating itself in reapect to Federal Reserve credit policy is clearly indicated by the following remarks of Dr. Miller: "It was my Opinion expressed several times in dis- cussions at Federal Reserve meetings. in the opening month of the year 1929. that the Federal Reserve System.was drifting; that it was in the midst of a perilous situation without a policy. It was also my Opinion that the Fed- eral Reserve Board was far more alive and aware of the terrific implications of the situation existing at the Opening of the year 1929 than were the banks and that. in default of any program on the part of the Federal Reserve Board owed a reaponsibility to the country and to the future of the Federal Reserve System for which it must find a solution. That solution was found in a rejection of discount policy as a suitable expedient in the cir- cumstances. as they had been deve10ped. and the adoption of 'direct pressure'. "It was our belief that an increase to 6 per cent in February. 1929.* would have been nothing but a futile * The first half of 1929 witnessed a struggle be- tween the New York Reserve Bank. which wished to raise its rediscount rate to 6 per cent. and the Reserve Board. which refused to permit the advance. 52 gesture; that it would have been a practical declaration to the Speculative markets of the country that the doors of the Federal Reserve System were Open to all comers with paper of the kinds eligible for rediscount provided they paid 6 per cent. With call rates mounting to 8.9. 10.15. and 20 per cent. a 6 per cent discount rate would have been an admission of defeat and given great relief to the Speculative public."* In reviewing this last period we are introduced to the third and fourth instruments of Reserve credit policy. namely. "direct pressure" and publicity. As we shall see. neither exercised much restraint on the Spec- ulative situation. The "direct pressure" took the form of a letter sent to all Federal Reserve Banks on February 2.1929, in which the Board said that it "realizes that there are elements in the situation which are not readily amenable to recognized methods of banking control."** The letter indicated that pressure should be brought to bear on the banks to cut down unnecessary borrowings and to reduce speculative loans and investments. The Reserve Board. by clinging to an ineffective "warning" policy and insisting on direct action against * Hearings page 143 ** Hearings page 142 55 member banks to control the distribution of credit. attempted to keep business on the upgrade. starve out the call money market and put down the stock market at one and the same time. The effort to keep business on the upgrade wtimulated and maintained the very demand for. money for Speculative purposes that the Board sought to discourage. The attempt failed. and high call rates attracted money from all over the world. On August 8.1929 the New York Reserve Bank was allowed to raise its rediscount rate to 6 per cent. The effect of this action, however. had long since been dis- counted.* SUMMARY We have completed our survey of Federal Reserve credit policy for the period 1914 to October. 1929. It has been seen that in the early years of its life. the Federal Reserve System was incapable of evolving any prin- ciples of credit control which could be regarded as suit- able for permanent application. In the first years of its existence. problems of organization and the work of * With a 70 per cent reserve ratio existing at this time. it seems fair to conclude that the public was not convinced of the gravity of the situation. 54 familiarizing the banks of the country with the nature of its Operations demanded primary attention. Later. in the war and post-war period. the requirements of the Treasury were decisive in determining the nature of many of its . activities. But after industry began to recover from the disaster of 1920. we saw the elements of a credit policy formulated. By 1922. open-market Operations had been a- dopted as an instrument of credit control to supplement the discount rate. We saw. however. that it was not until 1924 that these two "weapons" were used to accomplish a definite objective. For the purpose of this study. there- fore. any justifications or criticisms of Federal Reserve credit policy will deal with the period 1924-1929. JUSTIFICATIONS OF FEDERAL RESERVE CREDIT POLICY We believe it is possible to justify the credit policy of the Reserve authorities for each of the years 1924 and 1927. Whether prOper measures were taken to pre- vent credit inflation after the objectives were attained is another question. to be considered shortly. THE 1924 CREDIT POLICY In 1924 Governor Strong of the New York Federal Reserve Bank took the position that the ReServe System had a rSSponsibility which transcended that owed to our own domestic situation. He maintained that this country could never hOpe for a permanent groundwork of prOSperity 55 until the world was back on a gold basis. and the world could never get back on a gold basis until we helped it.* This view found acceptance among the large banking in- terests in the East and the members of the Federal Re- serve Board. It was a plea that the United States do what it could to hasten the termination of the world period of currency unrest. Continued gold exports to the United States would sooner or later develOp their own correctives. But. unless encouraged by banking policies. then the real issue was, would these correctives accom- plish their mission before the movement toward gold restor- ation should be defeated? One way we had to help was by making conditions here favorable to the return of the world to gold. Until 1924 the interest rate in London had been steadily lower than the interest rate in New York. Consequently. New York was more attractive for funds and sterling exchange was constantly depressed. As a result of a policy of putting money into the market here and enabling member banks to pay off their debt at the Reserve Banks. money became easier in New York and the interest rates drOpped below those in London. In the Spring of 1925. England was able to go * See Burgess. W. R.. "Interpretations of Federal Re- serve Policy". for a deve10pment of Governor Strong's views on this question. 56 back on the gold standard and with her many other countries of the world. The groundwork was laid for the restoration of world trade on a gold basis. We do not know. of course, how much of this result was the effect of Federal Reserve credit policy and how much the effect of other forces. Nevertheless. we believe that the return of England and other countries to the gold standard in 1925 together with our own re- covery in business. furnish sufficient evidence to jus- tify the 1924 credit policy of the Reserve administration. THE 1927 CREDIT POLICY We have previously discussed to sOme extent the credit policy of 1927. In many reapects, it was a dupli- cation of the 1924 policy of the Federal Reserve System. The purchases of securities in 1927. as in 1924. were made at a time of business recession and price decline. They were made at a time also when certain of the EurOpean countries. who still maintained a paper currency. were be- ginning to consider the return to a gold standard. This attempt would be considerably furthered by moderately easy money conditions in the United States. which would make credits more easily available for those countries. The stabilization of most of the important countries of EurOpe eliminated the principal cause of the huge flow of gold which came to this country from 1920 to 1924. 57 The credit policy employed in 1927 was carried out with vigor. It achieved the ends sought. The res- toration of the gold standard was hastened and a powerful stimulus was given to domestic business activity. The policy entailed. however. a heavy rSSponsibility to guard against inflationary effects and to be prepared to take equally vigorous steps to curb such effects. To this prob- lem we shall now direct our attention. CRITICISMS OF FEDERAL RESERVE CREDIT POLICY Reviewing the record of Federal Reserve credit policy for the period 1924-1929. we may cite three definite criticisms: (l) The refusal of the Federal Reserve Board to raise the rediscount rate more than é-per cent at a time. Referring to the 1927 experience. Mr. Owen D. Young asserted that "the low rates were continued too long. An active. firm. and decisive policy of advancing rates should have been carried out in 1928. If it had been. I am of the Opinion that we would not have permitted our Speculative markets to absorb such a large amount of credit."* Dr. Miller. and other Federal Reserve officials. admitted that when the New York rediscount rate was raised from.3§ per cent to 4 per cent in January. 1928. it had * Hearings page 360 58 instead been raised to 5 per cent. it would have had a more effective result in giving notice that the Reserve System had started out with the conviction that there was something that needed correction. In raising the rediscount rate % per cent at a time in January. May. and June. 1928. the System allowed the money market to become accustomed to each change be- fore the next occurred, thus losing a decisive effect. Looking back over the eXperience of 1929 it appears that during Spring and early summer the New York Reserve Bank was right and the Federal Reserve Board was wrong. A check to business and financial activity in the spring would have saved the country the abnormal summer and fall bull market in stocks and the early autumn boom in new capital issues.* By summer the whole business and financial machine had acquired too much momentum. A sounder and firmer credit policy earlier in the year would undoubtedly have helped to prevent this excess momentum and attendant over confidence. Hindsight is. of course. easier than foresight; and the absence of inflation in * New issues for the first half of 1929 broke all previous records. amounting to 26.250.000.000. In Sept- ember the huge total of 51.615.000.000 was reached. Source: Commercial and Financial Chronicle Vol. 129 Oct. 5.1929 page 2374 59 commodity prices made correct judgement of the situation more difficult. But one of the main lessons to be learn- ed from the experience seems to be that the Board should hesitate greatly to veto such action as the regional banks wish to take as a result of their judgements of conditions in their reSpective districts. Certainly a politically appointed Reserve Board assumes a heavy responsibility when it attempts to dictate credit policies to the bank- ing officials actually in touch with credit conditions in commercial and financial centers. This raises the per- tinent question of the advisability of retaining the Secretary of the Treasury on the Board. With a political campaign impending. as in 1928 for example. a Board with the politically powerful Secretary of the Treasury at its head. cannot be trusted to take the necessary steps to check credit inflation at its inception. which is always the apprOpriate time to apply the remedy. (2) Open-market Operations have practically sub- merged the rediscount operations of the System contrary to the intent of the Federal Reserve Act. In recent years. as an example. the rediscount Operations of several Reserve Banks of the South and Central West have been very slight as compared with the volume of their Open-market dealings.* * Auxilliary statements Accompanying the Report of the Banking and Currency Committee of the United States Chamber of Commerce On the Federal Reserve System. P889 51 40 In reviewing the course of money rates in the United States during the period 1924-1929. so far as in- fluenced by Federal Reserve credit policy. the foremost influence must be assigned to Open-market Operations. While the rediscount rates of Federal Reserve Banks have undergone change from time to time. such changes more fI‘GQuently than not. have been made either in recognition of 9. credit situation brought about by antecedent Open- market operations or to accompany and reinforce a change of attitude assumed by the Federal Reserve officials towards the trend of business and credit conditions and needs. Such prominence as the Open-market Operations have in recent years attained was not anticipated at the time the System was organized. This view is succinctly Stated by Senator Glass as follows: "We had an Open-market provision in the Federal Re- serve bill. One has only to read the report made in 1913 to the House of Representatives on the bill as it passed and became a law to understand what the Open-market pro- ‘Vision of the bill was intended for. "It was intended for two purposes only: to enable the JFederal Reserve Bank to enforce its discount rate against the acquisitiveness and greed of any member bank in its regidn. an authority somewhat akin to the practice of the Bank of England. 41 "The other design of the Open-market provision was to enable the Federal Reserve Bank to use its idle funds. not in a Speculative venture, but to use its idle funds in a reasonable profitable way in order to cover its over- head. in order to pay its expenses." Also: "There appears to have been an extraordinary mis- conception by the administrators of the Act of its real purpose. In large degree the System has been transformed into an investment banking system, whereas the fixed pur- pose of Congress was to set up a commercial banking system and to preclude Speculative Operations."* The Federal Reserve Banks were then conceived of as banks of rediscount to which member banks would turn as they needed additional supplies of currency or Reserve credit. In brief. the Reserve Banks were to be institutions in which the initiative in creating new credit would rest _ with the borrowing member bank. the Reserve Bank playing its part in the process mainly through the establishment of rediscount rates designed either to encourage or to discourage the use of its facilities as the situation might seem to require. * Congressional Record Vol. 75 May 19.1932 page 10197 See also. Willis. R. Parker. "American Banking" 1923 page 161 42 The general attitude of the Reserve administration and the importance it assigned to Open-market Operations is possibly expressed by the following statement in the report of the Board for the year 1924: "By these purchases the Reserve Banks placed them- selves in a position. through the subsequent sale of securities. in case it should become desirable. to cause member banks to discount and to bring a larger part of the outstanding Reserve Bank credit under the influence of the discount rate."* (3) Lack of a definite credit policy which was particularly noticeable during the years 1928 and 1929. This criticism suggests a consideration of the much controverted question. namely: should the Reserve authorities assume reSponsibility for attempting to pre- vent crisis. including stock market crisis? In other words. should it be the business of the Federal Reserve System to try to cut off the tops and the bottoms of the business cycle? We merely wish to raise this important question now. postponing final discussion until the next chapter. when the proposal to increase the powers of the Federal Reserve Board will be considered. * Annual Report page 71 45 PROPOSED RECOMMENDATIONS In order to Provide a more effective Federal Reserve credit policy. the following recommendations have been suggested. These are the results of the in- vestigations conducted by the Senate subcommittee. (1) Open-market operations should be used only for real emergencies. The Federal Reserve Banks would then be Operated as institutions of rediscount in accordance with the in- tent of the Federal Reserve Act. Experience Seems to in- dicate that the attempt to manage credit from above. so to Speak. rather than at the primary points where it originates. has not been a success. and may well be aban- doned. except in those situations which call for ex- trardinary measures of credit control. A distinction should be made between certain routine - though very valuable - uses of the open market powers and their employment as an instrumentality of long- term credit policy. The present prOposal is aimed at the latter of the above Operations. The "routine" procedure is entered into to counterbalance the briefer tendencies of certain ever-recurring disturbing factors. principally government fiscal Operations. gold exports and imports. and changes in seasonal demand for credit and currency. 13y making apprOpriate sales or purchases of securities ‘the System.can smooth out the defects of such disturbing 44 influences with great success. A review of the System's Open-market Operations shows definitely that such dealings have enabled Reserve Banks to keep outstanding a larger volume of Reserve credit than would come into existence by rediscounting alone. Attention is once more directed to the Open-market purchases of government securities of the System during the recession years of 1924 and 1927.* (2) The rediscount rate should be used more effec- tively. Such a policy will help materially to curb Speculation. When credit demands are becoming excessive. and tend to resist ordinary measures of restraint, vigorous. corrective action in the form of rate increases should be promptly undertaken. Such action. by testing out the market and shaking loose weak holders of secur- ities. may bring loss to some. but such loss is in- significant in comparsion with the disasters of a major collapse. It is a fair conclusion that if the Reserve authorities expect to control credit inflation they must act decisively in the early stages of its devSIOpment, * Between February and August of the present year (1932) the System purchasesd over 21.000.000.000 of securities. A strong denounciation of this policy may be found in the Commercial and Financial Chronicle Vol. 134 July.l932 p.4551 45 before it obtains headway enough to be indifferent to moderate increases in interest rates. As soon as such a decisive advance in the rate has worked its influence upon the security market, then the rate can properly be lowered so that business need not be unduly hampered. When we are dealing with production. business. and trade. a gradually rising rate of interest is re- tarding and restrictive. but it is not particularly re- tarding or restrictive in Speculative expansion. The only kind of a rate change that is decidedly effective in dealing with a Speculative market is likely to be one that is sharp and drastic. (3) The Open-market operations of the System. when utilized. should require the sanction of at least five members of the Federal Reserve Board. The purchase and sale of government securities and acceptances by the System.bave frequently been pass- ed upon by a majority of a quorum of the Federal Reserve Board instead of a majority of the Board. Such a pro- cedure has made the Open-market investment committee a very powerful factor in the activities of the Federal Reserve System. It is desirable that Open-market oper- ations be passed upon by five members of the Reserve Board in order to assure impartial judgement from an independent group of men having the interests of the whole country in mind. By requiring an affirmative vote 46 of five members of the Reserve Board on Open-market Operations. the Board will retain the authority which it was given in the Federal Reserve Act. (4) The Secretary of the Treasury should be eliminated from the Federal Reserve Board. Dr. Miller would also eliminate the Comptroller of the Currency from the Board. By so doing the prestige of the Board will be increased. as Dr. Miller indicates in the following language:* "I am satisfied that the Federal Reserve Board will never function nearly as well as it might and should as long as it is not an absolutely independent body. made up of men of strength. independence. ability, and leader- ship. Because it will become more and more difficult as we go along to induce men to come on to the Board of the character and kind that must be on the Federal Reserve Board. if it is to do its job. unless they can feel that they are masters in their own house." The adOption of the first two recommendations will not require legislation. Their successful utilization. however. will depend largely upon.whether the last two proposals become law. An effective utilization of the re- discount rate cannot be expected until a strong. inde- pendent Board has been established free from any outside ------d-- ---------------------------------------- u------ * Hearings p-160 47 influence. The influence of politics on the activities of the Federal Reserve Board is aptly described by an expert: "---Mr.‘Mellon had made certain remarks which seem- ed to indicate either that he regarded himself as the Spokesman of the Federal Reserve Board or that this body was amenable to the influence of the national adminis- tration." As reported in the New York Times for March 27.1927 he said: 'I see nothing to indicate that business will not continue to be good throughout the country --- There is an abundant supply of easy money which should take care of any contingencies that might arise. I do not look for any change in the Federal Reserve rediscount rate for some time to come because I can see no reason for changing it.’ Further: 'Brokers' loans give a very good insight into the stock market situation. and they appear in a very healthy state.‘ "Inthe writer's opinion there is little question but that in Board councils the influence of the Treasury must have been exerted at this time against a program of severe measures of credit restraint."* * Reed. H. 1.. "Federal Reserve Policy. 1921-1950" page 137 48 Any system of government control will prove unsuccessful unless exceptional men can be induced to serve on the regulating board. By removing all possibil- ities of political authority and domination from.the Federal Reserve Board. an important step will have been made to build up a Board of men having "strength. in- dependence. ability, and leadership". THE OPEN MARKET POLICY CONFERENCE The mistakes of the 1927 adventure of the System.in its Open-market Operations has served to make the other banks. the outside banks in the Federal Reserve System. more solicitous, and it is largely due to their feeling that the open-market committee has recently changed its character and size. On march 25.1930. a new open-market procedure was adapted by the Federal Reserve Board. The more important provisions are:* (1) ’The Open-market investment committee. as at present constituted. is hereby discontinued and a new committee. voluntary in character. to be known as the Open-market policy conference. is set up in its place. (2) The open-market policy conference shell con- sist of a representative from each Federal Reserve Bank. designated by the board of directors of * Hearings page 158 49 E the bank. (3) The function of the Open-market policy con- ference shall be to consider. develop, and recommend policies and plans with regard to open-market operations. (4) The conclusions and / or recommendations of the open-market policy conference. when approved by the Federal Reserve Board. shall be sub- mitted to each Federal Reserve Bank for determination as to whether it will participate in any purchases or sales recommended.--- (5) An executive committee of five shall be selected from and be the members of the con- ference for a term of one year, with full power to act in the execution of the policies adopted by the open- market policy conference and approved by the Federal Re- serve Board. and to hold meetings with the Board as fre- quently as may be desirable. That such a policy conference is a step for- ward seems undeniable. It should be pointed out. how- ever. that the executive committee of five members is made up of the same personnel which formerly composed the Open-market committee. Legislation on the third pro- posal viz: Open-market Operations should require the sanction of at least five members of the Federal Reserve Board. is therefore still necessary. 50 CONCLUSION During the period 1922-1927 the Federal Reserve System had to deal with two unusual monetary problems which directly affected its credit policies. first. that created by huge gold movements, and second. the problem of international monetary stability. In addition. there were the continuing problems relating to stability in the money market and the attitude of the Reserve System to those business fluctuations summarized under the term "business cycle". Federal Reserve officials in their attempt to correct the above existing evils utilized two instruments of credit control. namely. Open-market Operations and the rediscount rate. In 1924 and again in 1927 redis- count retes were lowered at each of the 12 Reserve Banks. Simultaneously. the System made large purchases of government securities and bankers' acceptances. The immediate result was that many foreign countries were able to return to the gold standard. Due to the low rates of interest prevailing in New York City, these countries were able to obtain favorable loans and credits in this country. Our domestic situation benefited by low interest rates and early in 1925 and 1928 business was again in the upward phase of the business cycle. During the period 1927-1929 the Reserve officials failed to curb credit inflation because they 51 could not agree on a definite policy. The fact that 1928 was a Presidental year helps to explain the vacih- lating policy of the Reserve Board in attempting to con- trol credit at that period. The Glass Bill provides that the Secretary of the Treasury shall be removed from the Reserve Board in order that questions of policy may be decided without any outside administration in- fluence. In order that the Open-market privilege will not be abused in the future. the Glass Bill provides that at least five members of the Federal Reserve Board Inust pass on all Open-market Operations of the System. This provision recognizes that the primary instrument of credit control is the rediscount rate and that Open-market operations should be used with discretion. 52 CHAPTER II CREDIT GOING INTO THE STOCK MARKET. The stock market is dependent upon two prin- cipal sources for its credit - banks and large corp- orations.* Bank credit is provided directly by the member banks. When call rates are high. large corp- .orations and wealthy individuals loan their funds to the stock market. Such loans are usually classified by the reporting member banks in New York City as loans for Iccount of "others" to distinguish them from loans for "own account" and loans for corrSSpondents. Economists and students of the problem seem to agree that one of the znajor causes of the present depression was an overex- tension of credit during the period 1924-1929 which feund employment in loans against real estate. invest- :ments. and securities in the absence of a commercial de- xmand. Any legislation which aims to prevent the re- occurence of such an abuse of credit extension. should. * In many cases the loans advanced to the stock mar- ket by corporations may be said to have come indirectly frem banks. During the period 1926-1929 when corpor- atilons were loaning huge sums to the stock market they Var. simultaneously selling new securities to their “technolders and the public - including the banks. The ccfibumms headed "Investments" and "Loans on Securities" 55 therefore. prove salutary. We shall first consider the problem of bank credit; leaving the question of loans for account of "others" for the last part of this chapter. FEDERAL RESERVE CREDIT Section 13 of the Federal Reserve Act attempts to prevent Federal Reserve credit from.going into the stock market directly. The Federal Reserve System. as we have seen. was intended to be a commercial banking system and its primary purpose was to reSpond to the requirements of commerce. business. and industry. The Reserve Act provides that a Reserve Bank has the right to discount the paper of member banks, paper such as notes. drafts and bills of exchange, drawn for agri- cultural. industrial.or commercial purposes. Section 15 of the Act states that such definition shall not'in- cludc notes. drafts. or bills covering merely investments. or issued or drawn for the purpose of carrying or trading in stocks. bonds. or other investment securities. except bonds and notes of the United States Government. in the table on page 27 indicate the extent to which member banks advanced funds to corporations and in- diVi duals e 54 The Reserve Act does not, however, prevent Federal Reserve credit from going into the stock market indirectly. During 1928 and 1929 an effort was made to provide credit for trade and industry and keep it out of Speculative uses. The Reserve Banks released credit quite freely in the fall of 1928. but unquestionably the stock market received indirect assistance thereby. The money market cannot be divided into watertight compart- ments.* and Reserve credit cannot be released for any purpose without to some extent affecting all divisions of the money market. Its release for one purpose may set credit free for a wholly different purpose. HOW FEDERAL RESERVE CREDIT FLOWS INTO THE STOCK MARKET Reserve credit may flow into the stock market by the following methods: (1) Credits obtained by discounting eligible commercial or agricultural paper may be used in security Operations. There are no automatic devices or detectors for determining, when credit is granted by a Reserve .Benk in reSponse to e rediscount demand, whether the * The 1928 annual report of the Federal Reserve Board. page 8. frankly admits the error in the old con- cept of water-tight compartments as between Wall Street and the rest of the country. 55 occasion of the rediscount was an extension of credit by the member bank for Speculative use. Paper offered by a member bank when it is rediscounted with a Reserve Bank may disclose the purpose for which the loan evidenced by that paper was made. but it does not disclose what use is to be made of the proceeds of the rediscount. A farmer's note may be offered for rediscounting by a mem- ber bank when in fact the need for rediscounting has arisen because of extensions of credit by the member_ bank for stock market purposes. (2) Purchases of securities by Reserve Banks tend to relieve member banks from indebtedness to the Reserve Banks. and thus lead them to adopt a some- what more liberal lending policy. Following this "direct action" by the Reserve Banks. discount rates are usually lowered. Honey rates become easier and eventually a borrower's market is created. Individuals arethen able to borrow on security collateral at member banks. tak- ing advantage of the low carrying charges to increase their security purchases. If the Reserve Banks continue to buy secur- ities after the member banks are out of debt. the in- creased member bank reserves, as previously discussed. will be loaned to the highest bidder. which is frequent- ly the stock market. 56 (5) During 1928 and 1929 the practice arose among member banks to borrow from the Reserve Banks on their 15 day promissory notes secured by government securities.* The proceeds were then;loaned to individ- uals for stock market purposes. The 1928-1929 experience indicates that it is through this source that Federal Reserve credit can be released in a speculative market. and when so released, even though for commercial. industrial. or marketing purposes. it is quiet apt to go indirectly into the speculative loans. The Federal Reserve Board in its annual report for the year 1929 indicates the importance of the credit control problem thus.** "The protection of Federal Reserve credit against diversion.into the channels of speculation constitutes the most difficult and urgent problem confronting the Federal Reserve System in its effort to work out a tech- nique of credit control that shall bring to the country such steadiness of credit conditions and such maintenance of economic stability as may be expected to result from competent administration of the resaurces of the System." The question arises whether Federal Reserve Bank credit should be allowed to reach the stock market even *Section 13 Federal Reserve Act..Lmsnded June, 1917 **Annual Report p-16 57 indirectly or circuitously. PROPOSED NWT TO THE FEDERAL RESERVE ACT The Glass Bill. Section 11. aims to prevent the abuse of one of the practices enumerated above. namely. the lE-day promissory note privilege. The bill provides that while member banks are in debt to the Federal Reserve Bank for their own.notes secured by government securities. they shall not increase their loans-to their customers. based on collateral security. In other words. it is pro- vided that a member bank shall not simultaneously borrow on a lfi-day security note and at the same time increase its security loans. It is apparent that this proposal aims to cen- tralize large additional powers with the Federal Reserve administrators. We desire to review the issues involved in this important question. but first we shall consider the efficacy of the proposal itself. we believe the theory underlying this proposal. namely. that the Reserve Banks will be able to curb one form.of speculative activity by refusing to make loans to member banks on their 15-day security collateraled notes when the latter are also loaning funds to the stock mar- ket. is unfounded. The evidence presented before the sub- committee clearly indicates that member banks. especially those in New'York City. borrow on 15-day notes because of the greater convenience both to them.and the Federal Re- Serve Bank. we quote from.the statement of the Governor 58 of the New York Reserve Bank:* 'llmost every bank that seeks accomodation from the Reserve Bank on the security of government obligations has plenty of eligible paper to present to us and chooses the government security in preference to commercial paper. because that is a more simple operation when using individual collateral notes of different matur- ities. which they would have to submit to us.' If this form of borrowing were prohibited. the member banks would merely substitute the procedure of re- discounting eligible paper without any change in the use of the proceeds. There would be a different form of asset in the Federal Reserve Bank without in any way changing the substantial picture of the credit situation. It is believed. therefore. that this proposal would make the operation of the Reserve Banks less efficient and more expensive. It is to be noted that Section 5 of the Glass Bill empowers the Federal Reserve Bank and the Fefieral Reserve Board to prevent the misuse of Federal Reserve facilities for stock speculation.and other illicit pur- poses. If at any time it shall appear that the member bank seeking the privileges of the Reserve Bank is inp ordinately extended in stock mardet transactions or un- sound and unsafe loans. the Reserve Board. upon due notice and hearing. may suspend the facilities of the Reserve *Rearings p-Gz 59 Bank to that offending bank. It would seem. therefore. that any'misuse of the 15-day note privilege by member banks in the future will be corrected by this section. We shall new direct our attention to a con- sideration of the broader problem.which Sections 3 and 11 of the Glass Bill introduce. and which we endorse. namely.whether the powers of the Federal Reserve System should be enlarged. The controversy which these provis- ions have created centers around two questions; first. "Is it possible to 'earmark' Federal Reserve credit?" second. "Should the Federal Reserve Board control spec- ulation?" Clearly. if both of these questions are de- cided in the negative. the case for those who favor ex- tending Federal Reserve power will be materially Weakened. IS IT POSSIBLE TO 'EARMARK' FEDERAL RESERVE CREDIT? The majority of bankers who appeared before the subcommittee insisted that Reserve credit could not be 'earmarked'. The conclusions of Governor Harrison.of the New York Reserve Bank are in accord with this view and my be quoted as representative: '1 do not believe that it is a practical thing. re- sardless of our legal rights. to inquire what a borrowing member bank is going to do with the money it gets from thll Federal Reserve Bank. for the reason that it is an 60 impractical thing for the Federal Reserve Bank to try to control the application of the proceeds of a loan. In the first place. by and large. the banks themselves do not know what particular transaction or group of tran- sactions have made the loan necessary. They are running various departments. and at the end of the day they con- centrate all their figures and find they are deficient in their reserves and they come in to borrow because the law requires them to maintain their reserve position. It is the sum of all transactions that make it necessary."* Those who contend that it is impossible to arrange things so that credit can be siphoned into in- dustry and commerce and withheld from stock speculation claim.that to place in the hands of the Federal Reserve administrators the power to "condition“ the creation of credit by stipulations as to its use would be an exper- iment in bureaucracy of the most dangerous kind. It is. and should be. they assert. the sole business of the Federal Reserve System to deal with its member banks. and it is and should be the sole business of its member banks to determine what are the needs for credit creation and what are its preper uses. in so far as they can. There are many. including Senator Glass. who contend that Federal Reserve credit can and should be 'earmarked'. This view. to which we subscribe. holds ~------------------.---.----..-.---.-----.------.------- * Hearings page 48 61 that a Federal Reserve Bank should know for what purpose its loans are being used. for the same reason that a member bank knows to what extent and purpose its loans are being used by its customers. Even in the large New York City banks to which Governor Harrison has referred. bankers agree that loans for carrying investment securities can be 'earmarked'. Mr. Wiggin. of the Chase National Bank of New York. test- ified that "while you cannot 'earmark' any one loan. you can tell when the current is setting in or against that direction". It is usually impossible to say that a loan to a member bank is granted for this or that specific pur- pose. However. it would be possible to determine whether the loan and investment policies of a bank are incon- sistent with the purposes of the Federal Reserve Act. and. if so. to refuse accomodations to such banks. SHOULD THE FEDERAL RESERVE BOARD CONTROL SPECULATION? Since the stock market crash of 1929. the view seems to be gaining wider acceptance. among students of the problem. that the Federal Reserve authorities not only have the power to control speculation. but that it is their duty to do so when they feel that increasing speculative activities are tending to endanger the bank credit situation. This view holds that if the System is 62 to function in the discharge of its full duty. it must occupy a commanding position over the credit situation in the United States and in order to do this. it must be placed in.a position where it can control all the elements that enter into the credit situation. It is evident that bank loans made possible the commodity inflation of 1920. the land inflation of 1920 to 1927. and the security inflation of 1927 to 1929. Buyers would exhaust their purchasing power rather quick- ly if the banks did not replenish it. A real degree of responsibility therefore comes back to the banking sys- tem.of the country. If any power can prevent the con- ditions which lead to crises. that power lies with the banking system. The philOSphy of our present banking system is summarized by one authority in the following language:* "When a crash comes in Wall Street. Federal Reserve banks are expected to step in and to play a courageous and heroic part.---Furthermore. Federal Reserve banks are asked to help repair the damage after the storm has passed. to mitigate the harmful effects upon business. and to restore a healthy condition in industry. In other words. we insist that the Federal Reserve shall assume * Edie. L. D.. "The So-called New Era". See Pro- ceedings of the Academy of Political Science. January 1950 page 516 65 responsibility in the midst of a crisis and in the period of convalescence after the crisis. but according to our traditional philosophy. we have not been willing to assign them the reSponsibility for the prevention of a crisis. We must come to the principle that the function of a central bank is to prevent crises." The necessity for regulating bank credit in order to prevent crises is stated thus:* "The prevention of crises requires the prevention of the conditions which make crises inevitable. It re- quires the prevention of a train of circumstances which lead toward an unstable market position. These ante- cedent circumstances run according to a fairly simple and standard pattern. In simplest terms. every crisis must be preceded by rising prices of the goods or prOperties in the given market. these rising prices being supported. made possible and even stimulated by bank credit. The prices rarely if ever could go through the rising wave if they were not aided and abetted by bank credit." This view holds that greater stability and more continuous prOSperity depend on curbing the excess. and stimulating the deficiencies of business. and es- pecially upon curbing the excess. for overproduction. at least in the key industries. and overSpeculation are the forerunners of all business depressions. * Ibid page 516 64 Those who contend that the Federal Reserve Board should not control Speculation assert that con- ditions. to a large extent. bring about Federal Reserve policies rather than Federal Reserve policies bring about conditions. This group. composed largely of bank- ers. insists that the Federal Reserve System should keep its hands off of the Speculative field and Should keep within its real province of furnishing credit to member banks. I Much weight is attached to the argument that any attempt to control the security markets will auto- matically work to the detriment of business and industry. As expressed by one leading banker:* "The Federal Reserve System was adopted after long discussion and debate. Its object was made perfectly clear to the lowliest. It was to co-ordinate the activ- ities of 26.000 banks. mobilize their credit resources and marshal them constructively for the nation's business. But it was never intended that it should become the ring master of the stock exchange. These two functions are incompatible. You cannot raise the interest rates upon the broker without raising them in every field of activity. If the American banking system is to be made * Stokes. E. C.. Chairman of the First Mechanics National Bank. Trenton. New Jersey. Bankers' Magazine- Vol. 118 page 718 65 the regulator of the stock exchange and curtain its activities by high interest rates. than for every mer- chant. for every manufacturer. for every business man. for every farmer. for every promoter. or pioneer through- out the length and breadth of the land. it will make dearer the necessary capital without which.America cannot onward move." AS intimated previously. we believe that prompt action in raising the rediscount rate will effectively accomplish its object without retarding to any degree legitimate business. Business does not mind a high rate for a Short while - up and then down. The thing that is injurious to business is a prolongation of a rate structure which gradually kills off the bond and mort- gage markets. thereby making it more difficult for large corporations to extend their plant operations and ex- tensions. When a member bank seeks to replenish its re- serve at the Reserve Bank. the latter Should have the power to look behind the impaired reserves and determine if stock market loans are a substantial cause of the impairment. Protection of their credit against Spec- ulative uses requires that the Federal Reserve Banks Sheuld be acquainted with the loan leicies and credit fixtensions of their member banks. The use of bank loans 8gainst securities are greater when Security values are t0C) high than they are when security values are reasonable, 66 and the Federal Reserve authorities should. therefore. properly consider the level of security prices in fram- ing their money market policy, just as they may prOperly consider with concern a Speculation in commodities which suddenly raises commodity prices. Those who hold that the Federal Reserve Board Should not control Speculation seem to overlook the im- portant fact that the entire credit structure ultimately rests upon Federal Reserve credit as a base. Increased loans and investments of member banks. regardless of the purpose for which the loan or investment is made. result in the creation of additional deposits. A growth in deposits. resulting from an increase in any class of loan or investment. in turn increases the reserve re- guirements of member banks and consequently their demand for Federal Reserve credit. An excessive or too rapid growth in any field of credit. whether it be commerce. industry. agriculture. or the trading in securities is a matter of concern to the Federal Reserve System. Because the System has a broad responsibility for the general soundness of credit conditions. and be- cause a growth of bank credit for any purpose ultimately leads to a demand for Federal Reserve credit. we believe it is the duty of the Federal Reserve Board to use its influence against undue credit 6Xp8n810n in any direction. 67 MEMBER BANK CREDIT That member banks have had an important part in advancing credit to the stock market cannot be denied. The table on page 27 Shows that "loans on securities" for all member banks increased 129 per cent between 1921 and 1929. During this same period. "all other loans". which consist largely of commercial loans. show- ed a negligible growth and remained practically constant. notwithstanding the fact that money was abundant and cheap. Presumably the Slow growth of commercial loans was not due to any inability to get accommodation. but to certain other factors. Business was able to finance itself by issuing securities and it needed fewer dollars per unit of business. The tendencies of prices to fall kept business alert not to be caught with large inven- tories on a falling market. Member banks finding themselves with large excess reserve. as a result of gold imports and Open- market purchases by the Federal Reserve Banks. and not having the usual demands for commercial loans. loaned $5,695,000.000 on securities and purchased 34.050.000.000 of investments. bonds and mortgages. between 1921 and 1929. An examination of brokers' loans made by re- porting member banks in 1‘ew York City discloses that during the period 1926-1929 interior banks increased their'loans at a much higher rate than New York City banlgg. Loans for interior banks increased approximately 68 $1,000,000.000 from $2,000,000.000 to $3,000,000.000 whereas loans for New York City banks showed no material increase. fluctuating about the $1,000,000.000 figure.* The question arises whether high call loan rates Served as an inducement for the interior bankers to slight legitimate commercial and agricultural loans for the higher return. No statistical data were pro- duced. but the testimony of several witnesses indicated that such a Situation "might" have existed. The testimony before the subcommittee indi- cated that much of the credit used for stock Speculation in 1928 and 1929 was created by inexperienced and un- scrupulous bankers. Two of the largest bank failures in the country during 1930. the Bank of the United States in New York City, and the Bank of Kentucky in Louisville. resulted largely because bank deposits were used for security promotions by the officers of the banks. THE PROBLEM OF TIME DEPOSITS The Federal Reserve Act in its revision of the percentage of deposits which must be retained as bank re- serves.** has Opened the way for many changes in banking * Hearings page 156 ** Before 1914 as large reserves were required on time deposits as on demand. By the Reserve Act. the re- serve on time deposits was lowered to 5 per cent. and by 69 practice. Some of these changes are now becoming appar- ent. One in particular has played an important part in recent years in the expansion of bank credit, namely, the growth of time diposits in many banks to an equal place with demand deposits. This growth for member banks during the period 1920-1929 is indicated in the following table:* Date Demand Deposits Time Deposits Dec. 51,1919 $16.065.000.000 $5,506,000.000 Mar. 10,1922 15.484.000.000 6,662,000,000 Dec. 51,1929 18.861.000.000 15.255.000.000 Just what these largely increased time de- posits represent is a much-debated question. One author- ity states as his tentative conclusion that, "time de- posits in commercial banks are to a considerable extent genuine Savings deposits, that the convenient facilities and vigorous advertising campaigns of these banks have brought out considerable new savings. There are, however, undoubtedly large time deposits which represent transfers amendment in 1917 to 5 per cent. for all member banks. The reserve on demand deposits was reduced by the Reserve Act to 18.15 and 12 per cent, depending on whether the bank was located in a Central Reserve city, or a Reserve city, or any other city or town. By the amendment of 1917 the reserve on demand deposits was again lowered to the present rates of 15. 10 and 7 per cent. * Demand deposits are defined by the Reserve Act as 7O from.demand deposits of corporations and other funds not needed for immediate use."* The recent growth of time deposits raises the important question as to whether reserve requirements behind these are adequate. J‘rior to 1929 many banks, cepecially in the West, adopted the practice of manipu- lating their reserves and transfering demand deposit accounts to their time deposit accounts in order to avail themselves of the 5 per cent reserve on time deposits.** The reason for adepting this practice is obvious. A bank must keep 7.10, or 15 per cent in reserve behind its demand deposits, according to its location. A country bank has the lowest rate; the banks in New York and Chicago the highest. On these reserves deposited at their Federal Reserve Bank they receive no interest. Other things being equal, a bank would rather have a time deposit than a demand deposit. By transferring demand deposits to their time deposit accounts, these banks were in a position to those payable within 50 days upon demand. and time deposits as those payable after 50 days. * Burgess, w. R.. op. cit. page 58 ** Statement of Comptroller Pole. Hearings page 27 71 increase their loans to the highest bidders, who in 1928 and 1929, as we know. were stock market Operators and promoters. This fact explains to a brge extent the rapid growth of time deposits during the years 1928 and 1929. PROPOSED AMENDMENT TO FE ERAL RESERVE ACT In order to strengthen further the Federal Re- serve System in cOping with undesirable Speculative deve10pments, the Glass Bill, section 15. provides that the distinction between time deposits and demand deposits, so far as reserve requirements are concerned, Shall be eliminated. It is evident that the distinction between these two types of deposits has led to many abuses and has been a factor in making possible a growth of bank credit without a corrSSponding growth of reserves. The Glass Bill prOposes to remedy such evils by eliminating the discrepancy now existing in favor of time deposits. By requiring the same reserve requirement for both classes of accounts, the Bill recognizes the fact that, in effect and substance. they are identical. The objection may be raised that such a pro- posal at this time is deflationary in character. By raising the requirement on time deposits to the level of those on demand deposits, the proposed amendment vvould increase reserve requirements by $152,000,000 a 72 year for five years with an ultimate increase of $660, 000.000.* Unless there were a contraction in the amount of member bank deposits, this increase would result in an addition of about $250,000,000 to the gold requirements of the Federal Reserve Banks.** Such an increase in gold requirements, it may be urged. would be an influence in the direction of credit contraction without regard to the course of business. It should be pointed out, however, that the preposal increases the reserve requirements gradually over a period of five years so that the money market will have sufficient time to become accustomed to the change. Evidence shows that at the preSent time banks have sufficient resources to satisfy the demands of business. This favorable credit Situation will be an important factor in bringing about the next upward movement in the business cycle. The requirement of larger reservssfor time de- posits is intended also to provide for greater liquidity on the part of banks. Under existing conditions, in case of a run on a commercial bank, the demand deposits * Federal Reserve Bulletin April 1932 page 214 ** Reserve Banks are required by law to maintain a reserve of 55 per cent in gold in lawful money behind member bank deposits. 73 may be withdrawn by check through the clearing house and the bank's liquid assets exhausted. while the time depos- itors, after waiting 50 days, discover that their claims cannot be paid until such time as the bank's "frozen" assets can be liquidated. It would seem that if the banks have the privilege of withholding a time or savings de- posit for 50 days. the depositor should be entitled to protection. The Glass Bill provides for the segregation of the banks assets behing the savings deposits. Under this provision savings depositors are assured of the ul- timate solvency of their claims. We are now ready to consider the third and last form of credit upon which the stock market is dependent. LOANS FOR THE ACCOUNT OF "OTHERS" The great 'bull' market of 1927-1929 was unique in the fact that it was financed largely by cre- dit secured from non-banking sources, and only to a small extent by loans secured from commercial banks directly. During the period from December 51,1927 to October 4.1929, the total outstanding loans and invest- mants of all member banks increased from 354.250.000.000 to 555.910.000.000. andincrease of 4.7 per cent, or at the rate of about 2% per cent a year.* Obviously, * These banks represent nearly 75 per cent of the country's commercial bank resources. 74 there is nothing alarming about such a growth. which is rather closely parallel to the;normml.annual growth in population. During the corresponding period from January 25,1928 to October 2,1929, loans for account of others increased from $1,041,000.000 to 55.907.000.000, an in- crease of 275 per cent. 0n the latter date, loans for account of others consitituted 57% per cent of the total brokers' loans. Savings, profits and other free funds, which normally would be going into permanent investments, were attracted to the stock market for investment or loan. In the government statistical year ending June 50,1929, for the first time in twenty years. the aggregate of savings deposits in the United States showed a decrease.* This decrease in savings deposits reflects the changing attitude of individuals who, previously, had been Sat- isfied to receive the regular 5 and 4 per cent rate of interest on their savings. Every part of the country was undergoing the pressure of rising interest rates. The market had found a way to go around the banking system to the original source of funds. * See "Proceedings of the Academy of Political Science" Vol. 15 January 1950 page 554 75 BUSINESS CORPORATIONS SUPPLY LARGE SUMS Questionaires Sent by the subcommittee to seven New York City banks which handled in 1929 two- thirds of the brokers' loans for the account of "others". indicated that this vast volume of funds came from the following sources:* SOURCES OF LOANS FOR ACCOUNT OF "OTHERS" Business Corporations 58% Investment Trusts 8% Individuals 18% Foreign Banks 7.5% Foreign Individuals 2% The above calculations show that loans for the account of "others" originated in the main from business corporations.** If investment trusts are included, the total loans for "others" by domestic corporations to the stock market in 1929 were 66 per cent. thus indi- cating that any effort to control the expansion of such loans through laws affecting lending corporations direct- ly, would reach the bulk of such advances as are made through the New York reporting member banks. * Hearings page 1024 ** These funds were derived in part from profits and in part through the sale of securities. 76 POSITION OF LOANS FOR "OTHERS" IN THE CREDIT STRUCTURE Brokers' loans for the account of "others" constitute a peculiar development in the credit structure, since. unlike bank loans. they do not give rise to a correSponding increase in bank deposits. They represent merely the transfer of already existing deposits to other accounts. Nevertheless, in practice they con- stitute potential liabilities of the banking system. since on their concerted withdrawal they are replaced by loans advanced for the account of the banks themselves. In its annual report for 1929, appearing Shortly after the stock market crash, the Reserve Board refers to brokers' loans for the account of "others" as follows: "Loans to brokers by nonbanking lenders, although they do not directly involve member banks. have none the less an effect on the banking situation, both because the banks are aware of the necessity of taking over such loans in case an emergency develops and because their existence and employment results in a much more active use of bank deposits." Reserve officials pointed out that the danger to the credit position from such a large growth in this "bootleg" money in the market was in the irrSSponsibility of its lenders. It was said of the large corporations. individual lenders and foreign lenders who put funds into the call market that since they had no reSponsibility 77 to the money market, they might at any time withdraw their loans and leave the market suddenly void of funds, unless the New York banks assumed the loans. As we shall see shortly, this situation. while serious, was more a result than a cause of the decline. THE PART LOANS FOR "OTHERS" PLAYED IN OCTOBER, 1929 The decline in brokerage loans as reported by the New York Stock Exchange, and by the Federal Reserve Board, shows that during the last quarter of 1929 there was a huge reduction in such credit. The Stock Exchange reports for November and December Show that the total drop in borrowings in New York City by members of the Exchange amounted to $4,555,000.000 or over 50 per cent of the September 50 total of 38.559.000.000, which was the highest figure on record. From October 16 to Decem- ber 4 the Federal Reserve Board's figures of loans to New York brokers. made by New York City member banks, declined from 36.801.000.000 to $5,592,000.000, a drOp of 55.409.000.000. This decline was made up as follows: DECLINE IN BROKERS' LOANS-NEW YORK CITY MEMBER BANK (Oct. 16 - Dec. 4, 1929) Loans for own account $ 505,000,000 Loans for account of out-of-town banks 1,151,000,000 Loans for account of "others" 1,955,000,000 $5,409,000.000 78 POSITION OF THE NEW YORK BANKS The part which the New York City banks were called upon to play during the brief period after the stock market crash in 1929 from October 16 to October 50 is illustrated by the following table: TOTAL LOANS OF NEW YORK CITY MEMBER BANKS Oct. 16 Oct. 50 Total loans and investments 57.526.000.000 59.010.000.000 Total security loans 2,964,000,000 4,205,000,000 Total commercial loans 2,855,000,000 2,986,000,000 That the New York banks were called upon to shoulder a load is certainly the case. But it does not follow that the primary reason for this increased bur- den which the New York banks assumed was because the "others" became panicky. An inquiry made by oneinvestigator* among some of the leading banks of New York, and among a number of investment trusts and corporations which were lending substantial amounts on call, indicates that a very con- siderable number of loans were called by them for the purpose of buying securities. Some business corporations purchased their own stock for ultimate sale to employee, * Merriman. Norman, Ungerleider Financial Corpor- ation. New York City. 79 or for surplus account, while investing corporations bought stocks because they appeared to be too low. An indeterminate volume of loans was called for the purpose of converting the loans into bank deposits. In general, when the loans made by "out-of- town" banks and "others" were called for the purpose of converting them into bank depoSits, the funds were left in the New York banks and as a rule the latter banks took over the loans which had been made by them for the account of their customers or their correSpondent banks.* In taking over the loans the New York banks simply credited the deposit accounts of the out-of-town banks and the "others" and assumed the loan burden themselves. This shifting of loans for the account of "others" did not generally. therefore, play an important part in bringing on the liquidating movement, but appears to have been the consequence of the decline. SHOULD LOANS FOR "OTHERS" BE CONTROLLED? There is practically unanimous agreement among bankers. economists and Federal Reserve officials that loans for "others" should be controlled. To a large extent these loans for "others" represent an in- creased velocity of bank credits, thereby making * See December bulletin of National City Bank of New York, page 178. 80 Speculation on a large scale possible with comparatively little bank credit. Such a practice tends to creat fictitious security prices without adding anything to the material wealth of the country. Any effort to control the expansion of credit. such as was going on in 1928 and 1929, becomes prejudiced by the fact and to the extent that these loans for "others" can be made for Speculative purposes wholly outside of banking control. There were several occasions during this period when it is fair to say that a check in the Speculative use of bank credit was turned into an advance again by virtue of the fact that boans from "others" went up at an inordinate rate. If these loans are controlled, we may expect a more effective operation of the discount rate in regulating the flow of credit. Whether loans for the account of "others" can be controlled is a diSptted question. The New York Clearing House in November, 1951 passed a ruling which forbids its member banks to act as agents in placing loans to the stock market for the account of "others". But this ruling does not prevent funds from being loaned to the broker direct or through a private banker. If the banks are prohibited from acting as agents in placing such funds, it is likely that high rates during periods of wideSpread popular Speculation would tempt the banks or large private banking houses to develop Special agencies for placing these loans. 81 HOW CORPORATIONS MAY BE PREVENTED FROM LOANING FUNDS TO THE STOCK MARKET It is imperative, therefore, to get at the source of the loan in order to assure satisfactory control. While it may not be possible to control individuals from loan- ing direct to the call market, there is a possibility that corporations not engaged in the banking business might be so controlled by statutory prohibition. The power derived under the interstate commerce clause in the Constitution ( Article 1. Section 8 ) is invoked in the Glass Bill against corporations engaged in interstate commerce by prohibiting them from.making any loans outside of their particular businesses. CONCLUSION It has been the purpose of this chapter to Show how credit flows into the stock market and to indicate how the Glass Bill aims to prevent any future misuse of credit for Speculative purposes. FEDERAL RESERVE CREDIT- Sections 5 and 11 of the Glass Bill aim to place the reSponsibility of credit inflation on the Federal Re- serve System. Credit conditions are of major importance in the upward movement of the business cycle and in pre- cipitating the decline, so that the first and most im- portant method of controlling the business cycle and 82 preventing excessive expansion should be found in the fundamentals of our banking Situation. Additions to credits which cannot beeconomically validated by a commensurate effect in actual production are Specula- tive, and as such Should be subjected to control. so that business and industry can be maintained in a healthy state. Such control is primarily the respon- sibility of the Federal Reserve System and is so recog- nized in the Glass Bill. MEMBER BANK CREDIT Two definite advantages will result from the enactment of the proposed amendment rebative to time deposits: 4 (1) It will remove the desirability of bankers to increase their credit facilities in order to take advantage of high interest rates in a given industry or business. (2) More protection for time depositors is assured. Time deposits will be on an equal basis with demand deposits in respect to reserve requirements. Segregation of assets will provide additional safety for time depositors. When such advantages become actualities. we may once again look forward to an era of conservative banking. 83 LOAN FOR ACCOUNT OF "OTHERS" The experience of 1928 and 1929 has demonstra- ted that as long as brokers and dealers are permitted to borrow huge sums from lenders wholly outside of the control of the banking system and who have no reSpons- ibility to the money market, the effectiveness of the discount rate is very much minimized. The passage of the Glass Bill will prevent large corporations from loaning funds on the call loan market, with the result that the Federal Reserve Banks will have a more direct control over Speculation. If the superabundance of bank credit did not arise in the first instance, the problem of credit con- trol would not exist. AS the foot-note on page 52 in- timates, the problem of controlling loans for the account of "others" would. in a large measure, be eliminated if banks were prevented from making loans to corporations when the evidence disclosed that the funds were not be- ing used for productive purposes. The real problem then is to increase the powers of the Federal Reserve author- ities. and to impose upon them the reSponsibility of regulating the flow of credit in accordance with the legitimate demands of business, commerce, and agriculture. The importance that credit plays in our econ- omic structure was clearly recognized in a report on the problem of unemployment made by the President's Commit- tee in 1925 in the following paragraph:* "Credit conditions are of major importance in the upward movement of the cycle and in precipitating the decline, so that the first and most important method of controlling the cycle and preventing excessive expan- sion Should be found in the fundamentals of our banking Situation. Control of expansion so that production is allowed to increase and business is actively stimulated to a preper degree. while expansion is checked at the stage when it becomes dangerous, is a fundamental prin- ciple already a:cepted by bankers.* * Quoted from the Proceedings of the Academy of Political Science. January, 1950 page 511. 84 85 CHAPTER'III SECURITY AFFILIATES A great evil that has deve10ped in the bank- ing system in recent years has been connected with affiliates. particularly S0-called security affiliates. companies organized to sell bonds and stocks in com- petition with private investment banking houses. These companies, often owned and managed by the same people as the banks. are nevertheless independent corporations, and since they do not receive deposits and are not chart- ered as banks. have authority under the law to do many things that the banks themselves are not permitted to do. It seems evident,theref0re, that some form of control over these affiliates is necessary. A brief history of the security affiliate movement will serve to give us a better understanding of this important problem. BRIEF HISTORY OF SECURITY AFFILIATES The tendency to separate commercial banking from the merchandising of securities early became mani- fest in this country. Many of the failures of the early state chartered banks resulted from unwise and frozen security Operations, and merely served to increase the desire of legislatures to prevent the banks from en- gaging in investment banking activities. To legal 86 restrictions on the power of the banks to engage in investment banking may be ascribed the great development of corporations affiliated with banks in recent years. The first security affiliate on record was organized in 1908 by the First National Bank of New York City.* The method adOpted in organizing this company was followed as a model by many other banks subsequently. Today, however, a great diversity of practice exists among the banks possessing security affiliates as to methods of organizing and Operating them. The security affiliates may be orgainzed in any State, and several of them Operated by New York banks are organized in Delaware, because of more satis- factory charters available there.** The directors and officers of the security affiliate may or may not hold Similar posts in the bank. In some cases. a completely different set of individuals hold such posts in the two affiliated institutions, but it goes without saying that, through identity of stock owenership, there is identity of real control over the two. * Commercial and Financial Chronicle. Vol. 86 February 28. 1908 page 522. ** All affiliates are State-chartered corporations. The majority of them. or about two-thirds, belong to net- ional banks, and about one-third to State banks. The reason for this difference seems to be that State charters 87 DEFINITION OF SECURITY AFFILIATES The Senate subcommittee of the Committee on Banking and Currency defined a security affiliate for its questionaire as a corporation: (1) A part of all of the stock of which is depos- ited in trust for the benefit of stockholders of the bank; or (2) The shares of which are sold in units in combination with shares of the bank; or (5) A controlling interest in which is held by the same interests which control the banks; or (4) A controlling interest in which is held by the bank; or (5) A controlling interest in which is held by some other security affiliate of the bank. The definition used by the subcommittee would cover virtually every usual case, with the exception of bank-holding companies, in which case the security com- pany controls the bank, instead of the reverse. FUNCTIONS OF SECURITY AFFILIATES The more important functions of security affiliates as indicated by the answers to the subcommittees' are often more liberal than national charters, and grant powers which make an affiliate superflous. 88 questionaires are as follows: (1) Wholesalers of security issues. purchasing entire Offerings or participating in Syndicate groups which acquire whole issues of securities from corporations and governmental bodies. (2) Retailers of securities. maintaining corps of salesmen and often branches in States other than that in which the bank Operates, for the dis- tribution of stocks and bonds to institutions and pri- vate investors. (3) Holding and finance companies, carrying blocks of securities for control or otherwise. which the bank could not or would not list among its own investments. (4) Investment trusts, buying and selling secur- ities acquired purely for investment or Spec- ulative purposes. (5) An assets realization company, to take over from the parent bank loans and investments which prove doubtful or nonliquid. _ (6) A medium for supporting the market for the banks own stock. (7) A real estate holding company. In most cases the security affiliates have ex- ercised a combination of these functions. and in some instances they have exercised all of them. A majority of the banks possessing security affiliates have but one Such organization, but in other cases more than one cor- poration has been organized, at times with a Special- ization of function among them. Where a group of affil- liates is built up in this way, their affairs frequently become interlocked through mutual loans and stock hold- ings, so as to make any subsequent separation difficult, even if thought desirable. JUSTIFICATIONS FOR SECURITY AFFILIATES Those who uphold security affiliates advance two justifications for their existence: (1) They provide a complete financial service under one "roof". (2) They enable national banks to compete with trust companies, state and private banks. The security affiliates are required to render an essential investment banking service in financing large corporations and other clients of the banks. This is a service which cannot, except within very narrow limits, be fulfilled by the parent bank. Unquestionably many corporations and individuals are benefited by such a concentration of financial services in one institution and appreciate the privileges and facilities that such a departmental system offers. It must be admitted. however, that, as a rule, the advantage exists only when securities are advancing. 89 90 During a period of depression. many security affiliates discontinue their activities altogether and mark time until the next general advance in securities. Unless the affiliate has set up a surplus, the parent bank is called upon to advance running charges to it and the interests of depositors and stock holders alike are thus infringed upOn. A more serious defect is the diverse character of commercial and investment yanking. The commercial banker is engaged in the granting of short time loans; he must be acquainted with short time interest rates and particularly with local conditions. The investment banker, on the other hand, must be a student of national and international affairs. He deals in long time loans and money rates. When the officers of the bank and the security affiliate are identical, the difficulty of con- sidering both interests with the same degree Of intell- igence becomes apparent. A strong argument is advanced in favor of the second justification for security affiliates, viz., that they enable national banks to compete with trust com- panies, state and private banks. In addition to providing long-term funds for customers of the banks. affiliates bring to the bank a great deal of banking business such as trustseships, fiscal agencies. transfer agencies, registrations, de- posit accounts, and so forth. State institutions can 91 perform these services directly, and to place any re- strictions on national banks which would prevent them from rendering the same service through affiliates, it is asserted, would place them at a disadvantage in com- petition with state institutions and private bankers and would undoubtedly result in the withdrawal of many nat- ional banks from the Federal Reserve System. Trust companies and state banks are eligible for Federal Reserve membership but a great number have not joined because of the more rigid national banking laws. In recent years national banks, by means of their security affiliates, have been able to compete for the investment business with the state and private insti- tutions. Those who favor Security affiliates claim that this form of competition must be maintained if member- ship in the Federal Reserve System is to be encouraged. The Source of the trouble lies in the lax banking laws of many of the states. The competition of State banks and trust companies operation under loose State laws has been so great that it has forced the more conservative national banks to take more or less un- warranted chances in running their business. The net result of this competition between the State banking forces Operation under loose laws and the national banking system Operation under much more strict laws has been the disregard of a great many of the 92 fundamentals of the banking business; taking chances with depositor's money, and the incorporation and rapid growth of the affiliate business, giving an outlet to that Spec- ulative type of business quite contrary to legitimate com- mercial banking. From what has just been said it would seem that the immediate sulution to the problem of controlling the competition between state institutions and national banks and thereby providing an answer to the second argument advanced in favor of affiliates, rests with the individual states. In this connection it is gratifying to note that in January, 1951, the Superintendent of Banks of the State of New York introduced a bill before the State Legislature which proposed to amend the banking laws in order that the State examiners would have more control Over the activ- ities af all State banking institutions. A strong indictment of security affiliates is found in the Report of the Comptroller of the Currency for 1920.* portions of which are herein quated. The Report is particularly interesting because it required ten years be- fore any definite ligislation was preposed to remedy the evils mentioned therein: "many of the flotatbns promoted by the security corporations which are operated as adjuncts to national banks have proven disastrous to their subscribers. and have in some instances reflected seriously not only upon *Quoted on page 1067 of Hearings 95 the credit and the standing of the 'securities companies' by which they are Sponsored, but also in some cases have damaged the credit and reputation of;nati0nal banks with which the 'securities companies' are allied. "In times of rising prices and active Speculation some of these auxiliary corporations have made large profits through their ventures and syndicate operations, but their losses in other periods have been heavy, and they have become an element of increasing peril to‘the banks with which they are associated. "These ancillary companies are being used with in- creasing frequency for promotion of Speculation and for dealing in bonds and stocks, often those of new and un- seasonsd issues, and which are attended with imprOper hazard risk, and as a means of enabling banks to do. in- directly through their instrumentality, things which they can neither safely nor lawfully do directly." The following table shows that the banking affiliate has become an exceedingly important factor in the origination and distribution Of securities, bearing out the Comptroller's predictions: 94 TOTAL SECURITY ORIGINATIONS 1927 1928 1929 Bank Affiliates 12.8% 25.5% 41.5% TOTAL SECURITY PARTICIPATIONS 1927 1928 1929 Bank Affiliates 20.6% 20.4% 44.8% The above table indicates that in 1929 bank affiliates of the country originated 41.5 per cent of the new securities Offered to the public. In addition, the table shows that bank affiliates distributed 44.8 per cent of the new security issues. It was to be expected that the tremendous growth of security affiliates would be accompanied by some abuses. These will be considered Shortly. This raises 'the question whether affiliates should not be abolished altogether. The Glass Bill provides for their gradual abolishment over a period of three years. Among the more important reasons advanced why affiliates should be abolished are the following: (1) They played an important part in the Spec- ulative orgy during 1928 and 1929. Some of the banks have at times had a major interest in the operations of their affiliates. Frequently, the affiliates have been little more than market Operators. 95 (2) By reason of their access to the credit facilities of the banks with which they are affiliated, and the access of the banks to the Federal Reserve System, it has been made very easy for investment affiliates to Spread into dangerous zones. Knowing its access to the resources of the bank in case of need. secur- ity affiliates tend to assume various commitments less cautiously than do private investment banking houses. (5) A national bank lends not only its own cap- ital, but the money of its depositors, and in doing this is not expected to tie up its funds in long- time and unliquid loans in doubtful ventures. The affiliates theoretically invest and Speculate with their own funds - not with the funds of depositors. But as a matter of fact, evidence Shows that affiliates, as a result of interlocking directorates and a community of interest, often draw and absorb large sums of money from the allied banks and sometimes also borrow heavily from other banks which Operate affiliates, and so on, in an endless chain of reciprocal borrowing and mutual lending for the accomodation of Speculative cliques. (4) The bank is closely connected in the public mind with its affiliates and should the latter suffer large losses it is practically unthinkable that they would be allowed to fail. Instead, the bank would normally support it by additional loans or other aid. thus 96 becoming more deeply involved itself. The knowledge that the affiliate had suffered large losses may in itself be sufficient to cause unfavorable rumors, however unjustii fled, to Spread about the bank. (5) The goodwill of the bank with its depositors may be adversely affected to a serious degree when the latter suffer substantial losses on security issues purchases from the affiliate. Because of the tendency of the selling organization of the affiliate to consider the banks depositors as its preferred list of sales prOSpects, this condition may become an important handicap to a bank during a major period of security mar- ket deflation. (6) The bank may lend much more freely to customers on issues Sponsored by the security affiliate in order to facilitate their distribution, than it would otherwise do. Also. it may prove more difficult to insist upon the_maintenance of adequate margins on these secur- ity loans than on other such advances, in view of the fact that customers are encouraged to make the loans by the bank's own affiliate. . It must be admitted that the above abuSeS, actual and potential, make out a strong case against the security affiliate. The question arises whether the affiliate Should be divorced from the parent bank or be allowed to exist indefinitely as today constituted. 97 provided it exists under strict regulations. The Glass Bill. Section 16. provides for separating security affiliates from national banks after a period of three years. and makes the same provision in Section 5 for State banks which are members of the Federal Reserve System. The chief argument advanced by bankers in- opposing this provision of the Bill is that when secur- ity affiliates are withdrawn from the investment field, there will be an inadequate fiscal mechanism for dis- tributing the seucrities of industry as well as for the government itself. It should be noted, however, that with reSpect to the affiliate relationship the Bill allows a period of three years for a reorganization to be made, and at the end of three years it is not required that the affiliates shall be dissolved or that they shall go out of business. It is only required that they shall be disassociated from the institutions taking commercial and savings deposits. In addition to the requirement that the affiliate be divorced from the parent bank within a period of three years, the Bill provides in various ways that during this period the affiliates shall be subject to examination and control by the ComptrOller of the Currency. The main provisions are as follows: 98 (1) Limit the total amount a bank can loan to affiliates regardless of their number to 10 per cent of the capital and surplus of the parent bank. The evidence before the subcommittee showed a very high development of loans to security affiliates. Under such a system, the affiliate becomes in effect a brokers' department of the bank. It makes loans pri- marily to brokers and dealers, and borrows from the parent bank for that purpose to the full extent that the legal requirements permits. In the case of a bank having two or three strong affiliates, each one adequately capitalized and entitled to credit, it might Seem that each one ought to be treated on its own merit. This proposal. however, recognizes the fact that a bank's primary obligation is to its depositors and the public and not to its affiliate or stockholders. In the future it is to be hOped that this pro- posal will prevent an inordinate growth of affiliates such as occurred in the case of the Bank of the United States in New York City.* All affiliates will be regarded as a unit under the law and the existing law, which limits such loans by a bank to its affiliate to 10 per cent of the bank's capital and surplus, will apply to * This bank in 1929 had 59 different affiliates. 99 the aggregate and not separately to each affiliate. (2) Examination of the affiliate coincident with the parent bank's examination by the Comp- troller of the Currency. The comptroller has sought, and in many cases secured, permission to examine security affiliates as part of the examination of banks. However, he did not demand this as a right, and in some instances such per- mission was refused as not coming within his province. That some of the larger banks are already in accord with this proposal may be seen from the following statement taken from the testimony of the Chairman of the Chase National Bank of New York City:* Mr. Wiggin. At the time of the usual examination of the Chase National Bank by the bank examiners, one or two examiners are assigned to examine the Chase Bank's affiliates. Senator Bulkley. Do I understand they have an absolute right to do that? Mr. Wiggin. It is by courtesy. Senator Bulkley. DO you think that should be? Mr. Wiggin. Oh, I would go the whole distance and make it obligatory. This examination was first done at * Hearings pages 192-195 100 the time of our May, 1922 examination, and it has been followed regularly since that time. (5) Publish periodic statements of conditions, 1.8. a balance sheet and an income account. It is suggested that the affiliate issue its statements of condition semi-annually. This would be in accordance with the intent of the second prOposal. and is in agreement with the general publicity program of many corporations. The balance sheet should be a comparative statement showing the difference between the original cost price and the current market price of the securities held. The securities should be bisted according to groups, such as public utility. industrial. railroad, et cetera, in order that the public may be acquainted with the kind and character of the assets held. The balance sheet should also Show the amount of money which the parent bank has loaned to the affiliate. The income account Should show the amount and the source of all incomes received by the affiliate. (4) Prohibit the affiliate from dealing in the stock of the bank. Activities of affiliates in supporting a bank's Own stock have been the source of substantial loss in individual cases. It was precisely this type of activity which brought on the collapse of the Bank of the United 101 States and contributed to several large bank failures eleswhere. The bank merger movement of the last few years has at times resulted in large commitments in a bank's own stock, as efforts are made to advance the price of the stock of a bank in order to make it more attractive in an exchange for shares of another insti- tution. Also, certain mergers have involved agreements by the absorbing institution that shares of the bank being absorbed would be purchased by the security affiliate of the former if desired, and such arrangements have at times resulted in the affiliate acquiring quite large blocks of the bank's shares. Efforts made in some cases to push the sale of the bank's stock through the affiliate to depositors of the institution hurt the position of the bank when its shares suffer a major market decline subsequently. (5) Prohibit the affiliate from sellingsecurities to the bank for the trust account or for the commercial and savings departments. In the hands of a bank Officer who was not of the highest standard, there is some danger in the ex- ercise of the fiduciary function in that the security affiliate may sell undesirable securities to the trust department. When dealing with its affiliate, the bank is really dealing with itself in view of the identity of ownerhhip and management that is created. 102 (6) There should be a complete separation of the affiliate from the bank by placing the affiliate stock in the hands of trustees for the benefit of the stockholders of the bank. The affiliate should have its own capital and stand on its own feet. This prOposal. which aims to have the funds that support the security business segregated from the commerc- ial bank, like the preceding ones, excepting the first, has already been adOpted by the more successful security affiliates. The First Security Company, previously referred to, was the first to adept such a policy. This company was organized as a corporation endowed with general powers. having a capitalization of $10,000,000 equal to that of the bank. The bank then declared a cash dividend of 100 per cent. which, however. was not actually dis- bursed to its stockholders. Instead, with their prior approval, this sum was directly subscribed to the stock of the security company. The stock was then deposited under a trust of which six senior officers of the bank were made trustees. Shareholders of the bank had indorsed on their stock certificates 8 statement that they had a beneficial interest in an equal number of shares of the security affiliate, which were to be insepargble from those of the bank. 105 CONCLUSION These proposals are a forward step in bringing security affiliates under the control of the Federal Re- serve authorities without at the same time inflicting too severe penalties upon them. The adOption of these proposals should help materially to check the Spiral of credit inflation by minimizing the possibilities for security Speculation and manipulation by national banks and their affiliates. The prOposals aiming to give more publicity to the operations of the security affiliates are ex- tremely important in a program of credit control. In those cases where the Comptroller has not had access to the books of the affiliate. his examination of the parent bank could not be complete.- He should not be held reSponsible for the solvency of a bank without having the authority to examine the security affiliate as well. The determination of the earning power of security affiliates in any one year, as is the case of all companies whose assets consist chiefly of securities held for investment, is complicated by variations in the market values of stock and bond holdings. Evidence pre- sented before the subcommittee indicates that the whole- sale underwriting of securities tends at times to leave the security affiliates with big unsold commitments that, 104 in times of rapidly declining prices. may result in large losses.* Activities of a bank's security affiliate as a holding or finance company or an investment trust are alSo fraught with the danger of large losses during a deflation period. Bank affiliates of this kind Show a much greater tendency to Operate with borrowed bunds than do organizations of this type which are independent of banks, the reason being that the identity of control and management which,prevails between the bank and its affiliate tends to encourage reliance upon the lending facilities of the former. ' We conclude that any business which is subject to the possibility of large, sudden losses. as the above examples indicate, and which is affected with a public in- terest, Should be under rigid regulation and control by the government. * According to published announcements, the National City Company reduced its capital in 1951 from $55,000,000 to $11,000,000. The Chase Securities Corporation in 1951 reduced its capital, surplus and undivided profits from $110,000,000 to $58,000,000. These reductions of capital. as well as numerous dissolutions, appear to be retrench- ments consequent upon losses; they do not appear to be due to voluntary change of policy. 105 CHAPTER-IV BANK EXAMINATIONS The thousands of commercial bank failures during the past decade have proved the necessity of more rigid bank examinations SS'a means of controlling the flow of bank credit into the prOper channels. There are three kinds of examinations to which commercial banks may be subjected under present arrange- ments in the United States. The first, which applies to all banks, except private banks, is the examination prescribed by Federal or State statute. In the case of National banks this is carried out by the Comptroller of the Currency, while for State institutions, the reSpective State departments of banking perform this function. A second kind of examination is that made by the Federal Reserve Banks of their member institutions. Such examination is less formal, and usually much less complete, than in the case of the examinations prescribed by statute for the legally constituted authorities. A third kind of examination is that carried out by a limited number of local clearing houses. In the case of the New York Clearing House, for example. the examination of members has become so thorough, and insistence upon compliance with recommendations made is 106 SO great, that such examinations is regarded as consid- erably more significant than that of the statutory author- ities. The examination by the Federal Reserve Banks in the New York district has tended to become more and more prefunctory. reliance being placed upon the other examin- ing agencies for the most part by the Reserve Bank.* The fact that since the inauguration of bank examinations by the New York Clearing House for its members, no bank in that group has ever been closed because of insolvency is attributed in part to the effectiveness of its system of examination.** The American Bankers' Association has estab- lished 26 regional and county clearing house associations throughout the United States to carry on in a small way, the ideas of the New York Clearing House. That they have served a real purpose is indicated by the teStimony of the President of that association:*** "I do not know whether the system (regional clear- ing house associations) has been in effect long enough to tell what the result will be. but I know that it has checked men who were guilty of duplicate borrowings and prevented the banks from making losses by reason of the information they obtained from the county credit bureaus. * Hearings page 75 ** Ibid page 1069 *** Ibid page 584 107 It has been very helpful to the banks in that reSpect." The fact remains. however, that bank depositors and the public in general still look to the Comptroller of the Currency for information concerning the solvency and condition of the national banks. The Comptroller's position and suggestions are. therefore, pertinent to a discussion looking towards an improvement in the ex- aminations of national banks. "The examinations of the Comptroller's office, as time has gone on, have gradually been improved, until today I think they are about as complete as can be made. The one weakness. perhaps, is the fact that notwith- standing an examination may deve10p certain practices in banks which are objectionable, we have very little beyond moral suasion to enable us to correct these con- ditions except for direct violations of law, as distin- guished from bad practices which may eventually bring the bank into trouble. But there are two things: In the case of violation of law we may request the Attorney General'to bring suit for the forfeiture of charter. However, in most instances. the punishment is out of all proportion to the offense. In cases of bad practices, we can put the banks on the list for frequent examinations - examine them as frequently as we feel necessary - and usually that is a question of making bad matters worse. 108 So that we have often thought that under a prOper arrangement, if the Comptroller's office had a right to recommend the removal of a bank officer to a board such as theEbcretary of the Treasury and the Comptroller and the governor of the Federal Reserve Bank in the district in which the bank might be located or, in fact, the Fed- .eral Reserve Board. for that matter, I doubt whether it would be very necessary ever to put that into practice. I think the mere fact it was on the statute book would be a deterrent which would be very valuable and enable us to be more effective in certain cases than we are now."* The reason for such an autocratic proposal as giving permission to remove an officer of a bank, by a board. upon the suggestion of the Comptroller is that in many cases the mere threat of repeated examinations and of ultimate forfeiture of charter is quite ineffective. While it is true that the Comptroller has the right to summon the board of directors of any national bank and require the board to correct irregularities that might lead to disaster, still where the board is obdurate or the bank is under the domination of a single person, which is very often the case. it is easy to exact any sort of promise but performance is another thing. They * Hearings page 4-5 109 know that any authority will hesitate a long while before putting the burden on depositors of closing the bank when there is any chance of saving it at all. If a man is to be a prOper supervisory author- ity. SO the argument runs. he must be an autocrat. He must be above influence of any kind, and must do what (he thinks is right without assistance or suggestion from the outside. Finally, he must have some means whereby he can enforce what he believes is right. A majority of bankers naturally Object to any such intermediate remedy as a means of correcting an infraction of banking rules. They contend that it is radical and drastic and is an authority that should not be given a public official. They further contend that the removal of an officer is a notice to the public that there is something wrong in the bank, which might easily cause a run that would result in the closing of the bank. VIEWS OF MR. MELVIN W. TRAYLOR MI. Melvin W. Traylor, one of the most out- standing and respected bankers of the country. does not believe irregular practices in banking would be overcome be granting arbitrary power to the Comptroller to re- move the guilty officers. "I can envisage circumstances where it might be a salutary remedy, but I am afraid that, inherent in it, 110 is the germ of more evil than good that would be accom- plished."* Mr. Traylor contends that there are remedies other than closing the bank which can be utilized under the present law. "I believe that the right of refusal to certify a national bank as a depositor for public funds, so far - as it applies to the Government, that the right of call- ing the board of directors together and telling them as a practical matter if a certain thing is not done the Comptroller is going to slap an assessment on the direct- ors or their stock, and anyone of a dozen things that he could do, which I know he did to me, would get results. "I think the 60 day's notice, "Unless you do reform, your membership in the system will be canceled," would be effective."** CONCLUSION The big question, in principle, is whether one individual should be given such a drastic right as re- moval of an officer not for any violation of law, but merely because he does not like the way he is doing business. If there is no other way of doing it, he should have that right. subject, of course, to the approval of * Hearings page 408 ** Ibid page 409 111 an appointed board. We believe that with a strong, independent Federal Reserve Board acting as final authority in all cases of removal, much of the present Opposition to the Comptroller's proposal will disappear. Once the poli- tical influence is removed from the Reserve Board the power given to the Comptroller will not seem to be too autocratic. In each case the Comptroller will simply place all the facts before the Reserve Board. The latter will then call in the accused officer and give him sufficient Opportunity to Show cause why he should not be removed. The Glass Bill in its present form has a pro- vision which should help materially to weaken the political argument advanced by the central bankers. There is now embodied in the bill a provision which authorizes the Comptroller and in addition, the Federal Reserve Agent.* when a bank is found in irregular and * Each Federal Reserve Bank is conducted under the supervision and control of a board of nine directors holding office for three years and divided into three classes, disignated as classes A, B, and C. _The three' members of class C are appointed by the Federal Reserve Board. One member of this class, who must be "a person of tested banking experience", is named as chairman 0f the board of directors of his district Reserve Bank. and is known as "Federal Reserve Agent". 112 illicit and unsound practices which it either fails or refuses to correct. to summon these bank officials to, a court of inquiry and give them a thorough hearing and, if the facts sufficiently warrant it. to suspend or dismiss the officers of the bank. This provision, like many others in the Glass Bill, prOposes to increase the power of the Federal Re- serve Board in order to assure a more rigid control of bank credit. 115 BIBLIOGRAPHY Government Publications Hearings beforethe Subcommittee of the Committee on Banking and Currency, United States Senate, Seventy-First Congress, 1950 Congressional Record Federal Reserve Publications Federal Reserve Bulletins Annual Reports. Federal Reserve Board Special Report Auxiliary Statements accompanying the Report of the Banking and Currency Committee of the United States Chamber of Commerce on the Federal Reserve System Periodicals Commercial and Financial Chronicle Proceedings of the Academy of Political Science American Economic Review Bankers Magazine 114 Books Burgess, W. R.. "Interpretations of Federal Reserve Policy", Harper and Bros., New York, 1928 Burgess, W. R.. "The Reserve Banks and the Money Market". Harper and Bros., New York,l927 Edie, L. D., "The Banks and Prosperity", Harper and. Bros., New York. 1951 Goldenweiser, E. A., "Federal Reserve System in Operation". McGraw Hill Book 00.. New York, 1925 Reed, H. L., "Federal Reserve Policy 1921-1950", McGraw Hill Book Co., New York, 1950 Willis, H. Parker, "American Banking", LaSalle Exten- sion University, Chicago, 1920 . Willis, B. Parker, "The Federal Reserve System", The Ronald Press 00.. 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