MEMBER BANK RESERVES REPORT OF THE COMMITTEE ON BANK RESERVES OF THE FEDERAL RESERVE SYSTEM With the permission of the Federal Reserve Board, and pending consideration thereof by the Board and the Federal reserve banks, the accompanying report of the Committee on Bank Reserves of the Federal Reserve System is being published for the information of the member banks of the system and others. interested in the subject. MEMBERS OF THE COMMITTEE E. L. SMEAD, Chief Division of Bank Operations, Federal Reserve Board, Chairman. IRA CLERK, Deputy Governor, Federal Reserve Bank of San Francisco. E. A. GOLDEN WEISER, Director, Division of Research and Statistics, Federal Reserve Board. L. R. ROUNDS, Deputy Governor, Federal Reserve Bank of New York. W. W. RIEFLER, Division of Research and Statistics, Federal Reserve Board, Executive Secretary. TERMS OF REFERENCE The subject of bank reserves is one of the utmost importance, requiring the most careful scientific study by experts devoting their entire time to the matter with a view of drafting a report to the Federal Reserve Board, proposing such amendments to the law or regulations as in their judgment may be necessary to remove any present inequalities or defects and to establish bank reserves throughout the country on a more logical or effective basis than now appears to be possible under present laws, State and Federal. (Resolution adopted at the conference of governors of the Federal reserve banks, December 12, 1929.) REPORT OF THE COMMITTEE ON BANK RESERVES OF THE FEDERAL RESERVE SYSTEM SUMMARY OF COMMITTEE RECOMMENDATIONS In accordance with its terms of reference, the committee has examined the operation of present legal requirements governing the reserves held by member banks and submits herewith definite recommendations for their improvement. These requirements are established by the Federal reserve act and apply to all banks, both State and National, which and members of the Federal reserve system. Changes in the law recommended by the committee are submitted at the end of this report in the form of a proposed amendment to section 19 of the Federal reserve act. In the event this amendment is adopted, Regulation D of the Federal Reserve Board will have to be modified to meet the changes proposed in the law. Modifications recommended by the committee are discussed in the body of the report. Defects of present reserve requirements. In the opinion of the committee, our present system of legal requirements for member bank reserves has never functioned effectively since its inception in 1914. It has not operated to relate the expansion of member bank credit to the needs of trade and industry, nor has it adequately reflected changes in the volume and activity of member bank credit. Furthermore, the committee also finds that present requirements for reserves are inequitable and unfair as between individual member banks and groups of member banks and do not adequately take into account genuine differences in the character of banking in which a member bank may be engaged. The committee takes the position that it is no longer the primary function of legal reserve requirements to assure or preserve the liquidity of the individual member bank. The maintenance of liquidity is necessarily the responsibility of bank management and is achieved by the individual bank when an adequate proportion of its portfolio consists of assets that can be readily converted into cash. Since the establishment of the Federal reserve system, the liquidity of an individual bank is more adequately safeguarded by the presence of the Federal reserve banks, which were organized for the purpose, among others, of increasing the liquidity of member banks by providing for the rediscount of their eligible paper, than by the possession of legal reserves. The two main functions of legal requirements for member bank reserves under our present banking structure are, first, to operate in the direction of sound credit conditions by exerting an influence on changes in the volume of bank credit, and, secondly, to provide the Federal reserve banks with sufficient resources to enable them to pursue an effective banking and credit policy. Since the volume of member bank credit needed to meet the legitimate needs of trade and industry depends on the rate at which credit is being used as well as on its aggregate amount, it is essential for the exercise of a sound control that legal requirements differentiate in operation between highly active deposits and deposits of a less active character. Requirements for reserves should also be equitable in their incidence, simple in administration, and, so far as possible, not susceptible of abuse. Similar principles underlie the present reserve law, which in requiring lower reserves against time deposits than against demand deposits, and lower reserves against the demand deposits of country banks than against the demand deposits of reserve and central reserve city banks may have been expected to impose higher reserves on more active deposits than on less active deposits. Notwithstanding the fact, however, that existing requirements would appear to be so arranged as to make reserve requirements vary with the volume and activity of deposits, experience shows that since 1914 and especially since 1922 the proportion of primary reserves held by member banks has steadily declined in relation to the volume of member bank deposits and to their activity. This outcome has been the result of defects in the definition of reserves, in the method of determining liabilities against which reserves must be carried, and in the classification of banks and of deposits for reserve purposes. The exclusion of vault cash from required reserves of member banks in 1917 has been followed by a reduction in the vault cash holdings of some city banks to a minimum; the rule that amounts due from banks may be deducted only from amounts due to banks has tended to decrease reserves in times of business activity and to increase reserves in times of depression, and the establishment of a low reserve against time deposits in 1914 has facilitated the growth of bank credit without a corresponding growth in reserves. Even if these particular defects in the present system of reserves had not existed, however, the rapid increase in the turnover of demand deposits which has occurred in recent years would still have tended to prevent reserve requirements from increasing in proportion to the growth in the effective use of credit by the customers of member banks. Proposals of the committee.-Before deciding to recommend fundamental changes looking toward the establishment of a new basis for calculating required reserves, the committee made every effort to frame provisions designed to correct the existing situation through modifications in the classification of cities for reserve purposes and in the classification of deposits subject to reserve, including a more stringent definition of time deposits. As these proposals were studied, however, it became more and more evident that they would not be effective and that an entirely new approach to the reserve problem was necessary. The committee proposes, consequently, to abolish completely the classification of deposits into time and demand deposits, and the classification of member banks according to their location, into central reserve city banks, reserve city banks, and country banks. Instead, the committee recommends that all member banks and all deposits be treated alike for reserve purposes, and that the formula used in calculating reserve requirements take into account directly, instead of indirectly as in the existing law, the activity as well as the volume of the deposits held by each individual member bank, without regard to the location of the bank or the terms of withdrawal on which the deposits are technically held. To accomplish this, the committee proposes that each member bank be required to hold a reserve equivalent to (a) 5 per cent of its total net deposits, plus (b) 50 per cent of the average daily withdrawals actually made from all of its deposit accounts. These withdrawals, which are shown by debit entries on the books of members banks, are the only real test of the activity of a deposit account and furnish the only basis by which that activity can be equitably and effectively reflected in requirements for reserves. Under this proposal, therefore, each deposit will carry a total reserve based on its activity as well as on its amount. A totally inactive deposit will carry a total reserve of only 5 per cent, while a deposit balance which is checked out on the average once a week will carry a total reserve equivalent to 12 per cent of its amount. For the average member bank the total reserve under the proposed formula will be equivalent to about 8 per cent of its deposits. To prevent this formula from imposing too great a burden in extreme cases, the recommendations of the committee also provide that in no case shall the aggregate reserve required of a bank exceed 15 per cent of its groos deposits. The committee proposes to include in legal reserves, in addition to the funds which member banks have on deposit with their Federal reserve bank, their vault cash, with certain limitations, as both classes of funds contribute to the strength of the reserve banks and have a direct effect on the reserve system's control of changes in member bank credit. It proposes also to place country member banks on a parity with city banks with respect to deductions from deposit accounts by permitting banks in calculating net deposits subject to reserve to deduct balances due from member banks and items in process of collection from total deposits instead of from balances due to banks alone, as is the practice at present. Volume of reserves.-The committee feels that the existing volume of reserves is sufficient at the present time to provide the reserve banks with the funds they require to perform their functions. Its proposals, consequently, do not contemplate a change in the total amount of reserves. They are intended rather to change the nature of fluctuations in the volume of reserves and to iron out inequitable features in their distribution among the member banks. A comparison of the reserve requirements proposed by the committee with present and past requirements is presented in the following table: SUMMARY OF PAST, PRESENT, AND PROPOSED RESERVE REQUIREMENTS FOR MEMBER BANKS Classification of banks Reserve required against Reserve held in the form of A. NATIONAL BANKS PRIOR TO THE ENACTMENT OF THE FEDERAL RESERVE ACT This distribution of reserves was to become effective in November, 1917. SUMMARY OF PAST, PRESENT, AND PROPOSED RESERVE REQUIREMENTS FOR MEMBER BANKS-Continued The calculation of net deposits subject to reserve has varied from time to time. At present net demand deposits include total demand deposits of individuals, corporations, etc., plus the excess, if any, of demand deposits due other banks over items in process of collection and funds held on deposit with other banks. Under the proposed plan, net deposits subject to reserve would include total deposits, both demand and time, less items in process of collection and deposits with other member banks in the United States. United States Government deposits, which have been exempted from reserve requirements since 1917, would require reserve under the proposed formula the same as all other deposits. Vault cash eligible for reserve excluded national bank notes, Federal reserve notes, and Federal reserve bank notes prior to 1917. Since 1917 no vault cash has been eligible as reserve. Under the proposed plan all kinds of currency and cash issued or coined under authority of the laws of the United States which are held in the vaults of member banks would be eligible to count as reserve. FAILURE OF EXISTING RESERVE REQUIREMENTS In the opinion of the committee, the principal purposes served by legal requirements for member bank reserves are, first, to help to regulate the volume of credit at member banks in accordance with the legitimate credit needs of trade and industry, and, secondly, to insure that the Federal reserve banks at all times have resources adequate to their rsponsibilities. The committee does not believe that it is the purpose of legal requirements for reserves to insure the liquidity of individual member banks, nor that it is possible for legal reserve requirements to accomplish this purpose. Liquidity. For many years, the maintenance of liquid assets available to meet withdrawals was regarded as the principal function of commercial bank reserves. Nevertheless, prior to 1914, when central reserve city national banks in this country were required to hold vault cash reserves as large as 25 per cent of both time and demand deposits they were forced to suspend payments at times of banking strain. The inauguration of the Federal reserve system with its provisions for the mobilization of banking reserves and for the rediscount of member bank paper was a recognition of the fact that a commercial bank does not guarantee its liquidity by maintaining its legal reserves. Το the extent that the member banks since 1914 have remained liquid through periods of unprecedented banking strain, they have been able to do so not because of the legal reserves that they have carried, but largely because they have been able by borrowing at the reserve banks to convert their eligible assets into cash. The effect of this borrowing, furthermore, has not been confined to paper which is eligible for rediscount at the reserve banks. The mere fact that the reserve banks stand ready to lend on eligible paper has helped to maintain a ready market for all types of sound bank assets. Under present conditions, therefore, in which member bank reserve balances cover only 7 per cent of their deposit liabilities, it is clear that the liquidity of the average individual member bank can be more adequately guaranteed by the possession of a substantial portfolio of eligible paper or of other assets readily convertible into cash in the market than by any practicable increase in its requirements for legal reserves. As our banking system is now organized, legal requirements for member bank reserves contribute to the security of bank depositors by providing the reserve banks with funds available for assisting banks in emergencies and by adding strength to the whole banking system through the exercise of credit control rather than through determining the volume of reserves held by individual member banks. In order to be able to utilize the strength of the reserve banks in emergencies, however, it is essential that the individual member bank maintain an adequate portfolio of sound assets readily convertible into cash, and, particularly, of assets eligible for rediscount at the reserve banks. It Control of credit. The most important function served by member bank reserve requirements is the control of credit. This function has a bearing on the liquidity of bank credit, for, in the nature of things, bank credit is most liquid when credit conditions are sound, and unsound credit conditions do not usually develop unless the banking community in general has expanded its credit beyond the needs of trade and industry. The overexpansion of credit may take a particular form, such as excessive loans on farm lands, on urban real estate, or on securities, or it may be more general applying to a wide range of bankable assets. Whatever its form, it has the effect of temporarily inflating the general purchasing power of the community and also of raising for a time the market value of bank assets beyond their intrinsic worth. is the function of reserve requirements to restrain such overexpansian by making it necessary for banks to provide for additional reserves before they expand their credit. To perform this function adequately, however, it is essential that reserve requirements reflect both the volume and the activity of credit outstanding, for unsound credit conditions can develop either out of an excessive volume of bank credit in relation to the needs of trade and industry or out of an excessive use of a given amount of credit. Credit could be expanded indefinitely, for example, without any inflationary effect whatever, provided the bank deposits thus created were never drawn upon to effect an exchange of goods or services. Conversely, it is possible for an unsound credit situation to develop without an increase in the volume of deposits, but merely out of an increase in their activity. Unsually, unsound credit conditions are accompanied by an increase both in the volume and in the activity of deposits. In 1928 and 1929, however, during the most extravagant phases of the stock market boom, excessive credit demands were reflected in an increase in borrowings from nonbanking lenders, and an unprecedented increase in the activity of bank deposits, without an increase in their total volume. Reserve requirements, consequently, failed completely during those crucial years to act as a brake on the unsound use of credit. Progressive diminution of member bank reserves under present requirements.-Between 1914 and 1931, the period covered by our present system of reserve requirements, total net deposits of member banks increased from $7,500,000,000 to $32,000,000,000, or more than 300 percent in less than two decades. Some of this increase reflects the accession of State banks to membership in the Federal reserve system, but the greater part reflects the expansion of member bank credit. While war financing and the huge inflow of gold which followed the war constituted the immediate driving force back of much of this expansion, it was facilitated by a progressive reduction in effective member bank requirements for reserves. Thus, member banks actually hold at the present time about $2,900,000,000 of reserves against $32,000,000,000 of net deposits. This includes both the legal reserves which they hold with the Federal reserve banks and cash which they hold in their vaults. If the vault cash reserve requirements of national banks prior to 1914 had been retained in the Federal reserve act up to the present time, |