The Banking Act of 1935
THE proposals affecting the banking system embodied in the new bill before Congress, known as the Banking Act of 1935, are of so fundamental a nature as to make the bill the most important piece of banking legislation since the Federal Reserve Act. The bill is of vital importance to every banker because it concerns the soundness and liquidity of banking assets. It is of importance to every bank depositor for the same reason, and it is of importance to every man, woman, and child because it concerns the purchasing power of money.
The bill is divided into three parts — Title I, containing amendments to the Federal Deposit Insurance Law; Title II, containing vital and far-reaching amendments to the Federal Reserve Act; and Title III, containing various amendments to the Banking Act of 1933 designed to clarify and improve the present law. Bankers generally approve the provisions of Titles I and III in substance, but have grave misgivings as to Title II in its present form. It is not the purpose of this article to deal with all three sections of the bill, but to urge the elimination from the bill of Title II, dealing with the Federal Reserve System. In so doing, the intention is not to oppose any and all changes in our central banking organization, but to stress the desirability of adequate study before legislating on so controversial and difficult a problem.
It is agreed that a thoroughgoing, scientific review of the entire field of banking and currency is badly needed. More than twenty years have passed since the Federal Reserve System was established. During this period the System has undergone constant alteration, partly as a result of internal administrative changes within the legal framework of the Act, and partly as a result of amendments made from time to time to the Federal Reserve law itself. In the important matter of credit policy, there has been a gradual departure from the ideas of the framers of the original Federal Reserve Act, who believed that the main business of a central bank was to hold the ultimate banking reserves of the country and to furnish business with an elastic currency, determining its rediscount rate in accordance with the status of the reserves entrusted to its care.
As time has passed, there has been a growing tendency on the part of the Reserve Banks to depart from this traditional attitude, and to attempt by means of credit policy to exert a conscious control over business and prices. Along with the growth of this control idea there has come, particularly in the recent years of emergency, an increased influence from Washington which has marked a further departure from the early conceptions of the Federal Reserve Act. And finally, in addition to these changes within the law there have been numerous amendments to the law itself which have vitally affected the whole Federal Reserve and banking structure.
While these changes have been going on in the Federal Reserve System, our currency laws also have been radically altered by the monetary legislation of recent years, including the revaluation of the dollar and the Silver Purchase Act. As a result of these changes in the Federal Reserve and in the currency base, our banking and money system has gone a long way from the well-ordered setup of 1914. It has become more or less of a legislative patchwork, pieced together at different periods, often under emergency conditions, without scientific basis, confusing to the business man, and almost certain to be a prolific source of trouble in the future.
There can be no question, therefore, as to the shortcomings of the existing system — if it can be called a system — and of the need for reform.
What the Bill Proposes
Just what are the reforms proposed in Title II that make this bill so outstandingly important? Briefly they may be summarized as follows: —
1. Giving more power over the Reserve Banks to the Federal Reserve Board and to the President.
2. Broadening the eligibility requirements for paper submitted to Reserve Banks for rediscount and as collateral deposited as security for notes.
3. Extending the powers of member banks to make real estate loans.
The purpose will be to discuss these three proposals in order, taking up first the matter of Federal Reserve organization and the central management of credit. This centralization of control is to be accomplished by: —
(a)Giving the President power to ask for the resignation of the Governor of the Reserve Board, instead of having him appointed for twelve years, as at present.
(b) Broadening the powers of the Reserve Board to raise or lower reserve requirements.
(c) Combining the office of Governor and Chairman of the Board of Reserve Banks, and requiring the election of Governor to be approved annually by the Reserve Board.
(d) Providing that the open market committee, which controls Reserve Bank purchases and sales of government securities, — in other words, the power to inflate or deflate, — shall be composed of the Governor and two other members of the Reserve Board, and two Governors of Reserve Banks elected by Reserve Banks, and making the decisions of this committee binding on all Reserve Banks.
The Central Control of Credit
It is apparent that this bill reflects the school of thought which believes that the banking system requires some kind of overhead control, apart from the ordinary supervisory functions connected with examinations, opening of new banks, and so forth, and that this overhead control should be responsible for regulating the aggregate amount of credit outstanding at any given time. This opinion is opposed by others who believe that the credit system will be managed best if left to the free play of natural economic forces. Those who adhere to this view stress the manner in which the credit system functioned before central banks tried to manage things by means of open market operations. When business expanded, the demand for bank credit increased. This led, in turn, to increased rediscounting with the central bank, often at a time when the latter was losing gold in consequence of rising prices and an adverse balance of international payments. The result was an advance in interest and discount rates. This acted as a natural corrective in the situation, checked the tendencies toward inflation, induced borrowers to liquidate, and recalled capital from abroad. As borrowers paid off their loans and gold flowed in from foreign countries, expanding the credit base, interest rates fell automatically, deflation was halted, and business was encouraged once more to go ahead.
The theory that central banks, by making money cheap or dear, should take the initiative in controlling business and prices has gained many adherents, both in this country and abroad. Yet it cannot be said that the conscious control of credit has made an impressive record in recent years. Open market operations have been used more often to prevent needed readjustments in the economic system than to facilitate them. As we look back to 1927, it is easy to see now that the cheap money programme of the United States in that year had that effect. At that time the United States was on the point of receiving large imports of gold from Europe. It was recognized that this gold was unneeded, and even a source of danger, as our stocks were already excessively large; moreover, it was feared that a gold movement of large proportions would endanger the newly reconstituted gold standards of Europe. It was with the purpose, therefore, of warding off this movement that our cheap money policy was adopted. The result, however, was to lay the basis for inflation here, while at the same time sparing European countries, particularly Great Britain, from the necessity of making readjustments in currency values and internal costs that would have restored the equilibrium in international payments. In other words, had it not been for the well-intentioned efforts of the central banks to ‘manage’ the situation, gold movements might have forced readjustments at that time which would have cost the world far less than the price paid ultimately for the attempt to bolster up artificial and unsound conditions.
Criticism of the Federal Reserve Banks
The proponents of the idea of the conscious control of credit criticize the present structure of the Federal Reserve System, with its division of authority between the Federal Reserve Banks and the Federal Reserve Board, as cumbersome and unwieldy. They contend that the failure to centralize responsibility was one reason for the failure of the System to promote business stability.
It will be admitted readily that the regional system of central banking, with its emphasis upon local needs, and its divided authority, is not ideally suited to the type of monetary management contemplated under this bill. Such a system has the faults and inefficiencies inherent in all democracies. There is no doubt as to the superior efficiency of dictatorship, provided always that the dictatorial powers are used wisely. Can it be taken for granted that they will be used wisely?
The assumption that the banking system in this country broke down because of too much laissez-faire and insufficient central control will, as has been shown, hardly bear analysis in the light of events over the past ten years. However much the policy may have appeared justified at the time, it was an attempt at management, and not laissez-faire, which was responsible for the cheap money programme of 1927 that many economists believe promoted the boom which ended in the fatal collapse. Moreover, it is interesting to recall, in view of the proposals to increase the powers of the Federal Reserve Board, that it was a regional Reserve Bank — the Federal Reserve Bank of Chicago — which held out in 1927 against the policy of reducing rediscount rates, and that it was the Board which forced that bank to fall in line with this policy against its wishes. Again, it was the Federal Reserve Bank of New York which early in 1929 voted again and again to raise the rediscount rate in an effort to check the wild speculation in the stock market, while it was the Board which again and again vetoed these requests for fear of the political consequences of an adverse effect upon business.
If any conclusion is to be drawn from the experience of recent years, it would appear to be that the System has suffered from too much central management rather than from too little. To judge from a strict interpretation of the record, it would look as though open market operations, instead of being handed over to the Reserve Board, ought to be abolished altogether.
Quantitative vs. Qualitative Standards of Credit
In the present-day discussion of monetary problems, there will be observed a tendency to stress the importance of quantitative, as distinguished from qualitative, changes in credit. The emphasis is on the aggregate amount of credit that can be got outstanding, rather than upon the uses to which this credit is put.
This will be noted not only in connection with the arguments made on behalf of enlarging the powers of the Reserve Board, but also in the constant pressure on the member banks to lend more freely and get more credit into circulation. In contrast with this newer theory, orthodox monetary doctrine has always taught that the important thing is to see to it that bank assets are of the right kind, — that is, self-liquidating commercial paper arising out of bona fide business transactions, — and that, if these principles of the granting of credit are adhered to, the matter of what total amount of credit ought to be outstanding will take care of itself.
The Federal Reserve Act was drawn by men who believed in the qualitative rather than the quantitative test of credit. As Professor Harold L. Reed, of Cornell University, has recently pointed out, almost every important feature of the act of 1913 expresses allegiance to this principle. The division of the Reserve System into twelve districts, the powers conferred on the regional Reserve Bank officers, the standard of eligibility set for paper submitted for rediscount, all reflect plainly the intentions of the founders to set up a system primarily for the accommodation of commerce and trade. In the original Federal Reserve Act not even United States Government securities were admitted as a basis for Reserve Bank credit. It is perfectly clear that there was never any intention of having the Reserve Banks assume responsibility for regulating the fluctuations of business.
Power of Central Bank to Influence Business Limited
Moreover, it will be granted by all but the most extreme advocates of managed credit that the power of the central bank to influence business is limited. The central bank can flood the money market with funds to the point of surfeit without assurance that the funds will actually be used by industry and commerce. Trying to force credit into employment has been likened to pushing at one end of a piece of string. Someone must take up the slack at the other end.
The central bank has no way of accomplishing this. It does not deal directly with the public. It affects money conditions through its discount rate and by buying and selling securities in the market. If the reserves of member banks are increased, the ability of these banks to lend will be correspondingly enlarged; but whether the loans will actually be made will depend upon factors beyond the central bank’s control, such, for example, as the lending policies of the member banks and the desire of business men to borrow.
It is true that a central bank can bring on contraction of credit with a considerable degree of success, by means of a high discount rate and by open market operations designed to reduce the reserves of the member banks. All experience indicates, however, that the promotion of expansion is quite another matter. We have had ample reason to know that low money rates and high bank reserves are not all that is needed to get business men to borrow. In the last analysis, this will depend upon the opportunities available for using money profitably. This, in turn, is a matter of the general state of equilibrium existent throughout the economic system. The danger in these efforts to stimulate business by pumping out vast quantities of credit is in the groundwork laid for later inflation, the tendency toward the deterioration of credit standards, and the diversion of attention from the true causes of maladjustment.
Independence of Controlling Authority Essential
It is evident, however, that the trend everywhere is toward further attempted management of credit and currencies. However much opinions may differ as to the wisdom of this trend, all must agree as to the importance of securing men of proper capacity, experience, and independence of judgment to exercise these vast powers. Especially is it important that this body should be as free as possible from the influence of the political government.
Government, in the very nature of the case, is disqualified for regulating the banking relations with the public. This is regardless of the goodness of its intentions. The political organization is too susceptible to public opinion. It is bound to be so. This is inherent in democracy. Often it becomes essential for central banks to do unpopular things in order to maintain sound credit conditions, such as put on the brakes when business and credit are beginning to show signs of overexpansion. With a central bank tied in and identified with a political party, what chance would there be of its doing so? Governments are more likely to be interested in staying in office than they are in maintaining sound credit conditions.
Moreover, the independence of the central bank and the State is peculiarly important at a time when the government is appearing as the largest borrower in the market. When the government dominates the central bank it is in a position to make the market for its own securities, thus preventing any true test of the soundness of its credit and removing all restraint upon continuous borrowing save only that which the government will be willing to impose upon itself. History has shown repeatedly the dangers of too close an association of central bank and Treasury.
The question, therefore, which the individual will want to ask himself about Title II is to what extent are its provisions likely to promote a capable and independent control of credit? Undoubtedly the proposal to raise the salaries of members of the Reserve Board to equal those of Cabinet officers ($15,000), with adequate retirement pay, deserves endorsement, as tending to enhance the dignity of a position on the Board and as affording inducements likely to attract capable men. The proposal, on the other hand, to have the Governor of the Reserve Board serve only at the discretion of the President is open to serious objection. If the President can force the resignation of the Governor at will, what likelihood is there of securing fearless and independent administration of that office, or of attracting men of high calibre to it?
Similarly, the proposal to make the tenure of office of Governors of the Reserve Banks subject to annual approval by the Reserve Board would tend to suppress all independence of view within the Reserve System and lead to mediocre appointments. If the new setup of the open market committee is to have any meaning at all, the two Governors of Federal Reserve Banks who, together with the Governor and two other members of the Reserve Board, compose this committee must be independent agents. They must not be mere creatures of the Board. Clearly these provisions relating to appointment and terms of Governor of the Board and of Governors of Reserve Banks should be eliminated from the bill, or at least substantially modified. The Federal Reserve System cannot be permitted to become the tool of the political party in power if it is to command the confidence of the country.
The Change of Eligibility Requirements
Aside from the question of the control of credit, Title II deals with changes in eligibility requirements for paper submitted for rediscount and as collateral for Federal Reserve notes. Originally, the Federal Reserve Act was based on the theory that Federal Reserve credit should be founded on short-term, self-liquidating paper rediscounted for the purpose of accommodating industry, commerce, and agriculture. The first great departure from this principle occurred during the war. At that time, member bank notes secured by United States Government securities were made eligible for rediscount and as backing for currency. Later, under emergency legislation of 1932 and 1933, the eligibility requirements were further broadened to permit Reserve Banks, under exceptional circumstances, to make loans to member banks which had exhausted their supplies of eligible paper, taking as security any collateral considered satisfactory; also, the eligibility requirements with respect to collateral for Federal Reserve notes were extended to include United States Government securities purchased in the open market (together always, of course, with at least 40 per cent of gold).
What the new bill proposes to do is, in effect, to make permanent the more liberal eligibility requirements contained in the recent emergency legislation. Reserve Banks would be enabled to lend to member banks on the security of any ‘sound’ asset, ‘subject to such regulations as to maturities and other matters as the Federal Reserve Board may prescribe.’ Federal Reserve notes would be backed by a minimum of 40 per cent of gold certificates, plus a first lien on all the assets of the Reserve Bank issuing such notes.
The question is, are these proposals sound? This answer is by no means simple. On the one hand, we have the traditional principle of central banking that central bank credit should be based on short-term, self-liquidating paper. This principle is a good one for several reasons.
Arguments against Changing Eligibility Requirements
First, it tends to keep the volume of central bank credit in step with the strictly commercial requirements of the country. If long-term assets are admitted to the central bank, funds are more likely to be diverted to capital uses and to speculation. It is not the function of the central bank to finance capital requirements or speculation.
Second, it provides as the basis of central bank credit a revolving fund of assets which, by virtue of near maturities, are being constantly tested for quality. In the case of long-term assets there may be no such testing for many years to come.
Third, it assures the central bank a portfolio of short maturities by means of which the bank can rapidly adjust its position by permitting these assets to mature without replacement. If the bank holds long-term assets it can adjust its position only by selling them and the market may not be prepared to receive them. In the case of certain types of assets, say real estate mortgages, political pressure might be such as to interfere with their sale.
Abroad, it is true that many central banks will discount other than shortterm trade paper, but they do so almost invariably at a higher rate, and usually they carefully supervise the use of the funds. In other words, this type of advance is looked upon askance. In the case of the Bank of England, there are no legal restrictions on the Bank’s investments; nevertheless, only in times of severest crisis does the Bank depart from prime bills, or government or certain of the best grade of colonial and municipal securities. The British joint stock banks rarely if ever borrow directly from the Bank of England. When they want funds they sell bills to the discount market, and then the market borrows, if it has to, at the Bank. The latter’s advances, therefore, are on the primest bills. It is inconceivable that the Bank would make a practice of admitting general bank assets as freely as Title II appears to contemplate.
Arguments for Changing Eligibility Requirements
On the other hand, against these objections to the liberalization of eligibility requirements is the great decrease in recent years in the volume of commercial paper of the self-liquidating type. This trend was in progress before the depression, and was due to a variety of causes, including need for less working capital as a result of speedier processes in industry and transportation and changed methods of corporate financing. As a result of this tendency, together with the great pressure to lend, following on gold imports and easy money policies, bank funds have tended to flow more and more into capital loans and investments. While it is impossible to obtain precise figures, it is doubtful whether there are at the present time more than $5,000,000,000 or $6,000,000,000 of the old-type self-liquidating commercial loans in the whole banking system. The question is pertinent as to whether we have a commercial banking system any more.
Obviously, a condition of this kind raises serious questions as to future banking policies. It is possible, of course, that old-time commercial paper may sometime come to life again. No doubt a revival of business would lead to some increase, and the closer supervision of corporate long-term financing may also have this effect. Ought eligibility requirements to be such as to promote a development of this kind by continuing to give preference to shortterm paper, or ought they to be revised on the assumption that a permanent change in financing methods has taken place?
There is much complaint that the present eligibility requirements are unduly restricting bank credit on the ground that banks are reluctant to make loans which they could not pass on to the Reserve Banks in an emergency. Is it desirable to try to remedy this situation by attempting to give liquidity to paper not fundamentally liquid by making it rediscountable at the Reserve Banks? Is this not merely passing the illiquidity on to the Reserve Banks? And are there not widespread dangers in such a policy — danger to the central bank of being involved in frozen paper, and danger to all banks in the encouragement given to the expansion of illiquid loans? May the solution not possibly lie in adjustments of a different character in the banking system? One suggestion has been that possibly a plan might be worked out for adjusting banking liabilities more in accordance with the nature and maturity of the assets, perhaps by the issue of debentures or certificates of deposits.
The point is that the subject is far too complicated and involved for a hasty judgment. The need is for careful study by the best-qualified experts. Time is not pressing. Banks have large supplies of eligible paper in the shape of government securities, and the huge excess reserves make the likelihood of rediscounting of any kind remote.
The Question of Real Estate Loans
This question is part and parcel of the same problem involved in the proposal to change eligibility requirements. To what extent should bank liabilities, which are in a large degree demand liabilities, be backed by longterm paper?
On behalf of the amendment, it is argued that, except in the Northeastern States, the mutual savings bank is practically unknown, and that the savings of the people, to a large extent, are kept in the commercial banks; that it is as sound to lend savings money in commercial banks on real estate as it is to lend savings money in savings banks on such security; and that, unless this is done, real estate in most sections of the country will be denied credit facilities to which it is entitled.
The objection to this argument is that commercial banks, in actual practice, are forced to regard their savings deposits as payable on demand; that any attempt to enforce the thirty-day payment clause in time of emergency would precipitate a run by the commercial depositors, thus gutting the bank at the expense of the savings depositors.
Various suggestions have been made for modifying this section of the bill, including the proposal for segregation of savings and commercial deposits in banks, also the proposal that the conditions on which real estate loans may be granted by member banks be left to the discretion of the Federal Reserve Board. It seems evident that the subject needs further study, embracing the whole field of mortgage financing — what the needs are, existing agencies for supplying them, and in general the problem of establishing this form of credit on a sounder basis.
Scientific Study of Ranking Reform Essential
All of this emphasizes the need for a careful and scientific study of the whole question of banking reform. What the situation requires is not more hurriedly enacted legislation, rushed through Congress without adequate opportunity for study and debate, but a carefully evolved programme in the preparation of which Congress should have the advice of the best-qualified minds in the country. No emergency demands immediate action, and, should one arise, the government already has ample powers for dealing with almost any conceivable situation.
With the multitude of problems pressing upon Congress, it must be realized that that body cannot possibly devote to Title II the attention that is essential to the task of reorganizing the banking system. Clearly, the subject is one which should be referred to an expert and impartial committee, which should explore all possibilities and report to Congress for action as the latter sees fit.