Functions of the federal reserve banks

The most important functions of the federal reserve banks are those of holding the reserves of the member banks and of rediscounting commercial paper for them. Under the old system, it will be remembered, a bank’s legal reserve consisted partly of cash in its own vaults and partly of deposit credits on the books of banks in large cities, especially New York. To meet a drain of cash a bank had to take money from its own vaults or it had to draw upon its New York accounts. With inelastic reserves, a drain of cash into general circulation or large exports of gold necessitated drastic reduction in credit, frequently with disastrous results.

Now, however, when a member bank’s deposits are as large as under the law its reserves permit, it may replenish its reserves by taking some of the commercial paper (loans and discounts) it holds and rediscounting or selling it to the federal reserve bank, which is always ready to assist in such operations, provided the paper is of approved quality. The result, of course, is a change in the form of the member bank’s assets. Its loans and discounts are reduced, but its deposit credits with the federal reserve bank, constituting its legal reserve, are correspondingly increased. It is now in a position to go ahead and give its customers the further accommodation they need.

Or take the case where the member bank needs something that will serve as actual money. Local causes or the recurrence of the harvest season have led to large withdrawals of cash from the bank. In such circumstances the member bank again sells some of its loans and discounts to the federal reserve bank, but it takes the proceeds not in the form of deposit credit but in the form of federal reserve notes which will serve its customers as well as any other form of money would.

The federal reserve banks, in turn, may go ahead and increase their own deposit liabilities and note issues without any arbitrary restrictions. Of course the bills of exchange and notes which they take over from member banks must be of high quality and must be composed of relatively short maturities, that is, the credits they extend run for only a short time. At maturity, in case further accommodations are needed by the member banks, the paper which has been paid off may be replaced by new. The federal reserve banks are compelled to keep gold reserves equal to 35 per cent of their deposit liabilities plus 40 per cent of their note issues.

These provisions may seem at first thought to indicate that the United States has held to the old discredited policy of fixed and rigid reserves. Closer scrutiny reveals the fact that the present requirements in their actual wording are not at all like the old. In the first place, the centralized responsibility of the federal reserve banks makes it certain that in normal times they will secure elasticity in the credit situation by holding large surplus reserves—reserves of much more than 35 or 40 per cent of their liabilities. In the second place, the 35 or 40 per cent limits are not absolute dead lines, for by permission of the Federal Reserve Board the actual reserve may be permitted to fall below these points. A tax is imposed upon the amount of the deficiency to insure that the reserves will be restored as soon as possible to a normal level.

Taking the system as a whole, it will be seen that it gives a thoroughly elastic supply of credit. It has all of the necessary elements: elastic note issue, elastic deposits and elastic reserves. The assets back of the note issues of the federal reserve banks are in general like those back of their deposits; namely, commercial paper which has been rediscounted for or bought from member banks. Notes may also be issued upon commercial paper bought in the open market, that is, from banks outside the system, from note brokers and others. Federal reserve bank notes are to be distinguished from federal reserve notes. They are issued upon the security of federal government bonds which the reserve banks are required to purchase from such national banks as desire to give up their note issue privilege. Most of the government bonds held by national banks as security for note issue pay only 2 per cent interest a year, and, without the note issue privilege, they would be worth much less than par in the market.

Reference has been made above to the open market operations of the federal reserve banks. These are likely to prove of increasing importance in the future. It is urgently hoped that the federal reserve system may be able not only to lessen the acuteness of periods of financial crisis by insuring that in times of financial drought the springs of credit shall not be dried up, but also that it will be able to correct some of the defects in our economic system that are primarily responsible for our recurrent panics. If a man is to fall over a precipice, he is fortunate if his fall can be broken or cushioned in some way. But he would have been yet more fortunate if someone had held him back before he came to the edge of the precipice. A wisely ordered banking system would tend to check and dampen the periods of overoptimism and of too rapid business expansion, as well as to relieve the severity of the ensuing periods of depression. Just as it is a sound national banking policy to lend freely to necessitous borrowers in times of depression, so it is an equally sound policy to retard the flow of credit in periods when rapidly advancing prices are tending to overstimulate business.