A History of the Federal Reserve, Volume 2 (91 page)

In addition to increasing the deposit insurance ceiling, discussed above, the administration’s banking bill (1) required non-member banks to maintain required reserves on time and savings deposits but permitted them to borrow at the Federal Reserve discount window, (2) authorized the Federal Home Loan Banks to require members to hold reserves with the Home Loan Banks, and (3) permitted the System to put regulation Q ceilings on a permissive and stand-by basis. Board members disliked opening the discount window to non-members. Their main concern was that non-members would gain advantages of membership without having to pay the cost of holding reserves against demand and time deposits at reserve banks. Large state member banks might withdraw. Many had done so because costs of membership rose with interest rates (Board Minutes, May 15, 1963, 5–6).
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Governor Mills described the provisions as “ominous” (ibid., 7).

The Board supported the legislation. Balderston spoke in favor of the bill, but he wanted to put the reserve requirement legislation in a separate bill. Mitchell supported the entire bill but wanted reserve requirements to apply to demand deposits (ibid., 9). The Board’s letter accepted the principal provisions. Mills dissented (ibid., 16). The bill did not pass.

In September, Chairman Martin testified on legislation to (1) permit banks to underwrite and deal in revenue bonds of state and local governments,
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(2) extend the authority of national banks to make real estate loans, (3) increase the loan limits to a single borrower from 10 to 20 percent of a bank’s capital and surplus, (4) permit national banks to increase lending on forest tracts, and (5) broaden the lending powers of savings and loan associations. In 1964 Congress approved more liberalized lending on forest tracts and permitted national banks to lend up to 80 percent of the value of real estate.

340. On December 31, 1965, there were 7,320 non-member banks and only 1,406 state member banks, representing 54.9 and 10.2 percent of all banks respectively. Total member banks, national and state-chartered, were 45.6 percent of all banks. The member banks were much larger. Deposit holdings of non-member banks were only 14 percent of total deposits. The number of insured non-member banks rose 5 percent between 1960 and 1965; state member banks declined 14.5 percent in the same period. This was the start of a growing number of banks leaving the System.

341. The bonds differed from general obligations because general obligations were full faith and credit obligations whereas interest payments on revenue bonds came from a dedicated source such as highway or bridge tolls. Revenue bond financing increased markedly in the 1960s, and banks wanted part of the business.

The Comptroller had ruled that national banks could underwrite revenue bonds. The Board’s legal staff believed this opinion violated the separation of investment and commercial banking (Glass-Steagall) provisions of the Banking Act of 1933. Charles Partee of the staff explained that critics of revenue bond financing complained that underwriting was subject to conflict of interest because the banks held deposits, provided trust services, and gave advice to the governmental units. Governor Mitchell responded that the problem was no different for revenue bonds than for general obligations that banks could underwrite under existing statutes, and there was no evidence that the problem was important.

Robertson and Shephardson did not see much benefit but also saw no harm. But Martin and Balderston opposed on the principle “that those who advise should not be also selling things that were on their shelves” (Board Minutes, September 18, 1963, 14). Mills opposed also. That made the vote three to three, so Shephardson changed to opposition making the vote to oppose the legislation four to two.

The Board either opposed most recommendations or urged more study of the need for change. Although Martin and most of the Board took pride in the belief that they favored increased competition in the marketplace, they did not vote that way. Many spoke in favor of stand-by ceiling rates instead of actual ceilings, but they favored making the change only “at the proper time.” That time never came. Similarly, they could see the risk in less rigid standards for lending and investing activities. Their caution did not stop banking changes. Changes occurred first because of the actions by Comptroller Saxon and later by the market rewarding innovators who found ways to avoid regulatory constraints.

Late in 1964 the Board considered thirteen legislative proposals that it agreed to submit as a package early in 1965. Discussion suggested that it did not expect Congress to act, but it wanted to tell the banking community and the public generally what it favored (Board Minutes, November 18, 1964, 11). The principal legislative proposals recommended broader powers to discount, extension of the Board’s powers over holding companies to include one-bank holding companies, and power to invest in obligations of foreign governments payable in convertible currencies and with not more than one year to maturity.

Discounting.
Two years before organizing its omnibus bill, a system committee proposed legislation eliminating vestiges of the real bills doctrine that required eligible paper to be short-term self-liquidating commercial or agricultural paper. The staff proposed to eliminate all statements in the law about eligibility requirements for discounts (Board Minutes, July 24, 1963, 7, 10). The Board took their advice and proposed “to make
advances to their member banks on any security satisfactory to the Reserve Banks subject to limitations, restrictions, and regulations prescribed by the Board of Governors” (Board Minutes, July 24, 1963, letter, Martin to Senator A. Willis Robertson).
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The letter noted that in 1932 Congress authorized the reserve banks “to make advances to member banks in exceptional and unusual circumstances on any security satisfactory to the Reserve Banks although at a penalty rate of interest (ibid., 2). Under section 10b, the penalty rate was a 0.5 percentage point increase in the discount rate. Legislation later made the authorization permanent and removed the restriction to “exceptional and unusual circumstances.” The penalty interest rate remained.

The Board explained that the “concept of an elastic currency based on short-term, self-liquidating paper is no longer in consonance with banking practice and the needs of the economy” (ibid., 2). It added that the more appropriate principle was (1) “soundness of the paper offered as security” (ibid., 2) and explained that “the nature of the collateral provides no assurance that the borrowing bank will use the proceeds for an appropriate purpose” (ibid., 3). Despite this clear statement, remnants of the real bills doctrine were not dead. The proposed legislation continued to refer to “the maintenance of sound credit conditions and the accommodation of commerce, industry, and agriculture” (Board Minutes, July 24, 1963, Draft of Proposed Bill Regarding Advances). And the draft bill obligated the reserve banks “to keep informed about the general character and amount of the loans and investments of its member banks with a view to ascertaining whether undue or inappropriate use is being made of bank credit for the speculative carrying of or trading in securities, real estate, or commodities, or for any other purpose inconsistent with the maintenance of sound credit conditions” (ibid.). The Board could bar banks that engage in “unsound practices” from use of the discount facility.
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When the Board returned to the issue the following year, Governor Mitchell suggested that the System should permit seasonal borrowing for banks that “needed such facilities” (Board Minutes, June 11, 1964, 14). This suggestion was adopted when the Board revised regulation A after extensive study and inability to get legislation passed.

342. The letter is dated August 21, 1963. Senator Robertson was chairman of the Senate Banking Committee. Draft legislation accompanied the letter.

343. Congress did not amend the statute. The Board tried again in 1964, with similar result. It also asked the reserve banks for comments on a revision to regulation A (discounts and advances) in case the legislation passed. The Board’s discussion brought out differences of opinion about the relative importance of protecting the assets of the reserve banks compared to providing credit facilities for members and the amount of discretion left to the reserve banks in setting conditions (Board Minutes, June 11, 1964, 8–13).

Edge
Act
and
Foreign
Banking

Growth of international trade and foreign investment awakened bankers’ interest in opening foreign branches to service their customers. Growth of the euro-dollar market and regulation Q restrictions gave additional incentives. The Board began to consider regulatory changes to expand the powers that U.S. banks could use abroad.
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The aim was “to free Edge corporations and the Board as far as practicable from an intolerable amount of regulatory minutia” (Board Minutes, January 17, 1963, 16). Chairman Martin explained that existing legislation and regulations did not encourage banks to establish foreign branches. Banks had to request permission to undertake each new activity. As a result borrowers used the Export-Import Bank and international agencies (ibid., 16).

On August 1, 1963, the Board adopted a substantial revision of regulation M spelling out the powers of national banks operating abroad. Over the objections of Governor Mills, the regulation permitted wide powers to foreign branches, including the power to establish branches in a country for which it has been approved by the Board. It had only to notify the Board. The powers granted to national banks under regulation M extended to state member banks under regulation H. Three weeks later, the Board revised and simplified regulation K; Edge Act corporations received powers similar to those approved for banks’ foreign branches.

Graduated
Reserve
Requirements

The President’s Committee on Financial Institutions reconsidered the recommendations of the Commission on Money and Credit.
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Some small banks in reserve cities paid the higher reserve requirements while some large suburban banks paid the country bank requirements. One of its recommendations called for replacement of reserve requirements based on location with requirements graduated by deposit size. The Board had often expressed concern about the inequities resulting from the existing system. It agreed to ask Congress to approve the new system, under which the Board could vary reserve requirements ratios as follows: 5 to 9 percent
on the first $5 million, 8 to 20 percent on the next $95 million, and 10 to 22 percent on any excess over $100 million.

344. Discussions began in December 1962 and continued the following month. With staff assistance, Governor Mitchell had revised regulation K (Corporations Doing Foreign Banking or other Foreign Financing under the Federal Reserve Act) and regulation M (Foreign Branches of National Banks). U.S. banks abroad operated under rules promulgated by the Board under the authority of the Edge Act passed in 1927 to permit American banks to operate separate corporations abroad.

345. See discussion of the Commission’s report earlier in this chapter.

Discussion concentrated on a few issues. First, the Board had always favored either extension of reserve requirement ratios to non-member banks or compulsory membership. The Board often argued that existence of non-member banks hampered monetary policy or reduced its effectiveness, but it did not explain why this was true. Governor Mitchell made clear that “he would not attach public policy importance to reaching 100 percent” of deposits in member banks (Board Minutes, August 12, 1964, 9). The discussion brought out that in practice Board members’ concerns were that non-member banks had the competitive advantage of lower cost of reserve requirements and, for some, non-par collection fees.

To meet the competition from small non-members, the Board wanted to keep the reserve requirement ratio on the first $5 million relatively low. “The primary reason for classification of banks according to deposit size . . . was to give an earnings advantage to smaller banks” (ibid., 13).
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Several governors spoke in favor of a uniform reserve requirement ratio for all banks, but they did not adopt it.

The existing range of reserve requirements for time deposits remained 3 to 6 percent. Proposals to apply different ratios for different types of time and saving deposits, within the 3 to 6 percent range, did not attract support.

Problems
with
Regulation
Q

Whenever the Board considered regulation Q ceiling rates, several members spoke in favor of asking Congress to remove them or put them on a stand-by basis. The Board hesitated because the time was not right when rates rose, and no one mentioned the subject when market rates were below ceiling rates. This happened so often that it casts doubt on the statements. The Board members did not propose raising the ceiling and then asking Congress to remove them.
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Several bankers who served on the Federal Advisory Council explained two of the problems caused by ceiling rates. First, banks could not be cer
tain whether they could renew certificates of deposit at unchanged rates when they came due. This was a significant source of funds for many banks. If rates rose above the ceiling, a bank would have to adjust to the loss of deposits. Second, one way that they adjusted was by selling municipal securities. This subjected the municipal market to sudden rate changes (Board Minutes, May 18, 1965, 19).

346. Board members expressed willingness to permit non-member banks to use discount facilities if they became subject to the Board’s reserve requirement ratios. The members recognized that Congress was unlikely to approve a proposal extended to non-member banks. The Board had tried several times without success.

347. Economists with very different policy views on some issues agreed that the distortions caused by ceiling rates were costly and that interest rate ceilings should end (Friedman, 1970; T
obin, 1970).