basic units of the system, namely, the member banks, are, within the limits prescribed by the national banking law with respect to loans to individuals, etc., free to expand deposits until their reserves fall to the prescribed minimum. As the deposits in the federal reserve banks themselves constitute the reserves for a considerable portion of the deposit liabilities of member banks, the reserve requirements for the federal reserve banks are properly more exacting. As the purpose of prescribing reserves is to check expansion, the banks are prohibited from making new loans, and incidentally from paying any dividends, when reserves fall below the prescribed percentages. Yet in order that the reserve requirements may not constitute an impassable "dead line" irrespective of the emergency, the Federal Reserve Board is authorized to suspend all the reserve requirements for a period of thirty days and, if necessary, to renew the suspension for periods of fifteen days. But to prevent this emergency expedient from resulting in turn in the evil of inflation, it is provided that when the Federal Reserve Board suspends the reserve requirements it must levy a graduated tax on the amounts by which the reserve may be permitted to fall below the specified level, and the reserve banks must then add such tax to the discount rates established by the Federal Reserve Board. A more adjustable check on expansion that can be applied before reserves drop to the danger point is found in the authority vested in the Federal Reserve Board to review and determine the rates of discount which the federal reserve banks may establish. How efficacious this authority will be remains to be seen. Much will depend upon the extent to which the discount rates of the federal reserve banks can be made to control the general market rates in their several districts.

Consideration should now be given to the plan by which the new system makes the centralized reserves and the notes of the reserve banks available to the member banks. First, it may be noted that the deposit balances in the reserve banks due to member banks are, within the limits already noted, to be counted as reserves by the member banks. This is of course a necessary corollary of centralized reserves. These deposits may be checked against member banks or be simply drawn down in reserve notes or lawful money. The important consideration for the member banks is therefore the maintenance of an adequate balance with the federal reserve bank.

This is made possible by provisions for rediscounting. With the indorsement of a member bank the federal reserve bank may discount

for such member bank certain notes, drafts, and bills of exchange. On the whole, therefore, it may be concluded that as long as a member bank keeps the required proportion of its reserves in lawful money in its own vaults the question of obtaining hand-to-hand money or that of strengthening reserves is simply one of having on hand an adequate supply of bills acceptable for rediscounting.

In connection with rediscounting, however, one important question remains. This relates to the provision made for one reserve district to get the advantage of possibly reduntant reserves in other districts. Students generally agree that nothing is so effective in bringing about a free flow of funds as an open discount market. With an open market under a system of centralized reserves local banks need turn to the central banks only when the credit on the basis of a given ratio of reserves has been entirely absorbed. Each bank buys or sells according to its own needs. If the paper available be of the proper character, and if the interbanking relations are such as to inspire the necessary confidence, this free flow of funds may not only characterize the country as a whole, but may also enter as an important possibility in international operations. Understanding the advantages of an open market, the framers of the law have endeavored to provide at least some of the facilities necessary to its creation. Member banks are permitted to "accept" on commission drafts or bills of exchange growing out of exports or imports having not more than six months' sight to run. The amount so accepted, however, is limited to half the bank's paid-up capital and surplus. For bills with strong banks as the acceptors there ought to be a wide demand. Such bills ought to flow wherever the rate of discount is lowest. To facilitate this dispersion, the law permits the federal reserve banks to discount these acceptances when they have the indorsement of at least one member bank. But should it be impossible to build up an open market, or should the possibilities of such a market prove at any time inadequate, there is the provision that the Federal Reserve Board may permit, and on vote of five members may compel, the reserve banks to rediscount for each other. Moreover, the Federal Reserve Board fixes the rates at which such rediscounts are made. Thus under a system of district centralization the effort is made to get the advantages of complete centralization.

I

For regulations of the Federal Reserve Board governing this business, see selection No. 156.-EDITOR.

148. DISCOUNT RATES ESTABLISHED

The following statement was issued by the Governor of the Federal Reserve Board on November 14, 1914, shortly after the inauguration of the system:

Rates of rediscount have been established as follows: New York and Philadelphia, 5 per cent for bills and notes having a maturity of not over thirty days, and 6 per cent for paper with a longer maturity; Boston, Cleveland, Richmond, Chicago, and St. Louis, 6 per cent for all maturities; Atlanta, Minneapolis, Kansas City, Dallas, and San Francisco, 6 per cent for bills and notes having a maturity of not more than thirty days, and 6 per cent for those having a longer maturity.

The Board took this action in accordance with the provisions of the Federal Reserve Act which authorized it to review and determine rates of discount fixed by each Federal Reserve Bank. Each of the banks was requested by telegraph to suggest a rate of discount for opening, and all of these replies were tabulated. The answers showed a very decided degree of uniformity, and many of the rates have been confirmed as suggested, the lowest suggested rate being 5 per cent while the highest was 7 per cent.

After full consideration of the facts in the situation, the Board felt it incumbent to adopt a moderate and conservative policy at the outset, in view of the fact that the exact conditions to which the banks will be subjected in operation cannot be precisely foretold. It was felt that the adoption of rates of rediscount which would adequately safeguard the resources of the various institutions would be the wisest policy at the beginning, in view of the disturbed conditions in the financial world. The Federal Reserve Banks have the right, with the approval of the Board, at any time to change the rates; and the present rates are, therefore, to be regarded as provisional and subject to revision. The Board expects to be governed entirely by experience as the new banks become firmly established and accumulate data which can be used for its guidance in reaching conclusions.

150. REDISCOUNTS BETWEEN FEDERAL RESERVE BANKS The following statement was issued by the Federal Reserve Board on March 10, 1915:

In view of the possibility of an early demand for rediscounts between Federal Reserve Banks, the Federal Reserve Board today fixed a rate of rediscount for the present between Federal Reserve Banks of 3 per cent for paper up to thirty days and 4 per cent for paper of maturities over thirty days and up to ninety days.

All applications for rediscounts are to be filed with the Federal Reserve Board, the Board reserving the right to apportion the applications for rediscount among other Federal Reserve Banks.

151. THE ADVANTAGES OF A DISCOUNT MARKET TO BANKERS'

BY FRANK A. VANDERLIP

Among other things it will be the function of the twelve regional banks to loan to member banks through rediscounting for them. Not sometimes, but always and under all circumstances, we are told, the member banks will be able to rediscount at the federal reserve bank. A banker who can look into the future and know with absolute certainty that, under any circumstances, he can rediscount commercial paper in his portfolio will have removed from his life a good deal of fear.

Let us see what it means. It means that commercial paper will become the most liquid asset in the bank's portfolio. According to the practice of American banks, a loan once made to a commercial borrower must remain in the bank's portfolio until the loan matures. The exception to that is in the case of country banks which may rediscount to a limited extent with their city correspondents; but the large banks cannot rediscount. Not only is there no place for them to go, but it would be considered an exhibition of weakness. Hence a loan made to a commercial borrower by a large bank is a complete absorption of that portion of the bank's loanable funds until the maturity of the loan. If the banks in the future under this measure can always borrow, then the type of commercial paper that the bill permits as collateral for such loans becomes the most liquid asset that the bank could have.

Adapted from "Rediscount Function of Federal Reserve Banks," Proceedings of the American Academy of Political and Social Science, IV (1913-14), 140–42.