The existing volume of national bank notes will not be reduced under the terms of the act, except in so far as the Reserve Banks convert 2 per cent. bonds into 3 per cent. bonds or notes. There may even be some slight increase in the total of national bank notes in circulation, since banks may use for this purpose the small quantity of bonds not already absorbed in this way. Little concern, however, need be felt because the national bank notes are not to be retired. Present requirements for money to be used outside the banks are sufficient to absorb all the notes at present; and with the growth in population a somewhat greater quantity could be absorbed in future.
LENDING OPERATIONS OF THE FEDERAL RESERVE BANKS
The normal lending operations of the Federal Reserve banks are limited to the rediscounting for member banks of commercial loans maturing within ninety days. Commercial loans are generally defined in the act as "notes, drafts, and bills of exchange arising out of actual commercial transactions; that is, notes, drafts, and bills of exchange issued or drawn for agricultural, industrial, or commercial purposes, or the proceeds of which have been used or are to be used for such purposes." The Federal Reserve Board is authorized to define more precisely the nature and character of eligible paper. To make assurance doubly sure, the rediscount of loans secured by stocks and bonds is specifically prohibited. The act also provides that six months' maturities of paper drawn and used for agricultural purposes or based on live stock may be rediscounted.
In confining rediscounts to commercial loans, the act is more stringent than that governing the operations of central banks in Europe. In practice, however, the bulk of the loans of these institutions are in connection with commercial transactions. While this restriction may in some particular emergency hamper the Reserve Banks in giving assistance to some threatened bank, it is upon the whole amply justifiable. Under our banking system in the past the collateral loan has enjoyed a prestige which it is hoped will be transferred to commercial loans. Exclusion of collateral loans from rediscount will certainly contribute much to bring this about. The restriction also gives the public greater confidence that the resources of the Reserve Banks will be generally available throughout the entire country.
One of the reasons which has been advanced for confining rediscounts to commercial loans is based upon certain misconceptions of the true nature of commercial paper—misconceptions which, if adopted by the management of the Reserve Banks in formulating their policy, may have disastrous consequences. It has been contended on all sides during the last few years that commercial paper was from its very nature liquid; and further, that credit could therefore safely be granted to an extent limited only by the amount of such paper. Both of these contentions are hopelessly fallacious. In an emergency, no kind of loan is liquid to any considerable extent. Business cannot suddenly be deprived of the amount of credit to which it has become adjusted. It is, indeed, often said that loans based upon any commodity entering into general consumption can be quickly liquidated. This can be done as regards any particular loan; but supplies for the immediate and distant future must be in process of production and they will require a new batch of loans. The view that credit can be safely granted to the full extent of merchandise in process of distribution and even in process of manufacture is equally fallacious. Credit affects price. Liberal discounts may cause speculative advances in commodity prices, stimulating excessive prices by wholesalers, jobbers, and retailers, as well as by speculative holders pure and simple. There is no mechanical or statistical test for the amount of credit which may be safely granted, whether the loans be commercial or collateral. Over-expansion is possible by both operations.
Commercial loans will become the most liquid asset that member banks can hold, simply because they can be rediscounted with the Reserve Banks. A smaller amount of Bank funds will be employed in the call loan market. But whatever amount remains available for that use will be subject to far less seasonal fluctuation both in volume and in rates. The retention of fixed reserve ratios, even though they may be suspended by the Federal Reserve Board, will probably lead many city banks to use the call loan market to a moderate extent, since it will enable them to avoid the necessity of resorting to the reserve banks for rediscounts whenever reserves momentarily drop below legal requirements. A somewhat larger proportion of time loans will doubtless be used in connection with stock exchange dealings; but the available supply of call money will presumably be sufficient to permit the continuance of the present American practice of daily delivery of securities.
At the outset, on account of the widespread prejudice among bankers against rediscounting, the demand for accommodation from the Reserve Banks may not be large; but this prejudice will surely die away in time, and most if not all of the Reserve Banks will suffer from no lack of regular business, except in periods of business depression. Member banks in those parts of the country in which the supply of credit is inadequate for local requirements will lend more closely, while banks which regularly have more funds than can be thus employed will purchase more commercial paper from note brokers and perhaps rediscount for banks in those parts of the country in which rates are normally high.
Aside from the government account, member banks are to provide the funds for the reserve banking system. Competition with member banks would therefore and justly occasion serious dissatisfaction. Managed by boards of directors a majority of the membership of which is to be selected by the member banks, there would seem to be little danger of serious competition from the Reserve Banks. Nevertheless the act places such restrictions upon dealings by the Reserve Banks with the general public that little or no competition will be possible.
The Reserve Banks are permitted to engage in three kinds of open market operations: (1) dealings in government securities, and also in obligations of the states and local bodies, maturing within six months and issued in anticipation of taxes; (2) dealings in foreign exchange; and (3) dealings in domestic bills of exchange.
The purchase and sale of government bonds and notes and state and local short-term obligations require no detailed consideration. In periods of inactive demand for rediscounts, investments of this kind will doubtless be made by the Reserve Banks in order to employ surplus funds.