A History of the Federal Reserve, Volume 2 (127 page)

The committee proposed two principal changes to meet these objectives: (1) “more objectively defined terms and conditions for discounting”; and (2) designing arrangements for borrowing to “provide credit for a specific type of need” (Board of Governors, 1971, 3). The categories were short-term adjustment credit, seasonal credit, and emergency credit. Each bank would have a “basic borrowing privilege” that gave it automatic access to assistance. The reserve bank could supplement the basic credit at its discretion. The revised system remained in effect until 2003.

Use of words like “borrowing privilege” reinforced the long-standing Federal Reserve claim that borrowing was a privilege, not a right, of membership, a claim that the System had worked to inculcate in its members. In a break from the past the Board staff made the amount borrowed depend on the interest rate or the spread between the discount rate and the market rate. The staff’s work recognized that cost mattered as did frowns at the discount window. Heretofore, System orthodoxy was that banks did not borrow for profit but only reluctantly and for need. The Board in 1955 had issued regulation A, which maintained a “considerable reluctance to borrow from the central bank” (ibid., 8). Assigning a borrowing line returned to the very earliest days of the Federal Reserve System.

The report recognized that banks had invested heavily in mortgages and municipal obligations to supplement loans. Markets for these assets were not as well developed as the government securities market, so banks were less able to adjust flexibly to adverse conditions. Also, administration of regulation A varied widely from one district to another. “A key objective . . . is to formalize the terms of limited and temporary access to the [discount] window” (ibid., 10). The report envisaged greater use of the discount window by banks needing temporary accommodation. Evidence suggests increased discounting especially in 1969, 1973–74, and thereafter.

The committee recommended setting the basic borrowing privilege for each bank as a percentage of the bank’s capital stock and surplus. To give greater relative assistance to small banks, the proportion of capital and surplus declined as the value of a bank’s capital and surplus rose. The basic credit was a privilege of membership, but it was subject to restriction if
a bank was in poor financial condition. Also, banks were told not to sell federal funds while in debt to the Federal Reserve.

249. Brunner and Meltzer (1964) proposed this arrangement to eliminate many of the so-called defensive operations.

A bank could borrow more than its basic credit line on request. Decisions would be subject to the same procedures developed after the 1955 revision of regulation A.

The report next considered revisions to two traditional Federal Reserve functions, providing seasonal credit and lender of last resort (provider of emergency credit). To assist banks, particularly rural banks, with financing seasonal demands, the committee proposed to establish “a seasonal borrowing privilege” for each bank. The reserve bank would extend credit for a longer term, more than four weeks and up to nine months in unusual circumstances. The report suggested that it expected banks to borrow for ninety days under this privilege. To prevent banks from speculating on rate increases by borrowing at a discount rate that they expected to rise, the report proposed charging higher rates on existing borrowing.

“Emergency Credit Assistance” offered borrowing facilities to “a troubled member bank, after having obtained the assurance of the chartering authority that the bank is solvent and that steps are being taken to find a solution to its problems” (ibid., 19). The report distinguished this part of its lender-of-last-resort function from the general assistance provided to the banking system through open market operations. It did not give an illustration of the circumstances in which a bank would be solvent but sufficiently illiquid to require this form of assistance. Although the report recognized that the “System should not act to prevent losses and impairment of capital of particular financial institutions” (ibid.) it provided no means to prevent such bailouts and, as future experience showed, the emergency credit facility was used for that purpose.

A landmark change came near the end of the committee report when the committee recognized explicitly that the Federal Reserve was the lender of last resort to the entire financial system, not just member banks or commercial banks.
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It limited its responsibility appropriately by restricting assistance to non-member institutions according to the “probable
impact of failure on the economy’s financial structure” (ibid., 20). Then it limited its responsibility further by noting that the Federal Reserve Act placed “stringent limitations” on the collateral it could accept—only “direct obligations of the United States” (ibid.). The report proposed to circumvent this limitation by lending to a member bank, on acceptable collateral, that would relend to the non-member institution. A federal agency such as the FHLBB, with lending authority and appropriate collateral, could replace the member bank. Loans would be made “at a significant penalty rate vis-à-vis that charged member banks” (ibid., 20). The report softened these restrictions by noting that in “an extreme emergency” consideration would be given to opening the discount window to non-member financial institutions offering to sell state, local, or government securities (ibid., 21). The Board used this provision to offer discount facilities during crises in 1987 and 1998.

250. The Board discussed emergency credit facilities for mutual savings banks during the credit crunch in 1966 (Board Minutes, June 27, 1966). A staff memo recommended special attention to mutual savings banks because they experienced relatively large deposit losses and did not have a lender-of-last-resort facility. The proposed assistance could be direct, or indirect by collateralized lending to a member bank that would relend to the mutual savings bank. The Board “should not insist on repayment terms so strict as to require unnecessary short-term adjustments in borrower activity” (memo, Staff to Board of Governors, Board Records, June 27, 1966,3). Later that summer the Board offered similar arrangements to the Home Loan Banks, but t
hey were not used.

The report also called for more frequent changes in the discount rate. It codified prevailing practice, not always observed, of setting the discount rate below the market rate in periods of restraint and above the market rate in periods of ease. Ease and restraint appear to refer to levels of interest rates. The committee did not explain why it retained procyclical fluctuations in the discount rate with a penalty rate limited to periods of ease. The only comment was reference to “instability in the structure of market rates” caused by “too frequent or poorly timed changes” (ibid., 22).

Within the System, most presidents supported the report. Francis (St. Louis) thought the report was too complicated and would make little difference, but he did not oppose it. Hayes (New York) reacted most negatively. He disliked the proposals to change discount rates frequently and by small amounts, and he agreed with Francis that the proposed borrowing lines did not simplify discount window administration. He argued also that the proposed arrangements made money market control more difficult, but he did not support the argument (Board Minutes, May 28, 1968, 9).

The Joint Economic Committee reported its view of the proposals (Joint Economic Committee, 1969). It commended several of the proposals, but it objected to the restrictions placed on loans to non-members, especially savings and loan associations. The Joint Economic Committee recommended that the Federal Reserve delay any changes until further study by the Banking and Currency Committee of Congress.

Subsequently, the Board made two main changes. It provided the seasonal credit facility for rural, mainly agricultural, credit. And it acted as lender of last resort to the financial system without adopting an explicit proposal. In October 1970, it made some technical changes recommended
by the Presidents’ Conference to eliminate old forms and to make procedures and administration of the discount window more uniform.

The first opportunity to use its broader role as lender of last resort came at about the time of the Penn Central crisis. On May 25, 1970, the Board discussed problems at some major brokerage houses following steep declines in share prices (Board Minutes, May 25, 1970, 1–3).

Consumer
Affairs

Senators Abraham Ribicoff (Connecticut) and John Sparkman (Alabama) introduced legislation to create a cabinet-level department, the Department of Consumer Affairs. Sparkman was chairman of the Senate Banking Committee and interested in regulating standards for issuing credit cards and limiting a consumer’s liability arising from unauthorized use of credit cards.

The Board did not support the legislation. Its draft reply said that “protection of consumers was not consistent with effective performance of the Board’s responsibilities in the field of monetary policy” (Board Minutes, March 19, 1969, 4). Mitchell objected that credit cards were a substitute for money and therefore of concern to the Board (ibid., 6), but Sherrill objected that if it accepted responsibility for non-bank credit cards, it would be “verging on responsibility for total credit control” (ibid., 7). The 1968 Consumer Credit Protection Act included “truth in lending” legislation. The Board became responsible for policing the provisions.

An issue that bothered Congress was unsolicited mailing of credit cards. Robertson said that Congress should not regulate this practice separately; it could prevent use of the mails if it wanted to prevent the practice. But Martin expressed concern that banks solicited users at a time (1969) when the System wanted to restrict growth of credit and money. Of course, banks could create money only if they held reserves. By restricting reserve growth, the System limited growth of money and credit.

By December, the Board changed its mind. It supported legislation restricting unsolicited mailing of credit cards and a limit of $50 on liability for unauthorized use of a credit card (Board Minutes, December 17, 1969, 6–7).

The Board received several requests in the late 1960s to comment on legislation permitting banks to operate mutual funds. The Board concluded that the benefits to the public from increased competition more than offset the risks to banks. They favored regulation by the Securities and Exchange Commission, not themselves or the Comptroller. Senator Sparkman preferred the Comptroller of the Currency. That agency was subject to oversight by his committee.

Organization
and
Administration

Issues continued to arise about the legal status of the reserve banks, the organization of the System, the division of responsibilities between the reserve banks and the Board, and the relation of monetary policy to the administration’s economic policy. Congressman Wright Patman continued to press for changes in the Federal Reserve Act to require an outside audit of the System’s accounts,
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the retirement of all government debt held by the System (to force the System to request appropriations from Congress) and other actions that would restrict independence. Patman never had sufficient following in Congress compared to the Federal Reserve, so he could not get his proposals enacted. Nevertheless, they made the Board conscious of the possibility of change and anxious about their legislative success. That may have been their purpose.

In 1968, the Johnson administration considered proposals to strengthen coordination of System and administration economic policies. The memo accepted the familiar language about “independent
within
but not
of
the administration,” but it did not offer an explicit meaning for that phrase (memo, Warren L. Smith to Larry Levinson, White House Confidential Files, Box FI9-1 LBJ Library, November 4, 1968; emphasis in the original). The administration was about to leave office, so it is hard to accept the proposals as a serious effort.

The memo credited Martin with “successful coordination” with administration policy (ibid., 3) but noted that Martin’s term ended in little more than a year. The problems Smith considered were familiar from discussions going back to 1935. Presidents voted on monetary policy but were not subject to presidential appointment and Senate confirmation. The FOMC was too large to be efficient. The chairman’s term should be coterminous with the president’s term or nearly so. He proposed to reduce the statutory length of terms to seven years with possible reappointment and put control of all policy instruments in a single entity, either the Board or a revamped FOMC. The memo also suggested reducing or ending geographical limitations so that more than one Board member could come from a single district.

The most radical proposal called for a restructured Board of Governors consisting of a chairman and two members in Washington with the four
remaining members assigned to four super-regions. Each of the twelve reserve bank presidents would report to one of the four regional Board members. The presidents’ advice on monetary policy actions would be indirect.

251. The Board was willing to have its income and expense accounts audited by an accounting firm. It opposed an audit by a government entity, the General Accounting Office, especially an audit of the System Open Market Account. In a letter to Congressman B. Fletcher Thompson, the board argued against the view that the debt they held was distinct debt effectively retired from circulation while at the same time arguing that approximately 90 percent of the interest they received was returned to the Treasury (Board Minutes, June 6, 1967).

The last proposal changed the basic compromise under which Congress agreed to create the System as a mix of public and private interests, and it reduced the role of the reserve banks. Two years earlier, Congress approved legislation permitting the Board to move in the opposite direction by increasing the reserve banks’ responsibilities by delegating some Board activities.

The Board approved the first list of delegated responsibilities in June 1967. The list included: (1) authority to approve domestic branches of statechartered member banks, (2) extensions of time for registration by a bank holding company, and (3) extensions of time for registration of securities of state member banks. The Board retained authority to review decisions if there were complaints (Board Minutes, June 5, 1967, 14–16).

This was the first of many delegations to reduce the Board’s activity and recognize the additional responsibilities Congress had given it in the 1960s. In 1970, the Board extended the staff’s responsibility for bank mergers when the staff members agreed unanimously. And it gave advance approval of reserve bank discount rate schedules that called for renewal unless the Board had approved a change elsewhere.

At a time of increased government regulation, issues arose about the applicability to the Board and the reserve banks of new regulations of employment practices, release of information, and privacy of personnel information. The System had developed rules requiring senior staff and consultants to report confidential information on outside employment, business activities, and financial interests. Bank examiners had to report their indebtedness. The Board wanted these rules waived. The rules did not apply to the reserve banks because they were not considered federal agencies (Board Minutes, February 15, 1967, 13–16).

Board members and staff were not consistent as to whether the reserve banks were federal agencies. Discussing application of the 1964 Civil Rights Act, the Board’s counsel said that they were divided on whether the reserve banks were agencies for the purposes of the act (Board Minutes, May 26, 1965, 11–20). Board members divided also, but they did not want to raise the issue for discussion by Congress or the administration.
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Re
serve bank counsel agreed unanimously that the banks were not agencies of the federal government.

252. After much active discussion, the Board decided to avoid the issue and rejected the application of Title VII of the Civil Rights Act on other grounds. Governor Robertson dissented. No one doubted that Title VII, making discrimination based on race illegal, applied to the entire System and to member banks. In a suit tried in San Francisco concerning five
large depositors in the failed San Francisco National Bank, the federal district court dismissed charges against the San Francisco reserve bank on grounds that it was an agency of the federal government (Board Minutes, April 29, 1
966, 6).