A History of the Federal Reserve, Volume 2 (128 page)

Debt
and
Dealers

Some issues returned several times. Members of Congress pressed the Board and the FOMC to conduct open market operations or do repurchase agreements in federal agency securities, particularly securities of the housing finance agencies. The Board objected to mandates of this kind but did not object to legislation authorizing purchase of agency securities at its discretion. Congress approved legislation in 1966 authorizing open market operations in direct obligations of any federal agency.

The FOMC voted on October 7, 1969, to permit the manager to lend securities to government securities dealers. The purpose was to reduce the number of transactions in which one party failed to deliver securities to complete the transaction. The problem arose because the FOMC had begun again to use longer-term securities in open market operations. Loans were usually for one to three days. The initial program was for six months in order to learn how it worked. In March 1970, the FOMC renewed authorization (memo, Alan R. Holmes to FOMC, Board Records, March 4, 1970).

Late in 1968, the SEC delivered a report to the Board on the use of advance information on a Treasury financing in 1967. It found that the employees of a government securities dealer had access to such information (Board Minutes, December 2, 1968; February 13, 1969).

The Glass-Steagall Act (1933) separated investment and commercial banking. As the economy expanded and borrowing increased, banks pressed to remove many of the 1930s regulations and legislation. The Board considered making a recommendation in its 1966 Annual Report to permit commercial banks to underwrite state and local revenue bonds, but it decided against doing so. The Comptroller ruled that national banks had the authority, but in a lawsuit brought by an investment bank, the court ruled against the Comptroller.

Congress responded by introducing legislation permitting banks to underwrite revenue bonds. Banks had retained authority to serve as underwriters of state and local general obligations. The Senate committee asked the Board and the Comptroller to conduct a study to estimate the cost saving to state and local governments from extension of authority to revenue bonds. The study found that underwriting costs would decline.

The Board divided on the desirability of legislation. Five members favored the bill. Governor Daane opposed because he liked the separation of commercial and investment banking and did not want “a continuing erosion of barriers” (Board Minutes, August 18, 1967, 15). Chairman Martin was ambivalent at the time. He was concerned about conflict of interest by banks, but he liked the idea of lower costs to state and local governments. The following year, Martin changed his mind, and the Board supported revenue bond underwriting (ibid., March 6, 1968, 5–7). Congress approved the change.

One-Bank
Holding
Companies

The Board inadvertently failed to include one-bank holding companies under the 1956 Bank Holding Company Act. It took fourteen years to remedy that oversight, but Congress approved legislation in 1970 authorizing the Board of Governors to regulate these companies. The legislation also defined a bank as an institution that received deposits and made loans.

Several issues about holding companies remained contentious before the legislation passed and even after. Principal among these were limits on the scope of bank holding companies, such as whether they could include commercial and industrial activities or, more broadly, precisely the type of activities that could be specified in the legislation. The Board tried several times to draw up a list of activities that it would approve, but it could not agree. The Board also could not agree on whether a grandfather clause should protect arrangements reached before the legislation. Robertson opposed a grandfather clause, and both he and Brimmer insisted that only one agency should regulate holding companies; they preferred the Board, of course, but they did not say that in the Statement of Principles prepared for Congress
²⁵³
(Board Minutes, February 20, 1969). After considerable discussion, the Board prepared a list of eleven activities that bank holding companies could do, then added a twelfth that gave it authority to approve activities “functionally related to banking” (Board Minutes, May 13, 1969, 2, letter, Robert Cardon to House Banking Committee). The legislation did not adopt a list; in the end it reused but modified the language of the 1956 act setting standards for approval.
²⁵⁴

253. By December 1970, the number of bank holding companies was 11.8 percent of all commercial banks. They held 16.2 percent of deposits. Passage of the amendment increased the percentages to 36.2 and 55.3 percent respectively in the first year (1971). By 1979, the percentages reached 52.8 and 67.8.

254. Maisel wrote that despite many previous discussions, the staff did not have a firm idea about what the regulations should cover. The staff proposed that the Board use the list it
had sent to Congress as the basis for hearings. At the hearings, banks or others could comment on the list and propose additions. A unique feature of Maisel’s proposal was that the hearing officers “have a good economic background” and, before proceeding, should take a training course. The Board adopted his proposal (Maisel diary, January 13, 1971, 9–10).

The Board eagerly accepted authority over holding companies. Regulatory authority strengthened its control of banks’ expansion, thereby strengthening the System’s support for its actions by an important group. That group was likely to support the System in issues with the Congress.

Other
Regulations,
1965–71

Despite its name, the voluntary credit restraint program required the Board repeatedly to issue regulations specifying what it permitted. For example, in 1965, the Board discussed whether the System’s acceptance portfolio should reduce its holdings of acceptances of foreign banks. Other regulations of international transactions included making more routine the approval of Edge Act corporations (foreign branches of domestic banks) to reduce the Board’s workload following the expansion of such branches (Board Minutes, January 7, 1969, 6–10). Activities of the growing number of foreign banks in the United States also raised new issues. Among them was whether to exempt such banks from regulation Q ceilings on payment of interest to their employees. The Board, acting under congressional authority, suspended regulation Q ceilings for time deposits of foreign governments and monetary authorities.

Several of these examples show that, as is often the case, regulation created two incentives. One was for the regulated to invent arrangements that avoided the regulation without violating the law. The second was for the regulator to develop exceptions that suited some of its purposes. And of course, the two interacted. New exceptions created potential opportunities to avoid regulation. The Board was asked by Congress to report on or stop particular practices of this kind. One of many examples was the use of branches in Puerto Rico or the Virgin Islands to attract corporate deposits by paying above regulation Q ceilings. This problem largely ended after June 1970, when some CDs of $100,000 or more became exempt from ceiling rates.
²⁵⁵

In July 1971, First National City Bank proposed that the Board eliminate reserve requirements on euro-dollar loans made to U.S. corporations by overseas branches of U.S. banks. The Board’s staff concurred. Regulation M
had been amended in September 1969, when the Board wanted to restrain euro-dollar borrowing. Relaxation of regulation Q for large CDs led to reduced reliance on the euro-dollar market to support bank lending.

255. One of the stranger administrative issues was a request from the Bank of Canada that the Board’s Annual Report for 1966 avoid showing that it had drawn on its swap lines in September and repaid in November. The Board’s monthly numerical data would show that a transaction occurred. The Board demurred (Board Minutes, Febru
ary 23, 1967, 5–8).

After President Nixon embargoed gold sales, the restrictions lost their original purpose. The staff memo noted also that the rules had become complex and difficult to administer. It recommended repeal. “The banks would be pleased to see that the System could remove a restriction once it has outlived its usefulness” (memo, Regulation M, Correspondence Box 240, Federal Reserve Bank of New York, September 14, 1971, 4).

Senator Gordon Alcott (Colorado) wrote to the Board in 1965 inquiring about his request that a new Federal Reserve district be created in the mountain states. Most of this area was in District 10, with headquarters in Kansas City. A new district would have required legislation enlarging the number of districts; the original act specified a maximum of twelve districts. The Board replied that the costs involved in creating a new district exceeded the benefits (Board Minutes, August 9, 1965, 11–12).

Banking supervision and regulation was an issue from the past that would return many times. In the 1930s Eccles tried several times to get President Roosevelt to concentrate all regulation and supervision at the Federal Reserve (Meltzer, 2003, 487). He never succeeded. The Comptroller of the Currency in the Treasury Department continued to supervise national banks. Because the Federal Reserve did little in 1931–33 to prevent failure of a large part of the banking system, the Federal Deposit Insurance Corporation now supervised (and insured) a large number of banks.

In 1965, members of the House Banking Committee introduced legislation creating a banking agency that would centralize all federal bank supervision and regulation. The proposed legislation abolished the Office of the Comptroller of the Currency and transferred its functions to the proposed banking agency together with the supervisory functions of the Federal Reserve and the FDIC. One bill would have put the banking agency in the Treasury Department. Another would have created an independent banking agency. Authorizing the Treasury to directly supervise banks was an invitation to get more banks engaged in campaign finance and possible corruption.

The Federal Reserve always claimed that bank supervision and regulation were essential for effective conduct of monetary policy, but it rarely offered reasons that convinced most outsiders or its staff that its argument were valid or persuasive. Many countries separated bank supervision and monetary policy without experiencing difficulties.

One of the Board’s main contentions was that the discount function could be administered properly only if the Federal Reserve had continu
ing contacts with banks eligible to discount. Other arguments were even weaker. Governor Daane argued that the Federal Reserve was responsible for “sound credit conditions,” so it had to be concerned about individual bank positions (Board Minutes, April 5, 1965, 13). This reasoning overlooked the fact that many banks were not members of the Federal Reserve System and, of those that were, the
Comptroller’s
office regulated, supervised, and examined national banks. The Federal Reserve received data from the
Comptroller’s
office.

Governor Shephardson added that the System implemented monetary policy “through the commercial banking system. The Federal Reserve should have close relationships with the commercial banks and an opportunity for close observation of activities within the banks” (ibid., 16). The examples he gave were the regulation of time deposit interest rates and the quality of credit, but only the second would seem to be relevant. The second is a throwback to early mistaken concerns about real bills and speculative credit. Shephardson did not remember that the use of credit and the type of borrowing or collateral securing the credit were not the same.

Governor Robertson, often the maverick, disputed these claims. First, “he did not believe that any Board member or Reserve Bank president made a judgment on monetary policy on the basis of examination reports. . . . [Second,] all the information needed by the Federal Reserve would be obtained through access to reports of examination plus the right to require any information it desired from banks coming to the discount window” (ibid., 17–18). Then he added that giving the Federal Reserve responsibility for examinations risked raising pressures to adjust examination standards to support monetary policy. However, he shared Daane’s concern that, if the federal government took responsibility for all banking regulation, it risked becoming absorbed by the executive branch (ibid., 19).

Daane probably expressed the more serious concern when he said that, if the Federal Reserve lost its supervisory and regulatory functions, “it would be more vulnerable to a move to bring monetary policy matters within the sphere of the Executive Branch of the government” (ibid., 12). He did not explain why this was likely. The most plausible reason is that the System relied on the membership for political support. Once it lost direct contact and close relations with the member banks, and the right to approve mergers, branching, and acquisitions, it could not count on their political support for an independent monetary authority. Banks and the Federal Reserve had a common interest in low inflation, so it is hard to know how much weight to put on this argument.

Governor Robertson favored an independent banking agency, and Governor Mitchell was not averse to that solution, although he preferred to
have the Federal Reserve perform the function. He was most explicit about citing the problems in the current arrangement. The current regulatory “setup was working less and less effectively. . . . [T]he situation had become intolerable” (ibid., 13). Banking was changing rapidly, and regulation had not changed with it.
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The legislation did not pass, but it returned several times.

The 1960 Bank Merger Act required bank regulatory agencies to consider the competitive effects of bank mergers and acquisitions. In some cases after the Federal Reserve approved a merger or acquisition, the AntiTrust Division of the Department of Justice acted to overturn the merger even if the banks had consolidated or started to consolidate.

Congress considered legislation in 1965. Members of the Board believed that the Department of Justice should have only a limited time, perhaps ten days, after the Board’s decision in which to notify the banks that it proposed to go to court to stop the merger as a violation of anti-trust legislation. The proposed legislation required the Justice Department to act within thirty days of the Board’s decision. Chairman Martin wanted to support the legislation but also suggested changes that, if adopted, would reduce the Department’s role. The Board approved his suggestions.

In 1918, the Federal Reserve began issuing notes denominated at $500, $1000, $5000, and $10,000, to be used principally for settling interbank balances. It stopped printing these denominations in 1946 but continued to pay out the stocks on hand. By 1969, the stocks had diminished to the point where additional notes would have to be printed. Banks rarely used the notes for settlement.

The Reserve Bank Presidents’ Conference recommended in March 1969 that the Federal Reserve request the Treasury to authorize it to stop issuing notes in these denominations. The Board had first made this recommendation in 1946 (Board Minutes, May 6, 1969, 7–10). The Board’s letter to Secretary David Kennedy noted that an earlier effort to eliminate those notes had claimed that most of the notes were used for illegal transactions. The Board and the Treasury had no evidence to support the claim, so it reversed a 1964 decision ordering the large-denomination notes withdrawn.

The Board did not repeat the claim. It suggested that production of additional notes would require new plates and that the cost of producing the plates exceeded the benefits. The Treasury accepted this reason. On July 14,
1969, the Federal Reserve and the Treasury issued a joint statement ending issuance of the four denominations. The $100 note was the largest remaining denomination.

256. A staff member raised a question about capture. Would a single banking agency be more open to capture by the industry? Governor Robertson acknowledged the point but did not see why it would be more true of a single banking agency (Board Minutes, A
pril 5, 1965, 22).