The Basis for Credit Expansion Under the Federal Reserve System

Abstract

T HE chief defect of the old national banking system was its decentralization resulting in scattered bank reserves. Even though the national banks of the United States possessed enormous aggregate cash reserves yet, before the establishment of the federal reserve system, those reserves were ineffective. There was no method of mobilizing cash for use where and when it was needed. No responsible body was empowered to adopt or carry out discount or other policies to avoid a financial panic or to handle a panic when it occurred. Other countries had economic crises; the United States not only had crises but financial panics as well. This is the reason that under the national banking system the United States was called an international financial nuisance. Previous to the establishment of the federal reserve system country banks were allowed to keep three-fifths of their required reserve of I 5 per cent in reserve city or central reserve city banks. Reserve city banks were allowed to keep half of their required reserve of 25 per cent in banks of central reserve cities. National banks in the central reserve cities, New York, Chicago, and St. Louis, were required to maintain a cash reserve of 25 per cent. Under the reserve system just described the ratio of reserve to net deposits, during the period I909-I4, for all national banks averaged between I9 and 22 per cent. The aggregate lawful money held was between 852 and 904 million dollars and aggregate net deposits ranged between 6,164 and 7,293 million dollars and the ratio of cash to net deposits for all national banks between I2 and I4 per cent (Table I). The inter-bank reserve relations resulted, therefore, in a cash reserve of about I2 per cent appearing as a legal reserve of about 20 per cent. Under the old national banking system, an increase of one dollar in lawful money would be the basis for an average increase of about eight dollars in loans and deposits. During the period I909-I3 the national banks of New York City held upwards of one-third of the specie in the vaults of all national banks of the United States.' In spite of a system which compelled the scattering of reserves and of responsibility for financial policies, New York City was the outstanding and even dominating capital of the national banking system. Because of the fact that New York City was, by force of circumstances, the financial capital and main reserve center of the United States, the weekly statements of the New York Clearing House Banks were rightly considered the most important data available upon which to base a judgment of current credit conditions. Of the items published in the weekly statements of the New York banks the excess reserve was generally considered the most significant single item. An excess reserve in New York meant that banks there could increase their loans and deposits to four times the amount of the excess, or that they could respond to the demands of country banks for cash and still maintain the legal ratio of 25 per cent. A deficiency in reserves was often the signal for a tight money market in New York, erratic fluctuations in call rates, apprehension on the part of country bankers, and a drain of cash to the interior. Under the federal reserve system, however, the figures for reserves and excess reserves of New York banks (or any other group of member banks, for that matter) have lost their former significance. Since June 2I, I9I7 every member bank has been required to maintain reserve balances in the federal reserve bank of its district. Cash in the vaults of member banks does not now count as reserve. In other words, legal reserves of member banks now consist only of deposits with the federal reserve banks. These reserve deposits are required to be not TABLE i. SELECTED ITEMS FROM THE REPORTS OF ALL NATIONAL BANKS IN THE UNITED STATES EACH YEAR FROM I898 TO I9I4 *