periods of unprecedented banking strain, they have been able to do so not because of the legal reserves that they have carried, but largely because they have been able by borrowing at the reserve banks to convert their eligible assets into cash.

The effect of this borrowing, furthermore, has not been confined to paper which is eligible for rediscount at the reserve banks. The mere fact that the reserve banks stand ready to lend on eligible paper has helped to maintain a ready market for all types of sound bank assets. Under present conditions, therefore, in which member bank reserve balances cover only 7 per cent of their deposit liabilities, it is clear that the liquidity of the average individual member bank can be more adequately guaranteed by the possession of a substantial portfolio of eligible paper or of other assets readily convertible into cash in the market than by any practicable increase in its requirements for legal reserves.

As our banking system is now organized, legal requirements for member bank reserves contribute to the security of bank depositors by providing the reserve banks with funds available for assisting banks in emergencies and by adding strength to the whole banking system through the exercise of credit control rather than through determining the volume of reserves held by individual member banks. In order to be able to utilize the strength of the reserve banks in emergencies, however, it is essential that the individual member bank maintain an adequate portfolio of sound assets readily convertible into cash, and, particularly, of assets eligible for rediscount at the reserve banks.

Control of credit.-The most important function served by member bank reserve requirements is the control of credit. This function has a bearing on the liquidity of bank credit, for, in the nature of things, bank credit is most liquid when credit conditions are sound, and unsound credit conditions do not usually develop unless the banking community in general has expanded its credit beyond the needs of trade and industry. The overexpansion of credit may take a particular form, such as excessive loans on farm lands, on urban real estate, or on securities, or it may be more general applying to a wide range of bankable assets. Whatever its form, it has the effect of temporarily inflating the general purchasing power of the community and also of raising for a time the market value of bank assets beyond their intrinsic worth. It is the function of reserve requirements to restrain such overexpansian by making it necessary for banks to provide for additional reserves before they expand their credit. To perform this function adequately, however, it is essential that reserve requirements reflect both the volume and the activity of credit outstanding, for unsound credit conditions can develop either out of an excessive volume of bank credit in relation to the needs of trade and industry or out of an excessive use of a given amount of credit. Credit could be expanded indefinitely, for example, without any inflationary effect whatever, provided the bank deposits thus created were never drawn upon to effect an exchange of goods or services. Conversely, it is possible for an unsound credit situation to develop without an increase in the volume of deposits, but merely out of an increase in their activity. Unsually, unsound credit conditions are accompanied by an increase both in the volume and in the activity of deposits. In 1928 and 1929, however, during the most extravagant phases of the stock market boom, excessive credit demands were reflected in an increase in borrowings from nonbanking lenders, and an unprecedented increase in the activity of bank deposits, without an increase in their total volume. Reserve requirements, consequently, failed completely during those crucial years to act as a brake on the unsound use of credit.

Progressive diminution of member bank reserves under present requirements.-Between 1914 and 1931, the period covered by our present system of reserve requirements, total net deposits of member banks increased from $7,500,000,000 to $32,000,000,000, or more than 300 percent in less than two decades. Some of this increase reflects the accession of State banks to membership in the Federal reserve system, but the greater part reflects the expansion of member bank credit. While war financing and the huge inflow of gold which followed the war constituted the immediate driving force back of much of this expansion, it was facilitated by a progressive reduction in effective member bank requirements for reserves. Thus, member banks actually hold at the present time about $2,900,000,000 of reserves against $32,000,000,000 of net deposits. This includes both the legal reserves which they hold with the Federal reserve banks and cash which they hold in their vaults. If the vault cash reserve requirements of national banks prior to 1914 had been retained in the Federal reserve act up to the present time,

member banks would now be required to hold about $4,400,000,000 in reserves instead of $2,900,000,000. This means that in the aggregate total reserve requirements of member banks are now about 35 percent less in proportion to their deposits than they were before the Federal reserve act was passed. It is clear, consequently, that the large expansion of member bank credit since 1914 has been facilitated by a progressive diminution in reserve requirements as well as by large imports of gold. Without this diminution member banks would have needed in order to expand their credit to its present volume additional Federal reserve bank credit to the extent of $1,500,000,000. By applying to the reserve banks for this additional credit, the member banks would have correspondingly increased the effectiveness of reserve bank credit policy. Of the total decrease of $1,500,000,000 in present requirements as compared with pre-war requirements, about one-half reflects the effect of the amendment which removed vault cash from required reserves in 1917, while the remainder reflects in part the lowering of reserve requirements by the original Federal reserve act, and in part, the rapidly decreasing proportion of member bank deposits which have been classified as demand deposits since the inauguration of a lower reserve on time deposits in 1914. This decrease has occurred, moreover, during a time when the average turnover of all deposits has increased, indicating that differentials in reserves as between time and demand deposits and as between demand deposits at city and country banks have not effectively registered changes in the activity of deposits or in the use of member bank credit by the community. Such figures as are available for earlier years indicate that the average turnover of bank deposits in this country increased steadily from 1914 up to 1929. Between 1925 and 1929, alone, estimates made for the committee indicate that the rate of turnover of the average dollar deposited in member banks increased from 24 times a year to 33 times a year, notwithstanding the fact that 64 cents of this dollar was classified as a demand deposit in 1925 as against 59 cents in 1929.

Failure of existing requirements to reflect credit developments. In the accompanying chart there is portrayed the extent to which existing legal requirements for reserves have failed to reflect credit developments at member banks in recent years. The upper line reflects movements in the total dollar volume of transactions which pass through the deposit accounts of customers of member banks. The middle line shows member bank time and net demand deposits combined and reflects movements in the total volume of member bank deposit liabilities. The bottom line shows the reserve balances which member banks have maintained with the Federal reserve banks. During the period covered by the chart all the legal reserves have been held in this form. The lines are plotted as index numbers with January, 1924, equal to 100.

This chart brings out the failure of member bank reserve balances under our present reserve requirements to reflect fundamental changes in the demand for credit. In the first year shown on the chart, 1924, the total volume of debits or check payments made through member-bank accounts was low, reflecting a relatively inactive business situation. Member-bank requirements for reserves, however, increased in 1924 more rapidly than in any other year shown on the chart because the inactive local demand for funds throughout the country caused banks to redeposit funds with their correspondent banks in the larger cities, which were required to hold reserves of 10 or 13 per cent against these funds. As a consequence, an inactive demand for funds from trade and industry in 1924 was reflected in a sharp increase both in member-bank deposits and in member-bank requirements for reserves. During 1925 and 1926, on the contrary, when business became more active, these redeposited funds were withdrawn from correspondent banks and loaned directly in the market, with the result that aggregate requirements for factor in the credit situation in 1928 and 1929 when an extraordinary demand for funds from the stock market was met without an increase in reserve requirements of member banks. In fact, the aggregate legal requirements of member banks for reserves were about $75,000,000 lower in September, 1929, at the very peak of reserves remained for two years at about the level of December, 1924, failing completely to reflect an increase in the market demand for funds.

The failure of reserve requirements to reflect fundamental changes in the demand for funds and to operate in such a manner as to bring these changes under control became a major factor in the credit situation in 1928 and 1929 when an extraordinary demand for funds from the stock market was met without an increase in reserve requirements of member banks. In fact, the aggregate legal requirements of member banks for reserves were about $75,000,000 lower in September, 1929, at the very peak of the stock-market boom than in

Vault cash. After reviewing member bank operations during recent years the committee is convinced that the removal of vault cash from required reserves in 1917 has had undesirable consequences that were not forseen at the time. Prior to 1917, member banks in central reserve cities were required to hold aggregate reserves equal to 18 per cent of their demand deposits, the corresponding percentages for reserve city and country member banks being 15 and 12 per cent respectively. At the same time, the requirement against time deposits was 5 per cent at all classes of member banks. Part of these reserves were held as balances with the reserve banks and part as cash in the vaults of the member banks. Federal-reserve notes and national-bank notes held by member banks, however, could not be counted as legal reserves. Under the 1917 amendment, reserve requirements against demand deposits were reduced by 5 per cent and against time deposits by 2 per cent at all classes

of banks, and at the same time member banks were required to hold all of their legal reserves on deposit with the Federal reserve banks.

The main purpose of the 1917 vault-cash amendment was to concentrate the gold holdings of the country in the Federal reserve banks. Up to that time, member banks had been required to hold their vault-cash reserves in gold or lawful money, with the result that the monetary gold resources of the country were only partially mobilized in the Federal reserve banks, a large proportion being absorbed in the form of circulating notes held by the member banks and the public. The 1917 amendment corrected this situation by removing the inducement for member banks to hold their vault cash in the form of gold rather than Federal-reserve notes and so permitted the mobilization of gold in the Federal reserve banks.

In addition to concentrating the gold resources of the country in the Federal reserve banks, however, the 1917 vault-cash amendment incidentally opened the door for a gradual diminution in the actual reserves of the member banks. In the last 14 years, the amendment has permitted a reduction in aggregate reserves, amounting at the present time to over $700,000,000. Had this amendment not been passed, consequently, member banks today would be required, other things being equal, to hold aggregate reserves more than $700,000,000 larger than their present legal reserves plus their holdings of vault cash. These additional reserve requirements would have exercised a wholesome restraint during the boom period which culminated in 1929 and the policy pursued by the Federal reserve system would have been much more effective had the member banks at that time been forced to borrow this additional $700,000,000 from the Federal reserve banks.

Between June 1917, before the new requirements went into effect, and June, 1930, net demand plus time deposits of member banks increased from $12,000,000,000 to $32,000,000,000, but holdings of vault cash at the same time decreased from about $800,000,000 to less than $500,000,000. By making progressive economies in their use of vault cash at a time of rapid increase in their deposit liabilities, member banks were able to reduce their cash holdings to less than 3 per cent of their net demand plus time deposits by 1919, to less than 2 per cent by 1924, and to less than 1% per cent by 1930. The chart shows that this reduction has been especially marked at large city banks. In New York City member bank holdings of vault cash in June, 1930, were equal to threefourths of 1 per cent of their net demand plus time deposits and to less than 1 per cent of their net demand deposits alone.

Part of this decline reflects a reduction in the operating requirements of banks for vault cash. The American public has widespread banking facilities and is thoroughly educated in the use of checks. Their demand for pocket currency, consequently, is relatively small since its use is limited largely to transactions in which currency is the only convenient method of payment. In recent years there has also taken place a rapid increase in the use of checks for wage payments which has materially reduced the demand for cash for industrial pay rolls. While this substitution of checks for currency may reflect a socially desirable development, it does not constitute a logical or valid reason for a reduction in the reserve requirements of member banks since the effect upon business activity and upon the position of the individual member bank is the same whether a depositor's account is drawn upon to make payments by check or by currency.

By no means all of the economies in the use of cash which member banks have been able to effect since 1917, however, reflect the substitution of checks for currency in making payments. On the contrary, a special study of the daily vault cash holdings of member banks has shown definitely that location in the vicinity of a Federal reserve bank or branch is the largest single factor accounting for the reduction in member bank holdings of cash. This investigation showed that member banks situated close enough to Federal reserve banks or their branches to be able to deposit surplus currency at the reserve banks or to obtain additional currency supplies from the reserve banks within a few minutes, maintained vault cash holdings equal on the average to only 1.38 per cent of their net demand deposits. This group of member banks holds about 60 per cent of the total deposits of all member banks.

During the same period, the remaining member banks held vault cash equivalent to 4.64 per cent of their net demand deposits, or more than three times the proportion that was held by member banks close to the reserve banks. The investigation also showed that member banks located within short distances of cities where Federal reserve banks or branches are located held as high a proportion of vault cash, on the average, as country member banks, which

1918 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930

The 1917 amendment eliminating vault cash from legal reserves, consequently, has had two unfortunate effects. First, it has materially reduced the total reserve requirements of member banks and thus further facilitated expansion of bank credit at a time when huge gold imports arising out of war and postwar disturbances were already placing difficulties in the way of the effective administration of the country's credit resources. Second, these reductions in aggregate reserve requirements have not been equally available to all member banks but have particularly favored those banks which are located in close geographical proximity to the Federal reserve banks. As these member banks 175541-34--PT 16—7