Under a system of centralized reserves - or to the extent that reserves are centralized - an individual bank may depend upon the agency or agencies holding the "mobilized" reserves. If there be no open discount market, and if at the same time market custom has set itself against special arrangements by individual banks, rediscounting by the central reserve agency is indispensable to a reliance upon discounted paper as a liquid asset. These collateral circumstances may, however, be favorable, and in such case the reserve-holding agency needs to be depended upon only when the possibilities in the open market or through private arrangement have been exhausted. The greater the degree of reserve centralization, however, the greater must be the assurance that, when the demands of the market have exhausted the other expedients, the reserve-holding agencies can be relied upon as purchasers of satisfactory discounted paper.

Discounts the most acceptable

Redis-counting and reserve organization

Even under a system of centralized reserves it is desirable, in the interest of ultimate economy, to have market conditions of rediscounting as open as possible. Where there is a broad and open market for rediscounts this may first be relied upon, and resort to the reserve agency is then necessary only when, on any given percentage of reserves, the available credit in the market has been exhausted. For example: Suppose that the percentage of reserves held to be necessary in a community is 10$. Bank A, we assume, with cash on hand and on deposit at the central reserve bank has a reserve of 20$. Bank B has, however, only 6$ and feels the need of strengthening its position. The percentage considered desirable at the reserve bank C is, we assume, 40%, but for the moment we assume that the reserve bank has a surplus, namely 45%. If directly or indirectly in the open market Bank B can sell discounts to Bank A, Bank B can strengthen its reserves while Bank A is simply utilizing its own surplus reserves. If, however, Bank B cannot sell some of its discounts in this manner to Bank A, but must turn immediately to Bank C, the reserve agent, the reserve-holding bank can extend credit to Bank B only by increasing its own liabilities, or in other words, by weakening its own reserves, notwithstanding the fact that some of its credit already extended to Bank A, in the shape of the deposit carried by Bank A, has not been fully utilized.

Centralized reserves and rediscounting

Importance of open market

Under a system of decentralized reserves rediscounting is possible when banks make special arrangements with each other. Banks in certain parts of the South and West in the United States thus often rediscount their paper with their New York correspondents. The possibilities of private arrangements of this kind are likely, however, to be restricted. A purely private bank, even though large, could not lend heavy sums of cash available for reserve purposes to other banks. On the other hand, where the law accepts as a part of lawful reserves the deposits by banks in other institutions not distinctively recognized as reserve-holding banks, as was the case under the National Banking System in the United States, only a proportion of the reserves could safely be so deposited, and the extension of credit in the shape of deposits by the bank acting as the reserve agent would necessarily be limited to this proportion. Furthermore, the bank holding the reserves being a profit-making institution is likely to estimate the credit it will extend to a correspondent bank rather on the basis of its correspondent's average balance than on the basis of such correspondent's real need.

There may also be, under a system of decentralized reserves, a free and open discount market. The development of an open discount market is possible under any system of reserves, but assuming its existence, under a system of decentralized reserves a bank wishing to strengthen its position can offer for sale in the open market any acceptable paper in its portfolio. Such sales would involve not only readjustments of credit, but in all probability also readjustments of cash holdings. Necessary readjustments of credit and of cash holding growing out of operations in an open discount market over a country as a whole would probably involve complications of accounting, shipping, etc., that would limit the scope of accomplishment of the market itself. But notwithstanding the limitations that scattered reserves might impose on the scope of an open discount market such a market would contribute much to the free flow of credit.

Redis-counting and decentralized reserves

Open market here

Irrespective of the reserve system, an open market for discounts may then be considered highly desirable. The creation of such a market is contingent, however, upon the existence of certain factors of fundamental importance. In the first place, the credit instruments offered for sale must be of unquestioned standing and broadly acceptable. If paper is to pass freely from hand to hand it must be of a character to command absolute and general confidence. Paper based upon confidence in an individual is obviously not of that character, except where the individual concerned is a large firm of national standing. The "commercial paper" market in the United States was confined -at least up to the establishment of the Federal Reserve System - to the paper of relatively few large firms. The notorious Westinghouse and Claflin failures amply disclosed, however, the unsafe character of much of such paper. Hence in Europe the operations of the discount market involve in first instance the transformation of individual credit into bank credit. Bills drawn on and accepted by banks constitute the most desirable form. Trade bills drawn against commodities represent perhaps the next most desirable form. Purely individual instruments like promissory notes would naturally come last in the list of acceptable paper for broad marketing purposes. The almost exclusive dependence upon the promissory note (with often only a single name) in general commercial banking practice in the United States, precluded the development of an open discount market.