§ 5. Reserves against Federal Reserve notes. The rule applying in normal times to reserves against note issues is that each bank must provide a reserve in gold equal to 40 per cent "against the Federal Reserve notes in actual circulation, and not offset by gold or lawful money deposited with the Federal Reserve agent." At least 5 per cent is to be on deposit in the Treasury of the United States. The proportion of reserves to the liability for note issues by any bank, however, may be allowed to fall below 40 per cent, on condition that the Federal Reserve Board shall establish a graduated tax of not more than 1 per cent per annum (it evidently might be made less if the Board chose) upon such deficiency, until the reserves fall to 32 1/2 per cent and thereafter a graduated tax of not less than 1 1/2 per cent on each additional 2 1/2 per cent, deficiency or fraction thereof.5

This tax must be paid by the Reserve bank, but it must add an amount equal to the tax to the rates of interest and discount charged to member banks. The effect of these rules is to give a power of note issue in time of emergency without compelling the Reserve banks to lock up their reserves held against notes. Suppose, for example, that the circulating notes were in normal times $1,000,000,000, and the reserves, therefore, were $400,000,000, and the rate of discount 5 per cent. Then the circulation might be doubled with the same reserves, the proportion thus falling to not less than 20 per cent of outstanding notes, and the rate of discout to customers rising to 13.5 per cent (5 plus 8.5). Or, to take a most extreme supposition, suppose that the withdrawal of gold had been so great as to reduce the reserves against notes to $50,000,000; yet outstanding notes might still be doubled, becoming $2,000,000,000, the proportion of reserves falling to 2.5 per cent, the rate of discount rising to 24 (5 plus 19).

5 This may be shown in the following table:

When reserves against notes are the tax rate upon the total deficiency shall be counted as a part of the reserves of member banks. The legal minimum reserves for country banks (as fixed by amendment June, 1917) is 7 per cent; for banks in reserve cities 10 per cent; for banks in the three central reserve cities 13 per cent, all of which must be kept in the Federal Reserve bank, till-money not being counted as part of the reserve.7

Fig. 3 shows the changes in the reserve percentages of the the twelve Federal Reserve banks, combined, in the first seven years. It was above 80 until 1917, and about 90 in April just as we entered the war. It fell to about 55 in the war period, where it remained until the latter part of 1919, and fell to 40 the first half of 1920, the period of greatest speculation and highest prices. The reserve of some of the banks fell several points below 40. (The average reserve requirement against notes and deposits together was about 38.) Recall this chart when considering §§ 11-13 below.

§ 6. Reserves against Federal Reserve bank deposits. Every Federal Reserve bank shall, under normal conditions, maintain reserves in lawful money of not less than 35 per cent against its deposits. But the Federal Reserve Board may suspend any reserve requirement in the Act for a period not exceeding thirty days and from time to time renew the suspension for periods not exceeding fifteen days; but in that case it must establish a graduated tax upon the amounts by which the reserve requirements may be permitted to fall below the levels specified as to note issues. Although the amount of the tax on the deficiency of reserves against deposits is not indicated in the act, it is plainly the thought that the Board will follow somewhat the same rule as in respect to excess note issues. The great discretionary power as to reserve requirements thus lodged in the hands of the Board makes possible at times of emergency the use of the reserves both of the Reserve banks and of the member banks, down to the last dollar, if need be, without violation of law. This gives practically unlimited opportunity to expand credit both by the issue of bank-notes and by discount and deposit in periods of financial crises.

§ 7. Reserves in member banks. Important changes were made in the rules as to the reserves against deposits that had been in force under the old national banking system. A new distinction was made between time and demand deposits. Time deposits are defined as those payable after thirty days or subject to not less than thirty days' notice; and demand deposits as those payable within thirty days. In every case the reserve requirement against time deposits is now only 3 per cent (first 5 per cent, but later amended). This gives encouragement to banks to maintain savings departments and to make agricultural loans. The Federal Reserve banks take the place of the banks in reserve and central reserve cities as the depositories of funds that were6

6 The complete application of the new rule was deferred for a period of three years from the passage of the act.

These legal requirements as to proportion of reserves, as compared with those of national banks under the old law, are smaller by 53 per cent, 60 per cent, and 48 per cent, respectively (though practically less reduced because till-money is no longer counted). The large increase in lending power thus given to the member banks explains in part the large expansion of banking credit between 1915 and 1920, the encouragement of speculation in 1918-1920, and the large earnings of most member banks.8

§ 8. Rediscounts by Federal Reserve banks. More important than any other single feature of the act is that by which each Federal Reserve bank is to rediscount notes, drafts, and bills of exchange arising out of actual commercial transactions, when endorsed and presented by any of its member banks. This, quite apart from the note issues, gives a power to the banks collectively, under the general supervision and control of the board, to expand credits indefinitely at any time for real business purposes. This enables any business man who can offer commercial paper of sound quality to borrow on it at some rate of discount, even in the most stringent times. And, in turn, every member bank should be able at such times to rediscount such paper and thus secure credit toward its reserve requirement on the books of its Federal Reserve bank. Suppose, for example, that a member bank (in a central reserve city) saw its reserve in the Federal bank fall below 13 per cent of its demand deposits. It could by rediscounting $13,000 worth of notes increase by $100,000 the amount to which it might legally extend credit to its customers. The deposits of the Federal Reserve bank would then be increased $13,000, against which it must have a reserve of 35 per cent or $4550. If the reserves of any Federal Reserve bank fall too low, it can in turn rediscount its paper with the other Federal Reserve banks.9 If the time comes when no one of the twelve banks can longer maintain a 35 per cent reserve the Board may reduce or suspend the requirement, levying a tax graduated according to the deficiency. The provision here for elasticity of credit, combined with union and solidarity of all the central banking reserves of the country to meet unusual demands in emergencies, exceeds any needs that can be expected to arise.

7 By amendment, September, 1918, banks in outlying districts of central reserve cities, or of reserve cities, may, by affirmative vote of five members of the Federal Reserve Board, be permitted to hold reserves less than the usual 13 and 10 per cent, respectively.

8 The original act reduced the legal minimum of reserves required of each of the three classes of banks to 12, 15, and 18 respectively, and laid down an over-ingenious rule for the proportion that must be left in the member bank's own vaults and in the Federal Reserve Bank, respectively, or that might be in either place.

§ 9. Changes in national banks. There was thus created a national system of reserves, but it will be observed that membership in the new system of the Federal Reserve banks was not limited to national banks, but was opened on equal terms to banks organized under state laws. While in most respects the general banking law remained as it was, certain changes of importance were made. The percentage of reserves required of all member banks (as above indicated) is a substantial reduction of the former requirement for national banks. In some other respects the powers of national banks were enlarged. One with a capital and surplus of $1,000,000 may with the approval of the Board establish foreign branches, and one not situated in a central reserve city may lend on farm-lands for a term not longer than five years, but not to exceed one third of its time deposits

• See on "piping" provision, § 2, above. or 25 per cent of its capital and surplus. National banks may now be granted permission by the Board to act as trustee, executor, administrator, or registrar of stocks and bonds, thus having the rights that have proved in many cases to be of advantage to trust companies organized under state laws.