The paragraph of the Federal Reserve Act prescribing the conditions when the reserve requirement may be suspended, and the penalties for violation, is very loosely drawn. It provides a graduated tax for deficiencies of reserves against notes, but not against deposits. Formerly, in order to determine whether a deficiency of reserve existed, the practice of the federal reserve banks had been to subtract 35 per cent of the deposits from the existing reserve and see whether the amount remaining equaled 40 per cent of the federal reserve notes outstanding. But in February, 1920, when this method showed that actual deficiencies existed, the method was changed, so that now 40 per cent of the federal reserve notes is subtracted from the actual reserves, and the deficiency or excess is shown with respect to deposits. By this change in method of calculation, therefore, the provisions of the law which aimed at checking inflation of the credit of reserve banks through the graduated tax on deficiencies of reserves, and through rising discount rates, were nullified. Hence, until the law is amended this phase of the law is held in suspension, and the 40 per cent requirement is rather a danger sign than anything else.
In addition, the federal reserve authorities have taken the view that so long as the reserves of the system as a whole are sufficient, it matters little what the condition of any one of the twelve banks may be, for the Federal Reserve Board has authority to cause any one of the reserve banks to rediscount paper for another, and in this way reserve balances can be shifted at will. The reserve banks may also borrow from one another to "adjust" their reserves. From these operations two technical expressions have arisen: "unadjusted reserves," signifying the reserves which the banks would actually have if they had not borrowed from the other banks, and "adjusted reserves," signifying the reserves after the money borrowed has been added or money loaned has been subtracted. There are arguments both for and against this interpretation of the law. On the one hand, it certainly gives the system more elasticity and unity and possibly makes it more serviceable in emergencies, and there is no doubt that such method of "adjusting" reserves is within the rights of the banks. On the other hand, if the limitations of the law were applied to the banks as individual institutions, more conservative banking would probably be the result.
Another device for obviating deficiencies of reserves has been the substitution of legal tenders for gold. According to the law the legal tenders can be used as reserves only against deposits, and against the notes a gold reserve is required. In recent years legal tenders have constituted a larger proportion of the total reserves of the federal reserve system against its deposits. The substitution of legal tenders for gold in the reserves increases the "free gold" and encourages further expansion. So long as the legal tenders are acceptable freely at par, they will serve as reserve quite as well as gold; but a certain risk is thereby incurred, and such use is a pyramiding of credits. Besides it is a fair surmise that the framers of the Federal Reserve Act intended that the reserves against deposits should also be gold, no less than was the case with reserves against notes.
Another factor that affects the reserve ratio is the deposit of gold, legal tenders, and silver by the Treasury. By making such deposits the Treasury might in an emergency relieve the banks from deficiencies of reserves. At any rate it is well, in reading the weekly statements of the federal reserve banks, to observe to what degree the increase of reserves arose from this source and to what degree the banks actually contracted their liabilities.