146. The Federal Reserve Act

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This section is from the book "Introduction To Economics", by Frank O'Hara. Also available from Amazon: Introduction To Economics.

146. The Federal Reserve Act

When the need for banking reform was sufficiently recognized the Federal Reserve Act was passed (1913) modifying the national banking system in many important features. A Federal Reserve Board, consisting of seven members, was created to supervise the system. Under the direction of this Board the country has been divided into twelve districts, in each of which there has been established a Federal reserve bank. National banks in each of the districts have been compelled to subscribe to the capital of the Federal reserve bank of their district, and banks other than national banks have been allowed to subscribe to the capital of the new banks under certain conditions. Banks subscribing to the capital of the Federal reserve banks are called member banks.

Under the new law the system of note issue has been essentially modified. The Federal reserve banks are gradually to take over the government bonds which have heretofore served as the security for the notes issued by the national banks, and they may issue Federal reserve bank notes to take the place of the national bank notes that are retired. This substitution of Federal reserve bank notes for the national bank notes does not constitute a radical change in the system. But in addition to the Federal reserve bank notes there are issued under the new plan Federal reserve notes. The Federal reserve notes are to be issued to the Federal reserve banks by the Federal Reserve Board and are to be secured, not by government bonds, but by commercial paper which has been purchased by the reserve banks from member banks. These Federal reserve notes are to furnish the elastic element in the currency system. Their amount will increase when there is much money work to be done and decrease when there is less money needed. The new system is elastic where the old system was inelastic.

In the second place, the reserves will be mobilized under the new system so that the reserves of each member bank will serve as a support for all other banks in the system. After a period of transition to the new system has passed a certain definite proportion of the reserves of the member banks which must be held against deposits is to be kept on deposit with the Federal reserve banks. The reserve banks are thus in a position to use a part of the reserves to discount commercial paper for member banks. The reserve banks must keep on hand a reserve of 35 per cent against the deposits kept with them by member banks.

In the third place, when depositors threaten a "run"ona member bank the member bank may, if it possesses suitable commercial paper, present this paper to the reserve bank for rediscount. If the reserve bank is unable to rediscount the paper out of its ordinary funds, it may apply to the Federal Reserve Board for Federal reserve notes and make payment for the rediscounted paper in these notes. The reserve bank is required to maintain reserves in gold of not less than forty per cent of its Federal reserve notes but this requirement may be relaxed by the Federal Reserve Board. The result of the provision for rediscounting the paper of member banks is that no bank that is solvent and that does a conservative banking business is likely to be put in such a position in times of financial stress as to be unable to secure money with which to meet the demands of its depositors.