Thomas Tooke

The mechanics through which the Fed encouraged Malinvestment in 1913

In Unreserved Banking on April 27, 2012 at 12:53 am

In  a previous post we have discussed the level of unreserved banking which the Federal Reserve System brought about. Today I want to show how exactly the Malinvestment was encouraged by the Federal Reserve System.

As Kemmener discussed in 1920.

Take the case of a bank in a central reserve city which had been normally carrying a cash reserve in the neighborhood of say 25 per cent, because that was the minimum per-centage required by law, or because experience had shown that a reserve about that size was best suited to its particular type of business, or both of these reasons. Such a bank we will assume after the establishment of the federal reserve system, of which it became a member, found that the legal reserve requirement against demand deposits was cut to 13 per cent and that the greater liquidity of its assets brought about, through the facilities for rediscount and collateral loans offered by the federal loans offered by the federal reserve system would apparently make it safe for it to reduce its reserve to 17 per cent (namely, 13 per cent legal reserve in the form of a deposit with its federal reserve bank and 4 per cent cash in vault).

What would be such a bank´s probably course of action under these circumstance? The answer is obvious. It would reduce its normal reserve percentage from 25 to 17 because by so doing it would increase its profits without materially weakening its financial position or impairing its efficiency. The most likely method of doing this and the method that would probably be used, if possible, would be for the bank to extend its loan and deposit accounts. To do this it might well reduce its discount rates, extend the credit limits of its best customers, and possibly extend credit to others whom it had previously refused out of what might appear to it now to have been an excess of caution (emphasis added). In this way the loan account would be expanded, deposits would be increased, and the reserve percentage (legal plus till money) would be reduced from 25 per cent to the new norm of 17 per cent, the bank thereby probably realizing for its stockholders substantially increased profits.


So the leverage in the economy is actually not regulated by the Fed, but promoted by its existence, note the impact on lending to clients which were before denied credit for lack of credit quality.


If this reduced reserve requirement were limited to one bank, the possibility of deposit expansion thereby created would be small because the enlarged deposits resulting from the increased loans would tend to give the bank an unfavorable clearing house balance, and to draw quickly away thereby a part of its reserve money. Under the conditions, however existing during the war period this opportunity and this motive for reserve reduction, or in other words for loan and deposit expansion, were open to all of the national banks in the country and to large numbers of state banks and trust companies. It was but natural therefore that they should all endeavor to expand, in order to take advantage of the opportunity to increase their profits. The last few years have been highly profitable years for commercial banks.



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