# LOANS TO THE BANKS - The Mystery of Banking

One method by which the Central Bank expands or contracts total bank reserves is a simple one: it increases or decreases its outstanding loans of reserves to various banks. In the mid-nineteenth century, the English financial writer Walter Bagehot decreed that the Central Bank must always stand ready to bail out banks in trouble, to serve as the “lender of last resort” in the country. Central Banks generally insist that borrowing from them is a “privilege,” not a right conferred upon commercial banks, and the Federal Reserve even maintains this about members of the Federal Reserve System. In practice, however, Central Banks try to serve as an ultimate “safety net” for banks, though they will not lend reserves indiscriminately; rather, they will enforce patterns of behavior upon borrowing banks.

In the United States, there are two forms of Federal Reserve loans to the banks: discounts and advances. Discounts, the major form of Fed loans to banks in the early days of the Federal Reserve System, are temporary purchases (re discounts) by the Central Bank of IOUs or discounts owed to banks. These days, however, almost all of the loans are out right advances, made on the collateral of U.S. government securities. These loans are incurred by the banks in order to get out of difficulty, usually tosupply reserves temporarily that had fallen below the required ratio. The loans are therefore made for short periods of time—a week or two—and banks will generally try to get out of debt to the Fed as soon as possible. For one thing, banks do not like to bein continuing, quasi-permanent debt to the Fed, and the Fed would discourage any such tendency by a commercial bank.

Figure below describes a case where the Central Bank has loaned $1 million of reserves to the Four Corners Bank, for a two-week period. CENTRAL BANK LOANS TO BANKS Thus, the Central Bank has loaned$1 million to the Four Corners Bank, by opening up an increase in the Four Corners checking account at the Central Bank. The Four Corners’ reserves have increased by $1 million, offset by a liability of$1 million duein two weeks to the Central Bank.

When the debt is due, then the opposite occurs. The Four Corners Bank pays its debt to the Central Bank by having its account drawn down by $1 million. Its reserves drop by that amount, and the IOU from the Four Corners Bank is canceled. Total reserves in the banking system, which had increased by$1million when the loan was made, drop by $1 million two weeks later. Central Bank loans to banks are a factor of increase of bank reserves. It might be thought that since the loan is very short-term, loans to banks can play no role in the bank’s inflationary process. But this would be as simplistic as holding that bank loans to customers can’t really increase the money supply for any length of time if their loans are very short-term. This doctrine forgets that if outstanding bank loans, short-term or no, increase permanently, then they serve to increase reserves over the long run and to spur an inflationary increase in the money supply. It is, admittedly, a little more difficult to increase the supply of outstanding loans permanently if they are short-term, but it is scarcely an insurmountable task. Still, partly because of the factors mentioned above, outstanding loans to banks by the Federal Reserve are now a minor aspect of Central Bank operations in the United States. Another reason for the relatively minor importance of this factor has been the spectacular growth, in the last few decades, of the federal funds market. In the federal funds market, banks with temporary excess reserves at the Fed lend them literally over night to banks in temporary difficulties. By far the greatest part of bank borrowing of reserves is now conducted in the federal funds market rather than at what is known as the discount window of the Federal Reserve. Thus, during the 1920s, banks’ borrowed reserves from the Federal Reserve were at approximately 4 to 1 over borrowings from the federal fund market. But by the 1960s, the ratio of Federal Reserve to federal funds borrowing was 1 to 8 or 10. As J. ParkerWillis summed up, “It may be said that in the 1920s Federal Funds were considered a supplement to discounting, but that in the1960s discounting had become a supplement to trading in Federal Funds.” To get an idea of the relative importance of loans to banks, on January 6, 1982, the Federal Reserve Banks owned$1.5 billion of IOUs from banks; in contrast, they owned almost $128 billion of U.S. government securities (the major source of bank reserves). Over the previous 12 months, member banks borrowing from the Fed had increased by$335 million, where as U.S. government securities owned by the Fed increased by almost \$9 billion.

If the Fed wishes to encourage bank borrowings from itself, it will lower the rediscount rate or discount rate of interest it charges the banks for loans. If it wishes to discourage bank borrowings, it will raise the discount rate. Since lower discount rates stimulate bank borrowing and hence increase outstanding reserves, and higher discount rates do the reverse, the former is widely and properly regarded as a pro inflationary, and the latter an anti-inflationary, device. Lower discount rates are inflationary and higher rates the reverse.

All this is true, but the financial press pays entirely too much attention to the highly publicized movements of the Fed’s (or other Central Banks’) discount rates. Indeed, the Fed uses changes in these rates as a psychological weapon rather than as a measureof much substantive importance.

Still, despite its relative unimportance, it should be pointed out that Federal Reserve rediscount rate policy has been basically inflationary since 1919. The older view was that the rediscount rate should be at a penalty rate, that is, that the rate should be so high that banks would clearly borrow only when in dire trouble and strive to repay very quickly. The older tradition was that there discount rate should be well above the prime rate to top customers of the banks. Thus, if the prime rate is 15 percent and the Fed discount rate is 25 percent, any bank borrowing from the Fed is a penalty rate and is done only in extremis. But if the prime rateis 15 percent and the Fed discount rate is 10 percent, then the banks have an incentive to borrow heavily from the Fed at 10 percent and use these reserves to pyramid loans to prime (and therefore relatively riskless) customers at 15 percent, reaping an assured differential profit. Yet, despite its unsoundness and inflationary nature, the Fed has kept its discount rate well below prime rates ever since 1919, in inflationary times as well as any other. Fortunately, the other factors mentioned above have kept the inflationary nature of member bank borrowing relatively insignificant.