1As payment of interest on Federal Reserve note. IV. How and why did member bank required reserved accounts at the Federal Reserve banks and the portfolio of United States Government securities owned by the Federal Reserve banks reach the $20 billion level which produces average annual net profits of over $260 billion? The answer is simply that the United States Government elected to finance a $200 billion portion of the cost of World War II on credit, by the issuance of securities, rather than by taxation. Between war-bond drives as the Treasury drew on its accumulated bank balances to meet its current deficit, deposits of businesses and individuals increased. The result between 1940 and 1945 was a $90 billion increase in total bank deposits. The banks invested $53 billion of this increase in United States Government securities, $10 billion in loans to finance war industry, and the remainder had to be set aside as reserves in the Federal Reserve or in correspondent banks. The required reserves of member banks rose $8 billion. The members met this increase in reserve requirements by selling securities to the Reserve banks. The Reserve banks not only purchased whatever amounts of Government securities were necessary to supply banks with reserves but also to meet the steady growth in demand for currency by the public. To make possible this inflation of bank credit and currency, temporary legislation was passed which permitted the Federal Reserve banks to collateralize Federal Reserve notes with United States Government securities. The temporary legislation was permanently codified in June 1945 by Senate bill 510 which also permanently reduced to a uniform amout of 25 percent the gold certificate required as a reserve against Federal Reserve notes and deposit liabilities. The parts played by the commercial banks and the Federal Reserve banks in financing World War II which brought about the large reserve deposits of the members in the Federal Reserve banks invested in United States Government securities is apparent from the following data: Selected items from statements of condition, Federal Reserve bank, Dec. 81, 1940-56 [Billions of dollars] 1940. 1941. 1942 1943. 1944 1945. 1946. 1956. 1940. 1941. 1942. 1943. 1944. 1945. 1946. 1956 Required reserves in 1940 were only $7 billion, the remaining $7 billion was excess. Selected items from statements of all United States commercial banks [Billions of dollars] 1 Estimated. V. Is it not logical to assume that the Federal Reserve banks might dispose of the major portion of their Government bonds sometime in the future and revert to their 1940 status when Reserve balances of $14 billion vastly exceed their $2 billion holdings of United States Government securities? Present Federal Reserve law accommodates an inflated and radically changed monetary situation which appears to be rather permanent, with bank deposits, reserves at the Federal, and their holdings of United States Governments at higher levels. Unless further increases in the public debt are expected, there would be no need for the Treasury to sell any substantial amount of Government securities to the banks to create reserves. A decline in business activity and reduced demand for currency would bring about an automatic increase in bank reserves. With a concomitant decline in deposits, a reduction in reserve requirements would occur. If we enter a deflationary period, it would be desirable for the United States Treasury to retire its $63 billion worth of nonmarketable United States Government bonds, most of which are in the hands of nonbank investors. This would bring about an overall increase in the deposit structure of the country and bank reserves. In such a period the Federal Reserve banks would have to increase further their holdings of United States Government securities. Liquidation of the public's holdings of E, F, H, and K bonds would create a better capital market for United States Government securities in the event of another war or other period of large deficit financing. A final reason why the Federal Reserve banks might not be disposed to sell their holdings of Government securities below a certain level is the absence from their portfolio of any considerable volume of other earning assets. The need for earning assets incidentally was among the reasons given by the Federal Reserve Board for the passage of the 1945 law mentioned above. VI. What was the original intent of Congress? The original Federal Reserve Act was not a revenue bill to produce income for the United States Treasury. Furthermore, the original acts were passed before Federal income taxes imposed any burden on the banking industry. VII. Why should the Federal Reserve banks build up a sinking fund which will permit the elimination of a $3 billion contingent liability of the United States Treasury? 1. There is precedent for the Federal Reserve banks to underwrite the capital requirements of the Federal Deposit Insurance Corporation. In 1935 the Federal Reserve banks made a $139 million capital contribution to the FDIC. This recognized that the entire commercial banking industry including both member and nonmember banks would benefit directly from the establishment of the FDIC. So today, banking as a whole will benefit by this plan which will encourage self-reliance by the banking industry, in contrast to continued dependence upon the Federal Government for credit. 2. It is in the interest of the banking industry to encourage the reduction of the direct, indirect, and contingent debt of the Federal Government. The example set will be a good one for other segments of the financial industry which rely on Federal subsidy and guaranty, which are major causes of increases in the Federal debt, both direct and indirect, which hit an alltime high in 1956, as shown below. Combined total, direct debt and investment, guaranties, and insurance of U. S. Government, 1945-58 The preceding figures do not include contingent liabilities of the United States Treasury to lend : Federal Deposit Insurance Corporation. Federal home loan banks___. Federal Savings and Loan Insurance Corporation_. Total $3, 000, 000, 000 1, 000, 000, 000 750, 000, 000 4,750, 000, 000 3. The elimination of the United States Treasury's obligation to lend the FDIC will in effect take the Government out of business-the bank deposit insurance business. When accomplished, the ultimate ownership of the FDIC would become "mutualized," and responsibility for the management and direction of this impor tant agency will become more a responsibility of the banks and through the Federal Reserve banks rather than of the Government through the Secretary of the Treasury and the Comptroller of the Currency. This is only proper; the banks were the original source of all of the capital of the Federal Deposit Insurance Corporation. VIII. What disposition is made of the earnings of other governmental credit agencies? Are these earnings not returned to the United States Treasury? The earnings of other quasi-governmental credit agencies have not been returned to the Treasury after the retirement of original Government capital subscriptions. Earnings of the Federal land banks, Federal intermediate credit banks, banks for cooperatives, and the Federal home loan banks are returned to the owner members either as interest, patronage refunds, or dividends. Title IV (Federal Home Loan Bank Act section) of the Financial Institutions Act of 1957, S. 1451, does not provide for the earnings of these central banks of the savings and loan industry to be paid to the United States Tereasury. Instead, earnings of the home loan banks derived from member reserves (deposits) and subscribed capital are returned to member savings and loan associations as interest on member deposits and dividends, where they are not even subject to Federal or State income taxes. Nor does the Financial Institutions Act of 1957 provide for any payment to the United States Treasury by the Federal home loan banks of any franchise taxes. The consolidated balance sheet and profit and loss statements of these banks set forth the source and application of their earnings. Consolidated statements of the Federal home loan banks IX. What is the Federal income tax status of each of the financial institutions covered by S. 1451? Although the bill was not designed to codify tax law, S. 1451 continues the complete or substantial exemption from Federal income taxes of the following institutions: Banking industry: Federal Reserve banks, Federal Deposit Insurance Corporation. Savings and loan and cooperative credit industry: Federal home loan banks, Federal Savings and Loan Insurance Corporation, Federal savings and loan associations (as mutuals), and S. 1451, of course, does not extend exemption from Federal income taxes to commercials banks. X. Would the commercial banking industry be better off if the Federal Reserve banks were not exempted from Federal income taxes? The answer is an emphatic "Yes." In 1956, the Federal Reserve banks paid to the United States Treasury $402 million in lieu of franchise taxes. If all of the Federal Reserve banks and FDIC had not been exempted, they would have had to pay only $299 million of Federal income taxes. This is illustrated by the following: Distribution of net income and pro forma tax liability of the Federal Reserve banks and the Federal Deposit Insurance Corporation, year ending Dec. 31, 1956 [In millions of dollars] If S. 1451 is passed without amendment, the Federal Reserve banks will continue to pay 90 percent of their earnings to the United States Treasury. This is a prohibitive price for an artificial exemption from a 52-percent Federal income tax, and an absurd situation. XI. Is there not another better alternative? Perhaps an amendment of S. 1451 which would require the Federal Reserve banks to pay interest to member banks on their reserve balances? At first thought, this is an appealing suggestion since member bank earnings would be increased. The suggestion is reasonable particularly as attention is invited to the fact that the Federal home loan banks pay interest to their member savings and loan associations on certificates or deposits, as provided by sections 11 (a) and (c) of title IV of S. 451. If membership in the Federal Reserve System provided for the receipt of interest on reserve balances, Federal membership would become quite attractive, and many nonmember banks would apply for membership. This would bring about a decline in the deposit structure of the commercial banks located in reserve and central reserve cities which could not compete, since Federal and most State laws prohibit banks from paying interest on reserve (demand) balances. The shrinkage in deposits would shift a substantial segment of the Nation's capital now available for loans to industry and agriculture to reserve balances in the Federal Reserve banks where they could only be invested in United States Government securities. The extension of membership by State banks to the Federal Reserve System would be damaging and disruptive to our financial system. The magnitude of and importance to our dual banking system of correspondent relationships and of our State banks is clearly apparent from the following tabulation of bank reserves and interbank deposits: |