Comments on
“The Promise and Performance
of the Federal Reserve as a
Lender of Last Resort: 1914-1933”
Ellis W. Tallman
Oberlin College
The Federal Reserve System as
Lender of Last Resort
• Remains an important and relevant question
– Important for future progress – what went wrong?
• Federal Reserve Act –
– Aimed to address known flaws in the National
Banking System (1863-1913)
– Paper shows that the Federal Reserve Act solved a
lot of those problems
• But it was not enough – 1929-33 sufficient proof
Alternative Explanations
• Flaws in the structure of the Fed System
– Too decentralized, unable to coordinate policy
• Required leadership that system lacked
• Devotion to gold standard
– Prevented expansionary policy during depression
• Fed adherence to flawed policy framework
– Relied on nominal interest rate and level of discount
window borrowing as policy indicator
Why was the Fed unsuccessful as
Lender of Last Resort?
• Thesis in this paper:
– The US banking structure was the core problem
• Federal Reserve Act –
– Unable to solve the flaws in the US banking system
– Unable to mimic the money market conditions of the
European Central banks
• Intuitively plausible explanation
– Challenge: to bring compelling evidence to the issue
Proposed thesis: How does it add
to our understanding?
• Flawed banking system
– This idea – not extensively developed in the paper
• The flawed design of the Fed
– Comments will focus on this idea
• Three key flaws of the Federal Reserve Act
– 1) Reluctance of Fed members to borrow at discount
window
– 2) Limited membership of the Fed System
– 3) Restricted eligibility of discount window collateral
Reluctance to Borrow
• Was reluctance a result of “direct pressure”?
– 1928-29 – Federal Reserve was exceedingly
concerned about extensive credit in call loan market
• Aversion to call loan market – was common among
the monetary reformers circa 1910
– Huge volume of discount window borrowing 1919-20
• Something must have changed
• Aversion to borrowing may have been induced
rather than implicit in the Federal Reserve Act
Limited Fed Membership
• Non-member banks suffered higher failure rates
than member banks, 1929-33
– Unable to access lender of last resort liquidity
• Board had Power to allow lending to nonmembers
– Was allowed in 1921 but then rescinded in 1923
• Similar, but restricted, ability to lend to member banks to
lend to non-member banks allowed during WW I
– Federal Reserve Act had the capability to overcome
this limitation
Restricted Eligibility of Discount
Window Collateral
• I agree completely with this idea
– The restrictions on collateral for discounting
• Limited pool of eligible collateral for
rediscounting
– Consistent with “flawed policy framework”
• Can this issue help differentiate the paper’s
thesis from alternative explanations?
Extend Analysis -- Evidence
• Compare components of collateral at Fed DW
– Collateral for discount window loans during 1919-20?
• Was the composition so different from 1929-33?
• Banker’s acceptance market never grew to the
extent that Paul Warburg had hoped
– Was that sufficient for failure?
– Was there any alternative asset class that could have
been a satisfactory substitute?
• For example, expanded purchase, rediscount of gov’t debt
Suggestions
• Current version focuses on 1929-1933
– More analysis on the earlier period for comparison
– Examine closely “lender of last resort” experiences
• Bring more evidence to bear on thesis
– Did policy change 1923-28 relative to policies during
WW I and contraction that followed?
– Quantitative comparison of liquidity provision across
time
• What might have worked?
Was it all about “acceptable”
collateral?
• Collateral restrictions arose from aversion to the
call loan market
– No way to rediscount call loans
– Hope was that banker’s acceptance market would
replace it
• This paper rightly emphasizes the issue
– Warburg - discount market for banker’s acceptances
to replace call loan market as secondary liquidity
source (also in Meltzer 2003, pages 254-55)
• Question: why did the call loan market remain
so important after the Federal Reserve Act?
Holy Grail of Monetary Reformers
• Break the link between capital market and
money market (payment system) in US
– Underlies significance of reducing role of call loan
market investments in NYC bank assets
• Glass-Steagall Act
– Separated investment from commercial banking
– Benston 1990, others – no evidence that investment
banking had large negative effect on bank problems
– Then why separate investment, commercial banks?
• Perhaps to try again to break the link above?
Culprit: Daily Settlement of stock
exchange transactions
• Paul Warburg and the call loan market
– Call money market arose from demand for daily
settlement at New York Stock Exchange
– Combination of overnight settlement along with the
lack of a central bank and ‘modern paper’
• Put the US financial market at risk for recurrent crises
• Warburg wanted credit market more akin to
Europe, where term settlement existed
– He was aware of the flaws in the US system
• President of the American Acceptance Council
– Would likely agree that banking system must change
Summary
• Challenge of paper –
– Find evidence on collateral composition
– Compare 1929-33 with earlier periods when
restrictions were lifted, or were not binding
• Why was the call loan market so active?
– Much attention from Fed 1928-29
– Unusual policies to thwart lending
R
Figure 1: Federal Reserve Credit, Monthly: 1922-1929
2
1.8
1.6
1.4
Billions of US $
Federal Reserve Credit
1.2
1
0.8
Discount Window Credit
0.6
0.4
0.2
Banker's Acceptances
0
q
Figure 1 Extended: Federal Reserve Credit, 1917-1935
4
3.5
Billions of US $
3
2.5
2
1.5
1
0.5
0
Banker's Acceptances
Discount Window Borrowing
Government Securities Held
Federal Reserve Credit
Is the thesis a controversial insight?
• An opinion held by various contemporaries of that period
– Paul Warburg, J. Laurence Laughlin (often tied with real bills)
• Numerous discussions of the flaws in the US banking structure
• Warburg 1930, text from 1927 speech
– “The country must have a wide and freely used bill market if it is
ever to enjoy as perfect a banking system as that to which it is
plainly entitled.” p. 459
– “With us, on the other hand, the banker’s acceptance does not
occupy a similar position as the principal connecting link
between the Reserve System and the commercial banks.” p. 464
• Laughlin 1933, page 19, quoting a letter January 1911
– “….some measure must be provided for enlarging the reserves
so as to increase the lending power of a bank in time of panic.
… enable the transformation of short time paper or securities into
means of payment which would enlarge reserves.”
During WW I, Board authorized Reserve
Banks to discount for non-members
(prohibited in Act)
In 1921, Board authorized Reserve Banks
to discount for member banks any eligible
paper acquired from non-members
Authority for this activity was rescinded
in 1923
Was this quantitatively important?