a surplus fund until that fund equals 100 per cent of the subscribed capital stock Thereafter, excess earnings must be divided, 90 per cent going to the government as a franchise tax and 10 per cent being set aside as additional surplus for the bank. This disposal of earnings is a guarantee that the Reserve banks shall not become mainly profit-seeking institutions. They exist chiefly for service and only incidentally for profits.

One of the Class C directors is designated by the Federal Reserve Board as Federal Reserve Agent and as Chairman of the Board of Directors. The chief duties of the Federal Reserve Agent are:

1. To promote friendly relations with member banks, and by publicity and education, bring about effective coöperation.

2. To have custody of the backing for Federal Reserve notes, to receive and pass upon applications for note issue, and to issue the notes to member banks.

3. To supervise examinations of member banks, and to safeguard the enforcement of the law.

4. To maintain statistical records of business and finance, and to make such reports and publications as may be helpful to banking and business.

The Federal Advisory Council consists of one representative from each district, selected by the directors of the Federal Reserve bank. Most selections are of prominent bankers, and are looked upon as honorary. Members serve without compensation and for a term of one year, unless reëlected. The Council is intended to form a point of contact between actual bankers and the agencies of government. Its recommendations are purely advisory, although in practice the government agencies have gone out of their way to solicit the advice and aid of the Council, to the end that solid bonds of coöperation might be maintained.

Reserves. Under the Federal Reserve Act, member banks in central reserve cities must maintain reserves of 13 per cent of their demand deposits, in reserve cities 10 per cent, in all other cities and towns 7 per cent. In cities of all sizes, reserves against time deposits must be 3 per cent. Under the old National Bank Act, the reserves were 25, 25, and 15 per cent, respectively, against both time and demand deposits combined.

These reserve ratios apply to the member banks alone. But the Federal Reserve banks also have reserve requirements. Gold reserves must be 35 per cent against deposits and 40 per cent against Federal Reserve notes. The ultimate reserve against demand deposits of a rural bank is, therefore, 35 per cent of 7 per cent of such deposits, or only 2.45 per cent. The ultimate reserve against demand deposits of a bank in New York City is 35 per cent of 13 per cent of such deposits, or only 4.55 per cent. In general, one dollar of reserves in the Federal Reserve bank may support as much as about twenty dollars of demand and time deposits of member banks.

The new reserve ratios made possible a thinner reserve backing for bank deposits. Under the new law, each dollar of reserves in a Federal Reserve bank came to support about 50 per cent more deposits and notes than under the old law. During the period 1917 to 1923, the volume of gold reserves increased materially and since each dollar would support more credit than ever before, a marked expansion of bank credit occurred. This expansion contributed to the inflation of prices which occurred during the period.

But in spite of the fact that the reserve ratios were thinner than before, they were far safer. The entire legal reserve of each member bank must be carried with the Federal Reserve bank of its district. This arrangement was intended as a blow to the excessive centralization of reserves in New York City for call loan speculation. Whatever vault reserve a bank carries for till-money purposes does not come under legal regulation and does not count as reserve. Everything which is to count as legal reserve must be in the hands of the Reserve banks.

The Reserve banks pay no interest on legal reserves deposited with them. At first, member banks thought it a hardship to give up the 2 per cent interest which their deposits with correspondent banks had yielded, but in the course of time it appeared that this loss was offset by the fact that smaller total reserves could be carried and by other advantages of bank coöperation.

The concentration of legal reserves is a pronounced step in the direction of mobilizing reserves for emergency purposes. The member bank can replenish reserves in time of stress by either of two methods. First, it can send additional cash, in the form of gold, Federal Reserve notes, currency, or checks drawn on other banks. But in time of stress, these sources of new reserves are likely to be exhausted. Second, it can borrow the additional reserves from the Federal Reserve bank, by rediscounting commercial paper. This method is the special reliance for emergency elasticity of credit and mobilization of reserves. Banks short of reserves may borrow them from the Reserve banks. They can borrow, either on their own secured promissory notes, or by selling to the Federal Reserve the notes, drafts, or acceptances of their customers. The constant access to this flexible source of reserves protects the member banks from the panicky feeling which otherwise occurs in time of strain and crisis. In addition, it gives seasonal elasticity to reserves and credits, and adjusts banking facilities to business needs.

But it may happen that all the member banks in a given district will over-borrow from the Reserve bank, and exhaust its reserves. If emergency demand for reserves in any district reaches this extreme, it is possible for the Reserve bank of that district to borrow from some other Federal Reserve bank. The Federal Reserve Board in Washington may permit or compel such interdistrict borrowing. In 1920, Federal Reserve banks in St. Louis, Minneapolis, Dallas, Kansas City, Richmond, Atlanta and New York borrowed heavily from other Reserve banks, principally from Boston and Cleveland. Such borrowing spreads

reserves out to the greatest possible use, and adjusts reserves to the sectional differences prevailing at the time.

But it is conceivable that the expansion might continue to such a point that for the country as a whole, reserves in Federal Reserve banks would be below legal requirements. This contingency is provided for by the rule that the Federal Reserve Board may suspend for a limited time any reserve requirements, but shall impose a graduated tax upon the amounts by which reserve balances are allowed to fall below legal requirements. The over-expansion is permissible, but only under penalties which tend to make it as short lived as possible. This provision of the law has not been used up to the present date, although in 1920 reserves were nearly reduced to the point where suspension would have been required.

In making current reports of reserve ratios, the Federal Reserve Board follows the policy of consolidating the reserves against both notes and deposits. Thus, if the reserve ratio is reported as 60, the ratio means that gold reserves are 60 per cent of the combined Federal Reserve note issue and deposit liabilities of the Federal Reserve banks. This consolidated ratio is often used as an index of business expansion. If gold reserves remain constant, a decline of the ratio means that notes and loans have expanded to meet the expanding needs of business. The significance of the index depends upon whether the change is due to expanding gold supply or to expanding bank credit. The heavy inflow of gold imports to the United States during the war and post-war period upset the normal significance of the reserve ratio, since fluctuations in that ratio reflected gold movements rather than business movements.

Discounts. When a bank discounts paper for a customer, it buys from him a promissory note, draft, acceptance, or bill of exchange, and calculates the purchase price at the face amount of the paper less the interest deducted in advance. Discounting is a method of extending credit to borrowers. If a member bank, having bought such paper from a customer, decides to resell the paper to another bank or to the Federal Reserve bank, the process is known as rediscounting.

Only certain kinds of paper are eligible for rediscount with the Federal Reserve bank. Eligible paper presented by a member bank for rediscount must have a maturity at the time of discount of not more than ninety days if the loan is for a commercial purpose, and of not more than nine months if the loan is for an agricultural purpose. Paper must arise out of actual commercial transactions, and must be issued or drawn for agricultural, industrial, or commercial purposes. Paper must not be issued or drawn for investment purposes, or for speculation on the stock exchange. However, paper drawn for the purpose of carrying or trading in bonds and notes of the government of the United States is eligible for rediscount. All such paper rediscounted for member banks must bear the indorsement of the member banks, and therefore must be two name paper or better.

In addition to rediscounting customer's paper, member banks may discount their own promissory notes directly with the Federal Reserve

bank. Such notes must be for periods not exceeding fifteen days, but may be renewed. They may have as collateral either securities of the United States, or commercial paper otherwise eligible for rediscount.

The Federal Reserve banks may go outside the member banks and buy commercial paper in the open market. By the open market is meant not any single building such as the stock exchange but that network of banks, brokers, and commercial paper houses which daily engage in the purchase and sale of notes, bills and acceptances. Before the Federal Reserve Act there was no open discount market worthy of the name in the United States. In this respect, the United States stood in sharp contrast to European countries, where a highly organized discount market was considered the essence of sound banking. The framers of the Federal Reserve Act had in mind the creation in this country of an open market modelled somewhat after European practice. The Federal Reserve Board and banks have deliberately done all within their power to encourage and stimulate the development of the market, and the result has been the expansion of open market facilities to an encouraging degree. The Federal Reserve banks are authorized to purchase and sell in the open market principally bankers' acceptances and bills of exchange, domestic or foreign, and with or without the indorsement of a member bank. They may also purchase or sell acceptances of Federal Intermediate Credit Banks and of National Agricultural Credit Corporations, whenever the Federal Reserve Board shall declare that the public interest so requires.

Finally, Federal Reserve banks may rediscount paper for each other. The Federal Reserve Board has power to permit or compel Federal Reserve banks to rediscount the discounted paper of other Federal Reserve banks at rates of interest to be fixed by the Board. This interdistrict rediscounting is intended to secure the mobilization of reserves, by enabling those districts which are over-expanded to borrow from those districts which are under-expanded.

Discounting and rediscounting in the ways specified is intended to remedy the great defect of the old National Banking system. Reserves are organized and controlled to the end that they may be moved promptly to the points where they are most needed. This feature of the Federal Reserve plan is a primary reliance in averting panics and in insuring the safety and stability of banks.

Each Federal Reserve bank announces from time to time its official discount rate. The power to fix the official rate is divided between the bank and the Federal Reserve Board. In general, the Federal Reserve bank takes the initiative in proposing that changes be made in the rate, and the Federal Reserve Board accepts or rejects the proposal, although the Board itself may take the initiative if it considers that the bank is slow to propose needed changes. The power to fix the official discount. rate is of the greatest importance to the successful administration of the banking system.

The importance of the official rate may easily be exaggerated, but

it is safe to emphasize the fact that it is of fundamental influence in all banking policy. The interest rate has a strong influence upon the pace of business. Inflation and boom may be held in check by a timely raising of the rate, and recovery from depression may be stimulated by a timely lowering of the rate. The rate is an instrument of control over business

But the degree to which the official rate can affect the market rate of interest will depend largely upon the extent to which member banks feel obliged to borrow from the Federal Reserve banks. Obviously, if the official rate is merely theoretical, and no paper is presented for rediscount, the official rate cannot affect the market rate. At what times, then, do member banks tend to borrow from Reserve banks? At times of abnormal demands from their customers for credit. When business expands, bank loans expand. But banks find their own resources exhausted, and so turn to the Reserve banks. By rediscounting commercial paper, reserves may be replenished. If the member bank is charged a high rate on such borrowing, it will in turn pass the cost on to its customers in the form of higher market rates. Thus, the official rate will be passed on to the market, and will become effective. This process may go on haltingly and incompletely, but it will nevertheless be a most important influence in time of expansion and abnormal demand for credit.

But this process depends upon an initiative taken by member banks in applying for rediscounts. If they do not apply, the official rate cannot directly affect them. In order to make the rate effective at such times, it is necessary for the Reserve banks to deal in the open market. To tighten money rates in the open market, the Reserve banks will sell commercial paper already in their possession. Such sales to private parties in the open market will drain out the funds belonging to those parties. The private buyers will have commercial paper, but will have divested themselves of money. The Reserve banks will have the money, and such withdrawals will make money scarce and will make the market "tight." To ease the money market and depress rates, the Reserve banks would buy commercial paper, thereby flooding the market with new funds. By buying or selling in the open market, the Reserve banks may help to make the official rate of discount effective. There are limitations upon the use of this power, but in spite of limitations, the power is a potent weapon of control.

Numerous factors enter into the determination of what is a proper discount policy. The Federal Reserve Board in April, 1923, adopted the following resolution: "That the time, manner, character, and volume of open market investments purchased by Federal Reserve banks be governed with primary regard to the accommodation of commerce and business and to the effect of such purchases and sales on the general credit situation." Although this resolution refers specifically to openmarket transactions, it may safely be taken as the principle which is