BANKS • Paper Eligible for Rediscount The discount operations of the federal reserve banks are of three classes: i. For member banks.
2. Open-market purchases and sales.
3. For other federal reserve banks.
Paper that is eligible for rediscount is defined by Section 13 of the Federal Reserve Act and by Regulation A of 1917 of the Federal Reserve Board. Paper eligible for purchase in the open market is defined in Section 14 of the act and in Regulation B of 1917. In general terms the definitions limit these operations to paper based on commercial origin having short maturity, and bearing the indorsement of a member bank (if it is for rediscount). During the war it was found advisable to admit to discount "war paper" (i.e., notes of a member bank in favor of the federal reserve bank and accompanied by United States securities as collateral). War paper is not commercial, and the proceeds may or may not be used to extend loans for commercial purposes.
1. Rediscounting for Member Banks Before 1914 one of the serious defects in the American bank ing system was the want of a discount market—a dependable source of funds for the banks at all times, on the basis of commer cial paper. The federal reserve banks provide by the rediscount process such a source for the member banks, who are thus no longer dependent upon their correspondents for accommodation.
Until June, 1917, however, the member banks had made rela tively little use of the rediscount privilege. The operation was novel to most members and the inertia of custom was enough to keep them from using the federal reserve banks as a source of funds. There was also a sentiment adverse to rediscounting, for to rediscount the paper of customers was thought to reflect dis credit upon a bank's management and this unwarrantable sen timental objection had to be smoothed away. The wide-spread skepticism of country banks about the federal reserve system, the general attitude of waiting to see what it would do, and the ignorance of the banking fraternity concerning the new system, were also contributory factors toward delaying rediscounts.
Finally, there was a dearth of eligible paper in the portfolios of the members.
These various obstacles in the way of rediscounting were lessened by a campaign of education about the new system, by the development of acceptances as a commercial instrument, by the cumulative experience of members with the reserve banks, and by the admission of many state banks to the reserve system.
Effect of War on Discount of Commercial Paper The most important cause of change in attitude towards re discounting was the necessities of war finance, with its huge spas modic receipts and payments handled through the banks. The war made it necessary to have an ever ready source of funds in large abundance, and this was afforded by the reserve banks. As the discount rate at the reserve bank was prevailingly below the market rate for funds, the motive of profit also inclined the member to use the reserve bank rather than the correspondent with which it had previously dealt.
On the other hand, the use of war paper lessened the necessity for the use of commercial paper, and the great preponderance of borrowings by members from the reserve banks has been on war paper. War paper as an element in the earning assets of the reserve banks reached its height in May, 1919. Since that date. not only has the volume of war paper declined but the volume of commercial bills has increased faster than the volume of war paper has declined, with the result that the commercial paper now (1921) constitutes about half of the earning assets, and the fraction will continue to grow larger. Many of these facts are shown by Figure 9.
Statistical Statement of Rediscounts War finance operations have so disturbed discount operations that it is impossible to show the normal seasonal variations in the discount holdings of the reserve banks. Undoubtedly as soon as the Treasury operations become stable and normal, the graph of average monthly holdings of the system as a whole and of each reserve bank will show a certain symmetry for the various seasons.