Journal Issue

Banking and Money Market Arrangements in the United States

International Monetary Fund. External Relations Dept.
Published Date:
September 1970
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Frederick C. Dirks

MODERN COUNTRIES need a medium of exchange—the money supply—in amounts that are appropriate to the economy. They also need a network of financial institutions to facilitate the mobilization of savings so as to make these available to prospective investors. This requires in turn a variety of credit instruments involving differing degrees of safety, yield, and maturity in order to attract individual savers with various preferences, and a financial network that can transfer these savings rapidly to the points where they are wanted.

Such flexibility in the arrangements is not available through any one kind of credit institution, and most industrialized countries have evolved in the course of their history a variety of institutions to meet those needs, with channels among them so that funds may flow from one to another. In the United States the variety is perhaps greater than in most countries, partly because of the size of the country and the diversity of industry, partly because of an early bias against a centralized government and governmental control. This tradition has also resulted in a “dual” banking system under which both the Federal Government and the individual states charter and regulate banks, with only informal coordination among the various regulatory authorities.

Probably no government would deliberately plan such a heterogeneous collection of institutions, but it has evolved in response to economic pressures into a network capable of responding sensitively to the financial needs of the production sectors.

A Money Supply with Flexibility

The concept of the money supply in the United States consists of currency outside banks and demand deposits of the private sector, adjusted to exclude interbank deposits and cash items of banks in process of collection. It includes balances held in U.S. commercial banks by domestic and foreign individuals and business firms, and by state and local governments, and also foreign demand balances held at Federal Reserve Banks (i.e., in banking offices of the central bank).1 At the end of December 1969 the money supply according to this concept amounted to $206 billion, equal to nearly one fourth of the annual gross national product.2 Of this total, 23 per cent was currency in circulation, while 77 per cent was demand deposits. About nine tenths of the currency is in paper form, consisting almost entirely of Federal Reserve notes backed mainly by Government securities. No money is redeemable in gold within the United States, and no gold circulates as money. (All gold coin was withdrawn from circulation by a series of Executive Orders in 1933.)

The overwhelming volume of private payments in the economy are effected by means of checks drawn on demand deposits. These checks are deposited by the recipients in their own bank accounts. The banks effect the collection of these checks by a clearing process which, for checks drawn on and deposited in banks in the same city, may be undertaken through a local clearinghouse. Most of the checks drawn on out-of-town banks are sent for collection to the Federal Reserve Bank or branch which serves that district. The balances which each of the 12 Federal Reserve Banks find to be due to and from other districts are cleared daily by telegraphic advice. A relatively small volume of checks—those deposited in banks which are not “members” of the Federal Reserve System—are collected by being sent to correspondent banks in one of the larger cities.

The money supply is flexible in the sense that it responds to the needs and desires of the private sector. Currency needs are expressed seasonally and cyclically by withdrawals from banks by individuals and business firms having deposit accounts there, and by the banks replenishing their supply of currency from the nearest central bank office (Federal Reserve Bank or branch). Following seasonal peaks there is a return flow of currency into the banks. That part of the money supply that consists of demand deposits reflects mainly the lending activities of the banking system in response to consumer and business needs, but important variations in it arise from fluctuations in the Government deficit (or surplus), in the balance of payments, and in the shift of deposits between demand and time categories.

The Assortment of Banks

The commercial banking structure of the United States comprises about 14,200 head offices, with more than 20,000 branches and additional offices. Most of these are relatively small single-office banks but a considerable number, both small and large, have branches within their own state. Banks are not permitted to have branches in more than one state,3 but a bank may solicit accounts from business firms that operate in many states. Bank charters may be issued by either federal or state authorities, and two thirds of all commercial banks hold state charters. Banks are regulated and supervised by the chartering authorities, but the majority of state-chartered banks are also under joint supervision by a state and federal agency. About 43 per cent of the banks, holding 82 per cent of all private demand deposits, are “members” of the Federal Reserve System and are thus directly subject to some central bank control. (These percentages imply that member banks are typically much larger in size than nonmember banks.) In addition, about 98 per cent of the banks have the funds of their depositors insured (up to a maximum of $20,000 per depositor) and are subject to supervision by the Federal Deposit Insurance Corporation. For this protection to depositors, each bank pays a small insurance premium.

Each of the 50 states can establish its own requirements for bank operation, although convenience and self-interest have led to considerable informal coordination among them and with the nationally chartered banks that also operate in their territory. A state-chartered bank that wishes to be a member of the Federal Reserve System must, however, observe Federal Reserve requirements, which may be more exacting than its state requirements. This multiplicity of authorities arises from the fact that the U.S. Constitution reserved the right to coin money to the Federal Government, but made no similar reservation about bank charter or regulation. Federal regulation has since been imposed upon this heterogeneous system, but the fact of state sovereignty works to limit the scope of the regulation.

U.S. banks render a wide range of services. While a few of them confine their operations to very large corporations and are called “wholesale” banks, and some others cater especially to small businessmen to whom they also offer a variety of advisory services, most banks extend credit to wide groups of borrowers. Small banks, by maintaining a correspondent relationship with a big city bank, are able to offer many of the same services as large banks. The big city correspondent may be used to collect checks drawn on other big city banks, and to make remittances to or collections from other countries; it is often asked to participate in business loans that are too large for the small bank to handle alone, and is also a source of information for customers of the small bank who may be seeking new commercial connections in the big city.

In recent years nearly all banks have accorded increasing attention to small individual depositors, and the bank credit extended (directly or indirectly) to consumers in some years has exceeded the amount, of credit going to finance business operations. Banks that provide savings facilities—and most do—have to meet the competition of other (nonbank) institutions operating in the same general field. Commercial banks also compete with other lending agencies, some of them sponsored or regulated by the Government.

The Evolution of Monetary Control

Monetary control over commercial banking operations, which is now exercised by the Federal Reserve System, has evolved from experiments over nearly 200 years.

During most of the first 90 years of independence (which began in 1776) banknotes were issued mostly by banks chartered by individual state governments, sometimes with no restrictions as to collateral. Over issue led to widespread and sharp currency depreciation. A series of efforts at national and regional levels to put the privileges of money issue on a more orderly basis had only limited success. During the Civil War of 1861-65 (between the northern and southern states) the financial pressures on the Federal Government led to the establishment of a system of national banks with the power to issue banknotes backed by Federal Government bonds. Establishment of the new notes was assisted by the levy of a tax on the use of notes issued by state banks, but the new notes also gained acceptability through their uniform quality, in contrast to the miscellany of existing currency which traded at varying discounts. The basis of the new currency was equally unresponsive to seasonal and cyclical needs, however, and repeated experience with cyclical crises of confidence led eventually to the establishment of the Federal Reserve System in 1913.

This System provided flexibility in the money supply by enabling member banks to discount their commercial and agricultural paper at the central bank (thus replenishing their lending ability as business expanded), it established an interregional system for clearing checks and currency, pooled the reserves of large numbers of commercial banks to assist in mobilizing the flow of funds to points of strain, and provided more adequate banking facilities for the Federal Government. Central banking functions are in the hands of 12 operating regional Reserve Banks, with a central policymaking Board of Governors in Washington.

All nationally chartered commercial banks are required to be members of the Federal Reserve System, but membership for the state-chartered commercial banks is optional. Member banks assume the obligation to meet certain minimum requirements as to the amount of their capital, the centralizing of their reserves with the Reserve Bank in a stipulated ratio to deposits, and other operating regulations which include the payment at par of checks drawn on them and observing certain ceilings on interest rates payable on deposits. Reciprocating these obligations, membership in the System carries the privilege of borrowing (usually referred to as “discounting”) from the Reserve Bank and of using certain services, such as the supply of day-to-day currency needs of the member banks and the collection of checks drawn on other banks.


Note: Puerto Rico and Virgin Islands included in 2nd District (New York) for check clearing and collections; Alaska and Hawaii are included in the 12th District (San Francisco).

Although reserve requirements were originally imposed for safety reasons—i.e., to protect depositors from excessive note issue and to provide a pool of funds for meeting irregularities in the ebb and flow of bank liquidity—it became apparent over the years that reserve requirements also provided an instrument of control for the central bank, whereby it could regulate the rate of credit expansion and thus restrain business activity from expanding at an unsustainable rate. This possibility arises because an expansion of bank loans entails a corresponding expansion of bank deposits and, when reserves are required to be held in a stipulated percentage of deposits, the level of bank reserves becomes a limiting factor in the growth of loans. The need for reserves is a limiting factor, not only for the banking system as a whole, but also for the individual bank, since it tends to lose reserves if it expands more rapidly than surrounding banks, or if its customers incur a local or regional payments deficit vis-à-vis the customers of other banks.

The contrast between the U.S. philosophy of central bank control and that of other countries can be understood in the light of these payment flows among unit banks in a structure of thousands of independent banking offices. This structure, plus the emphasis given by history to the importance of domestic reserve assets, explains why changes in the availability of bank reserves have been considered a more strategic control device than changes in the discount rate, on which some other central banks have traditionally relied. In the United States changes in the discount rate may occasionally initiate a new policy phase; more typically they confirm a change already visible in market interest rates. (The volume of discounting has been regulated in recent times by specific principles for its use, as well as by the discount rate.)

Thinking has also evolved as to the most useful channel through which bank reserves could be influenced. During the first 20 years of Federal Reserve operations, reserve funds from the central bank were made available principally by discounting for the individual banks; the proportion of total reserves supplied via discounting ranged between 37 and 80 per cent during the 1920’s. Gradually, however, the more impersonal “open market operations” began to displace discounting as a means of supplying reserves. With this mechanism, when the Reserve Banks wish to add to the reserves of member banks, they purchase Treasury bills (occasionally other Government securities or bankers’ acceptances) from dealers in this paper; the purchases are paid for with Reserve Bank funds which the dealers deposit in their accounts with the member banks. Thus open market purchases add directly to member bank reserves, and they also put the dealers in a more liquid position, enabling them to take up more Treasury bills or other paper that individual member banks may wish to sell in order to increase their reserve positions. Changes in dealers’ positions are quickly reflected in the interest rates at which they offer to buy or sell, and, through these rates, changes in money market ease or pressure quickly spread to other banks in the System. As a corollary to the existence of these arrangements, individual banks facing temporary pressures are expected to adjust their reserve positions mainly through their own resources, with no more than temporary discounting at the Reserve Banks.4

Table 1.FLOW OF SAVINGS THROUGH MAJOR FINANCIAL INTERMEDIARIES(Totals for calendar year 1969, in US$ billions)
Net Increase in Loans and Investments 1
Savings AccumulatedMortgagesConsumer creditBusiness loansSecurities
Mutual savings330-101
Savings and loan associations4100
Credit unions11
Insurance and pension reserves1933-1116
Open-end investment companies61-03
Finance companies134

Except for investment companies (which did not reinvest all funds received), net growth in total loans and investments exceeded the total of savings accumulated because of funds obtained in other ways.

Except for investment companies (which did not reinvest all funds received), net growth in total loans and investments exceeded the total of savings accumulated because of funds obtained in other ways.

During the 1930’s, another instrument of policy—the adjustment of percentage reserve requirements—was devised as the only apparent way to neutralize the undesirable impact of very large gold inflows. Since then, occasional resort to adjusting reserve requirements has come to be regarded as a blunt but appropriately powerful instrument for influencing the rate of credit expansion in some circumstances. Day-to-day adjustments by the Federal Reserve to maintain the degree of reserve ease or tightness considered appropriate continues to be accomplished mainly through open market operations.

The Channels for Mobilizing Savings

Commercial banks, by their lending activities, affect the total amount of the money supply and facilitate changes in spending and investment patterns. These patterns are shaped also by accumulations of savings from the national income stream and their subsequent relending. A comprehensive presentation of the flows, and the channels through which they move, is available in a statistical cross-classification of the flow of funds which has been compiled and published for many years by the Board of Governors of the Federal Reserve System. Although too extensive to be shown and explained here, a rough picture of the major flows is afforded by looking at two condensed sectors.

In Table 1 are listed a group of financial intermediaries, through which $40-50 billion a year of savings have accumulated in recent years. On the average, commercial banks have accounted for about 30 per cent of this flow; in 1969, however, their time and savings deposits actually declined by $ 11 billion, owing in part to large business savers shifting funds to higher yielding market investments. The banks adjusted to the outflow by reducing their holdings of U.S. Government securities; their lending to business and consumer sectors was maintained at a high level.

The flow of savings into other intermediaries, being almost entirely from the household sector, was less affected. Mutual savings banks (mostly under state charter) and savings and loan associations (mostly under federal charter) are both cooperative types of institution; the great bulk of their funds goes into building mortgages. Credit unions, another type of cooperative, are limited in membership to persons working or living close together. Their loans are largely for consumption purposes.

Insurance and private sector pension funds also have directed considerable amounts of savings into housing and commercial mortgages, but the bulk of savings accumulated by them has gone into business securities. Finance companies are a financial intermediary but not a savings institution, since they raise loan funds by selling their own securities and commercial paper (negotiable short-term notes), with peak needs being covered by borrowing from the banks. Most of their funds are extended as short-term credit to consumers and business firms (the latter for working capital and purchase of equipment).

In addition to the flow through such institutions, personal savings are invested directly in various financial assets. The size of these direct transactions, in comparison with total personal income, personal consumption, and the flows through financial intermediaries, is illustrated in Table 2. The first column of the table shows the distribution of total personal income in 1969—largely into consumption expenditures and taxes, but leaving gross savings of about $47 billion. While real investment in housing totaled $27 billion, the lower part of the table shows that about three fifths of this was financed by borrowing through mortgages; other (shorter-term) borrowing was incurred to finance part of the consumption expenditures shown above. Borrowing thus supplemented gross saving by $30 billion, permitting an accumulation of financial assets by $50 billion during the year. Most of this accumulation was in financial intermediaries, as the table shows, but substantial amounts were also invested directly in Federal and local government securities.


Income before taxes747146
—Tax accruals11837
—Consumption expenditure, business withdrawals159297
+ Capital consumption allowances1066
+ Adjustments and discrepancy-3
= Gross saving4775
Real investment
Housing, plants and equipment27103
Net financial investment or borrowing (-)20-36
Increase in financial assets
Currency, bank deposits7-7
Savings at other financial institutions 289
Life insurance and pension reserves20
U.S. Government13-1
State and local42
Investment in unincoporated business 3-55
Trade and consumer credit19
Net increase in liabilities
Corporate securities16
Housing/commercial mortgages1710
Short-term credit
Other financial institutions 179
Other liabilities and capital (net)—14
Source: Federal Reserve Bulletin, May 1970, p. A 71. In the present abstract, consumer durable goods are classified with household consumtion rather than investment

Includes dividends paid by corporate business and a conceptual transfer of all income from unincorporated business to the household sector.

For business sector, consists largely of commercial paper.

Mainly appreciation on farm land which is realized and withdrawn at time of sale.

Source: Federal Reserve Bulletin, May 1970, p. A 71. In the present abstract, consumer durable goods are classified with household consumtion rather than investment

Includes dividends paid by corporate business and a conceptual transfer of all income from unincorporated business to the household sector.

For business sector, consists largely of commercial paper.

Mainly appreciation on farm land which is realized and withdrawn at time of sale.

In the nonfinancial business sector, gross saving was exceeded by real investment, so that this sector was a net borrower. The need for $ 111 billion for real investment was augmented by substantial sums used to extend trade credit and to finance the rising values of farm land. The shift from time deposits in commercial banks, mentioned earlier, was reflected in a decline of bank deposits and a rise in commercial paper holdings. These uses of funds were met by internal saving plus a net increase in liabilities by $63 billion. Nearly half of the latter sum was obtained through the sale of corporate securities and mortgages, some of which were bought by banks and other financial institutions. In addition, these institutions provided another $22 billion of short-term credit.

The Role of Markets for Trading Financial Assets

The role of financial intermediaries in directing new savings for investor convenience is supplemented by markets in which outstanding financial assets can be traded. These not only enable individuals and business firms to change the direction of their portfolio investment; they also help them to shift from saving in some years to dissaving in other years.

The most important market for such shifting is that in U.S. Government securities. Banks typically add to their holding of Government securities in years when business demand for loans is slack, and dispose of them later in order to expand their business loans. The larger business corporations also utilize the Government security market as a channel for investing temporarily idle funds. Insurance companies, which accumulate liquid funds at a more or less steady pace, necessarily bought very heavily of Government securities during World War II because business securities and housing mortgages were then in short supply. Since that time they have been liquidating these holdings in order to diversify their portfolios more broadly. The Government security market also operates, as mentioned earlier, to equalize pressures for funds among individual banks in various sectors of the country. The volume of trading in this market alone exceeds in value the entire gross national product.

Trading in more varied corporate securities takes place on the national securities exchanges with their ancillary networks of brokers and dealers which cover most of the large and medium-sized cities of the United States. In these markets it is possible for investors to buy or sell a wide range of equity securities within a few minutes merely by making a telephone call. The greatest numbers of equity securities are not listed on the securities exchanges, however, but are traded on a less liquid basis through “over-the-counter” transactions with brokers and dealers. Over-the-counter trading also predominates for trading in corporate bonds.

The characteristic market liquidity of what are legally long-term investment securities makes them attractive vehicles for a much greater number of savers than would otherwise be interested. Over one fourth of the adult population of the United States is reported to hold corporate securities of one kind or another. There is also substantial participation by investors from other countries in these financial markets. This participation accelerated after the removal of exchange restrictions in the major industrial countries a decade ago. The substantial flows of short-term and long-term capital in both directions every year suggest that these markets are not only U.S. markets but also world markets.

The effectiveness of these markets in attracting domestic savings, in mobilizing them for producer and consumer convenience, and in responding to central monetary policy all depends heavily on their capacity to react sensitively to variations in interest rates and market prices. This does not mean that these markets are entirely free; government regulation began a century ago to correct demonstrated abuses, and has adaptively faced new problems when they became acute. The system of mixed freedom and regulation is not perfect, and many feel there is much room for improvement. On the whole, however, it appears to have met the practical test of facilitating the mobilization of resources for a highly productive economy.

Techniques for Project Appraisal Under Uncertainty

by Shlomo Reutlinger


The primary purpose of this study is to present a feasible method for evaluating the riskiness of investment projects. A second objective is to show how quantitative evaluations of the riskiness of projects might be used in various decision problems. Throughout, the emphasis is on methodology and problems of measurement, not on description of various kinds of uncertainty problems, nor is much attention paid to theories which have no immediate applicability to project appraisal. Uncertainty is everywhere, as anyone knows; hence a general descriptive study of uncertainty is unnecessary and the specific sources of uncertainty must be identified for each specific case. In general, however, the uncertainty conditions relevant for this study are those unique to a particular project, and not to “global” uncertainties which affect the outcomes of all projects within a country.

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The organization of the Federal Reserve System is described below.


Outside this concept of the money supply are U.S. Government deposits (largely held at commercial banks) and domestically owned time and savings deposits in commercial and savings banks. At the end of 1969 these amounted to $7.2 billion and $260 billion, respectively.


Though a bank holding company may own and operate banks in several states.


These resources include the sale of Government securities from their portfolios and (since the early 1950’s) the borrowing of reserves directly from other banks that are in an excess position at the Reserve Bank. Trading in such excess reserves, known as “federal funds,” is conducted through certain dealers in Government securities acting as brokers between the interested banks.

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