Banking and the Federal Reserve System

In general, the rise of banks is also tied to the Crusades. With the advent of increased trade routes, more readily available spending money and a growing middle class banks became necessary to facilitate the growth of this trade. It was at this time that several great banking families, like the Rothchilds, emerged to lend money to merchants and traders. Since the United States is basically a new born nation banks were in existence long before America declared its independence from Great Britain. Banks in America, however, were rather infantile institutions in comparison to their European cousins.

From the 1700’s to 1863 banking in America was much a microcosm of America herself. Banks were crude, basically unregulated and highly entrepreneurial. These early American banks were state chartered and the states offered precious little supervision. As was mentioned earlier banks came to issuing private paper currency. This currency was supposed to be backed by gold or silver deposits but deposits often failed to meet acceptable levels. In some cases there was never even an attempt to maintain proper reserve levels. As these unscrupulous somewhat insolvent banks proliferated they began to spread more and more “bad notes around the country. These banks, known as wildcat banks were becoming an increasing problem.

Also during the early days of the American Alexander Hamilton proposed The First Bank of the United States. In 1790, Congress proposed that the Bank of North America take on the functions of a central bank. Its primary function would be to control the economy’s money supply. It would have the power to dictate what banks could and could not do. Instead of the state-chartered Bank of North America acting as the country’s central bank, he proposed the creation of a nationally chartered bank which would exercise control over the nation’s money supply and be authorized to extend credit to the government.

Thomas Jefferson and James Madison opposed the idea of a central bank altogether because, in their view, establishing a central bank exceeded the powers of the federal government under the strict interpretation of the constitution. Jefferson and Madison were convinced that the central bank would favor the already powerful northern merchant class. In fact, they were right and Hamilton knew it. Hamilton wanted the bank to issue loans thus tying the wealthy to the stability of the nation. In effect he was creating supporters tied to the new nation out of financial necessity.

Congress bought the Hamilton plan. In 1791, it set up the First Bank of the United States. The bank’s charter was designed to expire after 20 years but could be renewed by Congress. Actually, the First Bank of the United States performed reasonably well. It served as the government’s fiscal agent and even succeeded in dampening the inclination of the state-chartered banks to overissue notes. How? Since many of the state bank notes found their way to the First Bank, the Bank could present the notes to the state banks for payment in gold or silver. Aware of this prospect, the state banks became more careful about issuing bank notes in excess of their gold and silver.

The Second Bank of the United States

In 1811, when the time came to renew its charter, Congress declined to do so. The advocates of states’ rights won out. Over the next five years, the number of state-chartered banks almost tripled, from 88 in 1811 to 246 in 1816. Left without a central bank’s restraining influence on the issuance of bank notes, bank note depreciation and fraud became rather commonplace. By 1814, most banks had suspended specie payment. That is, they would no longer convert paper bank notes into gold and silver. Would you put your gold into such a bank? It didn’t take Congress long to regret having disposed of the First Bank. It became painfully clear that something had to be done to stabilize the money supply.

The answer, just five years after the demise of the First Bank, was to establish the Second Bank of the United States. This time, Congress gave the national bank the right to issue its own notes. These soon became the most widely accepted currency in the nation, preferred to the less-trusted notes of the state chartered banks.

Recognizing the weakness of these issues, the Second Bank pressed for sounder specie backing. The southern and western banks balked, viewing this pressure as discriminatory. Animosity toward the Second Bank intensified when it instructed northern banks not to accept bank notes from the southern and western banks which could not back their currency with gold and silver.

Like the First Bank, the Second Bank was a success, unfortunately, like the First, it was abandoned. When Andrew Jackson, an opponent of central banking, was reelected to the Presidency in 1832, the Second Bank’s existence was an election issue and Jackson promised to destroy the Bank. Unable to convince Congress to terminate the Banks charter, Jackson withdrew Treasury funds from the Second Bank and deposited it in state banks. This undermined the Second Bank’s ability to control the issuance of notes by state banks. By 1836 it had become just another bank in Pennsylvania.

From the demise of the Second Bank as a central bank until Congress passed the National Banking Act in 1864, the economy’s money supply was once again left in the hands of the state banks. Once again, unsound loans and overissuing of notes led to an unhealthy climate of unreliable money.

The National Banking Act

The cost of the Civil War pushed Congress far beyond its financial capabilities. The steady outflow of specie from the Treasury made it impossible for it to continue buying back its notes. Congress reluctantly allowed the Treasury to begin to print money. The Treasury printed Greenbacks, so called because of the ink used on the back side of the notes. They became the economy’s most common, but rapidly depreciating, currency. Once again, the government faced two classic problems: How to provide it self with the financial resources it needed to carry on the affairs of government and at the same time, stabilize the monetary system.

This time, it came up with a novel idea that ultimately was legislated in 1864 as the National Banking Act. The idea was to develop a national banking system. The act created a new office, Comptroller of the Currency, housed in the Treasury, which chartered national banks. A national bank had to buy Treasury bonds equal to one-third of its capital, and could issue notes only in proportion to its Treasury bond holdings. All nationally chartered banks had to have the words “national” or the initials “n.a.” in their title. You can identify some national banks just by name. The Chicago First National, The First National of Toledo, the First National of Fresno, and so on.

Now how do you reestablish people’s confidence in the banking system? Banks were no longer allowed to accept real estate as collateral for loans, nor lend more than 10 percent of the value of their capital stock to any single borrower. Also, each bank was required to provide financial reports to the Comptroller of the Currency and was subject to periodic bank audits. To encourage state banks to switch over to the national system, the Comptroller levied a 10 percent annual tax on state-chartered bank-note issues. This was a steep tax and it virtually eliminated the use of state chartered bank issued currencies, but there wasn’t a rush to conversion to become nationally chartered banks. For one thing, not all state-chartered banks could afford the minimal capital required to obtain a national charter. As a result, state-chartered and nationally chartered banks coexisted within the banking industry. This has become known as a dual banking system.

THE KNICKERBOCKER TRUST DISASTER

The 1907 Knickerbocker disaster was the final straw that broke the camel’s back. Both state and national banks, along with mushrooming financial trusts, were caught up in a whirlwind of speculative loans. In October, frightened depositors looked in horror at the collapse of the Knickerbocker Trust Company, a highly reputable and seemingly sound financial institution. The thought in everyone’s mind-as it would have been in yours-was, Who’s next? Panic spread. People ran to their banks to withdraw their deposits, and hard-pressed banks in turn scrambled for liquidity by calling in outstanding loans. Investment projects, in various stages of incompletion, were all-at-once suspended. Sound businesses, drained dry of credit, were forced into bankruptcy. The result was almost instant recession.

Once again, Congress was forced to intervene. This time, with Knickerbocker still fresh in mind, Congress broadened its concerns from simply coping with the chronic problems of overissue of bank notes and inadequate collateral to include a newly perceived menace, the overreach of powerful financial trusts. The response came in the form of the Federal Reserve Act of 1913.

 

THE FEDERAL RESERVE SYSTEM

The Federal Reserve Act of 1913 created the Federal Reserve System, commonly referred to as the Fed. Why the Federal Reserve System and not the Federal Reserve Bank? The Fed was designed as a system because Congress wanted a decentralized central bank. The decentralization was essentially geographic, reflecting people’s desire for regional monetary independence.

The need for such regional autonomy has since dissipated, but the structure remains intact. The Fed’s structure is simple. It consists of 12 District Federal Reserve Banks, each serving a region of the country. The larger District Federal Reserve Banks have smaller branches. Under this arrangement, a bank in a specific district would use its own District Federal Reserve as its central bank. In this way, banks in Omaha, Nebraska, or Ocala, Florida would not have to depend upon banking decisions made in New York. The map below shows the geographic domain of the 12 District Federal Reserve Banks and their locations.

Who Owns the Fed?

The Federal Reserve System is not owned by the government. Although created by and responsible to Congress, the Fed pursues an independent monetary policy which at times can conflict with government’s economic policy. For example, the government may be pursuing a stimulative fiscal policy (lower taxes, increase government spending) while the Fed may be more interested in controlling inflation.

Who owns the Fed, then, if not the government? Each District Federal Reserve Bank is owned by its member banks. Each member bank contributes 3 percent of its capital stock to the Federal Reserve Bank in its district and another 3 percent is subject to call by the Fed. These are what are known as a banks “reserve requirements.” Of the more than 12,000 banks in the country, fewer than 5,000 are chartered nationally; the rest remain state-chartered. When the law was first passed only nationally chartered banks could join the Fed. Today, this is no longer the case and any bank can join.

All nationally chartered banks must be members of the Fed. The state chartered banks can choose to be members. Even though less than 13 percent of he state-chartered banks are members of the Federal Reserve System – 971 out of 7,653 banks in 1993 – they, along with nationally chartered banks hold more than 50 percent of all deposits in our economy.

The Fed’s Purpose and Organization

The Federal Reserve System’s main responsibility is to safeguard the proper functioning of our money system. It is the watchdog of our money supply, our interest rates, and the economy’s price level. Obviously, if it’s going to do that job at all, it has to monitor the activities of the nation’s financial institutions, anticipate what they will do, prevent them from doing some things, encourage them to do others, and do all this without interfering too much in the conduct of private business. Impossible? Some people think so. But these same people are unable to imagine a modern economy operating without a central bank.

The Fed’s organizational structure is not very complicated. The nucleus of the Federal Reserve System is its Board of Governors, which meets in Washington, D.C. The Board consists of seven members, appointed by the President and confirmed by the Senate. Each serves a 14 year term. Appointments are staggered, one every other year, so that no President or Senate session can manipulate the composition of the board. This also ensures continuity. The Chairman is a board member appointed by the President to a four-year term. Chairmen may be reappointed, but they cannot serve longer than their 14 years on the Board. Typically, chairmen are reappointed for lengthy periods that overlap Republican and Democratic presidents. Paul Volcker, who preceded current Chairman Alan Greenspan, was appointed by Jimmy Carter and twice reappointed by Ronald Reagan. Greenspan has continued into the Clinton administration. Much earlier, William McChesney Martin chaired through the Eisenhower, Kennedy, and Johnson administrations and even into the early Nixon years.

More often than not, Board members are drawn from within the banking industry, either from commercial banks or from the Fed’s District Banks. Volcker, for example, came from the New York Fed. Such ties to banking experience can be both helpful and problematic. While members must understand the complexities of banking, their strong connection to the industry seems to compromise, for some people, their role as guardians of the public trust. But not all come from banking. Arthur Burns, for example, left his professorship at Columbia University to serve as chairman during the late Nixon years.

DISTRICT FEDERAL RESERVE BANKS

The 12 District Banks make up the second tier of the Fed’s structure. Each is managed by a board of nine directors, six chosen by the member banks of the district, the other three appointed by the Board of Governors. The President of each district bank is selected by its nine directors.

FEDERAL OPEN MARKET COMMITTEE

The nerve center of the Fed is its Federal Open Market Committee. Here, the Fed exercises monetary control over the economy through its open market operations. The 12 person committee is composed of all seven members of the Board of Governors who each have one vote, as do the President of the New York Fed, and four District Presidents who rotate voting on the Committee. Its composition reflects the power of the Board, the unique position held by the New York District, and the Fed’s commitment to regional representation.

THE EFFECT OF THE GREAT DEPRESSION

Despite the creation of the Federal Reserve System in 1914 American banking policy was not fully developed. The reality is that many banks that had been only marginally sound during the 1920’s and had lent more in risky speculative investments then they had in reserve. This was due to several reasons. One, federal law allowed banks to invest in real estate financial services. Banks were not just savings institutions, they were investment oriented. Two, only a small number of banks were members of the Fed and were not subject to the Fed’s reserve requirements. Three, Federal Reserve policy was typically laissez faire in this period and did not take the policy steps needed to intervene in a potential collapse. Fourth, and last, deposits were not insured.

In 1929 there were some 25,500 banks in America, none of which had any type of deposit insurance. When the stock market crashed many banks lost investments that were tied to the market. When what was in actuality a very small number of banks closed and declared insolvency, people panicked and rushed to the banks to get out their money. Lines that would ring around the block formed as there was a “run” on the banks. No bank, no matter how solvent, can withstand such a run because banks operate on what is known as fractionalized deposits, or the notion that only a fraction of the deposits are held on to. The rest of the money is used to make investments and a profit. Few could handle it the run and some had actually lost their depositors money. The nation was in a full blown panic and looked to newly elected President Franklin Delano Roosevelt for leadership. FDR declared a bank holiday closing the banks, banks were reopened months later after significant legislation had been passed. Banks were reformed and the panic had subsided. Insolvent banks were closed and depositors who lost money received some compensation. The banks that remained were more secure. They linchpin of FDR’s plan was the creation of the Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC). The purpose of these acts was to insure depositors against loss. Initially each depositor received coverage only $2,500 per depositor. Over the years its has increased and the limit is now $100,000.

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