Federal Reserve System - History ; Banks and banking - History ; National Bank Act

Verle B. Johnston

English

Research Papers in Economics

December 30, 1983
Origins
Since thefederal Reserve System reached
the 70th anniversary ofits creation by the
Congress on December23, areview ofsome
ofthe principal events that led to its estab-
lishmentand which subsequently shaped its
structure and expanded its objectives and
responsibilities, including the conceptof
monetary policy and Fed "independence,"
is timely. This Letter will focus on the devel-
opments leading upto the passage ofthe
Federal Reserve Act. In particular, itwill
review the structure ofearly banking in this
country and the inadequacies the Actwas
intended to correct.
In the beginning...
Except for two brief periods early in its
history, the United States did not have a
federal "central bank" until the passage of
the Federal Reserve Act in 1913. Banks char-
tered by their state legislatures dominated.
Derived from English banking, these banks
issued privatebanknotes backed bydeposits
ofgold and silver in their vaults. Knowing
that not all notes would be redeemed at the
same time, some banks issued more notes
than there was backing in gold and silver
specie, leading to what we call inflation.
Also, because each bank issued its own
banknotes, transfers among banks was diffi-
cult. Moreover, theirvariety was confusing
and allowed easy counterfeiting.
In the periods 1791 to 1811 and 1816 to
1836, the United State? Congress chartered
two national banks, known as the First and
Second U.S. Banks, respectively. In part, the
purpose ofthese banks was to control both
the expansion ofstate banks and the pro-
Iiferation ofbanknotes. In the five-year
interval between the two U.s. Banks, for
example, the volume ofstate banknotes
almost tripled and prices rose by about 20
percent. They were able to achieve a sub-
stantial degree ofmonetary stabiIity by
periodically presenting for redemption in
1
specie the currency issued by state banks,
thus placingthe latterundersomeconstraint
to limitthe issue ofsuch notes. Both Banks
also acted as fiscal agents ofthe U.S. gov-
ernment (receiving and disbursing govern-
ment funds) and engaged actively in direct
lending to businesses.
Neither U.S. Bank survived because of
hostile attitudes toward centralized control
embodied in federal chartering, as well as
potential implicationsofrestricted credit
availability. Many farmers, in particular,
welcomed the inflation caused by state
banks as a means ofrepaying theirdebts in
"cheaper" dollars than those they bor-
rowed. Moreover, both Banks were 80
percent privately owned and controlled and
much ofthe opposition towards the First
Bank, at least, stemmed from the fact that
English interests held a significant share of
the Bank's stock. The Second Bank's charter
expired largely because ofopposition by
President Andrew Jackson, who was con-
cerned that it would lead to a concentration
ofeconomic power in large banks in the
Northeast.
Many also were hostiIe to the concept ofa
national bankbecause they doubted thatthe
Constitution allowedtheCongresstocharter
banks. However, in a landmark decision in
1819 (McCu1I0ch vs. Maryland), the Su-
preme Courtupheld the constitutionality of
the Second U.s. Bank as a "necessary and
proper" exercise by the Congress of its
power "to coin money and regulate the
value thereof."
FollowingPresidentJackson's vetoofthe bill
to renew the charterofthe Second Bank of
the United States, the Treasury undertook
various central banking functions. Mean-
while, the numberofstate banks more than
doubled to 1,600 between 1836 and 1860.
Among them were issued almost 9,000 dif-
ferent kinds ofnotes thatwere subjectto
widely varying, and in many cases, very
substantial discounts.If~cd! ~IT'@.li ll« C~~~IT'\o/~
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Opinions expressed in this newsletter do not
necessarily reflect the views of the rnanagement
of the Federal Reserv(;, Bank of San Francisco,
or of the floard of Covernors of the' Federal
Reserve System,
The National Banking Act
In 1864, the National flanking Act was
passed to provide a market for government
bonds and to help establish a uniform cur-
rency. The Act was also designed, in part, to
help stabilize the currency as prices had
risen over 65 percent from the outbreak of
theCivil War in April 1860. Millionsof
dollarsofnon-interest bearing "green-
backs" notofficially redeemable in specie
had been issued by the government to meet
its financing needs and these had contrib-
uted to the inflation during the War.
The Act provided for the federal chartering
ofprivate banks on the basis ofstipulated
minimum capital requirements and the
maintenance ofrequired reserves against
deposits. National banks were divided into
three tiers: central reserve city banks
(originallybanks in NewYork, Chicago, and
SI. Louis), reserve city banks, and country
banks. Country banks had a 15 percent
reserve requirement, 9 percent ofwhich
could be kept as deposits with their corres-
pondent reserve city banks. Reserve city
banks had a25 percent reserve requirement,
upto halfofwhich could be kept as deposits
with theircorrespondentcentral reserve city
banks. Central reserve city banks had to
keep all oftheir 25 percent reserve require-
ment as vault cash. This system of reserve
"pyramiding" meant that, in particular
cases, a given dollarofreserves held in
supportofdeposit liabilities could be
counted as reserves three times.
In addition, national banks were given
aythority to issue their own notes to the
valueof90% oltheirholdingofspecific U.S.
government bonds. In this way, the amount
ofnotes in circulation at any time would
2
depend upon national banks' holdings of
bonds. CreateI' control over currency issues
also was achieved bythe imposition in 1865
ofa confiscatory 10 percent federal tax
on all state banknotes (which, in 1860,
accounted for almost one-half of all cur-
rency and coin in circulation). The tax
forced all but a small volume ofthese notes
outofcirculation, and for awhile, led most
state banks to switch to a national charter.
However, the development and spread of
checking deposits enabled state banks to
make loans bycreditingdeposits rather than
simply by issuing notes. As a result, the
numberofstate banks soared from 325 in
1870to 5,000 by 1900.
By 1910, state banks numbered 14,000-
double the numberofnational banks-but
national banks now accounted for aquarter
ofall currencyand coin in circulation, while
gold and gold certificates accounted for 45
percent, and silver certificates, coins and
miscellaneous coins, the remainder. The
relative influenceofthese currency and
deposit developments is evident in the fact
that over the entire period since 1860, per
capita currency in circulation increased
from $30 to $34, whileper capita deposits
soared from $19 to $194.
The National Monetary Commission
The various efforts at currency and banking
reform notwithstanding, the period from
1873 to 1913 was marked by six financial
"panics" ofvarying degrees of intensity, the
most serious occurring in the 1890s and in
1907. The "panics" resulted in the suspen-
sion ofspecie paymentsbylargenumbersof
banks, in the inabilityofbusinessmen and
farmers to obtain credits to finance inven-
tories and the production and transportation
ofcrops, and in large numbers ofbusiness
failures. After "The panic of'07," the
Congress called for the creation ofa
National MonetaryCommission "toenquire
and reporttothe Congress at theearliest date
practicable" what changes were necessaryordesirable in themonetarysystem to avoid
a recurrence ofthe financial panics that
periodically had gripped the nation.
The National MonetaryCommission was
chaired by Senator Nelson Aldrich, a Rhode
Island Republican who also was chairman
of the Senate Finance Committee, and
included in its studies an examination of
the central and private banking systems in
Western Europe. Submitted to the Congress
in January 1912, the Commission's Report
attributed the"currency problem" and the
recurring financial panics to several specific
and widely recognized factors.
First, the Commission identified the lack of
provision for the mobilization ofthe cash
reserves ofbanks and for their use wherever
needed in timeoftrouble. Reserve pyramid-
ing meant that a shortage in currency at
country banks could lead to claims on a
central reservecitybank's reserves. The cen-
tral reserve citybankwouId sometimes have
to meet this demand by calling in its short-
term loans. As a result, interest rates could
rise very sharply. Ofcourse, ifitfailed tocall
in its loans, country banks would notget the
needed currency and mightfail, creating a
financial panic. Second, due to its rigid de-
pendenceon the amountofu.s. bonds,
national banknote currency was unable to
respond to the changing needs ofbusiness,
that is, the supply ofmoney couId not be
adjusted to meet the changes in the demand
for money. Third, the Commission cited a
lackofcooperation "ofany kind" among
banks outside the clearing house cities, and
fourth, the lackofa wf'lI-developed dis-
count market and a market for commercial
paper available for investment by banks.
The last was blamed for an "unhealthy con-
gestion" offunds in the main moneycenters,
where they were used in "dangerous spec-
ulation" that often resulted in "injurious
disturbance" to bank reserves.
Subsequently, Senator Aldrich formalized
3
the Commission's recommendations in a
bill, generally known as the "Aldrich Plan,"
toestablish a"National Reserve Association
ofthe UnitedStates." The measure garnered
strong bankersupport but was specifically
rejected, along with any proposal for a
"central bank," by the Democratic party in
its 1912 platform. The attitudes toward cen-
tralized control had notdied with the First
and Second Banks ofthe United States and
President-elect Woodrow Wilson was par-
ticularly unreceptive to theAldrich bill's
provisions for acentralized organization
controlled by private interests.
Consequently, under Wilson's guiding
hand, Congressman CarterGlass (D-Va),
the incomingchairman ofthe House Bank-
ing Committee, drafted and submitted an
alternative proposal "to provide forthe
establishment ofFederal Reserve banks, to
furnish an elastic currency, to afford means
of rediscounting commercial paper, and to
establish a more effective supervision of
banking." It immediately came under
savage attack from supporters ofthe rival
"Aldrich Plan," includingthe American
Bankers Association, as being, among other
things, "socialistic."
In spite ofsubsequent(and current) claimsof
various Fed critics, the twoproposals dif-
fered in their emphases upon government
and private participation and centralism vs.
regionalism, as well as in their specific
provisions for reserve mobilization, note
issue and discounting. These differences,
and the resulting adoption ofthe Federal
Reserve Act, will be the subject ofthe next
Letter.
Verle 8. JohnstonSS",:> lSl:Il:I
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
·me.) IO:lSpueJ:I ues
oSL 'ONllWBld
OIVd 19V1SOd's'n
llVW SSVTllSBI~
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
12/14/83
Change
from
12/7/83
©5>~~5>\\Jf'@,]~ '\ill,@~
~© 1l!'\ill'@<tdI
@,m,]@~@CQI TI'@,]@[l5)@~
1)\ill <;\l\illJlll JJ\W0]@(Qj \\lJ;JJ JJ\W<;\l',B@(Q]
Change from
.year ago
Dollar Percent
Loans (gross, adjusted) and investments· 164,861 65 1,653 1.0
Loans (gross, adjusted) - lotal# 144,694 - 10 2,350 1.7
Commercial and industrial 43,949 - 247 - 1,113 - 2.5
Real estate 57,629 20 435 0.8
loansto individuals 25,568 196 1,775 7.5
Securities loans 3,436 42 473 16.0
U,S. Treasury securities'" 7,862 79 845 12.0
Othersecurities· 12,305 - 4 - 1,542 - 11.1
Demand deposits - total# 43,636 -1,801 - 431 - 1.0
Demand deposits - adjusted 30,516 - 632 2,091 7.4
Savings deposits - totalt 66,366 - 303 29,044 77.8
Timedeposits - total# 70,183 - 157 - 23,281 - 24.9
Individuals, part. & corp. 64,256 - 220 - 19,260 - 23.1
(large negotiable CO's) 17,285 - 128 - 15,057 - 46.6
Weekly Averages Weekended Weekended Comparable
ofDaily Figures 12/14/83 12/7/83 year-ago period
Member Bank Reserve Position
Excess ReselVes (+)/Oeficiency (-) 55 80 113
Borrowings , 5 5 110
Net free reselVes (+)/Net borrowed{-) 49 75 3
*Excludes trading account seCUritIes.
# Includes items not shown separately.
t Includes Money Market Deposit Accounts, Super-NOW accounts, and NOW accounts.
Editorial commentsmaybeaddressed totheeditor(GregoryTong)orto theauthor ••••Freecopiesof
this and other Federal Reserve publicationscan be obtained by calling orwriting the Public
Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702,San Francisco94120.
Phone(415) 974-2246.

Origins

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