History of the Federal Reserve - Definition and Overview

This page is about the history of the Federal Reserve, as well as the history of US central banking.

1791-1836: The First and Second Bank of the United States

The first bank with central banking powers in the US was the Bank of North America (chartered 1781). After independence, in 1791, the First Bank of the United States (1791-1811) was chartered. It was modelled after the Bank of England and differed in many ways from today's central banks. For example, it was partly owned by foreigners, who would share from its profits - the reason for its eventual break up. It was also not solely responsible for the country's money supply; its share was only 20%, while private banks accounted for the rest.

After a five year interval, its successor, the Second Bank of the United States (1816-1836), was chartered. It was basically a copy of the First Bank.

1837-1862: Free Banking Era

In this period, only state-charted banks existed. They could issue bank notes against specie (Gold and Silver coins) and were regulated by the states in reserve requirements, interest rates for loans and deposits, the necessary capital ratio etc. The Michigan Act (1837) allowed the automatic chartering of banks that would fulfill its requirements without special consent of the State legislature. This eased creating unstable banks even further, lowering the supervision by the states that adopted it. The value of bank bills could be below its face value, according to the bank's financial strength. By 1797, there were 24 charted banks in the US while with the beginning of the Free Banking Era (1837) there were 712.

The banks were very unstable compared to todays commercial banks. The average lifespan of a bank was five years; about half of the banks banks failed, a third of which because they couldn't redeem their notes. Also without a central bank responsible for monetary policy, the money supply and price level were much more volatile than today.

During the free banking era, some local banks appeared that took over the functions of a central bank. In New York, the New York Safety Fund acted as a deposit insurance for its member banks. In Boston, the Suffolk Bank guaranteed other banks on-par value of their notes in exchange for reserves. Another private institution that took up work of today's central banks was the clearinghouse. It acted as lender of last resort, when a bank needed liquidity, e.g. in a bank run

1863-1913: National Banks

Some of the problems of the free banking era were solved with the National Banking Act, besides providing loans in the Civil War effort of the Union. The provisions were

• To create a system of national banks. They had higher standards concerning reserves and business practices than state banks. The office of Comptroller of the Currency was created to supervise these banks
• To create a uniform national currency. In order to achive this, all national banks were required to accept each others currencies at par value. This eliminated the risk of loss in case of bank default. The notes were printed by the Comptroller of the Currency to insure uniform quality and prevent counterfeiting.
• To finance the war. National banks were required to back up its notes with Treasury Securities, enlarging the market and raising its liquidity.

As described by Gresham's Law, soon bad money from state banks drove out the new, good money; the Government imposed a 10% tax on state bank bills, forcing most banks to convert to national banks. By 1865, there were already 1500 national banks, 1870, 1638 national banks stood against only 325 state banks. The tax led in the 1880s and 1890s to the creation and adoption of checking accounts. By the 1890s, 90% of the money supply was in checking accounts. State banking had made a comeback.

Two problems still remained in the banking sector. The first was the requirements to back the currency up with Treasuries. When they fluctuated in value, banks had to recall loans, or borrow from other banks or clearinghouses. The second were seasonal liquidity spikes. A rural bank would have deposits at a larger bank that it withdrew when the need for funds was highest, e.g. in the planting season. When the combined liquidity demands were to big, the bank again had to find a lender of last resort.

These liquidy crises led to bank runs, causing severe disruptions and depressions, the worst of which was the Panic of 1907

1913-Present: The Federal Reserve System

Source

This article is an excerpt of A Brief History of Central Banking in the United States (http://odur.let.rug.nl/~usa/E/usbank/bankxx.htm) by Edward Flaherty.