Banking and the Federal Reserve System

Banking and the Federal Reserve

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
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

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

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

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

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

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 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



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

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

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.


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.


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


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.