The rise of commercial banks

Transfer banking. Goldsmith banking. From warehouse receipts to promissory notes, financial intermediation and fractional reserve banking. Negotiable (transferable) banknotes and checks. Banks reduced the costs of monetary exchange, resulting in fractional reserve banking, credit money and financial intermediation.

Fractional reserves and money

Customers deposit 1000 oz at a single bank. __________________________________ 1000 oz (coins) | 1000 oz (receipts) Money supply in economy = 1000 oz gold coins, since they are withdrawn for payment. Bank loans 100 oz in coins because of fungibility and idle reserves; receipts become notes. ______________________________________ 900 oz (coins) | 1000 oz (notes) 100 oz (loans) | Money supply = 1,100

Fractional reserves and money

______________________________________ 1000 oz (coins) | 10,000 oz (notes) 9000 oz (loans) | Money supply = 10,000 oz (worth of notes). The money supply has grown 10-fold without increase in the underlying commodity

Note exchange and redemption

Redemption costs and non-local note acceptability gold/silver still circulated. Solutions to non-par/non-acceptability branch banking brokers banks clearinghouses

The benefits of net-clearing

Issued by A Held by A Held by B 4000 Issued by B 1000 Issued by C 2000 2000 Total claim 3000 6000

Held by C Total debt

2000 6000

2000 3000 4000

4000

Potential problems of fractional reserves

Evolution of banking reduces transactions costs and reduces the need for commodity reserves. But
Over-issue of banknotes and inflation Banking panics and deflation

Banking crises and panic

Bank runs Bank failures Declines in the money stock Suspension of payments/convertibility.

Ultimate cause: incomplete information about bank-specific risk. Runs on or failures of a particular bank can lead to a general distrust of many banks, even healthy ones.

The Panic of 1907

May 1907 to June 1908: recession in which real output fell 11%. October 14: eight banks in New York required assistance with withdrawals. October 21: Knickerbocker Trust Co. (third largest in NY) suffered a run because of its connection to the troubled banks. The run forced suspension of payments. October 21-23: runs occurred on other large trusts in NY, but although assistance was given by the NYCHA to prevent failure, a general alarm remained. October 24: Treasury provides assistance, but bank loans in NY collapsed and stock market prices collapsed.

The Panic of 1907

By the end of the week, the runs in NY seemed under control, but the panic spread throughout the country. NYCHA started issuing clearing house certificates. But NY banks suspended payment to country banks demanding currency and specie for the correspondent bank balances. Soon thereafter, suspension of convertibility occurred nationwide. By February, the crisis was over as confidence was restored, primarily through restrictions of payments. The US money stock declined during the recessionary period, but at a faster pace from October to February because of the panic.. This panic was the major impetus to the formation of the Federal Reserve System in 1913, the US central bank.

Features of central banks

Bank for other banks; private commercial banks can hold deposits and borrow from the central bank. Reserves centralized at the central bank; private banks hold claims on the central bank. Note and deposit issue serve as high-powered money, and are not typically redeemed. Monopoly over note issue, usually legal tender. Other special privileges from the government (if they are not actually part of the government); e.g. they keep government deposits. Monetary policy Lender of last resort make loans to other banks in times of liquidity crises Authority to regulate banks and the financial system.

Lender of last resort

Classical view (Bagehot and Thornton): central bank should lend to any healthy bank, at a penalty rate, that is need of liquidity, by buying (discounting) their assets.
Walter Bagehot, 1826-1877

Lender of last resort

Free-banking view Panics due to legal restrictions on a) branchbanking; b) note issue The role of clearinghouse associations.

The Bank of England

A central bank is not a natural product of banking development. It is imposed from outside or comes into being as the result of Government favours. Vera Smith, 1936 The Bank of England arose as a private bank given special privileges in return for lending to the British government.

The Bank of England: a timeline

1694: Chartered as private bank to buy public debt 1697: Monopoly of chartered banking and limited liability 1708: Allowable capital doubled, and note issue was prohibited to any bank with more than six partners 1797: War-time suspension of convertibility fiat money 1797-1821: Inflation; discovery of monetary policy 1816: Move to gold rather than bimetallism 1821: Resumption of convertibility to gold. 1826: Joint-stock banks (non-partnerships) 65 miles away from London were allowed note issue to provide some financial stability outside London. 1833: Bank of England notes made legal tender 1844: Bank Charter Act split BoE into Issue and Banking departments. 1946: Bank of England Act nationalizes the bank.

Political Ravishment, or The Old Lady of Threadneedle-street in Danger!,

The Colonial period

Money and monetary standards during the American colonial period followed Britain. Money was in terms of British pounds/shillings/pence, defined in terms of silver and gold. Spanish silver dollars, pieces of eight defined as 387 grains of pure silver, or about 4.5 silver shillings.

The Colonial period

First government-issued paper money by Massachusetts in 1690, to finance soldiers defeated on raids to Quebec

20 shillings, 1690

The Colonial period

Colonial governments began issuing bills of credit, debt promising to pay silver in the future. These bills were generally transferable without endorsement, so they circulated as a medium of exchange, and were convertible on maturity

Revolutionary war finance

As with England in the late 1600s, financing the Revolutionary War was difficult for the colonies: no taxing authority and couldnt borrow effectively. Continental Congress issued bills of credit paper money called Continentals that were not tightly linked to gold and silver

33 cent US Note: a Continental. Issued February 1776

The first American banks

The Pennsylvania Bank (1780) didnt issue notes. Bank of North America (1781) incorporated by Continental Congress to help finance government expenses; issued banknotes.

Constitutional monetary standards

The Constitution gives sole right to Congress to coin Money and regulate the Value thereof and forbade state governments from issuing bills of credit or coining money. Coinage Act of 1792. US dollar equal to 371.25 grains (0.7734 ounces) of pure silver or 24.75 grains (0.05156 ounces) of pure gold (nominal silver price was $1.29 per ounce and that of gold $19.39 per ounce.); mint ratio 15 to 1. There was to be free coinage.

First Bank of the United States

Private bank with 20 year charter, 1791-1811. Motives: a) finance new government; b) facilitate payment of taxes; c) convenience and resource saving of paper money. Privileges: a) Convertible notes accepted by government for taxes and payments; b) government depository; c) could branch in any state; d) no other banks to be established during life.

Alexander Hamilton

Suspension of convertibility
With War of 1812, US Treasury issued interestbearing notes that were held by banks as reserves, so banknotes increased, leading to inflation and shortage of specie. Suspension of convertibility followed. At wars end, with government finances improving, a national bank was once again proposed as means to improve the payments system and to resume convertibility.

Second Bank of the US and resumption

Chartered 1816 to 1836. Similar rights and privileges To provide uniform currency. Temporary resumption in 1817, but Second BUS over-issue led to inflation/suspension. Convertibility generally restored in 1821.

Nicholas Biddle

Andrew Jackson

Coinage Act of 1834

Reduced gold content of the dollar from 24.75 grains to 23.22 grains pure gold, or Pg = $20.67. The mint ratio (silver to gold) increased to 16 to 1. With the relative price of gold still 15.5 to 1, gold replaced silver as the commodity money. Thus, from 1792 to 1834, silver was the primary commodity money; from 1834 to 1860, gold was, even though there was a de jure bimetallic standard

The Free-banking period

With the demise of the Banks of US, the federal government stepped out of the bank-regulation and chartering business. Even though states couldnt constitutionally issue money, they could charter banks. Many states enacted free-banking laws: a) free entry with minimum capital requirement; b) note issued secured by state bonds; c) notes had to be redeemable in specie on demand; d) limited liability.

Pre-war composition of the money stock

1859: the money stock in the US was just over $670 million. 40% specie in circulation, 27% state bank notes, 33% bank checking deposits. Bank reserves of specie fluctuated between 20% and 35% of note and deposit liabilities.

Greenbacks
Feb. 1862: US Government issued notes to finance the Civil War, the so-called Greenbacks. Unbacked by gold or silver true fiat money and supported by legal tender laws (see top of notes to the right). Dollar price of gold doubled during this period.

The National Banking System

National Bank Act 1863 Standardized bank notes 110% backed by US bonds Legal tender, but convertible into lawful money (base money).

Bank note issued by Quakertown National Bank 1897

The National Banking System

1865: 10% tax on state banknotes and the rise of demand deposits.

Bank note issued by Quakertown National Bank 1897

Resumption of convertibility
Resumption at $20.67 was desired, requiring deflation as greenbacks were retired. Resumption Act of 1875 ended the suspension of convertibility.

The Crime of 1873

Coinage Act of 1873 eliminated the freecoinage of silver, in effect removing silver from the monetary system. This was an important political issue in US for years to come
William Jennings Bryan

The Founding of the Federal Reserve System

The Panic of 1907 and the National Monetary Commission Federal Reserve Act of 1913 Federal Reserve to issue notes with 40% gold backing, to promote an elastic currency.

Nelson Aldrich

The Great Depression

Collapse of the banking system
average suspensions from 1921 to 1929: 635 average suspensions 1930 to 1933: 2299; with 4004 in 1933 alone.

Banking Holiday and reforms

Creation of the FDIC Reorganization of the FED The US stock of gold was nationalized

Gold re-valued to $35/ounce.

Bretton Woods
Fixed exchange rates US to hold gold Dollars to serve as reserve currency Collapse in 1971 as US inflation increased Gold outflows and Nixons closing of the gold window in 1971.

Banking Business
Balance sheet of commercial banks _____________________________________________________________________ Reserves (liquid assets/cash) | Checkable deposits Securities (mostly government) | Non-transaction deposits Loans (commercial, consumer, etc.) | Borrowing (Fed, banks) | Net worth (equity capital)

Loans and securities: 80% Reserves: 3% Checking accounts: 10% of total liabilities. Basic tradeoff of banking: interest earning versus liquidity

Banking industry
Dual banking system and supervision Restrictions and government intervention
Branching: National Banking Act 1863, McFadden Act 1927, Riegle-Neal Act 1994 Scope: Glass-Steagall Act of 1933, Gramm-LeachBliley Act of 1999 Interest rates: Reg. Q, DIDMCA 1980 Deposit insurance: FDIC in 1934.