Banks Belonging To The Federal Reserve example essay topic

Not banks but merchants were the sources of money and credit in the colonial period of American history (1607-1783). It was only after independence that the first commercial bank received a charter of incorporation - the Bank of North America, in 1781. British merchant banking houses stood at one end of a long chain of credit that stretched to the American frontier. They gave short-term (less than a year) credits to American merchants who then extended them to wholesalers of their imports, and the wholesalers passed them on to both urban and rural retailers - country stores and wandering peddlers. When the Constitution went into effect in 1789 the nation boasted three commercial banks, the Bank of North America, chartered by Congress at the behest of Robert Morris, the superintendent of finance, and two state banks, those of Massachusetts and New York. The primary function of these and later commercial banks was the making of short-term loans, which they did either by issuing their own bank notes or by creating a deposit in the name of the borrower (opening an account to the person's credit) and dispersing checks to draw against it.

Since the bank notes were promises to pay specie to the bearer on demand, banks had to maintain adequate reserves in order to do so. Defining adequacy, however, was no easy task, and numerous banks were forced into bankruptcy because they had over expanded their loans and discounts. Conservatism was the hallmark of the earliest commercial banks. The thinking of the time favored the establishment of a single quasi-governmental bank in each state that would operate in the public interest under private management.

The overriding fear of political leaders was that excessive numbers of banks or loans too much in excess of specie reserves would hobble the taxing and spending functions of government by swamping the economy in depreciated paper. Political leaders also recalled very well the wild inflation resulting from unrestrained governmental issues of continental and state bills of credit (paper money) during the Revolution, and in the Constitution they barred the states from issuing them. The management of the first Bank of the United States bus, chartered by Congress in 1791, reflected these concerns. Although the bus was a large commercial bank providing loans to the private sector as well as to government, its board of directors managed the institution in a highly conservative manner. Balance sheets for the years 1792-1800 reveal a generally high degree of success in maintaining the Bank's specie reserves.

The ratio between bank notes in circulation and specie holdings was quite small. Growing population and trade, however, created a need for comparable growth in the volume of money and credit - for a policy of accommodation rather than restraint. Sharp increases in the number of state banks and in their authorized capital stock represented a response to this need. During the life of the first bus (1791-1811) banks chartered by the states increased in number from 5 to 117, and their combined capital stock went from $4.6 million to almost $66.3 million.

The British raid on Washington in 1814 induced banks throughout the country (except in New England) to suspend specie payments. The bank note currency circulated at a variety of discounts from place to place, and since the government was compelled to accept it for taxes and imposts, the public finances became so disordered as to threaten the operations of the federal government. It was in this context of nationwide inflation and governmental derangement that Congress decided to charter a second bus (1816-1836). The expectation was that the institution would be able to force the state banks to resume specie payments and restore soundness to the currency. The Bank's success in achieving those objectives is mainly attributable to its president Nicholas Biddle (1823-1836). The mechanism was simple.

The nation's currency was largely made up of bank notes, most of it placed in circulation by state banks, so payments made to the federal government were likely to be in that form. And far more payments were made to that government than to any other transactor of business in the nation. In consequence, the government deposited large quantities of state bank notes in the bus and its branches, which therefore were creditors of the state banks and as such could insist on payment in specie. This threat, or its implementation, induced the state banks to keep their loans and discounts within bounds, which in turn enabled them to redeem their notes in specie at par. But the bus could not succeed equally well in both its fiscal and its monetary functions. If, as a great commercial bank, larger than any other and receiver of the government's deposits as well, it could succeed in maintaining sound money, it could not at the same time make available to the expanding population and economy the credit that was needed.

The nation's money was good, but there was not enough of it. Wholesale price indexes for all commodities from 1790 to 1860 reveal a long-term downward drift that commenced in 1820 and lasted till the eve of the Civil War, a drift that was interrupted only by speculative surges in the mid-1830's and mid-1850's. The policy of restraining credit expansion in the interests of monetary stability was the wrong policy for the times. Not surprisingly, that policy was vigorously opposed by political forces determined not to renew the Bank's charter. Although the 'bank war' (1829-1832) between the administration of President Andrew Jackson and the supporters of the Bank had other elements - most notably, Jackson's deep conviction that hard money rather than paper was the only sound money and that the economic power of the Bank threatened democratic government - it was Secretary of the Treasury Roger B. Taney's belief in free competition that led him to stop the deposit of government funds in the Bank in 1833. Moreover, he objected to the Bank's power to restrain the country's economic development.

The enactment of the Free Banking Act by New York in 1838 and later by other states reflected the same views. Previously, the states had granted charters to banks only by special legislative acts that were semi monopolistic in nature. Meanwhile, since the government had stopped depositing its funds (mainly state bank notes) in the bus that institution lost its power to influence the volume of business done by the state banks. Freed of restraint, the latter increased in number from 506 in 1834 to 901 in 1840 and 1,601 by the time of the Civil War. Some of these 'pet' banks were for a while selected depositories of federal funds, but in the main those funds were deposited at sub-treasury offices in major cities. These offices represented an effort in the 1840's and 1850's to establish an independent system that would separate the operations of the U.S. Treasury from any connection with the banks.

The effort was unsuccessful, however. The system fell far short of the purposeful influence over money and credit that a central bank would have been able to exercise. The vacuum created by the federal government's withdrawal was later filled by the large Wall Street banks. The effort to divorce government from the banking system came to an end in 1862 because of the chaotic condition of the currency caused by the government's need to finance the costs of the Civil War. The National Bank Act of 1863 invited state banks to take out federal charters, thereby becoming known as national banks. Each was required to buy government bonds in an amount equal to one-third of its paid-in capital stock.

The bonds had to be deposited with the U.S. Treasurer, who then turned over to the bank bank notes equal to 90 percent of the current market value of the bonds. To discourage undue credit expansion the act required national banks to keep reserves not only against their bank notes but also against their deposit liabilities. The amount of reserves depended on the size and location of the national banks. Small 'country banks' had to maintain reserves of at least 15 percent of their notes and deposits. Reserves for large banks in 'reserve cities' and for the 'central reserve city' of New York were 25 percent (in 1887 Chicago and St. Louis were added to the category of central reserve cities). The growth of the national banking system was slow until Congress imposed a prohibitive 10 percent tax on state bank notes in 1865.

By the late 1860's the new system covered about three-fourths of the nation's banking resources. The triumph was a brief one, for state banks possessed advantages over national banks - the latter being prohibited by law from making loans on real estate, for example. By the early 1870's the deposits of non national commercial banks roughly equaled those of national banks and from then until through the 1980's the deposits of the two classes of banks remained about equal in size. Other disadvantages, indeed defects, of the new system proved more important. Arbitrary limits placed by the law on the quantity of national bank notes that could be issued were soon removed by the Resumption Act of 1875, but the scheme by which the notes were apportioned by Comptroller of the Currency Hugh McCulloch resulted in a mal distribution injurious to the less populous states of the South and Midwest (the less advanced states needed more rather than less currency because of the ability of more developed ones to use checks and other credit instruments for business transactions). A more serious defect resulted from the pyramiding of reserves in the national banks of New York City, but even more important was the system's inability to do anything about periodic shortages of cash and credit.

The entire system was based on cash reserves and the total amount of cash could not be quickly altered. What was lacking was a central institution that could hold the reserves of the commercial banks and, above all, could increase those reserves. It was in response to these needs that Congress passed the Federal Reserve Act in December 1913. Instead of setting up a single powerful central bank, however, the act divided the nation into twelve districts and established a regional central bank in each. The nine-member boards of directors of the district Federal Reserve banks are subject to the direction of a seven-member Board of Governors appointed (since 1935) by the president and sitting in Washington.

The system's prime instrument of governance is its Open Market Committee, which meets about every three weeks to determine the monetary policy mix it believes best calculated to promote economic growth while dampening inflationary pressures. Although far from infallible, these determinations are highly influential because most of the country's banking resources are subject to the board's regulations. (National banks were required by law to become members of the system.) Member banks - now classified as 'reserve city' and 'other' banks - are required to keep their reserves in the Federal Reserve Bank of the district in which they are located. The amount of reserves may range, for reserve city banks, between 10 and 22 percent of their demand deposits, and for 'other' banks, between 7 and 14 percent. By raising or lowering percentages within these ranges the Board of Governors can either discourage or encourage member bank credit expansion. But this is a blunt instrument that is seldom used.

More sensitive are two other techniques available to the Fed. One is known as 'open market operations,' which consist of purchases or sales of government securities by the manager of the system's Open Market Committee, a vice president of the Federal Reserve Bank of New York. Purchases automatically increase and sales decrease the reserves of the member banks, thus permitting loan expansion or compelling contraction, respectively. The other involves altering the interest rate charged on loans and advances by Federal Reserve banks to member banks.

These techniques affect the quantity of money and its cost - factors of great importance to the investment decisions of business managers, and hence to the tone of the national economy. The present-day powers of the Federal Reserve System owe much to legislation enacted in response to the system's inability to prevent widespread bank failures in the early years of the Great Depression. (President Franklin D. Roosevelt's initial reaction to the failures was to issue an executive order in March 1933 temporarily suspending banking activities throughout the country and forbidding dealings in gold. No bank could reopen for business until its condition had been examined by the secretary of the treasury - in the case of member banks of the Federal Reserve - or by state authorities - in the case of state-chartered nonmember banks. Congress then followed with a law designed to get at the roots of the failures.) The Glass-Steagall Banking Act of 1933 established the Federal Deposit Insurance Corporation and required all members of the Federal Reserve System to insure their deposits. The act also increased the authority of the twelve Federal Reserve district banks to control the amount of credit extended to their members and prohibited the payment of interest on demand deposits to discourage outlying banks from sending large sums to New York - where they might feed speculation in securities by being re-lent on the call loan market.

In addition, the act required that banks belonging to the Federal Reserve divorce themselves from their security affiliates - necessitating that they choose between deposit and investment banking - and empowered the Federal Reserve Board to regulate bank loans secured by the collateral of stocks or bonds. Finally, partners or executives of security firms were barred from serving as directors or officers of commercial banks. For more than half a century this legislation secured bank depositors from loss. Regretfully, massive failures in the nation's savings and loan institutions in the late 1980's - many of them tinctured by fraud and mismanagement - revealed deficiencies in federal deposit insurance, requiring both a huge federal bailout of more than $150 billion and structural changes in the insurance program. At the beginning of the 1990's the latter had not yet been provided.

Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (1963); Bray Hammond, Banks and Politics in America from the Revolution to the Civil War (1957).