The rise of commercial banks

1. 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.

2. 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1000 oz (coins) | 1000 oz (receipts) Money supply in economy = 1000 oz gold coins, since they are withdrawn for payment.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

3. 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

4. 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

5. The benefits of net-clearing

6. 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

7. 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.

8. 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.

9. 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.

10. 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.

11. 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

12. Lender of last resort Free-banking view • Panics due to legal restrictions on a) branch-banking; b) note issue • The role of clearinghouse associations.

13. 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.

15. 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.

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

17. 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

18. First government-issued paper money by Massachusetts in 1690, to finance soldiers defeated on raids to Quebec The Colonial period 20 shillings, 1690

19. 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

20. As with England in the late 1600’s, financing the Revolutionary War was difficult for the colonies: no taxing authority and couldn’t borrow effectively. Continental Congress issued bills of credit – paper money called ‘Continentals’ – that were not tightly linked to gold and silver Revolutionary war finance 33 cent US Note: a Continental. Issued February 1776

22. The first American banks The Pennsylvania Bank (1780) – didn’t issue notes. Bank of North America (1781) – incorporated by Continental Congress to help finance government expenses; issued banknotes.

23. 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.’

24. 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. First Bank of the United States Alexander Hamilton

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

26. 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. Second Bank of the US and resumption Nicholas Biddle Andrew Jackson

27. 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

28. 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 couldn’t 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.

29. 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.

30. 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.

31. National Bank Act 1863 Standardized bank notes 110% backed by US bonds Legal tender, but convertible into ‘lawful money’ (base money). The National Banking System Bank note issued by Quakertown National Bank 1897

32. 1865: 10% tax on state banknotes … and the rise of demand deposits. The National Banking System Bank note issued by Quakertown National Bank 1897

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

35. Coinage Act of 1873 eliminated the free-coinage of silver, in effect removing silver from the monetary system. This was an important political issue in US for years to come… The Crime of 1873 William Jennings Bryan

37. 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

38. 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.

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

40. 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

41. 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-Leach-Bliley Act of 1999 • Interest rates: Reg. Q, DIDMCA 1980 • Deposit insurance: FDIC in 1934.