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  since they are withdrawn for payment.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.

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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
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.

18
The Colonial period

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

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
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
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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.

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
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
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 wars end, with
  government finances improving, a national bank
  was once again proposed as means to improve the
  payments system and to resume convertibility.

26
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
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 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.

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
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
32
The National Banking System

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

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.

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35
The Crime of 1873

• 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

William Jennings Bryan
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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
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.

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.