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8. Bank Theory, history of US banking
Q: From a historical perspective, how did depository intuitions develop?
1. Vault: Keep “money” safe.
2. Facilitate lending: Matching borrowers and lenders, specializing in:
• Maturity intermediation
• Asset diversification
• Information processing (private information)
• Monitoring and enforcement
3. Monetary policy: Governments use banks to enact monetary policy through control of the money
Merchant banks: Some of the first banks were founded by wealthy merchants
1500’s Medici Family in Italy, Fuggers in Germany
Wealthy merchants would extend credit to their customers, and in certain cases, overshadowed their
trading activity such that this was their main business.
These were private loans, involving only the capital of the merchant.
Some of these banks still exist today (eg. Rothschild), and are classically defined at investment banks. In
the U.S., investment banks started in this same vein, such as JP Morgan, Goldman Sachs, Morgan Stanley,
and these investment houses used their own capital or that borrowed from others to finance corporate
Merchant/Investment banks were organized as partnerships, they did not enter the commercial
mainstream and general populous.
Warehouse banks: Goldsmith’s of old would store gold in well protected vaults, for a small fee. Their main
purpose was security of gold assets, operating similar to a safety deposit box.
Anyone could deposit gold for a fee (Merchants, vendors, households …)
However, the homogeneity of gold didn’t require a separation of each customer’s deposit. Each
depositor received a receipt, and they didn’t necessarily withdraw the same gold that they deposited.
Also called 100% reserve banking
Fractional Reserve Banking: Since the bulk of deposits never leave the bank, warehouse banks recognized
that they could lend out excess deposits and earn interest on those loans.
Banks receipts on gold deposited in warehouse banks (demand deposits) can be used as a form of
payment, easier than that of gold.
Banks receipts are a form of “money”, which is just a store of value.
A warehouse can “create” new receipts in excess of their reserves (LOAN), and as long as the bank
maintains enough in reserve to meet depositor demands, they can lend these receipts and earn interest (this
is essentially a form of counterfeit!!)
Since these banks do not hold 100% of their reserves, they are referred to as “fractional” reserve banks.
Problems with Fractional Reserve banking: These banks only work if they are able to meet redemption
requirements, and if their customers are confident that this is true.
1. Fractional reserve banks have the ability to create money by issuing new receipts, but using these
receipts as money in the economy is limited by they reputation of the issuer.
2. Some famous families (merchants) of history had the reputation to do so, but even so, their ability
to create excess notes was limited.
3. Eventually, the end user of the note would choose to convert it to gold or an equivalent store of
value backing the note.
The fractional reserve “counterfeiting” operation is threatened by:
Reputation of the note – the institution backing the promise.
Increased likelihood of note redemption (a function of issuer reputation)
An increase in the note float (decrease in the proportion of reserves held to notes issued)
Central Bank: A bank with supreme reputation and credibility, created to mitigate the risks associated with
Bankers realized that it was in their interest to cartelize the industry to mitigate these risks. A
reputation greater than any one individual or family was needed.
The Bank of England (1690) is the first modern Central Bank, and until this century, was privately
The Federal Reserve Bank in the U.S. was founded in 1913 in response to the contagious bank runs of
1910 (bank runs are failures of fractional reserve banking).
While it is possible for a cartel of banks to organize and support each other, a government is best suited
for this task. Governments generally have more longevity than institutions, individuals or families in
Money Multiplier: The extent to which “money” can be created through fractional reserve banking is as
Total Quantity of Money = Money Multiplier * Monetary base
Money Multiplier = (1 + c) / (r + c)
r: reserve requirement
c: measure of money escaping the banking system (assumed to be 0 in our example)
MM = (1 + 0) / (.2 + 0) = 5 $100M *5 = $500M
Monetary Base: This is the amount of definitive money in the economy. The money creation process is
characterized by promises (money on demand demand accounts) but is based on an absolute amount of
Gold Standard: Prior to 1933, The U.S. Dollar was fully convertible into gold, From 1933 to 1971, it was
partially convertible into Gold.
Leaving the Gold Standard: After 1971, the monetary base in the U.S. was no longer based on gold.
Definitive money is now “Fed” money.
New Deposits New loans & Cash reserve
Original Bank $100 M $80 M $20 M
2nd generation bank 80 64 16
3rd generation bank 64 51.2 12.8
4th generation bank 51.2 41.0 10.2
5th generation bank 40.9 32.8 8.2
6th generation bank 32.8 26.2 6.5
7th generation bank 26.2 21.0 5.2
8th generation bank 21.0 16.8 4.2
9th generation bank 16.8 13.4 3.4
10th generation bank 13.4 10.7 2.7
Sum of first 10 banks $446 M $357 M $89 M
Sum or remaining banks $54 M $43 M $11 M
Total for Entire banking system $500 M $400 M $ 100 M
FED tools for monetary policy
1. Reserve Requirements: Changing the reserve requirement changes the money multiplier.
If the Fed increases the reserve requirement from 10 to 12%, then banks would have to recall loans
to the extent that is necessary to meet reserve requirements. Consider this affect on a monetary
base of $1,000 billion, assuming that no “money” leaves the banking system (all loans return as
10% reserve requirement: $1,000B*(1+0)/(.1+0) = $10,000 billion
12% reserve requirement: $1,000B*(1+0)/(.12+0) = $8,333 billion
The change in total quantity of money (supply) is $1,667 billion or 17%.
2. Open Market Transactions: The Federal Reserve can buy and sell government securities issued by
Open Market Transactions: The FED can change the level of reserves held by bank through the
purchase/sell of securities.
• FED Buying Securities: Converts non-loan assets into cash reserves which then can be used to
make loans. INCREASES RESERVES
• FED Selling Securities: Just the opposite. The composition of banks assets changes such that
there is a decrease in loanable funds and an increase in securities.
3. Discount Window: Since the discount window is rarely used by banks or other institutions, it’s
power is in signaling monetary policy.
The federal funds rate, which is the base rate used for consumer and commercial loans, moves
in accordance with the rate set by the discount window.
The FED will use open market transactions to support the signals sent through changes in the
discount window rate.
Early U.S. Bank development
1st Bank of the United States: 1791-1811
• Chartered 1791 to hold the deposits of the Federal Government, lasted 20 years
• Created under implied powers by the Constitution
• Unified state currency into a single national currency
• Assumed the war debts of each individual state
2nd Bank of the United States: 1816-1836
• Chartered 1816 after the turmoil following the war of 1812, also given 20 year charter
• The bank held federal deposits and made payments on behalf of the government
• The West’s distrust of the East resulted in non renewal of the charter in 1936, lead by President
• Federal deposits were transferred to state banks in 1936.
National banking system: 1836 - 1913
• 1840-1863 were the “free banking” years, with state charted banks largely unsupervised. Out west,
some of these banks became known as “wildcatter” banks
• National Bank Act 1863 provided for the federal charter of national banks, who had to hold
deposits with the OCC.
• Country banks (for farmers) held reserves at “Reserve City Banks” who held deposits at “Central
Reserve City Banks”. The central reserve banks held their reserves in cash.
Federal Reserve Bank: 1913
• Chartered in response to 1907 bank panic
• Chartered to provide an “elastic currency” to account for cyclical demand for credit
• Alleviated pressure put on commercial banks to solve crisis.
• 12 Regional banks would provide short-term credit for commercial banks to prevent bank runs and
• Governors in each region were former commercial bankers, and although they were overseen by
Washington, had broad powers of their own (ie. setting rates)
World War I: 1914 – 1917
• Gold inflows from Europe increased monetary base and lead to inflationary pressures.
• Fed was constrained in its effort to curb inflation through a decrease in money supply
Fed could not raise reserve requirements
Did not have experience with open market transactions
Could only use the discount window
• Made massive loans to allies which curbed the gold inflow.
• 1920’s the Fed began to learn monetary policy. In 1921, NY Fed discovered that interest rates
changed when they bought or sold securities
• 1923 created the Open Market Investment Committee (OMIC), turned into the Open Market
Policy Conference (OMPC) in 1930, and later the Federal Open Market Committee (FOMC) in
Great Depression: 1929 - 1933
• Stock market crash of 1929, $9 billion loss to 880 issues
• FED did not act as lender of last resort, and over half of all national banks failed
• Many banks were engaged in speculative investing (owned equity securities)
• 25% of American were out of work
• Glass Steagall (1933) separate banking form insurance and underwriting, and prohibited
ownership by non financial companies (GE, AMEX, Ford, GM cannot own a bank charter)
• Banking Act of 1935 – more centralized Federal bank control
created the Federal Deposit Insurance Corporation (FDIC)
granted more centralized monetary policy authority to the Federal Reserve Bank
Removed OCC from role in FED activities (FED autonomy initiated)
Created the FOMC
• 1933: Removed currency from gold standard, but still partially convertible to gold.
Post World War II:
• Massive Federal debt from the war
• Fed continued to buy treasury issues at low interest rates to keep inflation down.
• 1951: The Fed acted independently in its effort to conduct monetary policy. This caused a split
between Treasury and FED – a rift that still exists today.
• Fed was constrained in its effort to curb inflation through a decrease in money supply