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.
1000 oz (coins) | 1000 oz (receipts)
Money supply in economy = 1000 oz gold coins, since they are withdrawn for payment.
900 oz (coins) | 1000 oz (notes)
100 oz (loans) |
Money supply = 1,100
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
Redemption costs and non-local note acceptability → gold/silver still circulated.
Solutions to non-par/non-acceptability
Evolution of banking reduces transactions costs and reduces the need for commodity reserves. But…
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.
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
“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.
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.
Spanish silver dollars, “pieces of eight” defined as 387 grains of pure silver, or about 4.5 silver shillings.The Colonial period
20 shillings, 1690
33 cent US Note: a Continental.
Issued February 1776
The Pennsylvania Bank (1780) – didn’t issue notes.
Bank of North America (1781) – incorporated by Continental Congress to help finance government expenses; issued banknotes.
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
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.
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.
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.
Bank note issued by Quakertown National Bank
Resumption at $20.67 was desired, requiring deflation as greenbacks were retired.
Resumption Act of 1875 ended the suspension of convertibility.
William Jennings Bryan
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%
Checking accounts: 10% of total liabilities.
Basic tradeoff of banking: interest earning versus liquidity