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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.

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the rise of commercial banks
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.

fractional reserves and money
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Money supply in economy = 1000 oz gold coins, since they are withdrawn for payment.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

fractional reserves and money1
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

note exchange and redemption
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
potential problems of fractional reserves
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
banking crises and panic
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.

the panic of 1907
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.
the panic of 19071
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.
features of central banks
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.
lender of last resort
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

lender of last resort1
Lender of last resort

Free-banking view

  • Panics due to legal restrictions on a) branch-banking; b) note issue
  • The role of clearinghouse associations.
the bank of england
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.

the bank of england a timeline
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.

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.

The Colonial period
the colonial period1
First government-issued paper money by Massachusetts in 1690, to finance soldiers defeated on raids to Quebec The Colonial period

20 shillings, 1690

the colonial period2
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
revolutionary war finance
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

the first american banks
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.

constitutional monetary standards
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.’
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.

First Bank of the United States

Alexander Hamilton

suspension of convertibility
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.
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.

Second Bank of the US and resumption

Nicholas Biddle

Andrew Jackson

coinage act of 1834
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
the free banking period
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.

pre war composition of the money stock
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.

greenbacks
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.

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).

The National Banking System

Bank note issued by Quakertown National Bank

1897

the national banking system1
1865: 10% tax on state banknotes … and the rise of demand deposits.The National Banking System

Bank note issued by Quakertown National Bank

1897

resumption of convertibility
Resumption of convertibility

Resumption at $20.67 was desired, requiring deflation as greenbacks were retired.

Resumption Act of 1875 ended the suspension of convertibility.

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…The Crime of 1873

William Jennings Bryan

the founding of the federal reserve system
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

the great depression
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.
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 Nixon’s closing of the gold window in 1971.

Bretton Woods
banking business
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

banking industry
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.