Banking and Bank Regulation

 

Outline

1. Before central banking
   1. Commercial banking developed in the U.S. after the Revolution
      1. Commercial banks operated under state charters
      2. Banks issued paper money (notes) which they promised to redeem by paying the equivalent value in specie
      3. Reserves were held to cover ordinary demands for redemption

   2. With some exceptions, systems generally worked well
      1. Potential for bank (even a sound one) to run out of reserves should there be sudden extraordinary demands for redemption. Such bank runs led to bank failure
      2. Some banks followed unsound practices and issued too many notes

2. At the urging of Alexander Hamilton, Congress, in 1791, chartered the First Bank of the United States for a period of twenty years
   1. Although there is no precise definition of a central bank, there is some agreement as to its chief functions
      1. It is a lender of last resort to other banks and financial institutions
      2. It has a great deal of control over the money supply and uses its control to moderate fluctuations in the economy
      3. It regulates the activities of other banks, discouraging or punishing imprudent activities
      4. It lends money to the government

   2. The BUS was the first U.S. experiment with central banking and bank regulation
      1. The Bank was jointly owned by government and private shareholders
      2. The BUS performed several functions
         1. It acted as the banker for the federal government
         2. It regulated the commercial banks
         3. It disciplined other banks, restraining the impulse to lend too much and deplete reserves, by collecting their notes and presenting or threatening to present them for redemption
      3. There was substantial opposition to the bank, even in the Federalist Congress
         1. Many (including Jefferson) thought it unconstitutional
         2. Some feared creation of a "money-monopoly" which would endanger individual rights and liberties
         3. The South charged that it would favor the commercial North but not the agricultural South

   3. In practice, the BUS was run conservatively, and effectively performed many of the functions of a central bank
      1. Notes of the BUS were soon circulating widely, allowing banks to use them as reserves and economize on the use of gold and silver
      2. The BUS conservative lending policy put it in a position to restrain the smaller state banks from issuing as many notes as they would have liked
      3. Although it had no legal obligation to do so, the BUS became, in practice, the lender of last resort
      4. The BUS acted as a fiscal agent for the government, greatly facilitating government business

   4. Despite compelling arguments to continue its operation, the charter of the First Bank of the United States was not renewed in 1811
      1. The BUS had helped to create a sound monetary system for the nation
      2. Political opposition, similar to that of 1791, overrode economic considerations
      3. Personal politics influence the vote to recharter
      4. Small banks opposed the recharter at least in part because of the discipline it had imposed on their lending practices

3. Congress voted a twenty year charter for the Second Bank of the United States in 1816
   1. Inflation and difficulty financing the War of 1812 convinced many of the need for a Second Bank of the United States
      1. The charter of the second bank was similar to that of the first BUS
      2. Under the leadership of Nicholas Biddle in the 1820s, the Bank functioned much like a central bank
         1. It functioned very effectively as a lender of last resort
         2. It regulated state banks by adopting a policy of regularly presenting their notes for redemption
         3. It tried to impact the general economic climate by expanding and contracting loans
         4. It became the largest dealer in foreign exchange, and was therefore able to prevent severe specie drain

   2. Despite its contributions, the Bank's position was not secure, and its charter was not renewed in 1836
      1. Andrew Jackson was personally and politically opposed to banks in general, and the Bank of the U.S. in particular
      2. There existed a popular belief that the Bank was an instrument the rich used to oppress the poor

   3. The consequences of not renewing the Bank's charter have been debated by economic historians
      1. At one time, historians blamed the inflation of the mid-1830s and the depression of 1839-1843 on the death of the second Bank
         1. The absence of the Bank initiated a period of irresponsible, "wildcat," banking
         2. Irresponsible banking led to an increased money supply and inflation
      2. Recent scholarship suggests that inflows of silver from Mexico and Europe were the more likely cause of the inflation and subsequent collapse
      3. There is much evidence to suggest that the attack on the Bank did undermine public confidence in banks and in paper money, leading to a demand for specie that caused many bank failures, and thus the panic of 1837 and depression of 1839-1843

4. The period of relatively unregulated banking between the demise of the second Bank of the United States and the creation of the Federal Reserve in 1913 is known as the Free Banking Era
   1. Free banking meant that any individual or group could start a bank as long as they complied with certain regulations established by state governments before the Civil War. There was no federal oversight of the monetary and banking system until the National Banking acts of 1863 and 1864, and there was no central bank until the creation of the Federal Reserve in 1913

   2. Perhaps surprisingly, free banking did not result in unstable and unreliable currency and it was not detrimental to the economy as a whole
      1. State governments chartered free banks and issued regulations concerning their operation
         1. Strictness of state regulation varied considerably
         2. A common and rather effective control measure was that banks were required to purchase bonds to back their note issues and deposit these bonds with the state banking authority if a bank failed, the bonds would be sold and the proceeds would be used to pay the note holders
      2. The market provided discipline for banks
         1. Customers wanted banks to be sound; banks that offered notes with a history of ready acceptance and stable value tended to prosper
         2. Bank Note monitors were published regularly by private companies; these listed the values of notes issued by all U.S. banks and other information, giving customers and users of bank money the information they needed to choose banks and deal with bank money
         3. The system worked well enough to be copied by the federal government in its National Bank acts of the Civil War years

Economic Concepts that support the historical analysis:

• money supply
• inflation
• recession