This article is about the history of the Federal Reserve, the central bank of the U.S.

1791-1836: The First and Second Bank of the United States

The first bank with central banking powers in the US was the Bank of North America (chartered 1781). After independence, in 1791, the First Bank of the United States (1791-1811) was chartered. It was modelled after the Bank of England and differed in many ways from today's central banks. For example, it was partly owned by foreigners, who would share from its profits - the reason for its eventual break up. It was also not solely responsible for the country's money supply; its share was only 20%, while private banks accounted for the rest.

After a five year interval, its successor, the Second Bank of the United States (1816-1836), was chartered. It was basically a copy of the First Bank.

1837-1862: Free Banking Era

In this period, only state-charted banks existed. They could issue bank notes against specie (Gold and Silver coins) and were regulated by the states in reserve requirements, interest rates for loans and deposits, the necessary capital ratio etc. The Michigan Act (1837) allowed the automatic chartering of banks that would fulfill its requirements without special consent of the State legislature. This eased creating unstable banks even further, lowering the supervision by the states that adopted it. The value of bank bills could be below its face value, according to the bank's financial strength. By 1797, there were 24 charted banks in the US while with the beginning of the Free Banking Era (1837) there were 712.

The banks were very unstable compared to todays commercial banks. The average lifespan of a bank was five years; about half of the banks failed, a third of which because they couldn't redeem their notes. Also without a central bank responsible for monetary policy, the money supply and price level were much more volatile than today.

During the free banking era, some local banks appeared that took over the functions of a central bank. In New York, the New York Safety Fund acted as a deposit insurance for its member banks. In Boston, the Suffolk Bank guaranteed other banks on-par value of their notes in exchange for reserves. Another private institution that took up work of today's central banks was the clearinghouse. It acted as lender of last resort, when a bank needed liquidity, e.g. in a bank run

1863-1913: National Banks

Some of the problems of the free banking era were solved with the National Banking Act, besides providing loans in the Civil War effort of the Union. The provisions were

• To create a system of national banks. They had higher standards concerning reserves and business practices than state banks . The office of Comptroller of the Currency was created to supervise these banks
• To create a uniform national currency. In order to achieve this, all national banks were required to accept each others currencies at par value. This eliminated the risk of loss in case of bank default. The notes were printed by the Comptroller of the Currency to insure uniform quality and prevent counterfeiting.
• To finance the war. National banks were required to back up its notes with Treasury Securities , enlarging the market and raising its liquidity.

As described by Gresham's Law, soon bad money from state banks drove out the new, good money; the Government imposed a 10% tax on state bank bills, forcing most banks to convert to national banks. By 1865, there were already 1500 national banks, 1870, 1638 national banks stood against only 325 state banks. The tax led in the 1880s and 1890s to the creation and adoption of checking accounts. By the 1890s, 90% of the money supply was in checking accounts. State banking had made a comeback.

Two problems still remained in the banking sector. The first was the requirements to back the currency up with Treasuries. When they fluctuated in value, banks had to recall loans, or borrow from other banks or clearinghouses. The second were seasonal liquidity spikes. A rural bank would have deposits at a larger bank that it withdrew when the need for funds was highest, e.g. in the planting season. When the combined liquidity demands were too big, the bank again had to find a lender of last resort.

These liquidy crises led to bank runs, causing severe disruptions and depressions, the worst of which was the Panic of 1907

1913: Creation of the Federal Reserve System

Early in 1907, New York Times Annual Financial Review published Paul Warburg's (a partner of Kuhn, Loeb and Co.) first official reform plan, entitled "A Plan for a Modified Central Bank," in which he outlined remedies that he thought might avert panics. Early in 1907, Jacob Schiff, the chief executive of Kuhn, Loeb and Co., in a speech to the New York Chamber of Commerce , warned that "unless we have a central bank with adequate control of credit resources, this country is going to undergo the most severe and far reaching money panic in its history." "The Panic of 1907" hit full stride in October. Other financial persons who advocated a central bank with an elastic currency after the Panic of 1907 include Frank Vanderlip , Myron T. Herrick, William Barret Ridgely , George E. Roberts , Isaac N. Seligman and Jacob H. Schiff . See, Myron T. Herrick "The Panic of 1907 and Some of Its Lessons", Annals of the American Academy of Political and Social Science, vol. 31 (Jan.-June 1908), as reported by Charles P. Kindleberger "Manias, Panics, and Crashes" (4th ed.).

It is significant that all of these people save Seligman were unqualified in their advocacy of a central-bank elastic currency (i.e., expanding during a boom and contracting during a bust), despite the U.S. enjoying robust growth without a central bank, and that Herrick thought "the laws of finance are...as sure in their operation as the laws of physics."

In 1910, Senator Nelson Aldrich, Frank Vanderlip of National City (Citibank), Henry Davison of JP Morgan, and Paul Warburg of Kuhn, Loeb and Co. met secretly at Jekyll Island, to discuss and formulate banking reform, the Aldrich Plan . It proposed a system of 15 regional Reserve Banks managing the money supply and providing liquidity, but run by private bankers. It was rejected by Congress.

Finally in 1913 in the Federal Reserve Act or Owen-Glass Act, the modern Fed was created: a system of eight to twelve regional Reserve Banks, owned by its commerical member banks and supervised by the Federal Reserve Board. The board and its chairman are appointed by the President.

1913-present: Recent changes

The Fed's power developed slowly in part due to an understanding at its creation that it was to function primarily as a reserve, a money-creator of last resort to prevent the downward spiral of withdrawal/withholding of funds which characterizes a monetary panic. At the outbreak of World War I, the Fed was better positioned than the Treasury to issue war bonds, and so became the primary retailer for war bonds under the direction of the Treasury. After the war, the Fed, lead by Paul Warburg and New York Governor Bank President Benjamin Strong, convinced Congress to modify its powers giving it the ability to both create money, as the 1913 Act intended, and destroy money, as a central bank could.

During the 1920s, the Fed experimented with a number of approaches, alternatively creating and destroying money and, in the eyes of many scholars (notably Milton Friedman), helping to create the late-1920s stock market bubble. In 1928 Strong died, leaving a tremendous vacuum in Fed governance from which the bank did not recover in time to react to the 1929 collapse (as, for instance, the Fed did after 1987's Black Monday), and the Fed adopted what most would consider today to be a restrictive policy, exacerbating the crash.

After FDR took office in 1933, the Fed became subordinated to the Executive Branch, where it remained until 1951, when the Fed and the Treasury department signed an accord granting the Fed full independence over monetary matters while leaving fiscal matters to the Treasury.

The Fed's powers have not significantly changed since 1951, though it has frequently adopted different policy approaches.

Source

This article is an excerpt of A Brief History of Central Banking in the United States by Edward Flaherty , with the post-1913 history adapted from a senior thesis at Yale University.