4.2 The U.S. Banking System Prior to the Fed
79
issued only against U.S. government securities owned by the banks but held with the U.S.
Treasury Department. These banknotes, backed by government securities, were supposed to
provide citizens with a safe and stable national currency. Improved bank supervision also was
provided for with the establishment of the Offi
ce of the Comptroller of the Currency under
the control of the U.S. Treasury.
Weaknesses of
the National Banking System
Although the national banking system overcame many of the weaknesses of the prior systems
involving state banks, it lacked the ability to carry out other central banking system activities
that are essential to a well-operating fi nancial system. Three essential requirements include
(1) an effi
cient national payments system, (2) an elastic or fl exible money supply that can
respond to changes in the demand for money, and (3) a lending/borrowing mechanism to help
alleviate liquidity problems when they arise. The fi rst two requirements
relate directly to the
transferring and creating money functions. The third requirement relates to the need to main-
tain adequate bank liquidity. Recall from Chapter 3 that we referred to bank liquidity as the
ability to meet depositor withdrawals and to pay other liabilities as they come due. All three
of these required elements were defi cient until the Federal Reserve System was established.
The payments system under the National Banking Acts was based on an extensive net-
work of banks with correspondent banking relationships. It was costly to transfer funds from
region to region, and the check clearing and collection process sometimes was quite long.
Checks written on little-known banks located in out-of-the-way places often were discoun-
ted or were redeemed at less than face value. For example, let’s
assume that a check written
on an account at a little-known bank in the western region of the United States was sent to
pay a bill owed to a fi rm in the eastern region. When the fi rm presented the check to its local
bank, the bank might record an amount less than the check’s face value in the fi rm’s checking
account. The amount of the discount was to cover the cost of getting the check cleared and
presented for collection to the bank located in the western region. Today, checks are processed
or cleared quickly and with little cost throughout the U.S. banking system. Recall from Chapter 3
that the current U.S. payments system allows checks to be processed either directly or indirectly.
The indirect clearing process can involve the use of bank clearinghouses as discussed in Chapter 3
or a Federal Reserve Bank. The role of the Fed in processing checks is discussed in this chapter.
A second weakness of the banking system under the National Banking Acts was that the
money supply could not be easily expanded or contracted to meet changing seasonal needs
and/or changes in economic activity. As noted, banknotes could be issued only to the extent
that they were backed by U.S. government securities. Note issues were limited to 90
percent
of the par value, as stated on the face of the bond, or the market value of the bonds, whichever
was lower. When bonds sold at prices considerably above their par value, the advantage of
purchasing bonds as a basis to issue notes was eliminated.
2
For example, if a $1,000 par value bond was available for purchase at a price of $1,100,
the banks would not be inclined to make such a purchase since a maximum of $900 in notes
could be issued against the bond, in this case 90 percent of par value.
The interest that the
bank could earn from the use of the $900 in notes would not be great enough to off set the high
price of the bond. When government bonds sold at par or at a discount, on the other hand,
the potential earning power of the note issues would be quite attractive and banks would be
encouraged to purchase bonds for note issue purposes. The volume of national bank notes,
thus the money supply, therefore depended on the government bond market rather than on the
seasonal, or cyclical, needs of the nation for currency.
A third weakness of the national banking system involved
the arrangement for holding
reserves and the lack of a central authority that could lend to banks experiencing temporary
liquidity problems. A large part of the reserve balances of banks was held as deposits with
large city banks, in particular with large New York City banks. Banks outside of the large
cities were permitted to keep part of their reserves with their correspondent large city banks.
Certain percentages of deposits had to be retained in their own vaults. These were the only
2
A bond’s price will diff er from its stated or face value if the interest rate required in the marketplace is diff erent from
the interest rate stated on the bond certifi cate. Bond valuation calculations are discussed in Chapter 10.
80
C H A PT E R 4 Federal Reserve System
alternatives for holding reserve balances. During periods of economic stress, the position of
these large city banks was precarious because they had to meet
the demand for deposit with-
drawals by their own customers as well as by the smaller banks. The frequent inability of the
large banks to meet such deposit withdrawal demands resulted in extreme hardship for the
smaller banks whose reserves they held. A mechanism for providing loans to banks to help
them weather short-term liquidity problems is crucial to a well-functioning banking system.
The Movement to Central Banking
A
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