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Laying the Foundation for the Fed

Posted on January 29, 2019

"If you are in banking and lending, surprise outcomes are likely to be negative for you." - Nassim Taleb

2019-01-29_franklins_eyeball.jpgLast week we had the opportunity to give a presentation on the Federal Reserve including the history, structure, and a deep dive into some of the extraordinary measures the Fed took during the 2008-09 Global Financial Crisis. Over the next couple weeks we will be posting a new series on the Federal Reserve based on our talk after we updated and revised our original series from 2013 entitled Fed Ed. The first couple weeks we will take an in depth look at the history behind the Federal Reserve and how it came into being.

First Bank of the United States (1791 – 1811)

The roots of the Federal Reserve can traced all the way back to our country’s origins and the American Revolutionary War. In order to finance the war, the Continental Congress issued a fiat currency or promissory note called a Continental. Although the US was able to successfully finance its war efforts and ultimately defeat the British, the value of the Continentals quickly eroded to nothing after the war due to the fact that they had no formal institutional backing.

2013-10-29_hamilton.jpgAlexander Hamilton (of present day Broadway fame) proposed the idea of a national bank in order to solve this problem and establish financial order, clarity, and precedence for the newly formed United States. At first, this idea wasn’t well received and many thought that it was un-constitutional, but Hamilton was able to convince the powers that be (specifically President George Washington) that it was indeed constitutional and much needed. The First Bank of the United States was established in 1791 with a 20 year charter and a 20% ownership stake by the US government.

The First Bank of the United States was by-and-large a success in many ways. It was very well capitalized, which allowed it to quell several bank runs by providing liquidity to state chartered banks. Its notes were also seen as rock solid so they traded at par which was the closest thing the country had to a national currency. The Bank was not popular amongst many rural Americans who believed it put too much power into the hands of the elite. Additionally, many didn’t like the fact that 20% of the Bank was foreign owned and a good deal of people still thought it was unconstitutional. As such, after the Bank’s 20 year charter expired in 1811, the government decided not to renew it and sell their stake in order to pay off existing debts and avoid raising taxes.

Second Bank of the United States (1816 – 1836)

Five years after the First Bank’s charter expired, the Second Bank of the United States was created and structured very similar to the first. During the brief period of time between the two banks, government officials realized that there was a huge divergence in the availability of credit in different parts of the country and wanted a centralized bank which could support state chartered banks in providing a more uniform credit system.

Unfortunately, the Second Bank did not enjoy much of the same success as the First Bank and was plagued with poor management and outright fraud. The actions of the Second Bank enraged enough people that two different cases, both of which were defeated unanimously, were brought before the Supreme Court to strike it down as unconstitutional.

In 1828, Andrew Jackson, who was known to be anti-Second Bank, was elected President on the Democratic ticket. The embedded cartoon from this period of time in our nation’s history actually depicts the Bank’s president as the devil with Andrew Jackson toppling the Second Bank to the approval of Uncle Sam. In 1832, Jackson vetoed a bill to renew the bank’s charter which later expired in 1836.


Free Bank Era (1837 – 1862)

The period of time following the end of the Second Bank of the United States is known as the free bank era. During this time, the US government had no oversight over banks which were all chartered at the state level. In 1837 the state of Michigan passed an act which allowed for banks which met specific reserve requirements to receive an automatic charter. Most of the other states adopted similar rules which led to a massive influx of privately owned, state chartered banks.

2019-01-29_Free_Bank_Era_Notes.PNGThe free bank era is probably the best example of truly decentralized, free market banking system. Unfortunately, this era was fraught with defaults and bank closures due to several complicating factors, the largest of which being the fact that there was no elasticity in the different forms of currency being used at the time. With no common currency, privately issued bank notes were used as tender. These notes would commonly trade at a discount to their face value to account for the risk of redemption (e.g. bank failure), which made trade very difficult as merchants would have to keep track of the discount rate on hundreds of different bank notes.

Also, similar to modern day banking, state chartered banks during this time were required to hold a percent of their outstanding debts/loans in reserve. If you think about a bank today, those reserves might take the form of US dollars, Treasury notes, commercial paper from other banks, or even gold. Back in the middle of the 19th century, the only things a bank might hold in reserve were debt instruments (e.g. bonds) of other companies or banks and gold. The problem was, these assets commonly fluctuated in price which means the denominator in the following reserve requirement equation was constantly changing.

Total Loans/Debts Outstanding
Assets Held in Reserve

As such, when the value of the reserves changed significantly, banks would be in violation of their reserve requirement which forced them to either reduce their lending activity or in extreme circumstances actually recall loans. In an era well before FDIC insurance where bank failures were common place, even the slightest hint of financial trouble from a bank would spread like wild fire and lead to run on the bank. Such was the case during the free bank era as the average lifespan of a bank was only 5 years and about half of the banks eventually failed.

Next week we will look at the period of time after the free bank era leading up to the creation of the Federal Reserve known as the National Bank Era, the circumstances which gave rise to the Fed, and the early years of our modern day banking system.

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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