Academic journal article Federal Reserve Bank of St. Louis Review

Furnishing an "Elastic Currency": The Founding of the Fed and the Liquidity of the U.S. Banking System

Academic journal article Federal Reserve Bank of St. Louis Review

Furnishing an "Elastic Currency": The Founding of the Fed and the Liquidity of the U.S. Banking System

Article excerpt

Financial crises often result in sweeping changes in financial regulation. The financial crises of the 1930s, for example, led to major changes in U.S. regulation of commercial banks and securities markets and the introduction of federal deposit insurance. Similarly, following the financial crisis of 2007-08, the Dodd-Frank Act of 2010 introduced the most far-reaching changes in U.S. bank regulation since the Great Depression, while U.S. and foreign authorities agreed on new capital and liquidity rules affecting large, internationally active banks. (1)

Financial crises--especially those involving the banking system--can also fundamentally alter the role of governments or central banks as lenders of last resort. Major changes in the rules governing Federal Reserve (Fed) lending were enacted both during the Great Depression and following the crisis of 2007-08. In the 1930s, concerns that the Fed did too little to save the banking system or protect the economy prompted Congress to enact legislation that expanded the Fed's ability to lend to banks and other firms and restructured the Federal Reserve System in an effort to make it a more-responsive lender of last resort. In 2007-08, the Fed lent heavily to commercial banks and other financial institutions, in some cases using authorities granted during the Great Depression. Concerns that the Fed had too much latitude led Congress, in the Dodd-Frank Act, to rein in the Fed's ability to lend to distressed firms.

Economists and policymakers are interested in how banks respond to changes in regulation and the rules governing access to a lender of last resort to determine whether those changes have their intended effects. Such changes can affect banks' incentives to take risks, engage in certain activities, or grow in size, with implications for the broader economy. (2) New restrictions on a central bank's lending authority, for example, might cause banks to reduce the liquidity services they offer to their customers to lessen the chance they will need to borrow from the central bank, while an easing of restrictions might lead banks to take greater risks, knowing that the central bank will backstop them in a crisis.

This article examines how the U.S. banking system responded to the founding of the Federal Reserve System in 1914. The Federal Reserve was established primarily to bring an end to the recurring crises that plagued the U.S. banking system, which reform proponents saw as stemming from the nation's "inelastic" currency stock and dependence on interbank relationships to allocate liquidity and operate the payments system. The Federal Reserve Act was intended to solve these problems by creating a new currency--Federal Reserve notes--supplied by regional Reserve Banks through lending to their member banks. Member banks would hold reserve deposits with their Reserve Bank and acquire additional reserves or currency from the Reserve Bank as needed to accommodate the short-term credit and liquidity needs of local commercial and agricultural activity. Moreover, the Reserve Banks would provide check clearing and other payments services to their members. Although not stated as such in the Federal Reserve Act, the Fed was intended to perform the functions of a central bank, including serving as lender of last resort for the banking system.

In focusing on the need for an elastic currency, reform advocates noted that banking crises tended to occur at times of the year when the demands for currency and bank loans were normally at seasonal peaks and money markets were at their tightest. Moreover, they blamed the interbank system, upon which the banking system depended for seasonal accommodation and interregional payments, for transmitting shocks throughout the banking system. Researchers have shown that market interest rates exhibited much less seasonal variability after 1914 than before, suggesting that the Fed's founders accomplished their goal of eliminating seasonal strains in money markets (e. …

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