Defects of the old national banking system

After the failure of the Aldrich Bill, it appeared for a time as if banking revision would become a football of politics, particularly as in the political campaign of 1912 all three of the leading parties advocated banking reform in terms not ultra-precise and definite. But soon after the election of President Wilson, the study of banking reform was, at his initiative, begun anew. In 1913 the Federal Reserve Act passed Congress. To appreciate its real significance we must first understand the evils it was designed to cure. Of the defects of the old national banking system, those most emphasized in popular as well as in purely banking circles were the following:

1. Decentralized reserves. Cash reserves were parceled out among the vaults of 7500 individual banks.
2. Rigid reserve requirements, under which banks were compelled to refuse new loans when their cash reserves had fallen below the minimum set by law.
3. The inelasticity of the note issues, or the inability of our currency to adjust its volume to the varying needs of trade.

To many Americans unacquainted with centralized banking institutions, it was exceedingly difficult to apprehend clearly the operation of a system in which each individual bank was not the holder of a large part of its own cash reserve. But to the European, it would have been equally difficult to visualize the working of the American system. For the European has been accustomed to the great central banking institutions in whose vaults are held in large measure the nations ultimate cash reserve.

It is not difficult to perceive the advantage of the centralized European systems in times of credit crises. If business can be carried over a threatened period of adversity, lack of business confidence may not become general and the soundness of credit may remain unimpaired. Through long experience, the leading bankers have learned that the only safe policy in such times is to lend freely, to convince the business public that the banks are prepared to throw their resources generously at the disposal of trade. Discount and interest rates will undoubtedly be raised in order to cut off the less urgent demands for loan accommodation; but the legitimate demands for credit must be met. Any other policy can only mean an accentuation of the public’s fears. But such a policy requires courage. It is useless to ask each individual banker to go ahead blindly, in time of financial stress, risking the solvency of his own bank, perhaps. Somewhere in the banking system there must be some responsible, central authority to which the banks of the country as a whole may look for initiative and guidance in general banking policies and which, most of all, shall be in a position to assure individual banks that they are not incurring undue risks in holding to the right rather than the wrong financial policy. Thus the Bank of England, in announcing its official discount rate, virtually guarantees the other banks of that country that they can, at the stated rate, secure funds to maintain or to replenish their own reserves. But where under the old system were banks to obtain the funds for such an expansion of loans? Nowhere was there a central banking institution with funds husbanded for just such occasions. Least of all could one bank turn to another for aid. In time of threatened danger each institution set to work to put its own house in order, to diminish its loans so that the claims on its cash might be lessened. With each bank thus impelled to look first to its own interests, and with no means of effective cooperation among the banks, a general credit stringency might arise, which in its beginnings could easily have been handled had some means existed for placing the aggregate banking resources at the disposal of the threatened community.

How well the old system deserved the reproach, “Breeder of Panics,” is indicated by the following remarks of Paul Warburg, a distinguished banker, for some time a member of the Federal Reserve Board:

If after a prolonged drought a thunderstorm threatens, what would be the consequence if the wise mayor of a town should attempt to meet the danger of fire by distributing the available water, giving each house-owner one pailful? When the lightning strikes, the unfortunate householder will in vain fight the fire with his one pailful of water, while the other citizens will all frantically hold on to their own little supply, their only defense in the face of danger. The fire will spread and resistance will be impossible. If, however, instead of uselessly dividing the water, it had remained concentrated in one reservoir with an effective system of pipes to direct it where it was wanted for short, energetic and efficient use, the town would have been safe.

We have paralleled conditions in our currency system, but, ridiculous as these may appear, our true condition is even more preposterous. For not only is the water uselessly distributed into 21,000 pails, but we are permitted to use the water only in small portions at a time, in proportion as the house burns down. If the structure consists of four floors, we must keep one-fourth of the contents of our pail for each floor. We must not try to extinguish the fire by freely using the water in the beginning. That would not be fair to the other floors. Let the fire spread and give each part of the house, as it burns, its equal and inefficient proportion of water. Pereat mundus, fiat justitia!

When we consider likewise the rigidity of our legal reserve requirements, many similar analogies might be made, all to the detriment of the old system. What would we think of a government which, having in time of peace established naval and military reserves, should insist that they should not be used in time of war, in order that the reserve forces should not be diminished? Would we regard a waterworks system as efficient, if, during a general conflagration, water could not be used when the supply in the reservoirs had fallen below what was normally regarded as the proper reserve for safety? Yet by our reserve law, banks were unable to utilize their funds to their maximum capacity at the very time when business stood in most urgent need for credit! Indeed, the United States was one of the few countries in the world which, by law, required a cash reserve to be held against deposits.

It was obvious also that the currency system of the United States was decidedly inelastic. Its volume could not vary according to the varying needs of trade. Particularly evident was this weakness in the period of greatest stress, the fall crop-moving season. In the late winter, banks in the agricultural districts found themselves with more money on hand than they needed. So large sums were shipped east, largely to New York, where a small rate of interest was paid on bankers’ deposits. Along came the harvest season, and the need for cash in the interior annually caused a wholesale withdrawal of these funds. Each fall the principal banks of New York had been obliged to surrender about fifty millions of dollars to satisfy such demands. In addition, gold was often imported from Europe in large quantities. The high rates of interest on these foreign loans added to the real costs of moving the crops. Europe was exacting a toll for furnishing the funds which should have been forthcoming here.