Financial Update (April-June 1996)

Payments System Safety Evolved
From National Banking Era Lessons

Traditional adage: History repeats itself.

The economic twist: The point is to prevent history from repeating itself, at least in terms of the banking crises that marred the National Banking Era.

In an article in the September/October 1995 edition of Economic Review, William Roberds, a research officer with the Federal Reserve Bank of Atlanta, examines an earlier period of U.S. history to shed light on the Fed's role in providing liquidity for the payments system. The Fed's safety net for the payments system is provided in three forms: the provision of reserves through open market operations, the issuance of loans through the discount window, and the provision of "daylight" credit over Fedwire, the Fed's electronic system for large fund transfers.

In outlining the reasons that lessons from the National Banking Era (1864-1914) are relevant today, Roberds notes that the period was a time of tremendous growth and innovation in financial markets and institutions, as is also the case today.

Because no central bank existed during the National Banking Era, banks relied on private clearinghouses to provide liquidity in times of high demand. During a banking panic, the clearinghouses usually issued loan certificates to provide liquidity for the banking system, although these certificates were not legally sanctioned until the Aldrich-Vreeland Act passed in 1908.

In reviewing individually the panics of 1873, 1884, 1890, 1893, 1907, and 1914, Roberds notes that issuing loan certificates was not always successful in diffusing a panic. Timing was important—if the certificates were not issued soon enough, distrust spread among depositors and the panic took hold. But timing wasn't everything. Structural weaknesses in the banking industry could undermine the timely issue of loan certificates. For example, in the 1893 crisis, the banks' inability to diversify geographically meant loan certificates could serve only as local currency. Rural banks, which widely experienced runs, did not have access to loan certificates.

Today, the banking industry is much more diversified, and depositors are insulated from disruptions by the Fed's safety net. Scholars almost universally agree that Fed policies, in concert with policies of the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation, have succeeded in averting major banking crises since the 1930s.

At the same time, however, structural changes in the banking industry have led banks to take more risks. The passage of the Federal Deposit Insurance Corporation Improvement Act and the Basle Accord seek to limit this risk-taking behavior. FDICIA and Basle are justified because they improve economic efficiency and lessen the likelihood of taxpayer bailouts, Roberds says.

The liquidity crises of the National Banking Era and the shortcomings of the solutions, in Roberds' analysis, offer valuable insight into and justification for the safety net that the Fed provides for the payments system.

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