Financial System and Financial Panics

1. Financial System and Financial Panics • Economists often speak of economies as if they had ‘real’ and ‘financial’ halves. That can be confusing though it’s supposed to make things easer to understand. • The financial aspect of the economy includes such topics as money, banks, stock and bond markets, and interest rates. • Financial markets are conduits for savings and information. • Economic catastrophes are always most visible in, and are usually intensified by, financial markets.

2. Types of Financial Panics • Stock Bubbles and market collapses • ‘Black Thursday, Monday and Tuesday’ 1929: 100 Billion evaporates over 2 months. • Black Monday 1989: 500 billion dollars evaporated from the Dow Jones index (30 companies) • Housing Bubbles and collapses • not as deep, but more often more damaging for banks and the economy. (Japan 1990’s)

3. Types of Financial Panics • Bank Panics-Collapses • USA many in 1800’s, as there was no central bank. • USA three waves of bank closures in 1930’s, even though we got the “Fed” in 1913 we did not have bank deposit insurance until 1930’s. • Stable banking system after WWII with the Fed occasionally assisting the rescue a financial institution. (LTCM) • Currency crises • when a currency suddenly collapses • East Asia had currency and bank crises in 1996-97 • Debt Crises • happen when many bond holders are not paid. • Debt crisis of 1980’s was a public debt crisis.

4. USA Banking History • First and Second Bank of US • “Free” Banking Period with no central bank. • 1913-1930’s Early FRB • WWII-1973 Fed with fixed exchange rates • 1995-Now: New Transparent, Interest Rate Setting Fed

5. Each Bank Used to Print its Own Notes! • Before the 1860’s each bank usually printed its own notes. If the bank went out of business you might be out of luck, so some of the notes might only be accepted “at a discount”. . .give you 50 cents for that dollar bill… By 1900 all notes issued by Banks, like this one were “Federal Notes”. National Bank of the Republic of Chicago, 1902 note, asking $375 on ebay

6. Bank Panics! • Each bank kept reserves of other monies (especially “US” dollars issues by the Federal Gov) which customers could demand if they suddenly didn’t trust the notes. Federal Dollars were generally exchangeable into gold, or silver. • “From 1792 to 1873 the U.S. dollar was freely backed by both gold and silver at a ratio of 15:1 under a system known as bimetallism. In this system, the dollar could be exchanged for 371.25 grains (24.06 g) of silver or 24.75 grains (1.60 g) of gold.” After 1900 gold only. http://www.answers.com/topic/history-of-the-united-states-dollar

7. First Bank of the United States (1791-1811) • “Alexander Hamilton's brainchild, a semi-public national bank, was a crucial component in the building of the early U.S. economy. The Bank prospered for twenty years and performed traditional banking functions in exemplary fashion. With a main office in Philadelphia and eight branches nationwide...” • Citation: Cowen, David. "First Bank of the United States". EH.Net Encyclopedia, edited by Robert Whaples. August 15, 2001. URL http://eh.net/encyclopedia/article/cowen.banking.first_bank.us

8. 1811 Fall of the First Bank • The opponents charged that because three-fourths of the ownership of the stock was held by foreigners, that the Bank was under their direct influence. The charge was false, as foreigners were prohibited from electing directors. The opposition also charged that the Bank was concealing profits, operating in a mysterious fashion, unconstitutional, and simply a tool for loaning money to the Government. • Citation: Cowen, David. "First Bank of the United States". EH.Net Encyclopedia, edited by Robert Whaples. August 15, 2001. URL http://eh.net/encyclopedia/article/cowen.banking.first_bank.us

9. Second Bank of the US • The Second Bank of the U.S. was chartered in 1816 with the same responsibilities and powers as the First Bank. However, the Second Bank would not even enjoy the limited success of the First Bank. …Jackson believed that the nation's money supply should consist only of gold or silver coin minted by the Treasury and any foreign coin the Congress chose to accept. • (Ends 1836) • Edward FlahertyFrom Revolution to Reconstruction - an .HTML projecthttp://www.let.rug.nl/usa/E/usbank/bank04.htm

10. Free Banking • Under free banking, a prospective banker could start a bank anywhere he saw fit, provided he met a few regulatory requirements. Each free bank's capital was invested in state or federal bonds that were turned over to the state's treasurer. If a bank failed to redeem even a single note into specie, the treasurer initiated bankruptcy proceedings and banknote holders were reimbursed from the sale of the bonds. • Michigan, NY (1837) then many Citation: Bodenhorn, Howard. "Antebellum Banking in the United States". EH.Net Encyclopedia, 2001. http://eh.net/encyclopedia/article/bodenhorn.banking.antebellum

11. “Free” banking boom Growth of Banks prior to Civil War boosted growth, but outside of the East Coast banks were especially unstable. Source: Bodenhorn, Howard. "Antebellum Banking in the United States". http://eh.net/encyclopedia/article/bodenhorn.banking.antebellum

12. New England Banking: fewer shaky notes due to the Suffolk System • The Suffolk Bank was chartered in 1818 and within a year embarked on a novel scheme to deal with the influx of country banknotes. • …the Suffolk collected a large quantity of a country bank's notes, it presented them for immediate redemption with an ultimatum: Join in a regular and organized redemption system or be subject to further unannounced redemption calls.4 • …it required them to keep noninterest-earning assets on deposit with the Suffolk in amounts equal to their average weekly redemptions at the city banks. • (So Banks were forced to limit their note issue.) Citation: Bodenhorn, Howard. "Antebellum Banking in the United States". EH.Net Encyclopedia, 2001. http://eh.net/encyclopedia/article/bodenhorn.banking.antebellum

13. Between 1836 and 1913 the US had no central bank • Banks issue liquid liabilities in the form of deposit contracts but invest mainly in illiquid assets. Historically, this mismatch resulted in frequent banking panics. • One of the main roles of central banks has been to try to eliminate panics. • Europe: Crises eliminated by central banks in the last half of the nineteenth century. • US: Crises endemic in the last half of the nineteenth century Source: F. Allen at Wharton

14. “Consumers know that during recessions they will want to dissave, drawing down bank accounts. But, banks, like other firms, tend to fail during recessions. When consumers forecast a coming recession they withdraw deposits in advance to avoid losses due to bank failure.” G. Gorton 1988 O.M.W. Sprague (1910): 1893, and 1907 full-fledged crises 1884 and 1890 less severe. Increase in currency/deposit means deposits fall! F. Allen@Wharton and Gary Gorton 1988

16. Before 1913 the apex of the system could not create reserves! The money supply was not sufficiently elastic to allow for seasonal and other stresses on the money market and the fact that reserves were pyramided. Banks' required reserves could be held in national banks in larger cities ("reserve city banks"). Reserve city banks could, in turn, hold a portion of their required reserves in "central reserve city banks,“ Grossman 2003 Reserve Banks City Banks Country Banks

17. 1909 Crisis and 1913 FRB • The crisis of 1907 . . . led to a reconsideration of the monetary system of the United States. • The stated goals of the Federal Reserve Act were: " . . . to furnish an elastic currency, . . . [and] to establish a more effective supervision of banking in the United States" • Furnishing an "elastic currency" was important goal of the act, since none of the components of the money supply (gold and silver certificates, national bank notes) were able to expand or contract particularly rapidly. • The inelasticity of the money supply, along with the seasonal fluctuations in money demand had led to a number of the panics of the National Banking era. These panic-inducing seasonal fluctuations resulted from the large flows of money out of New York and other money centers to the interior of the country to pay for the newly harvested crops. If monetary conditions were already tight before the drain of funds to the nation's interior, the autumnal movement of funds could -- and did --precipitate panics Source: Grossman 2003

18. 1930’s Bank Panics 1st panic 1930. 2nd panic 1931. 3rd panic 1932-1933. FDIC 1933.

19. FRB structure • SEE • http://www.federalreserveeducation.org/fed101/ • Functions • Supervise the soundness of the banking system • Lender of last resort (lend to banks in trouble) • Monetary Policy

20. FRB only one regulator • Shares bank regulation • “The Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corp. (FDIC), the Office of Thrift Supervision (OTS) and state banking authorities also regulate financial institutions. The OCC charters, regulates and supervises nationally chartered banks. The FDIC, the Federal Reserve and state banking authorities regulate state-chartered banks. Bank holding companies and financial services holding companies, which own or have controlling interest in one or more banks, are also regulated by the Federal Reserve. The OTS examines federal and many state-chartered thrift institutions, which include savings banks and savings and loan associations.” • It regulates only part of the financial system • SEC securities and exchange commission • Futures and Commodities regulators • Office of Federal Housing Enterprise Oversight • FBI Fraud • Various State Insurance and Pension Regulators: NY State Regulation of Monoline Insurers

21. FRB Independence: BOG terms • Board of Governors: The board consists of the seven governors, appointed by the president and confirmed by the Senate. Governors serve 14-year, staggered terms to ensure stability and continuity over time. The chairman and vice-chairman are appointed to four-year terms and may be reappointed subject to term limitations.

22. FRB Periods • 1913-gold standard+WWI • Short sharp depression after WW1 • 1930’s GD varying gold price • 1940’s WWII, keep I low for fed gov. • demand is literally rationed • 1950’s + 60’s Bretton Woods System • fixed exchange rates and capital immobility • 1973 US off gold to a flexible exchange rate • rising capital mobility • the one great peace time inflation in US history

23. FRB Independence: Funding • The FRB owns and holds a very large stock of Treasury Bonds and Bills. It is owed interest on these. It agrees to give back this interest to the Treasury. It funds its operations with the retained interest payments. Its budget does not appear in the President’s annual budget (which must be passed by Congress).

25. FRB Balance Sheet, May 24 ’04In Billions, with rounding Assets Liabilities+Capital US Securities 714.0 Notes 689.0 Gold 11.0 Reserve 36.5 SDR’s 2.2 Other 27.7 Forex+other 36.8 Capital 18.8 In collection 5.7 Premises 1.6

26. Bank Capital • Commercial Banks are banks that offer checking accounts (Merchant banks like Goldman Sachs do not) • Bank capital (aka net worth or shareholder’s equity) is = to the bank’s assets less its liabilites: what it owes to others. • Its assets are largely gov. bonds and its portfolio of loans. Its liabilities are largely checking accounts, CD’s (time deposits) and bond borrowing.

27. Bank Capital • There are many rules about when banks must declare that one of their loans has gone bad and must be “written down”. • When loans are written down the value of bank capital falls and the bank’s stock price falls at the same time.

29. Bank Capital • Bank capital bears the brunt of bad lending so: • 1st bank capital rather than the FRB and FDIC bear the brunt of bad lending • 2nd bank share holders have an incentive to monitor bank management and keep losses small