Michael D. Bordo, Rutgers University and NBER David C. Wheelock, Federal Reserve Bank of St. Louis Prepared for the Federal Reserve Bank of Atlanta Conference

Michael D. Bordo, Rutgers University and NBER David C. Wheelock, Federal Reserve Bank of St. Louis Prepared for the Federal Reserve Bank of Atlanta Conference Commemorating the 100 th Anniversary of the Jekyll Island Conference Jekyll Island, Georgia, November 5-6, 2010 The Promise and Performance of the Federal Reserve as Lender of Last Resort 1914-1933 1

Introduction The financial crisis of 2007-2008 has raised many renewed questions about how central banks should carry out their responsibilities as lenders of last resort In this paper, we examine the origins and early performance of the Federal Reserve as lender of last resort The record of the past may help inform current discussions about how the Fed should act as a LLR 2

Introduction (cont.) We consider why the Feds performance as LLR during the Great Depression failed to live up to the promises of those who designed the system The Fed was established to overcome the problems of the National Banking era: seasonal money market stringency and recurrent banking panics The panic of 1907 led to the Aldrich-Vreeland Act of 1908 and the National Monetary Commission 3

Introduction (cont.) Paul Warburgs study of the NMC led to a plan for a US central bank and a European style discount market The Warburg Plan greatly influenced the bill drafted by Senator Nelson Aldrich that came out of the Jekyll Island meeting of November 1910 4

Introduction (cont.) The Aldrich Bill of 1912 had great impact on the Federal Reserve Act of 1913, especially the provisions concerning the rediscounting of commercial paper and bills of exchange for member banks, which were fundamental to how the Fed would serve as lender of last resort to the banking system The framers of the Federal Reserve believed that if the Reserve Banks discounted eligible commercial paper that banking panics would be prevented from occurring 5

Introduction (cont.) Neither the Aldrich Bill nor the Federal Reserve Act dealt explicitly with financial crises nor prescribed how the Fed should respond to banking panics The Feds failure to prevent or counteract panics was a principal cause of the Great Depression We trace the Feds failure to act as an effective lender of last resort during the Great Depression to defects of the Federal Reserve Act and more broadly of the US banking system 6

Introduction (cont.) The Act failed to recreate the money market conditions and other institutions that enabled the Bank of England and other European central banks to function effectively as lenders of last resort The Act created a system that depended critically on the competence of the individuals running the system rather than a set of rules or principles to guide LLR policy 7

Introduction (cont.) Finally, the Act failed to replace the crisis-prone U.S. unit banking system with a more stable, concentrated banking system, such as those of the UK and Canada 8

Banking Reform Defects of the National Banking System The recurrent instability of the National Banking Era was the principal motivation of the reform movement that led to the Federal Reserve Act US financial instability in the 19 th century reflected two fundamental problems Unit banking The absence of an effective lender of last resort Unit banking resulted from legal restrictions imposed by the federal government on interstate branch banking and by most states on branching 9

Defects of the National Banking System (cont.) Branching restrictions and the absence of a central bank reflected deep seated populist fears about the concentration of financial power The prototypical attempt to create a central bank with the First and Second Banks of the US foundered on the shoals of populism and states- rights The Free Banking era of 1836-63 was characterized by a multiplicity of bank notes circulating at varying rates of discount, frequent bank failures, fraud and banking panics 10

Defects of the National Banking System (cont.) The National Banking system was intended to overcome the perceived flaws of the free banking era The National Banking system did succeed in creating a uniform currency in the form of national bank notes backed by U.S. government bonds but it had three serious defects that were responsible for four severe banking panics Inelastic currency, seasonal stringency,inverted pyramid of credit 11

The Reform Movement Panics in 1873, 1893 led to calls for reform, but to no avail. The panic of 1907 broke the camels back and led to the Aldrich-Vreeland Act of 1908 The Aldrich-Vreeland Act institutionalized the emergency currency provisions developed by major clearinghouses to alleviate banking panics. The AV Act was only used once, to stem a crisis in 1914 at the outbreak of WW I 12

The Reform Movement (cont.) The AV Act also created the National Monetary Commission to study and recommend on a US central bank The NMC was headed by Nelson Aldrich, Chairman of the Senate Committee on Banking and Currency Aldrich was persuaded of the efficacy of the European-style discount and central banking Europe, by Paul Warburg, a successful German banker who had immigrated to the US in 1902 13

The Reform Movement (cont.) Warburg argued that in the advanced countries of Europe the presence of a discount market and a central bank that provided liquidity to back up the market and serve as lender of last resort in times of stringency prevented the type of financial instability experienced in the US Warburg believed that a market for bills of exchange (two-name bills), as exemplified by the market for bankers acceptances, would be more liquid than the existing U.S. commercial paper market (based on single-name promissory notes) 14

The Reform Movement (cont.) Warburg argued that the U.S. money market would be more liquid if banks were permitted to issue bankers acceptances Warburg believed that recreating as closely as possible the money market environment of England, France and Germany was a crucial step in bringing stability to the U.S. banking system The Bank of England acted as a backstop to the discount market, freely lending to them on the basis of sound collateral. The discount houses in turn backstopped the banking system 15

The Reform Movement (cont.) The German banks discounted directly with the Reichsbank Both central banks were highly successful in avoiding panics By contrast, the US before 1914 had thousands of small unit banks, no acceptance market and no central bank 16

The Reform Movement (cont.) The Federal Reserve system, with semi- autonomous regional Reserve Banks was made to fit the structure of the U.S. banking system. Unit banking and the dual banking system were not changed Warburg pushed for the development of a bankers acceptance market in the US 17

The Warburg-Aldrich Plan Warburg first proposed in 1910 the creation of a central bank with 20 regional branches controlled by bankers but regulated by government officials His United Reserve Bank would rediscount bills of exchange for its member banks, thereby providing liquidity to the market and establishing a LLR, following Bagehots strictures to lend freely in a banking panic 18

The Warburg-Aldrich Plan (cont.) Under Warburgs plan, the discount rate would be the key instrument of policy, to be supplemented by open market operations to help make the discount rate effective The Aldrich bill drafted at Jekyll Island was very similar to the Warburgs plan The key difference was in its structure. It called for a National Reserve Association, headquartered in Washington with branches across the country 19

The Federal Reserve Act Congress rejected the Aldrich bill in 1912. Popular distrust of Wall Street power and of bankers in general killed it The Democrats under Carter Glass put forward the prototype for the Federal Reserve Act. It replicated the key monetary and international policy provisions of the Warburg plan and the Aldrich bill 20

The Federal Reserve Act (cont.) The Federal Reserve Act changed the structure and governance completely from the Aldrich bill Rather than a central organization with many branches, the Federal Reserve System consisted of 12 semi-autonomous regional Reserve Banks and the Federal Reserve Board, appointed by the President, which had a general oversight role 21

LLR Provisions of the Federal Reserve Act Preamble: an Act to provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking The Act does not contain explicit instructions for how the Fed should respond in the event of a banking panic, i.e. how it should serve as LLR 22

LLR Provisions of the Federal Reserve Act (cont.) The authors believed they had created a fool- proof mechanism that would prevent panics from occurring in the first place The FR Act did not address sources of financial instability outside the banking system, i.e. trust companies Only national banks had to become members, state banks could join if they satisfied the same requirements as national banks 23

LLR Provisions of the Federal Reserve Act (cont.) Only member banks were given access to the discount window Relatively few state-chartered banks joined the Federal Reserve System To address the problem of an inelastic currency, the FR Act permitted member banks to rediscount eligible paper with Federal Reserve Banks in exchange for Federal Reserve notes or reserve deposits 24

LLR Provisions of the Federal Reserve Act (cont.) Fed notes and member bank reserves were elastic in that their volumes would vary with the amount of eligible paper that member banks rediscounted with the Reserve Banks, which in turn varied with fluctuations in the demands for currency and credit The FR Act limited the types and maturities of loans and securities that member banks could rediscount to short-term notes, drafts and bills of exchange arising out of actual commercial and agricultural loans (ie real bills) 25

LLR Provisions of the Federal Reserve Act (cont.) Warburgs views were also reflected in sections of the Act that permitted member banks to offer bankers acceptances based on international trade and which authorized FR banks to rediscount or purchase acceptances in the open market Reserve Banks set rates of discount on acceptances they offered to purchase in the open market The Feds acceptance buying facility was closer in form to the Bank of Englands discount facility than the Feds discount window 26

LLR Provisions of the Federal Reserve Act (cont.) Reserve Banks would purchase all of the eligible acceptances offered to them at their set bill buying rates If the U.S. acceptance market had developed to the extent it had in England in the nineteenth century, it is conceivable that the Fed would have been a more effective lender of last resort during the Great Depression But the acceptance market remained small and fell off sharply during the Depression 27

The Feds Performance as LLR to 1933 Despite numerous small bank failures, there were no episodes of banking distress or panic in the 1920s. It seemed that the Fed had indeed solved the problems that had produced recurrent banking panics in the past The Fed also succeeded in ironing out the seasonal variation in money market interest rates Seasonal accommodation was largely automatic, as the Feds founders had intended 28

The Feds Performance as LLR to 1933 (cont.) 29

The Great Depression The New York Fed reacted swiftly to the October 1929 stock market crash. However, the Fed largely ignored the banking panics of 1930-33 and did little to arrest large declines in the price level and output The Fed clearly failed to serve effectively as lender of last resort 30

Fed policy from the Stock Market Crash to the Bank Holiday Figure 2 shows the level and composition of Federal Reserve credit 1929-34 31

Fed policy from the Stock Market Crash to the Bank Holiday (cont.) Figure 3 shows that the monetary base and broader monetary aggregates increased after the stock market crash and then declined in 1930 and after every panic subsequently. According to Friedman and Schwartz this led to the subsequent decline in economic activity 32

Fed policy from the Stock Market Crash to the Bank Holiday (cont.) 33

Fed policy from the Stock Market Crash to the Bank Holiday (cont.) Figure 2 shows that Fed credit surged briefly following the stock market crash and during the banking panics of Oct-Dec 1930, Sept-Dec 1931, and Jan-March 1933 On each occasion, the increase in Fed credit (and its impact on the monetary base) was quickly reversed 34

Fed policy from the Stock Market Crash to the Bank Holiday (cont.) Meltzer (2003) explains why the Fed permitted Fed credit to contract after each shock by the Feds adherence to the Burgess-Riefler-Strong doctrine Based on this doctrine, developed during the 1920s, policymakers inferred that low levels of interest rates and borrowing meant that monetary conditions were very easy 35

Why Did the Fed Fail to Act as Lender of Last Resort During the Depression? Many studies have considered why the Fed failed to act effectively as LLR: 1. Friedman and Schwartz (1963) emphasize the Feds decentralized structure and lack of strong leadership 2. Wicker (1966), Wheelock (1991), Meltzer (2003) contend that the Fed followed a flawed policy doctrine. They misinterpreted the behavior of nominal interest rates and the level of borrowing from the Feds discount window 3. Temin (1989), Eichengreen (1992) focus on the role of the gold standard. Fed officials were extremely reluctant to take any action that would threaten adherence to the gold standard 36

Why Did the Fed Fail to Act as Lender of Last Resort During the Depression? (cont.) We believe there is more to the story, especially as to why the Fed failed to prevent or offset banking panics We argue that the Federal Reserve Act failed to recreate the features of the British banking system that made the Bank of England an effective LLR in the 19 th century 37

Why Did the Fed Fail to Act as Lender of Last Resort During the Depression? (cont.) We further argue that the restrictions on DWL imposed by the FR Act were both too limiting and left too much to the discretion of policymakers in administering the discount window to make it an effective mechanism for responding to banking panics 38

The Discount Window - A Flawed Mechanism The authors of the FR Act intended the discount window to be the primary means by which the Fed would furnish an elastic currency They restricted the types of loans and securities eligible for rediscounting with Reserve Banks to short-term commercial and agricultural paper and U.S. government securities 39

The Discount Window - A Flawed Mechanism (cont.) The first problem during the Depression was that many banks apparently lacked paper that was acceptable for rediscounting with Reserve Banks The second problem was that member banks were quite reluctant to borrow from the Fed in the event of a crisis This reluctance in part reflected the Feds administration of the DWL 40

The Discount Window - A Flawed Mechanism (cont.) Throughout the 1920s, Fed officials tried to discourage banks from continuous borrowing, especially loans for the purchase of stocks During the Depression, banks were reluctant to borrow, because of the stigma that they would be perceived as weak 41

Bankers Acceptance Purchases as an Alternative to the Discount Window Federal Reserve purchases of bankers acceptances were a second mechanism to supply currency or bank reserves in the event of a crisis Although the Fed did make large purchases of bankers acceptances during banking panics in the fall of 1931 and March 1933, the purchases were not large enough to offset the effects of currency and gold withdrawals from the banking system 42

Bankers Acceptance Purchases as an Alternative to the Discount Window (cont.) Although the Feds purchases of bankers acceptances provided some support to the banking system during the panics, the acceptance market was small and highly concentrated in NYC, which limited the usefulness of Fed purchases in a crisis The size of the acceptance market fell sharply from $1.6 billion at the end of 1929 to $700 million by mid-1932 43

Bankers Acceptance Purchases as an Alternative to the Discount Window (cont.) Although the Fed purchased approximately 80 percent of the outstanding acceptances in Oct 1931 and 50% in March 1933, this was tiny relatively to the size of member bank reserves 44

The Feds Decentralized Structure The authors of the FR created a decentralized structure to reduce concentration of the banking systems reserves in the central money markets and to limit the power of New York and Washington over the nations banks and economy The Feds decentralized structure proved unwieldy in responding to financial crises According to Friedman and Schwartz (1963), in the absence of effective leadership, the individual Reserve Banks acted competitively, rather than cooperatively, at critical points during the Depression 45

The Feds Decentralized Structure (cont.) The best example of this was when the Chicago Fed, in March 1933, refused a request from the New York Fed to exchange gold for U.S. government securities when gold outflows threatened to push the New York Feds reserve ratio below its legal minimum The FR Act left considerable discretion to individual Reserve Banks and the Board for implementing policy 46

The Feds Decentralized Structure (cont.) The Atlanta Fed, according to Richardson and Troost (2009), responded aggressively to allay local panics in its districts in stark comparison to the St. Louis Fed which did not The actions by the Atlanta Fed and the New York Fed in responding to the 1929 stock market crash suggest that the Federal Reserve had the tools and the power to respond effectively to financial crises 47

The Feds Decentralized Structure (cont.) But an effective response required leaders who were willing to improvise and test the limits of the Federal Reserve Act The Act did not provide an automatic, fool-proof mechanism to deal with crises, as the founders had hoped Instead, effective LLR action depended a great deal on the discretion of individual policymakers 48

Conclusion The LLR provisions of the FR Act contained features of the Warburg plan of 1910 and the Aldrich bill of 1912 Warburg envisioned the central bank to rediscount bankers acceptances to backstop a highly liquid and deep market like those of Europe and to provide LLR facilities in the event of a financial crisis The Fed failed to prevent a series of banking panics in the early 1930s, which worsened the Great Depression 49

Conclusion (cont.) In addition to the literature that emphasizes: 1) flaws in the Systems structure; 2) adherence to a flawed policy framework and 3) devotion to the gold standard, we offer a further explanation The failure of the FR Act to provide a discount mechanism and money market environment of the sort that had enabled the Bank of England and other European central banks to function effectively as lenders of last resort 50

Conclusion (cont.) This was manifest in three flaws: 1. the stigma problem 2. the Feds limited membership 3. the restrictive eligibility requirements Furthermore, the FR Act did nothing to reform the inherently unstable unit banking system A better alternative might have been to allow nationwide branch banking and consolidation of the banking industry as in Canada and the UK 51

Conclusion (cont.) The FR Act sought to create a U.S. bankers acceptance market and offered support to that market by authorizing the Reserve Banks to purchase bankers acceptances in the open market The Feds acceptance facility was similar to the Bank of Englands discount window in that the Fed purchased all of the eligible acceptances offered to it 52

Conclusion (cont.) The acceptance facility had at least 2 characteristics that seem good LLR practice: 1. lending was to the market, rather than to individual institutions or classes of institutions, against a standard financial instrument 2. the facility entailed little scope for discretion, except in setting the bill buying rate 53

Conclusion (cont.) Bankers acceptances never became the core instrument of the U.S. money market and the acceptance market fell off sharply during the Depression The US never developed the money market conditions that enabled European central banks to be effective lenders of last resort before World War I 54

Conclusion (cont.) In response to the Depression, the Banking Acts of 1933 and 1935 made significant changes in the structure and authority of the FR system 1. Policymaking authority was concentrated within the Board of Governors 2. The Fed was given the ability to lend on the basis of any sound collateral 3. The Fed could lend to nonbank financial institutions in a crisis, Section 13(3) The banking system was also subject to major reforms to make it less prone to instability (Glass-Steagall, FDIC, reg Q) 55

The Lessons of the Feds early experience as LLR The Feds early history shows that a LLR system that works well in one environment may not work in another environment Warburg sought to emulate the European CB mechanism and discount market For political economy reasons, U.S. banking systems were not fully adapted to the European system The FR Act overcame some of the flaws of the National Banking System (the inelastic currency), but not all of them Perhaps the Feds LLR mechanism would have performed better with a Canadian-European style branch banking system coupled with a deep acceptance market 56

The Lessons of the Feds early experience as LLR (cont.) The reforms of the 1930s focused on protecting bank depositors and preventing runs and hence they proved only partly helpful during the crisis of 2007-08 The 1930s reforms did not contemplate how to protect the banking system from instability coming from outside the banking system 57

The Lessons of the Feds early experience as LLR (cont.) The Section 13(3) lending programs created by the Fed in 2007-08 were helpful in alleviating the crisis, but required considerable discretion by Fed officials The Fed also resorted to bailouts, which may lead to moral hazard and compromise the Feds independence 58

The Lessons of the Feds early experience as LLR (cont.) A key lesson from the Feds early experience and the crisis of 2007-08 is that the tools of LLR must match the financial environment. A LLR mechanism must adapt to be effective It remains to be seen whether the reforms of 2010 have got it right 59

Documents

Michael D. Bordo, Rutgers University and NBER David C. Wheelock, Federal Reserve Bank of St. Louis Prepared for the Federal Reserve Bank of Atlanta Conference