“To establish a more effective supervision of banking”: How the birth of the fed altered bank supervision

Abstract

An Act to provide for the establishment of Federal reservaue banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes. Although the formation and development of the Federal Reserve have been intensively studied, histories of the Fed, from Milton Friedman and Anna J. Schwartz‘s Monetary History (1963) to Allan H. Meltzer‘s History of the Federal Reserve (2003–2009), have focused almost exclusively on monetary policy. The quiet work of bank supervision has seemed somewhat pedestrian compared with the high-profile determination of interest rates, monetary aggregates, and exchange rates. Yet, the founders of the Fed regarded bank supervision as a key element in their new policy regime, placing it in the title of the Federal Reserve Act. Unfortunately, in spite of this headlining, the effective approach to bank supervision that had developed under the National Banking System was slowly undermined in the Fed‘s first decade and a half. Although the National Banking System had frequent banking panics that increased the severity of recessions, its regulation and supervision successfully limited losses to depositors. Supervision before 1913 had a relatively light hand and may be characterized as a regime that aimed at reinforcing market discipline with prompt closure of insolvent institutions. Its panics were primarily driven by liquidity problems rather than by solvency issues, even if a few bank failures inaugurated a panic. The underlying causes of these frequent crises were the prohibition on branch banking, which created a fragmented system of undiversified unit banks, and the absence of a central bank.