Chapter 3The Federal Reserve

One of the “gap-fillers” catalyzed by the National Banking Acts were the aforementioned trust companies that grew into large, lightly regulated institutions.¹ In 1907, we see an example of a gap-filler creating the next crisis. The Knickerbocker Trust was a state-chartered trust company, and New York trust companies held reserves of only about 5%, versus 25% for national banks in the city. The Knickerbocker Trust got wrapped up in a copper speculation scheme and experienced a run on their bank. The failure of the third-largest trust company in New York City triggered the ensuing Panic of 1907. This is a case where we do see what happens when financial activity is pushed outside of a regulated ecosystem where safeguards are few and far between.

The response to the Panic of 1907 was the Federal Reserve Act of 1913, which created a central bank to provide a flexible currency and a lender of last resort the system had lacked. The Federal Reserve Act wrote the “real bills” doctrine, where access to the Fed’s discount window depended on presenting “eligible paper” defined as short-term, self-liquidating commercial loans.² The doctrine that had begun as a national-bank restriction now extended to every member bank that wanted access to the discount window, including state-chartered banks that chose to join the Federal Reserve System. It did not prohibit other lending, but it defined which loans the central bank would stand behind.

On the other hand, the 1913 Act did loosen the real estate prohibition, permitting national banks limited farm mortgages, the first of many retreats that would readjust the boundaries of what is considered “bankable”.³

By 1913, the transformation that started in 1863 with the National Banking Acts was structurally complete, although the consequences had only started to compound. What was determined to be “bankable” had a definition now, and what qualified was enforced by charter, doctrine, and a new central bank. Banks fund the short, the safe, and the self-liquidating. Everything else - the long, the bold, and the company visions - belonged somewhere else. In addition to the creation of the Federal Reserve as a backstop lender of last resort, the belief was that future panics would be few and far between. In Part II, we will see that other surprises lay ahead and that the system was not as resilient as designed.