Under normal circumstances, banking is a rather staid and unexciting business. Fortunately, bankers and their customers like it that way. However, there have been repeated episodes in which “sheer panic” would be the best description of banking conditions—the panic induced by a bank run and the specter of the collapse of a bank or multiple banks, leaving depositors penniless, bank shareholders wiped out, and borrowers unable to get credit. In this section, we’ll give an overview of the behavior and regulation of the American banking system over the last century.

The creation of the Federal Reserve System in 1913 was largely a response to lessons learned in the Panic of 1907. In 2008, the United States found itself in the midst of a financial crisis that in many ways mirrored the Panic of 1907, which occurred almost exactly 100 years earlier.

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The creation of the Federal Reserve System in 1913 marked the beginning of the modern era of American banking. From 1864 until 1913, American banking was dominated by a federally regulated system of national banks. They alone were allowed to issue currency, and the currency notes they issued were printed by the federal government with uniform size and design. How much currency a national bank could issue depended on its capital. Although this system was an improvement on the earlier period in which banks issued their own notes with no uniformity and virtually no regulation, the national banking regime still suffered numerous bank failures and major financial crises—at least one and often two per decade.

The main problem afflicting the system was that the money supply was not sufficiently responsive: it was difficult to shift currency around the country to respond quickly to local economic changes. In particular, there was often a tug-of-war between New York City banks and rural banks for adequate amounts of currency. Rumors that a bank had insufficient currency to satisfy demands for withdrawals would quickly lead to a bank run. A bank run would then spark a contagion, setting off runs at other nearby banks, sowing widespread panic and devastation in the local economy. In response, bankers in some locations pooled their resources to create local clearinghouses that would jointly guarantee a member’s liabilities in the event of a panic, and some state governments began offering deposit insurance on their banks’ deposits.

However, the cause of the Panic of 1907 was different from those of previous crises; in fact, its cause was eerily similar to the roots of the 2008 crisis. Ground zero of the 1907 panic was New York City, but the consequences devastated the entire country, leading to a deep four-year recession. The crisis originated in institutions in New York known as trusts, bank-like institutions that accepted deposits but that were originally intended to manage only inheritances and estates for wealthy clients. Because these trusts were supposed to engage only in low-risk activities, they were less regulated, had lower reserve requirements, and had lower cash reserves than national banks. However, as the American economy boomed during the first decade of the twentieth century, trusts began speculating in real estate and the stock market, areas of speculation forbidden to national banks.

Being less regulated than national banks, trusts were able to pay their depositors higher returns. Yet trusts took a free ride on national banks’ reputation for soundness, with depositors considering them equally safe. As a result, trusts grew rapidly: by 1907, the total assets of trusts in New York City were as large as those of national banks. Meanwhile, the trusts declined to join the New York Clearinghouse, a consortium of New York City national banks that guaranteed one another’s soundness; that would have required the trusts to hold higher cash reserves, reducing their profits.

The Panic of 1907 began with the failure of the Knickerbocker Trust, a large New York City trust that failed when it suffered massive losses in unsuccessful stock market speculation. Quickly, other New York trusts came under pressure, and frightened depositors began queuing in long lines to withdraw their funds. The New York Clearinghouse declined to step in and lend to the trusts, and even healthy trusts came under serious assault. Within two days, a dozen major trusts had gone under. Credit markets froze, and the stock market fell dramatically as stock traders were unable to get credit to finance their trades and business confidence evaporated.

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Fortunately, one of New York City’s wealthiest men, the banker J. P. Morgan, quickly stepped in to stop the panic. Understanding that the crisis was spreading and would soon engulf healthy institutions, trusts and banks alike, he worked with other bankers, wealthy men such as John D. Rockefeller, and the U.S. Secretary of the Treasury to shore up the reserves of banks and trusts so they could withstand the onslaught of withdrawals. Once people were assured that they could withdraw their money, the panic ceased. Although the panic itself lasted little more than a week, it and the stock market collapse decimated the economy. A four-year recession ensued, with production falling 11% and unemployment rising from 3% to 8%.

Concerns over the frequency of banking crises and the unprecedented role of J. P. Morgan in saving the financial system prompted the federal government to initiate banking reform. In 1913 the national banking system was eliminated and the Federal Reserve System was created as a way to compel all deposit-taking institutions to hold adequate reserves and to open their accounts to inspection by regulators. The Panic of 1907 convinced many that the time for centralized control of bank reserves had come. The Federal Reserve was given the sole right to issue currency in order to make the money supply sufficiently responsive to satisfy economic conditions around the country.

The legal status of the Fed is unusual: it is not exactly part of the U.S. government, but it is not really a private institution either. Strictly speaking, the Federal Reserve System consists of two parts: the Board of Governors and the 12 regional Federal Reserve Banks.

The Board of Governors, which oversees the entire system from its offices in Washington, D.C., is constituted like a government agency: its seven members are appointed by the president and must be approved by the Senate. However, they are appointed for 14-year terms, to insulate them from political pressure in their conduct of monetary policy. Although the chair is appointed more frequently—every four years—it is traditional for the chair to be reappointed and serve much longer terms. For example, William McChesney Martin was chair of the Fed from 1951 until 1970. Alan Greenspan, appointed in 1987, served as the Fed’s chair until 2006.

The 12 Federal Reserve Banks each serve a region of the country, known as a Federal Reserve district, providing various banking and supervisory services. One of their jobs, for example, is to audit the books of private-sector banks to ensure their financial health. Each regional bank is run by a board of directors chosen from the local banking and business community. The Federal Reserve Bank of New York plays a special role: it carries out open-market operations, usually the main tool of monetary policy. Figure 26.1 shows the 12 Federal Reserve districts and the city in which each regional Federal Reserve Bank is located.

Decisions about monetary policy are made by the Federal Open Market Committee, which consists of the Board of Governors plus five of the regional bank presidents. The president of the Federal Reserve Bank of New York is always on the committee, and the other four seats rotate among the 11 other regional bank presidents. The chair of the Board of Governors normally also serves as the chair of the Federal Open Market Committee.

The effect of this complex structure is to create an institution that is ultimately accountable to the voting public because the Board of Governors is chosen by the president and confirmed by the Senate, all of whom are themselves elected officials. But the long terms served by board members, as well as the indirectness of their appointment process, largely insulate them from short-term political pressures.

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Although the Federal Reserve System standardized and centralized the holding of bank reserves, it did not eliminate the potential for bank runs because banks’ reserves were still less than the total value of their deposits. The potential for more bank runs became a reality during the Great Depression. Plunging commodity prices hit American farmers particularly hard, precipitating a series of bank runs in 1930, 1931, and 1933, each of which started at midwestern banks and then spread throughout the country. After the failure of a particularly large bank in 1930, federal officials realized that the economy-wide effects compelled them to take a less hands-off approach and to intervene more vigorously. In 1932, the Reconstruction Finance Corporation (RFC) was established and given the authority to make loans to banks in order to stabilize the banking sector. In addition, the Glass-Steagall Act of 1933, which increased the ability of banks to borrow from the Federal Reserve System, was passed. A loan to a leading Chicago bank from the Federal Reserve appears to have stopped a major banking crisis in 1932. However, the beast had not yet been tamed. Banks became fearful of borrowing from the RFC because doing so signaled weakness to the public.

In the midst of the catastrophic bank run of 1933, the new U.S. president, Franklin Delano Roosevelt, was inaugurated. He immediately declared a “bank holiday,” closing all banks until regulators could get a handle on the problem. In March 1933, emergency measures were adopted that gave the RFC extraordinary powers to stabilize and restructure the banking industry by providing capital to banks either by loans or by outright purchases of bank shares. With the new regulations, regulators closed nonviable banks and recapitalized viable ones by allowing the RFC to buy preferred shares in banks (shares that gave the U.S. government more rights than regular shareholders) and by greatly expanding banks’ ability to borrow from the Federal Reserve. By 1933, the RFC had invested over $17 billion (2013 dollars) in bank capital—one-third of the total capital of all banks in the United States at that time—and purchased shares in almost one-half of all banks. The RFC loaned more than $34 billion (2013 dollars) to banks during this period. Economic historians uniformly agree that the banking crises of the early 1930s greatly exacerbated the severity of the Great Depression, rendering monetary policy ineffective as the banking sector broke down and currency, withdrawn from banks and stashed under beds, reduced the money supply.

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Although the powerful actions of the RFC stabilized the banking industry, new legislation was needed to prevent future banking crises. The Glass-Steagall Act of 1933 separated banks into two categories, commercial banks, depository banks that accepted deposits and were covered by deposit insurance, and investment banks, which engaged in creating and trading financial assets such as stocks and corporate bonds but were not covered by deposit insurance because their activities were considered more risky. Regulation Q prevented commercial banks from paying interest on checking accounts, in the belief that this would promote unhealthy competition between banks. In addition, investment banks were much more lightly regulated than commercial banks. The most important measure for the prevention of bank runs, however, was the adoption of federal deposit insurance (with an original limit of $2,500 per deposit).

These measures were clearly successful, and the United States enjoyed a long period of financial and banking stability. As memories of the bad old days dimmed, Depression-era bank regulations were lifted. Regulation Q was eliminated in 1980 and by 1999, the Glass-Steagall Act had been so weakened that commercial banks could deal in stocks and bonds among other financial assets.

Along with banks, the banking industry also included savings and loans (also called S&Ls or thrifts), institutions established to accept savings and turn them into long-term mortgages for home-buyers. S&Ls were covered by federal deposit insurance and were tightly regulated for safety. However, trouble hit in the 1970s, as high inflation led savers to withdraw their funds from low-interest-paying S&L accounts and put them into higher-paying money market accounts. In addition, the high inflation rate severely eroded the value of the S&Ls’ assets, the long-term mortgages they held on their books.

In order to improve S&Ls’ competitive position versus banks, Congress eased regulations to allow S&Ls to undertake much more risky investments in addition to long-term home mortgages. However, the new freedom did not bring with it increased oversight, leaving S&Ls with less oversight than banks.

Not surprisingly, during the real estate boom of the 1970s and 1980s, S&Ls engaged in overly risky real estate lending. Also, corruption occurred as some S&L executives used their institutions as private piggy banks. By the early 1980s, a large number of S&Ls had failed. Because accounts were covered by federal deposit insurance, the liabilities of a failed S&L were now liabilities of the federal government. From 1986 through 1995, the federal government closed over 1,000 failed S&Ls, costing U.S. taxpayers over $124 billion.

In a classic case of shutting the barn door after the horse has escaped, in 1989 Congress put in place comprehensive oversight of S&L activities. It also empowered Fannie Mae and Freddie Mac to take over much of the home mortgage lending previously done by S&Ls. Fannie Mae and Freddie Mac are quasi-governmental agencies created during the Great Depression to make homeownership more affordable for low- and moderate-income households. There is evidence that the S&L crisis helped cause a steep slowdown in the finance and real estate industries, leading to the recession of the early 1990s.

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The financial crisis of 2008 shared features of previous crises. Like the Panic of 1907 and the S&L crisis, it involved institutions that were not as strictly regulated as deposit-taking banks, as well as excessive speculation. And like the crises of the early 1930s, it involved a U.S. government that was reluctant to take aggressive action until the scale of the devastation became clear. Enrichment Module A: Financial Markets and Crises provides a detailed account of the financial crisis of 2008. To summarize the situation briefly, historically low interest rates helped cause a boom in housing between 2003 and 2006. With home prices rising steadily, loans to home buyers with questionable finances seemed deceptively safe, and the number of such loans exploded. But then housing prices started falling in 2006, leaving many borrowers with homes that were worth less than the mortgage loans used to buy them. The resulting losses for lenders caused a collapse of trust in the financial system. Lending institutions were reluctant to make loans, and firms had difficulty obtaining enough money to continue their operations.

Beginning in mid-2007, the Federal Reserve took ambitious steps to make more cash available in the economy. It provided liquidity to the troubled financial system through discount window lending, and bought large quantities of other assets, mainly long-term government debt and the debt of Fannie Mae and Freddie Mac. The Fed and the Treasury Department also rescued several firms whose collapse could have been catastrophic for the economy, including the investment bank Bear Stearns and the insurance company AIG.

By the fall of 2010, the financial system was relatively stable, and major institutions had repaid much of the money the federal government had injected during the crisis. It was generally expected that taxpayers would end up losing little if any money. However, the recovery of the banks was not matched by a successful turnaround for the overall economy: although the recession that began in December 2007 officially ended in June 2009, unemployment remained stubbornly high.

Like earlier crises, the crisis of 2008 led to changes in banking regulation, most notably the Dodd-Frank financial regulatory reform bill enacted in 2010. We describe that bill briefly in the FYI box that follows.