Topic 4: Banks and Money

Question 1

When was Fed and deposit insurance established?

Answer 1

fed - 1913
deposit insurance - 1933

Question 2

when was free banking era and when was national banking era

Answer 2

free banking - 1837-1863
NBE - 1864 - 1913

Question 3

What was the free banking era?

Answer 3

All banks were state chartered - bank licences were granted by states where the banks were located, any bank with sufficient capital could get one.
started in michigan in 1837
made banking industry more competitive

Question 4

Bank balance sheets during FBE

Answer 4

main assets - loans (mortgages mainly), corporate loans securities, specie (cash)

Main liabilities - banknotes, deposits, capital (equity)

banknotes and deposits were short-term, demandable debt

Question 5

what were banknotes

Answer 5

each bank could issue its own banknote
they were backed by state and federal bonds (collateral)
allowed banknotes could not exceed value of collateral mark to market
state auditor oversaw printing of each bank’s notes
banks had to pay specie (cash) on demand for bank notes they issued
if bank couldn’t pay specie on demand for banknote, state auditor could close banks and sell bonds and other assets to pay note holders

Question 6

why were bank notes useful

Answer 6

profitable because of seniorage + debt with 0 interest rate
banks essentially financed themselves with 0 interest using bank notes and then could lend out that money with interest to make interest income

Question 7

advantages of cheques over banknotes

Answer 7

less subject to theft
no need to give change
cheques grew in importance over banknotes over time

Question 8

what was bank regulation in the free banking era

Answer 8

sufficient capital needed
sufficient reserves (specie)
allowed bank notes could not exceed mark to market value of collateral

Question 9

how effective was bank regulation during the free banking era

Answer 9

implementation was uneven across states and often ineffective
banks misrepresented reserves to state auditors
bonds used as collateral for banknote issuance were valued at inflated prices

Question 10

how were banknotes priced

Answer 10

could be redeemed at the issuing bank at face value
if bank was solvent its banknotes were valued at par at the city where the bank was located (price below par - earn arbitrage profit by redeeming bank note)
bank notes were valued at a discount at other cities because:
cost of travelling to city where bank was located in order to redeem note
probability that bank becomes insolvent during travel time
discount was increasing in travel cost and time

Question 11

why would a consumer want to use bank notes as opposed to only depositing specie

Answer 11

for liquidity - can pay when travelling so needed as literal money despite not earning interest, because if you deposited you couldn’t spend it
more convenience in carrying notes vs coins around

Question 12

bank note discount formula

Answer 12

discount = 100 x FV-P/FV

Question 13

how did discounts vary

Answer 13

discounts could be significant, varied across banks but were equal to mode for most banks

discounts were higher for riskier banks (higher probability of insolvency before note was redeemed)

discounts were larger for new entrants (uncertainty about insolvency)

banks with higher discounts had higher redemptions (low discount notes were kept for transacting and high discount notes were redeemed)

Question 14

why were higher discount notes redeemed

Answer 14

less safe to keep, would want to withdraw specie instead of risking insolvency

Question 15

what was the mechanism that kept banks in check (mechanism involving the discount rates)

Answer 15

these high discount notes were not good for transacting
this was good because it was a monitoring mechanism for banks - if they were doing risky things and the discount was higher their notes would be redeemed a lot and not used for transacting which was bad for the bank so therefore it helped keep banks moral hazard in check

therefore moral hazard was kept in check through private initiative - banks that took excessive risk had higher discounts and thus higher redemptions. holders of the banknotes observed risk taking and demanded payment

Question 16

why was the bank note system inefficient (asymmetric info and liquidity wise)

Answer 16

pricing bank notes required expertise (is the issuing bank close to insolvency? is it taking too much risk?)

expertise was acquired by specialized bank note brokers

asymmetric info between brokers and general public, so there was asymmetric info about the value of money

Question 17

what was the national banking era

Answer 17

1863
national banks were created with tighter regulation that state banks (higher reserve requirements, supervised by comptroller of the currency)

creation of national currency
bank notes of each national bank backed by federal bonds (collateral)
collateral was deposited with the comptroller of the currency
banknotes printed by comptroller
each national bank had to accept banknotes of other national banks at par value

state bank notes were taxed out of existence

Question 18

what was the advantage of a national currency

Answer 18

traded at par therefore no expertise in pricing it therefore no symmetric info
money creating however was still decentralized

Question 19

what was different about cheques than notes

Answer 19

90% of money supply was in chequing accounts by 1890s

secondary market for cheques cannot develop
cheque=claim on individuals account at a bank and on bank itself
cheques value depends on bank AND individual’s solvency

accepted at par during normal times

Question 20

how were banks made to have no asymmetric info during national banking era i.e. Opaque

Answer 20

Bank note prices:
informative about solvency during free banking era but not during national banking era since traded at par and cheques were also accepted at par during normal times

Stock prices:
became relatively uninformative during NBE
reverse stock splits (high share price)
concentrated shareholdings

banking system during national banking era was designed to function with no asym info in normal times (opacity)

Question 21

how was moral hazard kept in check without market info during NBE

Answer 21

clearing houses which cleared cheques among their member banks and were well positioned to acquire info and monitor each member bank

Question 22

how does cheque clearing work

Answer 22

client of bank A issues cheque to client of B
deposits of bank A go down, deposits of bank B go up
assets of bank A go down, assets of bank B go up
A will transfer gold/specie to bank B

Question 23

how did clearing house monitoring work

Answer 23

membership criteria:
sufficient capital needed to be admitted as clearinghouse member
members subject to periodic audits by clearinghouse
clearinghouses often imposed stronger regulation on their members than public authorities did e.g. higher reserve requirements

members failing to meet criteria were fined and in extreme cases expelled, and expulsion was costly (bad signal on a bank’s solvency)

Question 24

how did clearing houses work during crises

Answer 24

members facing customer withdrawals could request loan certificates from clearinghouse which were used instead of cash in clearing process. freed up cash was used to meet customer withdrawals

to obtain loan certificates, members:
had to post collateral (typically loans) and were charged high interest (6-7%)

request for loan certificates were not disclosed publicly

when cash of all members was not sufficient to meet withdrawals, clearinghouses:
issued loan certificates to the public
there was a secondary market for these certificates
price reflected the publics perception of clearinghouse solvency
suspended convertibility when extreme (give them nothing)

Question 25

what financial crises were there during nat banking era

Answer 25

6 bank panics occurred
followed times of rapid growth
bank panics were more frequent that during the free banking era

Question 26

what triggered bank runs

Answer 26

runs occurred shortly after peak of economic cycle
not random - triggered by negative information

Question 27

why was fed created / role

Answer 27

clearing houses could not handle panics so there was demand for a central bank
fed was established in 1913
cleared cheques by all banks
lend to banks facing liquidity problems (lender of last resort)
take over main function of clearing houses

Question 28

federal reserve act of 1913

Answer 28

main responsibility of fed:
bank regulation and lender of last resort
banks must keep reserves within fed
capital adequacy monitored by fed
access to fed as lender of last resort

clear cheques by all banks
manage money supply (banknotes are a liability of the fed + fed determines monetary policy)

Question 29

free banking era summary

Answer 29

1837-1863
banknotes provided info and incentives, but this introduced asymmetric info problems

Question 30

national banking era summary

Answer 30

market info suppressed, incentives provided by clearing houses
no asymmetrical info problems during normal times
but bank panics became more likely