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
Slide 2
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
Slide 3
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
Slide 4
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
Slide 5
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
Slide 6
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
Slide 7
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
Slide 8
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
Slide 9
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
Slide 10
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
Slide 11
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
Slide 12
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
Slide 13
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
Slide 14
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
Slide 15
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
Slide 16
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
Slide 17
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
Slide 18
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
Slide 19
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
Slide 20
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
Slide 21
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
Slide 22
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
Slide 23
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
Slide 24
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
Slide 25
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
Slide 26
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
Slide 27
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
Slide 28
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
Slide 29
The Feds Performance as LLR to 1933 (cont.) 29
Slide 30
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
Slide 31
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
Slide 32
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
Slide 33
Fed policy from the Stock Market Crash to the Bank Holiday
(cont.) 33
Slide 34
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
Slide 35
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
Slide 36
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
Slide 37
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
Slide 38
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
Slide 39
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
Slide 40
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
Slide 41
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
Slide 42
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
Slide 43
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
Slide 44
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
Slide 45
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
Slide 46
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
Slide 47
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
Slide 48
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
Slide 49
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
Slide 50
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
Slide 51
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
Slide 52
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
Slide 53
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
Slide 54
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
Slide 55
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
Slide 56
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
Slide 57
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
Slide 58
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
Slide 59
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