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The Crisis in American Banking in The Early 20th Century

In the last three decades of the twentieth century banking crises were especially frequent. The Federal Reserve System was created in 1913. This was the beginning to a modern era of American banking. Federally regulated system of national banks dominated American banking up until the year of 1864. These banks were allowed to issue currency. The currency was printed by the federal government. The currency was created with specified size and specific design. The amount of currency that was issued was regulated by the national banks capital. At this time period there were various bank failures and financial crises.
The central problem against the banking system was in response to the money supply. They were having problems shifting the currency around the country in response to local economic changes. This issue eventually led to another issue called bank runs. Bank runs are a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. In the past bank runs have been known to be contagious, with a run on one bank leading to a loss of faith in other banks, causing more bank runs. This led to widespread panic and devastation in the local economy. The event of panic led to some state governments to offer deposit insurance on bank’s deposits; this guaranteed that depositors would be paid even if the bank was unable to come up with the funds.
The Panic of 1907 consequences devastated the entire country, leading to a four year recession. This panic started in New York institutions such as trusts, that accepted deposits, but they were meant to manage only inheritances and estates for the wealthy. They were less regulated because they were only supposed to be involved with low-risk activities. These trusts had lower reserve requirements and lower cash reserves than national banks.
During the first decade of the twentieth century the American economy boomed. Trusts started to speculate in real estate and the stock market. These were areas that were forbidden to national banks. Trusts being less regulated than national banks allowed them to pay higher returns to their depositors. Trusts grew rapidly because depositors considered them equally safe compared to national banks. The total assets in New York were as large as the national banks by 1907. The trusts declined to join the New York Clearinghouse because they would be required to hold higher cash reserves which would reduce their profits.
The failure of the Knickerbocker Trust, a large New York trust was the start of the Panic of 1907. It failed when it suffered massive losses in unsuccessful stock market speculation. This caused pressure for other New York trusts. Depositors became nervous and started to withdraw their funds. The New York Clearinghouse would not help or support the trusts. Twelve major trusts had gone under in just two days. The stock market plummeted and the credit markets froze. Stock traders could not get credit in order to finance their trades. Business confidence no longer existed, this became an all-time low.
A banker J.P. Morgan, New York’s wealthiest man stepped in to put an end to the panic. The crisis was rapidly growing and it would eventually submerge institutions in good standing, trusts and banks alike. He worked with other bankers and wealthy men including John D. Rockefeller and the U.S. Secretary of the Treasury. They worked to shore up the reserves of banks and trusts in order to withstand the massive amount of withdrawals. The panic ceased once people were completely certain that they were able to withdraw their money. The panic lasted only a little more than a week, however the panic and the crash of the stock market destroyed the economy. This brought a four year recession. Production fell 11% and the unemployment rate rose from 3% to 8%. The Panic of 1907 and the financial crisis of 2008 both caused large losses from risky speculation weakening the banking system.
The financial crisis of 2008 involved institutions that were not strictly regulated as deposit-taking banks. It also involved excessive speculation. The U.S. government did not want to take action until the scale of the crisis was obvious. Advances in technology and financial innovation cause a weakness in the system which played a huge role in 2008. The trust in the financial system collapsed. Financial firms suffered from large losses. It was a severe and vicious cycle leading to a credit crunch for the economy as a whole. Firms were unable to borrow, individuals could not get home loans and credit card limits decreased. Regulators tried to prevent a repeat crisis after noticing similarities in past crises. The Federal Reserve stepped in to help. They provided cash to the financial system, lending funds to institutions, and bought private-sector debt.
In 2008 they decided to allow Lehman Bros., a major investment bank, to fail. This was a bad decision considering widespread panic flooded the financial markets. The U.S. government intervened to support the financial system by putting capital into banks. The U.S. government was supplying cash to banks in return for shares. They were nationalizing the financial system.
By 2010 the financial system seemed stabilized. The recovery did not bring a successful turnaround for the whole economy. The recession ended in June 2009, however unemployment remained extremely high. The crisis of 2008 led to banking regulation changes. The Wall Street Reform and Consumer Protection Act was signed and put into law in 2010. This was the biggest financial reform since the 1930’s. The main change this act brought to bank was the creation of a new agency, called the Bureau of Consumer Financial Protection. The agencies mission was to protect borrowers from being exploited through financial deals they didn’t understand. They enforced bank style regulation including high capital requirements and limits on risks. Officials had the right to seize troubled financial institutions. The law established new rules on the trading of derivatives. The point was to make the risks taken by financial institutions, more transparent. The Dodd-Frank Bill revised financial regulation in efforts to prevent repeats of the 2008 crisis. The history of banking crises has provided informative and ideal perspectives for future prevention of these issues. The U.S. crises were unique and reflected peculiar features of U.S. law and banking structure.