Ronald W Melicher  Edgar A Norton Introduction to Finance  Markets, Investments, and Financial Management, 16th Edition Enhanced Wiley (2016)

Ronald W Melicher Edgar A Norton Introduction to Finance Markets, Investments, and Financial Management, 16th Edition Enhanced Wiley (2016)


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receive national charters, capital and 
reserve requirements on deposits and banknotes were established, and banknotes could be 
Federal National Mortgage 
Association (Fannie Mae) created 
to support the \ufb01 nancial markets by 
purchasing home mortgages from 
banks so that the proceeds could be 
lent to other borrowers
Government National Mortgage 
Association (Ginnie Mae) created 
to issue its own debt securities to 
obtain funds that are invested in 
mortgages made to low to moderate 
income home purchasers
Federal Home Loan Mortgage 
Corporation (Freddie Mac) 
formed to support mortgage 
markets by purchasing and holding 
mortgage loans
4.2 The U.S. Banking System Prior to the Fed 79
issued only against U.S. government securities owned by the banks but held with the U.S. 
Treasury Department. These banknotes, backed by government securities, were supposed to 
provide citizens with a safe and stable national currency. Improved bank supervision also was 
provided for with the establishment of the O\ufb03 ce of the Comptroller of the Currency under 
the control of the U.S. Treasury.
Weaknesses of the National Banking System
Although the national banking system overcame many of the weaknesses of the prior systems 
involving state banks, it lacked the ability to carry out other central banking system activities 
that are essential to a well-operating \ufb01 nancial system. Three essential requirements include 
(1) an e\ufb03 cient national payments system, (2) an elastic or \ufb02 exible money supply that can 
respond to changes in the demand for money, and (3) a lending/borrowing mechanism to help 
alleviate liquidity problems when they arise. The \ufb01 rst two requirements relate directly to the 
transferring and creating money functions. The third requirement relates to the need to main-
tain adequate bank liquidity. Recall from Chapter 3 that we referred to bank liquidity as the 
ability to meet depositor withdrawals and to pay other liabilities as they come due. All three 
of these required elements were de\ufb01 cient until the Federal Reserve System was established.
The payments system under the National Banking Acts was based on an extensive net-
work of banks with correspondent banking relationships. It was costly to transfer funds from 
region to region, and the check clearing and collection process sometimes was quite long. 
Checks written on little-known banks located in out-of-the-way places often were discoun-
ted or were redeemed at less than face value. For example, let\u2019s assume that a check written 
on an account at a little-known bank in the western region of the United States was sent to 
pay a bill owed to a \ufb01 rm in the eastern region. When the \ufb01 rm presented the check to its local 
bank, the bank might record an amount less than the check\u2019s face value in the \ufb01 rm\u2019s checking 
account. The amount of the discount was to cover the cost of getting the check cleared and 
presented for collection to the bank located in the western region. Today, checks are processed 
or cleared quickly and with little cost throughout the U.S. banking system. Recall from Chapter 3 
that the current U.S. payments system allows checks to be processed either directly or indirectly. 
The indirect clearing process can involve the use of bank clearinghouses as discussed in Chapter 3 
or a Federal Reserve Bank. The role of the Fed in processing checks is discussed in this chapter.
A second weakness of the banking system under the National Banking Acts was that the 
money supply could not be easily expanded or contracted to meet changing seasonal needs 
and/or changes in economic activity. As noted, banknotes could be issued only to the extent 
that they were backed by U.S. government securities. Note issues were limited to 90 percent 
of the par value, as stated on the face of the bond, or the market value of the bonds, whichever 
was lower. When bonds sold at prices considerably above their par value, the advantage of 
purchasing bonds as a basis to issue notes was eliminated.2
For example, if a $1,000 par value bond was available for purchase at a price of $1,100, 
the banks would not be inclined to make such a purchase since a maximum of $900 in notes 
could be issued against the bond, in this case 90 percent of par value. The interest that the 
bank could earn from the use of the $900 in notes would not be great enough to o\ufb00 set the high 
price of the bond. When government bonds sold at par or at a discount, on the other hand, 
the potential earning power of the note issues would be quite attractive and banks would be 
encouraged to purchase bonds for note issue purposes. The volume of national bank notes, 
thus the money supply, therefore depended on the government bond market rather than on the 
seasonal, or cyclical, needs of the nation for currency.
A third weakness of the national banking system involved the arrangement for holding 
reserves and the lack of a central authority that could lend to banks experiencing temporary 
liquidity problems. A large part of the reserve balances of banks was held as deposits with 
large city banks, in particular with large New York City banks. Banks outside of the large 
cities were permitted to keep part of their reserves with their correspondent large city banks. 
Certain percentages of deposits had to be retained in their own vaults. These were the only 
2A bond\u2019s price will di\ufb00 er from its stated or face value if the interest rate required in the marketplace is di\ufb00 erent from 
the interest rate stated on the bond certi\ufb01 cate. Bond valuation calculations are discussed in Chapter 10.
80 CHAPTER 4 Federal Reserve System
alternatives for holding reserve balances. During periods of economic stress, the position of 
these large city banks was precarious because they had to meet the demand for deposit with-
drawals by their own customers as well as by the smaller banks. The frequent inability of the 
large banks to meet such deposit withdrawal demands resulted in extreme hardship for the 
smaller banks whose reserves they held. A mechanism for providing loans to banks to help 
them weather short-term liquidity problems is crucial to a well-functioning banking system.
The Movement to Central Banking
A central bank is a government-established organization responsible for supervising and 
regulating the banking system and for creating and regulating the money supply. While central 
bank activities may di\ufb00 er somewhat from country to country, central banks typically play an 
important role in a country\u2019s payments system. It is also common for a central bank to lend 
money to its member banks, hold its own reserves, and be responsible for creating money.
Even though the shortcomings of the national banking system in terms of the payments 
system, in\ufb02 exible money supply, and illiquidity were known, opposition to a strong central 
banking system still existed in the United States during the late 1800s. The vast western fron-
tiers and the local independence of the southern areas during this period created distrust of 
centralized \ufb01 nancial control. This distrust deepened when many of the predatory practices of 
large corporate combinations were being made public by legislative commissions and invest-
igations around the turn of the century.
The United States was one of the last major industrial nations to adopt a permanent sys-
tem of central banking. However, many \ufb01 nancial and political leaders had long recognized the 
advantages of such a system. These supporters of central banking were given a big boost by 
the \ufb01 nancial panic of 1907. The central banking system adopted by the United States under the 
Federal Reserve Act of 1913 was, in fact, a compromise between the system of independently 
owned banks in this