Real-World
Economics

 

George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)rwEconomics.com

 

It ain't what you don't know that gets you into trouble.

It’s what you know for sure that just ain't so.
Attributed to Mark Twain (among others)

 

Home
Economic Papers
Political Essays
Bibiliography
Biography
Links

 

http://www.rweconomics.com/_themes/sandston/astonrul.gif

Excerpt from:

Where Did All The Money Go?

Chapter 5: Nineteenth Century Financial Crises

 

 This eBook is available in Kindle format at Amazon.com for a $4.95 contribution to this website.

 

http://www.rweconomics.com/_themes/sandston/astonrul.gif

Prior to the Civil War, all you needed to start a bank was a charter from a state and access to a printing press. Banks would accept deposits, make loans, and print banknotes that were, in essence, a promise by the bank to pay the bearer on demand an amount of gold or silver at a fixed price. Banks accepted deposits in the form of gold, silver, and banknotes issued by private banks and made loans, generally in the form of banknotes that they printed themselves. The banknotes printed by private banks circulated in the community alongside coins minted by the United States Mint and the mints of other countries. Given the lack of specie (i.e., gold or silver coins), banknotes printed and issued by private banks served as the primary medium of exchange in the economy and were the dominant form of money.

There was a great deal of financial instability caused by this kind of monetary system, and, as was noted in Chapter 4, there were at least three major financial crises prior to the Civil War, in 1819, 1837, and 1857. At the same time, there were two attempts by the federal government to regulate the financial system during this period. The first was the creation of the First Bank of the United States which existed from 1791 to 1811, and the second was the creation of the Second Bank of the United States which existed from 1816 to 1836.

First and Second Banks of the U. S.

The First and Second Banks of the United States were the only banks chartered by the federal government prior to the Civil War, and because of the fact that federal deposits were kept in these banks they dominated the financial system. They performed many of the functions of a central bank in that they policed the other banks in the system by collecting their banknotes and presenting them for redemption in gold or silver. This limited the ability of the other banks to print money, and in so doing the First and Second Bank of the United States helped to stabilize the money supply and credit conditions in the country.

These banks, however, were private institutions chartered to serve the interests of their shareholders, not to serve the public good, and it was felt by many that the political and economic power they wielded by virtue of their relationship to the government was abused. The fate of the Second Bank of the United States was sealed when its president, Nicholas Biddle, opposed Andrew Jackson in the 1832 election. A bill to renew its charter was vetoed by Jackson in that year, and the last nail was driven into its coffin in 1833 when Jackson decreed that no more government money would be deposited in the Second Bank of the United States. (Trumbore NCpedia Phillips)

The demise of the Second Bank of the United States left the country with no financial institution that could perform the functions of a central bank. The First and Second Banks of the United States were far from satisfactory in this regard,[24] but without them there was chaos. Since each bank was responsible for the banknotes it issued, one had to evaluate the worth of a given banknote on the basis of the soundness of the issuing bank—that is, its ability to honor its promise to redeem its banknotes in gold or silver. With hundreds of banks issuing these notes this was no easy task. There were over a thousand kinds of banknotes in circulation by 1860. Banknotes issued by failed banks circulated alongside the notes of sound banks and, of course, counterfeiting has always been a problem—even before the Civil War. As a result, banknotes did not necessarily trade at par, and the result was a very unstable and inefficient currency system that hindered the growth of trade and economic development.

National Banking Acts of 1863 and 1864

This situation changed dramatically with the passage of the National Banking Acts of 1863 and 1864. These acts created the National Banking System with the intent of providing a stable and uniform national currency and, not coincidently, to help finance the Civil War. These two goals were accomplished by requiring that the banknotes printed by federally charted national banks be backed by Treasury securities equal in value to ninety percent of the value of the banknotes printed by national banks. These securities provided a secure backing for National Bank Notes since they could be sold to redeem the notes if the issuing bank failed. In addition, in 1865 a 10% tax was levied on non-national-bank banknotes and on all transactions using non-national-bank banknotes. The existence of this tax essentially forced all banks that wished to print their own banknotes to join the National Banking System.

The fact that banks were forced to purchase Treasury securities in order to print banknotes not only helped to finance the Civil War, it also limited the amount of National Bank Notes that could be circulated in the economic system by the amount of Treasury securities that were available to banks to back the notes they issued. The result was a stable and uniform national currency made up of 1) National Bank Notes tied to the total value of Treasury debt outstanding, 2) United Sates Notes which were the greenbacks printed by the federal government to pay the troops during the Civil War, 3) gold and silver coins that were minted by the U.S. or other treasuries, and 4) Gold Certificates issued by the Treasury which were, in effect, warehouse receipts for gold held at the Treasury.

Solvency, Liquidity, and Banks

While the National Banking Acts of 1863 and 1864, bolstered by the 1865 tax on non-national-bank banknotes, did provide a stable and uniform national currency, these dramatic changes in our financial system did not solve the problem of financial crises. The reason is that these reforms failed to deal directly with the unique solvency and liquidity problems faced by banks that cause the financial system to be inherently unstable.

The Solvency Problem of Banks

The solvency problem faced by any businesses, including a bank, is best understood in terms of the fundamental equation of double entry bookkeeping:

Assets = Liabilities + Net Worth

where Assets denotes the value of everything the business owns; Liabilities denotes the value of everything the business owes to others, and Net Worth (also referred to as owner’s equity, equity capital, or just capital or equity) is defined as the difference between the value of the Assets owned by the business and the value of the Liabilities owed by the business:

Net Worth ≡ Assets - Liabilities.

The significance of this equation, for our purposes, is that it illustrates the solvency problem of banks, namely, the need to maintain a positive Net Worth. If the value of a bank’s Liabilities is greater than the value of its Assets, its Net Worth will be negative and the bank will be insolvent. The fact that it is insolvent means that if the bank is forced into bankruptcy the value of its assets are insufficient to cover the value of its liabilities, and some of its debtors will not get paid back all they have lent to the bank. Insolvency puts a bank in a very precarious position because, in an unregulated banking system without deposit insurance, no one wants to hold deposits in a bank that is insolvent. As a result, nineteenth century banks were susceptible to what is known as a bank run where all of its depositors lose confidence in the bank’s ability to meet its financial obligations and try to close their accounts at the same time.

The Liquidity Problem of Banks

Most businesses can meet their liquidity needs (i.e., their needs for cash) by structuring the term to maturity of their liabilities (i.e., debts that they owe) to match the term to maturity of their assets (i.e., things that they own). They can, for example, finance real estate which yields a return over a relatively long period of time with 15 or 20 year loans, equipment with a shorter lifespan with 5 to 10 year loans, and inventories with loans that correspond to the period of time it takes for their inventories to turn over. A business that has its liabilities structured in this way can generally muddle through, even if it is insolvent, with the hope of rebuilding its net worth so long as it can service its debt (i.e., make the requisite interest and principle payments) and so long as it can retain the confidence of its short-term creditors.

The situation is fundamentally different for a bank. As was noted in Chapter 4, banks are financial intermediaries. They are in the business of borrowing from the ultimate lenders, the bank’s depositors,[25] and lending to the ultimate borrowers, those who borrow from banks. At the same time, most of the assets of a bank are made up of relatively long-term commercial, business, and real-estate loans that it makes to its customers. These assets have term to maturities far beyond the term to maturities of the bank's deposits, many of which, namely, checking accounts, are payable on demand.[26] Thus, by their very nature, banks are not able to structure the term to maturity of their liabilities to match the term to maturity of their assets.

As was indicated above, an ordinary business can generally muddle through when it is in financial difficulty so long as it can service its debt and retain the confidence of its short-term creditors. This is so because, in general, a relatively small portion of an ordinary business's liabilities are short term and the number of short-term creditors with which it must contend is relatively small. As a result, an ordinary business generally has the option of sitting down with its local banker and suppliers, opening its books, and undertaking a rational discussion of its financial viability to arrive at a rational decision as to whether or not its short-term credit should be continued. The situation is much different for a bank.

Even a small bank has thousands, if not tens of thousands of short-term creditors that hold its deposits. Unlike the debts of most businesses, a large portion of a bank's debts (its checking accounts) are payable on demand. What’s more, in an unregulated financial system that lacks deposit insurance there is no incentive at all for the depositors of a bank to even listen if a bank tries to explain its financial situation. The depositors know that if the bank were to fail those who close their accounts first while the bank still has currency on hand to cover withdrawals will not lose their money while those who wait will not be able to get their money out of the bank until its assets have been liquidated. What’s more, when a bank is insolvent those who wait will not get all of their money back. As a result, in the absence of deposit insurance, even a rumor that a bank is insolvent can lead to a run that can force it out of business if it can’t come up with the cash (currency) needed to meet the demands of its depositors. And, as we will see, even if a bank is solvent before a run begins, if asset prices fall as the bank is forced to sell its assets in the face of a run it can be driven into insolvency.

The Uniqueness of Banks

Compared to banks, most businesses borrow relatively little compared to their net worth—that is, compared to the amount of money the owners have invested in the business—since creditors generally refuse to lend to a business if the owners do not have a substantial amount of their own money invested in it. In addition, the rates of interest businesses have to pay, especially small businesses, are generally fairly high, and business owners often find it more profitable to reinvest their profits in their business by paying off their debts as soon as possible than to continue to borrow. As a result, the leverage ratios of most businesses—that is, their total debt divided by their net worth—tend to be relatively low. [27]

The situation is much different for a bank. Banks are in the business of borrowing from one group of people and lending to another group of people. That's what banks do. They make a profit from the difference between the costs of the funds they borrow in the form of deposits and the revenues they receive from the loans they make to businesses and private individuals. So long as the costs of the funds they borrow are less than the revenues they receive from their loans banks can increase their profits by both borrowing and lending more money. As a result, unlike ordinary business owners, bank owners seldom find it more profitable to reinvest their profits in their bank by paying off their debts than to continue to borrow, and the leverage ratios of banks tend to be relatively high.

It is this fundamental difference between ordinary businesses and banks—that ordinary businesses generally have an incentive to pay down their debts and banks generally do not have an incentive to pay down their debts—that makes the financial system inherently unstable. To fully understand why this is so we have to take a closer look at how the banking system works.

Leverage, Profits, and Risk

What happens to the money when a bank makes a $1,000 loan? The person who borrows the money has but three choices as to what to do with it: 1) spend it, 2) just hold on to it, or 3) redeposit it in a bank. If the choice is to spend it, then the person or business that receives the money in payment for whatever is purchased is faced with these same three choices. If the choice is eventually made to redeposit the money that was lent in the bank that made the loan, the bank that made the loan is able to borrow the $1,000 back from the person who deposits it. As a result its deposits will increase by $1,000, and the lending bank gets the cash back. But even if the $1,000 is redeposited in another bank, whatever bank it is redeposited in will be able to borrow the $1,000 that was lent back from the person who deposits it and will be able to increase its cash by the $1,000 that was lent. Thus, even though the lending bank loses the cash when it makes a loan, some other bank in the system will eventually get the cash back if the money that is lent is redeposited in a bank.

The fundamental point that must be understood here is that when a bank makes a loan unless none of the cash that is lent by the bank is redeposited in the banking system, the banking system as a whole does not lose all of the cash that is lent. To the extent it is redeposited in the bank that made the loan that bank gets some of the cash back, and to the extent it is redeposited in some other bank that bank gets some of the cash. In either case the amount of cash in the banking system as a whole does not fall by the amount of the loan. What does change is the amount of money that the banking system is able to borrow from its depositors. Only if the non-bank public decides to hold all of the newly lent cash outside the banking system—and thereby, increases the total amount of currency held by the non-bank public outside the banking system by the amount of the loan—will the banking system not be able to borrow back some of the money that is lent.

To see how this works, consider what would happen if you were to start a bank in a small town with $1,000 in cash and if every time you made a loan all of the proceeds of that loan were subsequently redeposited in your bank. Each time you lent your $1,000 and it was redeposited in your bank you would be able to lend it again. As a result, your deposits would grow to $10,000 after you had lent your $1,000 and it had been redeposited in your bank ten times while your cash and equity capital would remain unchanged at $1,000. If we ignore the other assets and liabilities of your bank, your financial position after making those ten $1,000 loans would look like Figure 5.1 where your bank’s Assets are listed on the left side of the table in this figure, and its Liabilities & Net Worth are listed on the right side of this table.

F 5.1.png

The fact that your Deposits have grown to $10,000 after you have made ten $1,000 loans while your Cash Reserves and Net Worth remain at $1,000 in this situation means the leverage of your bank (your total debt divided by your Net Worth) increases from zero, when you had no debt in the form of deposits, to 10 when your deposits (your total debt) grew to $10,000.[28]

This is a very profitable position for you to be in so long as it costs you less to manage your deposits than you make from your loans. If, for example, you can lend at 5% and it cost you 3% to manage your deposits, before your deposits grew you could make only $50 a year by lending out your $1,000 worth of capital. After you lend your $1,000 ten times and your deposits grew to $10,000 you would then be making $200 a year on your $1,000 investment in your bank—you would be taking in $500 on the $10,000 you had lent at 5% and it would cost you $300 (3% of $10,000 worth of deposits) to manage your $10,000 worth of deposits. Thus, instead of making only a 5% return on your $1,000 worth of equity capital you would be making a 20% return on that capital.

Leverage is a beautiful thing for a bank when it comes to making money. If you were able to grow your deposits in this way to $30,000 by making $30,000 worth of loans that were redeposited in your bank, your financial situation would look like Figure 5.2.

F 5.2.png

Your leverage ratio would be 30 to 1, and you would be able to make $600 ($30,000x.05 - $30,000x.03 = $600). This would yield you 60% annual return on your $1,000 investment! Even if it cost you as much as 4% to manage your deposits you would still make $300 in this situation and earn a 30% return on your investment.

While leverage can be a money-making machine for banks, it also poses two serious risks. The first comes from the fact that the use of leverage increases the liquidity problem of banks. In the above example, you are only able to achieve a 30 to 1 leverage ratio because people are willing to lend you money by redepositing it in your bank. You have borrowed $30,000 from your depositors but only have $1,000 worth of cash on hand (Cash Reserves) as a reserve to meet the needs of your depositors for currency. If your depositors choose to take $1,000 worth of currency out of their deposits your financial situation would look like Figure 5.3.

F 5.3.png

Unless you can find an alternative way to raise cash in this situation—say, by borrowing from other banks or selling some of the asset you own for cash—you are going to be in trouble if your depositors try to withdrawal more cash since you have no cash to give them.

The second risk comes from the fact that the use of leverage increases your risk of becoming insolvent. If your bank is leveraged at 30 to 1, that means your net worth is equal to less than 3.4% of your assets. It also means that if the values of your assets falls by 3.4%—say, because some of your debtors go bankrupt or abscond with the money—your financial situation would look like Figure 5.4.

F 5.4.png

Your Loans would now be worth only $28,980 (.966x$30,000) which means that when we add this to your $1,000 worth of Cash Reserves the value of your Assets would be $29,980 while your liabilities, Deposits, would still be $30,000. You would be insolvent because your liabilities exceed your assets by $20, and you would not be able to pay off all of your depositors if you were forced into bankruptcy even though you still have $1,000 in cash to service your deposits.[29]

Finally, it should be noted that the ability of banks to increase the amount they can borrow by increasing the amount they lend is not unlimited. It depends crucially on the willingness of the non-bank public to keep their cash in banks. An expansion of bank loans is generally accompanied by an increase in economic activity that increases the need for the non-bank public to hold currency outside of banks to finance their day to day transactions. As a result, it is unlikely that all of the money lent will be redeposited in a bank.

If, for example, you started your small town bank with $1,000 cash and only 96% of your loans were redeposited in your bank you would not be able to leverage you capital 30 to 1 since 4% of the cash you lent would remain outside your bank as the currency held by the non-bank public increased. Thus, by the time you made $25,000 worth of loans your deposits would have increased by only $24,000, and 4% of the $25,000 you lent ($1,000) would not be redeposited. Your financial situation would then look like Figure 5.5.

F 5.5.png

At this point you would have no more cash to lend. Thus, the maximum leverage you could obtain would be 24 to 1 in this situation, but even this is not obtainable. If you did leverage yourself this far you would have no Cash Reserves to meet the demands of your depositors in the event one of them wished to make a withdrawal. To play it safe you would have to keep some cash on hand to meet this contingency.

If you chose to keep cash reserves equal to, say, 5% of your deposits to protect yourself from unexpected withdrawals you could then only lend $11,364 before your deposits rose to $10,909 and your cash fell by $455 (4% of your $11,364 worth of loans) to $545 (5% of your $10,909 worth of deposits). At that point your financial situation would look like Figure 5.6.

F 5.6.png

You would have to stop lending in order to maintain your Cash Reserves at 5% of your Deposits and would, by choice, be limiting your leverage to a ratio of 10.9 to 1.

Thus, banking was a continual balancing act during the nineteenth century between expanding leverage in order to increase profits while maintaining cash and equity reserves to deal with the liquidity and solvency problems that this expansion inevitably entails. This balancing act was made even more difficult by virtue of the fact that when times were prosperous and money was being made hand over fist, the temptation to allow cash reserves to fall and leverage to increase was, for many banks, irresistible. This was particularly so when people had confidence in the banking system and kept their money in banks.

Since, deposits expand automatically as banks expand their loans in this situation, banks automatically receive the cash they need to further expand their loans and, hence, their leverage. If banks did not make a determined effort to increase their cash and equity as their deposits were expanding during prosperous times their cash reserves as a percentage of their deposits would automatically fall and their leverage would automatically increase as well. It is not until the crisis came and the non-bank public lost confidence in the system and began to withdraw their cash from banks that banks would be forced to face the inevitable liquidity and solvency problems they had created for themselves.

Failings of the National Banking System

There were two major failings of the National Banking System. The first had to do with the inelastic nature of the supply of currency within the National Banking System. The second had to do with its failure to adequately regulate the behavior of banks.

Inelastic Supply of Currency

Even though the National Banking System was able to provide a sound and stable currency, it did so by tying the issuance of National Bank Notes to the amount of Treasury securities outstanding and making it impossible for non-national banks to issue banknotes. As was noted above, the result was a stable and uniform national currency made up of 1) National Bank Notes tied to the total value of Treasury debt outstanding, 2) United Sates Notes which were the greenbacks printed by the federal government to pay the troops during the Civil War, 3) gold and silver coins that were minted by the U.S. or other treasuries, and 4) Gold Certificates issued by the Treasury which were, in effect, warehouse receipts for gold held at the Treasury. All of these sources of currency were more or less fixed, and, as a result, there was no way by which the banking system as a whole could increase the amount of currency available to the non-bank public without reducing the amount of currency held inside the banking system. This led to a serious problem.

During the normal course of economic activity there were seasonal changes in the demand for currency on the part of the non-bank public. When the demand for currency increased, say during the spring when crops were planted and especially in the fall when additional cash was needed to pay seasonal workers during the harvest and to purchase the crops from farmers, currency would flow out of the banks. This would place a strain on the cash available to banks to meet the needs of their depositors. It would also cause a tightening of the market for bank loans as banks were forced to contract their lending as depositors withdrew cash from their accounts.

As currency flowed out of the banks to meet seasonal demands and banks were forced to cut back on their lending, interest rates would rise. The pressure on the banks for cash would thus be transmitted to those who relied on the banks for credit. Potential borrowers who were unable to get new loans and debtors who were unable to renew their existing loans at acceptable rates of interest would be forced to cut back their economic activity. At the same time, debtors who could not renew their existing loans would be forced to sell the collateral underlying these loans or to sell other assets they owned in order to meet their obligations to the banks. These forced sales of assets, in turn, caused a fall in asset prices throughout the system which strained the system even further as debtors found it more difficult to meet their obligations to the banks in the face of falling asset prices. If this strain became particularly severe it would cause some debtors to default which would threaten the solvency of their banks and, in some instances, lead to bank failures.

Bank failures inevitably shook the confidence of the public and created the possibility of a financial crisis through a run on the system. Once a run began, there was no mechanism within the National Banking System by which a run on the system could be contained since there was no way to replenish the cash that a panicked public took out of the banks. When a bank ran out of cash it would be forced to shut its doors whether it was solvent or not, and if the panic was sufficiently widespread the system would simply implode as the entire system was forced to suspend payments of cash to depositors. The end result was a massive disruption in economic output and employment with extreme hardship throughout the economy.

A Failure to Adequately Regulate the Behavior of Banks

The second major failing of the National Banking System was that there was no mechanism within the National Banking System to deal with the tenuous nature of the financial stability of banks. Specifically, there was no system of regulation within the National Banking System that regulated the behavior of banks that kept banks from engaging in the kinds of behaviors that lead to speculative bubbles and financial crises.

The instability caused by the rigidity of the supply of currency within the National Banking System became clear as the country worked its way through the financial crises of 1873, 1893, and 1907. The experiences of these crises eventually led to the creation of the Federal Reserve System in 1913 in order to deal with this problem. Unfortunately, as we will see, the need to adequately regulate the behavior of banks did not become clear, and the ability to adequately regulate the behavior of banks was not built into the Federal Reserve System.

 

 This eBook is available in Kindle format at Amazon.com for a $4.95 contribution to this website.

 

http://www.rweconomics.com/_themes/sandston/astonrul.gif

Amazon.com

Where Did All The Money Go?

How Lower Taxes, Less Government, and Deregulation Redistribute Income and Create Economic Instability

Amazon.com

http://www.rweconomics.com/_themes/sandston/astonrul.gif

 

 

Endnotes

[24] The Second Bank of the United States has even been credited with having caused the 1819 crisis.

[25] In the case of nineteenth century National Banks, those who held the banknotes printed by the bank were also the ultimate lenders. For ease of exposition and in order to highlight those aspects of nineteenth-century banking that are relevant to our modern financial system, the role of banknotes printed by National Banks in the National Banking system will be ignored in what follows except when explaining the limitations of the National Banking System.

[26] Again, for ease of exposition and in order to highlight those aspects of nineteenth-century banking that are relevant to our modern banking system the role of gold in the National Banking system will be ignored in what follows. See a Brief History of the Gold Standard in the United States published by the Congressional Research Service for a history of the way in which the Gold Standard affected the monetary system prior to its disintegration in the 1930s and its formal abandonment in 1973.

[27] The leverage ratio is sometimes defined as the ratio of total assets (rather than total debt) divided by net equity. Since the fundament equation of double entry bookkeeping (NE = A - L) implies that the assets over equity ratio (A/NE = L/NE + 1) is always one greater than the liabilities over equity ratio, the two ratios measure the same thing, and the choice between them is, for the most part, arbitrary.

[28] I have, again, simplified this example of a nineteenth century bank by ignoring the way in which banknotes printed by the bank fit into the operation of the bank and the role played by gold in a banking system encumbered by the rules of the gold standard that existed at the time. These are important to a faithful understanding of how the nineteenth century banking system functioned, but they are ignored here to simplify the exposition in order to highlight those aspects of the nineteenth century system that pertain directly to our modern system. (See: Brief History of the Gold Standard in the United States.)

[29] It should be noted that the liquidity and solvency problems of banks are distinct problems. The liquidity problem has to do with having enough cash on hand to meet your day to day obligations. The solvency problem has to do with having assets of sufficient value to cover your debts.

 

 Hit Counter