Publication - Did the founding of the Federal Reserve affect the vulnerability of the interbank system to contagion risk? - by Mark A Carlson and David C Wheelock
In the United States at the beginning of the 20th century, an extensive interbank system performed the clearing of payments and transferred money and capital from regions and sectors with surplus funds to those with deficits, all without the backstop of a central bank.
Due to legal restrictions on branching, the U.S. banking system was composed largely of small, single office banks, with business relationships between banks enabling the system to function. The interbank system had a core-periphery structure. To facilitate interregional payments, invest surplus funds, and to borrow funds when needed, banks throughout the country held substantial deposits with banks in larger cities, which comprised the interbank system’s regional nodes, or with major banks in the system’s core cities, especially New York City.
Contemporaries viewed the interbank system as inherently fragile, though necessary for the interregional movement of funds and operation of the payments system. Seasonal pressures, marked by high demands for cash and loans in peak seasons, routinely strained the system, sometimes to the point of crisis (Kemmerer 1910). Autumn, in particular, was a period of intense economic activity when banks were called upon to provide cash and loans to facilitate the harvesting and marketing of agricultural commodities, and to make payments across long distances. Banks in agricultural regions relied on correspondent banks for additional funds to meet local demands, but a relatively fixed supply of funds in the aggregate – which contemporaries referred to as an “inelastic currency” – meant that interest rates typically rose and credit became less available in peak-demand seasons.
Contemporaries also blamed the interbank system for transmitting shocks through the banking system. The interbank network likely made the banking system more resilient to isolated liquidity disturbances by allowing those shocks to dissipate over the wider banking system. However, interconnectedness meant that local or regional banking panics could become national in scope. Strains on the system became acute when shocks drove up liquidity demand throughout the country, as in the panics of 1893 and 1907 (Calomiris and Gorton 1991; Wicker 2000).
In panics, interbank networks transmitted shocks across the system and focused pressures on banks at the center of the network. A distinguishing feature of major banking panics was that banks throughout the country withdrew funds from banks at the center of the network simultaneously, rather than at the staggered times that characterized ordinary seasonal flows. Faced with considerably larger demand than usual, New York City banks would suspend cash withdrawals, which in turn caused banks in the rest of the country to suspend when they could not obtain funds from their New York correspondents.1
Reformers viewed disruptions to the banking system associated with suspension of the money center and other banks as having large economic costs (eg Sprague 1908). The Federal Reserve (Fed) was established expressly to prevent panics and their economic fallout (Owen 1919). To accomplish that objective, the Fed’s founders sought to reduce the importance of interbank linkages, and in particular the role of the New York City banks at the center of the interbank network, while at the same time alleviating money market pressures caused by seasonal and other fluctuations in the demands for money and credit. A system of quasi-public Reserve Banks was set up to supplant the private network of interbank relationships that had both been the conduit for transmitting crises throughout the country and failed to fully alleviate seasonal pressures.2
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