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Reflections On Deposit Insurance Robert P. B&k EDITOR'S NOTE: Th folowing article, which o@$na&‘appeared in zLG Bank’ 1990 Annual Report, y s is adapted&m an address on the subject by Robert P. Black, president of the Federal Reseme Bank of Richmond befbre the annual conventionof the West Viqinia Bankers Association,July 27, 1990. For many years deposit insurance was one of the few instances of government intervention in the economy that just about everybody-liberals and conservatives alike-agreed was a good idea. Since there was not much debate about deposit insurance, there was little discussion of it. The savings and loan crisis has changed all this. No one believes that deposit insurance was the only cause of the crisis, and probably only a minority of those who have studied the crisis think it was the principal cause. Nonetheless, there is now widespread agreement among those in the best position to judge that deposit insurance has at least contributed to the thrift problem. Deposit insurance is now getting a great deal of attention. The FIRREA (Financial Institutions Reform, Recovery, and Enforcement Act of 1989) law requires the Treasury Department to prepare a study of deposit insurance; the American Bankers Association has already published a proposal for reforming the deposit insurance system; and leading newspapers and financial periodicals currently are filled with articles about deposit insurance. I. NATUREOFTHE DEPOSITINSURANCEPROBLEM How did deposit insurance contribute to the thrift crisis and what risks does deposit insurance pose for the commercial banking industry in the future? The response to this question is that deposit insurance presents a “moral hazard” to banks and other depository institutions. Moral hazard, as applied to deposit insurance, means that the managers of a thrift or a bank may have an incentive to acquire riskier assets than they should because insured depositorssecure in the knowledge that their funds are safe in any event-will not penalize the institution by FEDERAL RESERVE withdrawing their funds or requiring that a risk premium be added to the rates paid on their deposits. The hazard is all the greater if, as in too many institutions at present, capital is relatively low so that shareholders-who often include managers-have only a modest amount of their wealth at stake in the institution. It seems clear in retrospect that the moral hazard associated with deposit insurance did in fact play a role in the thrift crisis, although it may not have been the initial cause of the crisis. Specifically, at least some thrifts invested the deposits entrusted to them in highly risky ventures that depositors would not have tolerated in the absence of insurance. With this unfortunate experience in mind, commercial bankers obviously need to be aware of the long-term risks that deposit insurance presents to the banking industry so that they can work with the appropriate regulators to evaluate and avoid these risks. Attention must also be given to the problems deposit insurance may cause in the U.S. economy as a whole as well as in particular depository institutions and industries. Risk may be systematically underpriced in the U.S. economy because deposit insurance reduces the risk premium depository institutions have to pay when they compete for deposits. Loan rates may therefore not reflect adequately the risk associated with particular loans. If this is true, too many economic resources are being drawn to relatively high risk ventures and away from lower-yielding but economically more defensible projects. The apparent excess supply of office buildings and condominiums in many parts of the country currently suggests that there may have been a significant misallocation of capital in the United States over the last decade. Deposit insurance may have contributed to this misallocation. If this conjecture is accurate, it is essential to correct the problem quickly since America must allocate its capital resources as productively as possible to strengthen its competitiveness in today’ highly efficient world markets. s BANK OF RICHMOND 3 II. WAYS To DEALWITHTHE~ROBLEM The key question, obviously, is: how should we reform the deposit insurance system? The recommendations that follow are not necessarily the views of the Federal Reserve as a whole although many of them are held widely in the System. Many also correspond to points Chairman Greenspan made in his testimony on deposit insurance reform on July 12, 1990, before the Senate Committee on Banking, Housing, and Urban Affairs. Before considering what reforms should be made it should be recognized that whatever problems may be associated with deposit insurance, it has produced significant benefits since its inception back in the 1930s. In particular, no systemic runs on federally insured institutions have occurred during this period. Every effort must be made to preserve this benefit. The old adage about not throwing the baby out with the bathwater seems especially appropriate in the context of deposit insurance reform. Moreover, any attempt to overhaul overnight a system as popular and extensive as deposit insurance would be unwise. A better approach would be to set strategic goals for reform of the system and then develop a long-range, phased plan to achieve these objectives with minimum disruption. The following recommendations are in this spirit. and settle the claims of uninsured depositors and unsecured creditors through a “final settlement payment,? the amount of which would be set so that the FDIC would break even over time in its receivership activities. According to the ABA this amount would be between 85 and 95 percent of uninsured and unsecured creditor claims. This plan is appealing because it would subject depository institutions to a greater degree of healthy market discipline than exists currently while at the same time giving uninsured depositors and unsecured creditors immediate access to most of their funds. It would also help neutralize the “too-big-to-fail” problem if it were applied)consistently and therefore were a credible, permanent policy known in advance by depositors, bondholders, and other creditors. There may be legal or technical problems with this approach which have not surfaced yet, but, apart from this possibility, the ABA’ proposal seems to have considerable merit. s Any proposal that holds out a hope of halting the erosion of the insurance funds deserves serious consideration. In dealing with the deposit insurance problem, the most urgent need is to accelerate the resolution of what are euphemistically called “capital-impaired” institutions: in plain English, insolvent or soon-to-beinsolvent institutions. This is the only sure way to protect the deposit insurance funds and prevent or at least limit further potential losses to taxpayers. Taxpayers are angry about their potential losses from the thrift crisis to date. They have no stomach for any further losses. One particularly sticky problem involved in accelerating the resolution of insolvent institutions deserves mention-the question of what accounting system should be used in determining insolvency. It is well known that conventional accounting practices based on historical book values do not always accurately reflect the true current condition of an institution. Consequently, some economists and others have urged the adoption of market value accounting in some form. There are a lot of knotty practical problems involved in switching to market value accounting, and the solutions to all these problems are not clear yet. Changes along these lines may have to be considered, however, since it will not be possible to improve resolution procedures unless accurate and timely information on the true condition of insured institutions is available. If a way can be found to develop this information, it would then be incumbent,on the supervisory agencies to review it at least annually for each insured bank in a full in-bank examination. Accelerating the resolution process and protecting the insurance funds, of course, are easier said than done. One intriguing proposal for accomplishing this is the American Bankers Association’ s “final settlement payment” procedure put forward in March of 1990. Under this procedure, an insured institution would go into FDIC receivership immediately upon a determination that it was insolvent. On the next business day the FDIC would give insured depositors access to their full balances up to $100,000 Finally, whatever specific procedures are adopted for resolving insolvencies, it is important that the Federal Reserve reinforce them in administering the discount window. In the past the Federal Reserve has provided extended credit on several occasions to undercapitalized institutions, including some that may have been insolvent on a market-value basis. This practice has evolved from the System’ “lenders of-last-resort” responsibilities and has reflected its desire to help prevent or at least limit the disruption Accelerating and Improving Resolution Procedures 4 ECONOMIC REVIEW, JANUARY/FEBRUARY 1991 that may occur when individual institutions fail. The availability of extended credit from the window, however, may facilitate the withdrawal of uninsured funds from troubled institutions prior to resolution. If so, it would tend to undermine reforms such as the ABA’ proposal since one of the principal benefits s of these proposals would be the increased depositor discipline it would stimulate. Therefore, it may be desirable for the Federal Reserve to reevaluate its extended credit policies in conjunction with the larger effort to improve the deposit insurance system. In doing so, it should be kept in mind that the System can discharge its lender-of-last-resort duties to a very substantial extent by supplying liquidity to the banking system through ordinary open market operations. Strengthening Capital Positions Although improving resolution procedures is particularly urgent in order to prevent any further erosion of the insurance funds, more fundamental reforms are also needed. Among the most important of these is an additional strengthening of capital positions. Considerable progress in. this direction has already been made with the new international riskbased capital standards, which are being phased in and will be completely in place by the end of 1992. Nonetheless, a strong argument can be made for even higher capital standards, as Chairman Greenspan has indicated quite forcefully. Higher capital ratios would obviously benefit the deposit insurance system. First, they would enlarge the buffer protecting the insurance funds. Second, they would reduce the moral hazard in the system because shareholders would have a proportionately larger interest in an institution and therefore would impose greater discipline on managers. Beyond these direct benefits to the insurance system, higher capital ratios would make it considerably more likely that banks would be permitted to engage in a wider range of activities. This is so because the additional capital buffer would reduce the risk that the safety net of which deposit insurance is a part would be extended implicitly to these new activities. Smaller institutions may not find this last argument of great interest, but many observers of the U.S. banking industry believe firmly that bank powers must be extended if American banks are to maintain their competitive position in world financial markets. One other argument for increasing bank capital merits special attention. In the present situation with relatively low capital ratios in many banks and, in practice, something approaching full coverage of all FEDERAL RESERVE depositors, the government and the taxpayer effectively are bearing most of the risk associated with the depository industry. The savings and loan debacle has made both the government and taxpayers keenly aware of the nature and full dimensions of this risk. Consequently, it is likely that the government will demand increased control and regulatory authority over banks and other institutions if it is asked to continue to bear this risk. Some sharpening of supervision and regulation is probably needed in view of the thrift problem. But a wholesale increase in regulatory control and interference would not serve the interests of either banks or their customers. The innovative banking activity that has served the United States so well in the past would be stifled and the industry would wither. This is obviously a strong argument for increasing capital ratios. For that matter, it is a strong argument for any change that increases market and depositor discipline. In short, there are several solid arguments for raising capital standards, and Chairman Greenspan stated in his testimony that the Federal Reserve currently is developing more specific proposals to accomplish this as smoothly as possible. Many bankers undoubtedly would like to know where they are going to find this capital and how much it is going to cost. Unfortunately, there is no simple answer to this question. An increased demand by the banking industry for capital would almost certainly raise its cost, and this in turn might lead to further structural changes and possibly slower growth in the industry. These things do not sound very desirable at first, but this kind of outcome might well be a blessing in disguise if, as is very likely, it were to increase the efficiency and therefore the viability of the banking industry over the longer haul. In any event, the alternative of greater regulatory control is almost certainly worse. It would probably be acceptable, in this regard, to count fully subordinated debt along.with equity capital toward fulfillment of required capital minimums. Most independent small and mediumsized institutions probably will find it less costly, however, to attract equity capital than investment in subordinated debt in the foreseeable future. Other Measures It has been emphasized already that the two most effective, practical steps that can be taken to deal with the problems in the deposit insurance system currently are (1) improving the procedures for resolving insolvencies and (2) increasing capital ratios. BANK OF RICHMOND 5 There are a number of other useful measures, however, that would complement these two primary reforms. Improved supervision clearly would be one such step. One of the great advantages of higher capital ratios is that they would reduce the pressure for any marked increases in regulation and supervision. Measured changes in supervisory activity such as annual in-bank examinations of all insured banks, however, would not be unduly intrusive and would benefit individual institutions as well as regulators. Another potentially helpful action might be to introduce a limited form of risk-based insurance premiums. Such premiums would link the price of insurance paid by a particular institution (and, indirectly, its customers) directly to the potential burden the institution is putting on the insurance fund and therefore give the institution an incentive to reduce this burden. It would not be a good idea, however, to base these premiums on a detailed categorization of assets according to risk. It is exceedingly difficult as a practical matter to define and rank such categories, and attempts might be made to manipulate the system in order to direct credit to favored industries. Consequently, any differentiation of premiums probably should be based primarily on capital adequacy. Whatever other reforms may be made in the insurance system, some people will not be satisfied unless action is taken to reduce the system’ overall s coverage from present levels. These people argue that in practice the system currently covers virtually 100 percent of deposits and a substantial portion of other unsecured liabilities. They argue further that this situation and the subsidization of risk-taking it entails will inherently produce a continuing, significant misallocation of resources and make the economy correspondingly less efficient-a condition the nation can ill afford when it is locked in a global competitive struggle with the highly efficient Japanese and German economies. This rather fundamental economic argument for reducing coverage is very persuasive. The question is: how should it be accomplished? The ABA proposal discussed above is one possibility. Another option, of course, would be to reduce the explicit insurance limit per account from the current 6 ECONOMIC REVIEW, $100,000 to something less. One does not have to be terribly astute to realize that this would be very difficult to achieve politically. It might also weaken the competitive position of U.S. banks in international money markets. A better approach might be to enforce the $100,000 limit more effectively by restricting the use of multiple accounts by individual depositors. This could be done in a straightforward way using social security numbers. Perhaps the most productive way to limit coverage, however, would be to introduce-or at’ least study the possibility of introducing-some form of coinsurance for larger insured accounts. Coinsurance probably would be as effective or nearly as effective in increasing depositor discipline on institutions as a reduction in the insurance limit. It also would be easier to sell politically since the public is now well accustomed to deductibles in their automobile and health insurance plans. The public might well regard a system likec this as a fair and reasonable effort to prevent a recurrence of the savings and loan problem. In considering such a system, however, it would be important to analyze carefully the implications of coinsurance for the competitiveness of U.S. depository institutions in world markets. III. CONCLUSION These comments and observations can be boiled down to two main points. First, prompt and meaningful reform of the deposit insurance system is needed both to correct the distortions the present system has introduced into the economy and, more urgently, to prevent the savings and loan disease from spreading to the commercial banking industry. Second, there are a variety of feasible options for reform available. Accelerated resolution procedures and higher capital ratios are especially important, and, as indicated above, a number of other beneficial changes could be made to supplement and reinforce these fundamental reforms. Some of these changes may require some adjustments, both in the Federal Reserve and other regulatory agencies and in the banking industry. If the changes are made carefully and diligently, however, American banking and financial markets will almost certainly be much stronger and more efficient in the years ahead. JANUARY/FEBRUARY 1991 Money, Credit, Payments Banking, and System Policy Ma&n Goodfiend * The modern payments system is a complex set of arrangements involving such diverse institutions as currency, the banking system, clearinghouses, the central bank, and government deposit insurance. While there is an enormous literature about its constituent parts, there is little unifying analysis. Monetary economists have long pursued deeper understanding of currency as the medium of exchange. But they have generally ignored the banking system and clearinghouses, even when focusing on monetary policy. Financial economists, on the other hand, have been keenly interested in banks as financial intermediaries and in government deposit insurance. But, by and large, they have ignored the payments system aspects of these institutions; and they have tended to treat medium of exchange and monetary policy issues only peripherally. To fully understand the payments system, though, including the evolution and structure of its constituent institutions, it is necessary to appreciate both its monetary and financial aspects. This paper presents a unified treatment by showing how the evolution of the payments system has been driven by efficiency gains from substituting credit, i.e., claims on particular institutions, for commodity money. The discussion emphasizes that the substitution of credit for commodity money was accompanied by arrangements to monitor and enforce restrictions on credit-issuing institutions. Among other things, it suggests alternative answers to some long-standing questions about banking. For example, it suggests why payments services and information-intensive lending have been provided jointly by the same set of institutions, i.e., banks; and it explains why T& authorisAsocibteDimctorof Research. Thtipaper ti reprinted fmm The U.S. Payments System: Efficiency, Risk and the Role of the Federal Reserve, edited by David B. Humphrey, KluwerAcademiG Publishers,1990. MikeBordo, MikeDotsey,Motoo Hamta, Bob King, TonyKupriaov, Ben McCOlum, and Clt#Stnith prv&ed he&W comments. The uiews are so/e/r thoseof the author and do not necessarily reflect thoseof the Fedeal Reserve Bank of Rkhmond. l FEDERAL RESERVE maintaining the value of bank deposits at par has been efficient, i.e., why banks have not been set up as mutual funds. Insights developed by explaining the private payments system are subsequently employed to evaluate public payments system policy. I focus on the need for public protection of the payments system. One can imagine a payments system not in need of protection; namely, one using only government currency or coin, i.e., cash, and perhaps a postal money-order system. However, the public has apparently been willing to accept some credit risk for the substantial efficiency gains that the use of credit instruments in place of cash has afforded. The public’ willingness to accept purely private measures s for controlling credit risk prior to the Federal Reserve and government deposit insurance indicates that private protection of the payments system was largely effective. I explore whether the development of the payments system by private decentralized competitive forces was deficient, however, by evaluating three prominent public payments system policies: monetary policy, central bank lending, and deposit insurance. Briefly, although valuing deposits at par and holding fractional reserves is efficient for individual banks, it has the potential for generating destabilizing systemwide bank runs that can be remedied most efficiently by central bank monetary policy. In contrast to monetary policy, fully collateralized discount window lending as practiced by the Federal Reserve matters only because the rules for pledging bank assets favor the Federal Reserve over private lenders. The provision of payments finality by private clearinghouses prior to the establishment of the Federal Reserve, however, suggests that some Fed lending in the process of making payments may be efficient. Moreover, it also suggests that Fed limits on direct access to the payments system are also efficient, both to protect Fed lending and to protect the interbank credit market. BANK OF RICHMOND 7 In contrast to safe discount window lending as practiced by the Fed, deposit insurance is a liability whose potential cost bank managers can increase by their choice of assets. Hence, deposit insurance must be supported by extensive supervision and regulation to protect the insurer’ funds. My discussion points s out some pitfalls of current protective provisions. It then uses insights developed in the discussion of private payments arrangements to suggest a tough exclusion principle as a potential remedy, and to critique an alternative proposal, narrow banking. The plan of the paper is as follows. Section I outlines the fundamental efficiencies of monetized exchange. Section II discusses the basic benefits and costs of substituting credit for commodity money. Section III treats the role of banks in the payments system, suggesting how the four characteristic features distinguishing banks from other financial intermediaries flow from the role of banks in providing efficient medium of. exchange services. Section IV explains further efficiencies made possible by the development of private multilateral arrangements among banks. It considers two historically important examples: The Suffolk Bank System and check clearinghouses. Section V evaluates the three public payments system policies mentioned above. I. THEMEDIUMOFEXCHANGE As the medium of exchange, money overcomes inconveniences associated with barter, most notably the double coincidence of wants and commodity indivisibilities.’ Money also naturally serves as the medium of account. Having high purchasing power to weight, money economizes on the cost of carrying or transporting assets to make payments. Equally important, money is .easily recognized, saving costly verification of its authenticity and value. Needless to say, money must also be a reasonably durable store of value. In the early hunting societies skins served as money.2 Such items as corn, tobacco, and olive oil served as money in agricultural societies. Of course, the precious metals silver and gold emerged as the most widely used commodity monies in the modern world. Their great value in nonmonetary uses, e.g., for ornamentation and jewelry, has given them considerable purchasing power portability. When properly alloyed, their durability is also very high. Both metals are readily divisible, though silver’ lower s purchasing power to weight has made it more convenient than gold for fractional coinage. And both 8 ECONOMIC REVIEW, metals are easily recognizable. Beyond their color and metallic ring, simple tests, e.g., specific gravity and acid tests for gold, identify them cheaply. Their coinability has made possible a further economization of verification costs in everyday exchange. A coin stamp certifies the original weight and fineness of the metal and, along with milling on the edges, makes evident any subsequent alteration. The exclusive use of commodity money in making payments would mean that each transfer of goods was accompanied simultaneously by a transfer from the buyer to the seller of a quantity of commodity money of equal value. From the modern point of view, making payments exclusively with commodity money seems highly restrictive. Yet if it were impossible to judge or guarantee individual reliability, e.g., if individual identities were private information, other arrangements for making payments would be infeasible.3 Settlement in paper claims’ on real assets would be ruled out because their value could not be verified. Likewise, individuals could not credibly precommit to settle in the commodity money itself, even in the near future. Since precommitment would not be enforceable, deferred settlement would not be feasible.4 Though it has been possible, of course, to develop systems for enforcing settlement in terms of paper claims or even bookentry claims, it is costly to manage them efficiently. Hence, it has remained efficient for society to finance the majority of its transactions with cash, i.e., government currency and coin.5 The need to employ cash gives rise to an inventory demand for it. The reason is that the cost of using cash is minimized by keeping an inventory on hand and replenishing it only infrequently. The average efficient cash inventory, i.e., the demand for cash, is smaller the lower is the replenishment cost. In addition, the efficient stock demand is lower the greater is the opportunity cost of holding it, i.e., the higher is the nominal rate .of interest. It is, of course, the real value of cash demanded that is determined according to the above considerations. Other things the same, the nominal demand for cash moves proportionally with the price level. The real demand, of course, is related to the real flow of cash purchases. II. CREDITINTHE,EXCHANGEPROCESS As a commodity, paper has all the attributes of an efficient medium of exchange, except one. Paper is highly divisible and portable, and it can be made JANUARY/FEBRUARY 1991 durable with the proper processing. But its purchasing power to weight ratio is far too low for it to be an efficient pure commodity money. However, if there is a technologically feasible means of information production and a means of enforcement that allows verification of the value of paper claims on real assets, then it becomes efficient for paper claims, i.e., warehouse receipts, to circulate in place of commodity money itself.6 The efficiency stems from the fact that the purchasing power to weight of paper claims exceeds that for commodity money. In addition, leaving commodity money in a central location yields economies of scale in storage. These factors, in turn, reduce the cost of replenishing money balances, now paper claims, and thereby reduce the efficient inventory of money to have on hand. At the social level the reduced stock demand for money provides a benefit by freeing some of the money commodity for nonmonetary uses. The abovementioned efficiencies are purchased at the cost of maintaining systems for monitoring and enforcement of the promise to honor the warehouse receipts. To understand the nature of these costs it is useful to view the leaving of commodity money at a warehouse as lending.7 The receipt, entitling its holder to reclaim the commodity money on demand, may be viewed as evidence of commodity money credit extended to the warehouse. Because the circulation of warehouse receipts in place of commodity money itself involves lending, it must be accompanied by rules and restrictions to protect the lender (claim check holder) against the possibility that the borrower (warehouse) will not repay the loan, i.e., that the warehouse will not honor its claim checks. Efficient loan design involves the costly accumulation of detailed information about borrowers. To economize on the expense of acquiring information, lending is typically undertaken in the context of longterm relationships. In addition to establishing the borrower’ reliability, there is usually an agreement to s restrict the borrower’ range of actions to reduce the s risk of default. Typically the borrower agrees to collateralize the loan. That is, the borrower accepts a set of restrictions on the use or transfer of an asset designated as security. In order to enforce compliance with such restrictions, loan agreements contain provisions for the lender to monitor the borrower.8 Warehouse receipts, like claim checks for laundries, entitle the holder to reclaim the exact items left there. Moreover, such claims restrict their issuers from using or renting the items. In effect, then, commodity monies left with a warehouse, i.e., commodity FEDERAL RESERVE money loans to the warehouse, are perfectly collateralized. They would be safe so long as someone representing the borrowers monitored the warehouse. Note .that even though each unit of commodity money in storage, in effect, collateralized a specific claim check, the claim checks could circulate interchangeably if the commodity money collateral were homogeneous. They would, however, have to be transferable. But this could be arranged either by allowing an initial depositor to endorse his claim over to another, or by having the claim simply promise to pay the presenter. Because foolproof monitoring of the warehouse would be very costly, it would be useful to put in place other safeguards to protect the loan collateral, i.e., the warehoused commodity money.9 An efficient means of doing so would .be for a wealthy man of long-standing reputation in the community to run the warehouse. Default would be known to be costly for such a man in terms of reputational capital. Equally important, he could pledge fiied property to further collateralize the loans in case of a misappropriation of the commodity money. In effect, he would provide capital to protect the customers of the warehouse against loss. All the costs of running the warehouse, including rent for the building, management fees, the cost of printing warehouse receipts, fees for monitoring and enforcing protective restrictions, and a return to the owner for putting up capital, would be built into the warehouse storage charge. If these costs were smaller than the benefits discussed above of using warehouse receipts as the circulating medium, then it would be more efficient for paper claims on commodity money to circulate in place of commodity money itself. Of course, a gain might only obtain for some transactions. If a warehouse were only known locally, for example, then commodity money would still be used for traveling. In fact, the evolution of the payments system has been, in large part, driven by efficiency gains from substituting credit, i.e., claims on particular institutions, for commodity money. The substitution of warehouse receipts for commodity money was only the first in a series of substitutions that have been found to be efficient. For reasons that will be discussed below, warehousing developed into banking relatively quickly. ,But the discussion of warehousing was conceptually valuable because it makes particularly clear the efficiency gains as well as the costs incurred in substituting credit for circulating commodity money. To reiterate, such substitution has BANK OF RICHMOND 9 been efficient because the costs of enforcing restrictions on and monitoring institutions that issue credit money have been less than the cost of using commodity money directly. In other words, the drive for greater efficiency, which has dictated a continuing substitution of credit for commodity money in making payments, has brought with it a need to make arrangements to protect the payments system. III. THEROLEOFBANKS Banks have been distinguished from other financial intermediaries by the following four characteristics. First, prior to the nationalization of currency, banks issued liabilities in the form of circulating banknotes. Second, bank deposits have normally been valued at par in terms of currency.iO Third, banks have provided checking services for their depositors. Fourth, banks have specialized in information-intensive lending.” That is, a large portion of bank’ assets have been loans which are not traded on secondary markets, and hence must be valued and managed entirely by individual banks themselves.12 A long-standing puzzle in understanding banking is why payments services and information-intensive lending have both been offered by the same set of institutions, namely, banks. This section explains the mix of services distinguishing banking from other financial intermediation as an efficient outcome of a further substitution of credit for commodity money in the payments system. Once the commodity money warehouses described above were set up, there was relatively little need for circulating claims to be cashed in. Claims might be made for travel, for payments to distant locations where the warehouse was unknown, in response to changes in the nonmonetary demand for the money commodity, or in response to changes in commodity money demand itself. But for the most part claims could simply circulate, the average inventory per person being determined efficiently as outlined above. Claims could retain their value indefinitely, with systems in place to monitor and safeguard the commodity money collateral in the warehouse. The payments system ‘ could be run even more economically, however, if the warehoused commodity money wereinvested at interest, leaving just enough to manage efficiently any claims that might be made. Keeping too small an inventory of commodity money would lead to excessively costly stockouts. Too large an inventory would be costly 10 ECONOMIC REVIEW, in terms of interest income foregone. Hence, a fractional reserve of commodity money was optimal. At the individual level, interest earnings could defray some of the fee for leaving commodity money at the warehouse. If large enough, they could provide net interest to claim check holders. The social value of fractional reserves was to free the money corn: modity for nonmonetary uses. By reducing the opportunity cost of money, i.e., lowering the implicit rental rate on money, fractional reserves also raised the efficient stock demand for money and reduced the cost of managing money balances. The efficiency gains of fractional reserves could not be had, however, without changing the character of the warehouse claim check. As discussed above, a conventional warehouse receipt specifies a perfect collateral interest in the particular units of commodity money left in a warehouse, implicitly restricting the warehouse to hold 100 percent reserves of commodity money, or getting permission from the specific customer who owns the collateral every time it is moved around. Hence, to get the efficiency gains of fractional reserve banking, depositors had to give up perfected collateral interest and become general creditors.r3 This point about the character of the deposit contract will be important below when I evaluate Federal Reserve discount window lending. A bank free to invest in interest-earning assets but without any expertise in information-intensive lending would lend on the basis of easily verified safe collateral, that is, on real bills; or it could lend to entities well-known to have good credit, such as bluechip firms or governments. Being based on publicly available information, such loans could take the form of traded securities. So although the incentive to hold fractional reserves explains why commodity money warehouses evolved into financial intermediaries, it does not explain the emergence of other distinctive features of banking, in particular, informationintensive lending. The following argument, however, suggests such an explanation. Having developed arrangements to support the efficient issue of notes, banks were positioned to further economize on the use of resources in making payments: they could offer checkable deposits and check collection services. Checks allowed individuals to make payments in person without carrying currency.14 Because checkable deposits provided banks with loanable funds, they could pay a competitive return either as explicit interest or by defraying the cost of check-clearing services. Of course banknotes likewise represented a source of JANUARY/FEBRUARY 1991 loanable funds for banks and could, in principle, pay interest to their owner periodically. Such interest payments, however, would cause the value of notes to rise as the interest payment date approached and to fall sharply immediately after. Moreoker, their value would fluctuate with the nominal interest rate that converts the future interest payment into a present value. Individuals using currency would thereby have to agree on its value before an exchange could take place. Such inconveniences have apparently made it inefficient to pay interest on currency. Hence, the primary efficiency gain made possible by checks was to allow society, in part, to substitute interest-earning checkable deposits for non-interestearning currency. In addition, checks made payments through the mail more convenient and reliable. A further saving was achieved because checks could be deposited directly and collected in bulk through the banking system. With no further arrangements among banks, checks would require immediate payment in commodity money when received by the paying bank. Once again, however, an efficiency gain was achieved by using credit in place of immediate settlement in commodity money, this time in the form of interbank balances. In general, checks sent for collection from one bank to another tend to net out, so if payment were always made as checks were received, commodity money would simply be shipped back and forth with neither bank accumulating or decumulating any on average. Banks could, therefore, economize on such shipping costs by simply holding credit balances on each other instead of requiring immediate settlement in commodity money. For example, instead of triggering immediate shipment of commodity money from bank A to bank B, checks sent for payment by bank B to bank A could result in bank A giving bank B a deposit. Bank B would then be said to have an interbank deposit at bank A. When the flow of collections reversed, bank A could acquire a deposit at bank B. To economize on commodity money shipping costs, banks agreed to make temporary loans to each other on demand as dictated by developments in the payments system.15 Just as noteholders made arrangements to protect commodity money deposited with more primitive banks, banks employing interbank balances developed systems and expertise in monitoring and managing loans to each other. In contrast to individual depositors with relatively small deposits at a single bank, banks themselves needed numerous interbank FEDERAL RESERVE relationships to provide efficient payments services to their customers. Moreover, such relationships were geographically spread out. In addition, payments system efficiency dictated that banks grant possibly large loans, by accepting balances at another bank, on very short notice, without the safety of specific collateral. In effect, banks offered lines of credit to their correspondent banks. Hence, banks had to be particularly careful about the correspondents through which they collected checks. Equally important, they had to devote resources to continually evaluate the creditworthiness of those banks with which they chose to have collection relationships. In other words, banks specialized in information-intensive lending to support efficient payments services for their customers. There are two important implications of this point. First, because banks had an incentive to monitor each other in the process of collecting checks, they could provide an economical indirect means for a depositor to monitor his own bank. A depositor could check what interbank collection relationships his bank could arrange. Since good banks had an incentive to publicize such arrangements, depositors would have little trouble monitoring interbank relationships. A substantial number of relationship terminations would be taken as evidence that a particular bank had become a bad credit risk. Depriving a weak bank of the ability to have its checks accepted for collection at other banks would also greatly reduce its ability to successfully market checkable deposits. Alternatively, banks might continue to accept for collection checks drawn on a bank perceived to be a bad credit risk, but announce that they would no longer hold deposits at the weak bank. Though it could still have its checks collected by other banks, the weak bank would be forced to hold larger cash reserves to manage its checkable deposits, forcing it to be less competitive in that respect. Second, the holding of interbank deposits rather than publicly traded securities by banks made it much more difficult for depositors to continually evaluate bank solvency. This led banks to devote more resources to monitoring each other and reinforced the need for additional safeguards, such as more capital.r6 I am finally in a position to suggest why payments services and information-intensive loans to nonfinancial firms have been provided jointly by the same set of institutions, i.e., banks. Imagine a set of finance companies satisfying the nonfinancial demand for information-intensive loans. They would develop the BANK OF RICHMOND 11 same expertise currently used by banks to manage their loans. Moreover, one would expect such finance companies to organize a network to allocate credit to the best prospects, and to help diversify their loan portfolios. Intercompany balances would be managed with the same systems used to manage information-intensive loans to nonfinancial borrowers. Intercompany borrowing and lending would exist even if finance companies offered no payments services. Now, one can imagine a separate network of mutual funds offering payments services. Would it be efficient for the finance and payments companies to exist independently? It would not seem so. Finance companies would have in place much of the network, systems, and expertise to run a reliable and efficient payments system. They would merely need to accept demand deposits and set up facilities for handling payments flows. The point is that systems to evaluate credit, monitor and enforce loan agreements, and extend credit on short notice are productive both in originating loans to nonfinancial borrowers and in managing lending to support an efficient provision of payments services. This, 1 am arguing, helps explain why institutions specializing in information-intensive lending, i.e., banks, have applied their expertise jointly to the production of payments services and nontraded loans. Moreover, nonfinancial lines of credit involve longterm relationships in which the finance company and the borrower each have an incentive to assure that the other has staying power. A finance company requires information about a borrower. But a borrower who pays an ongoing fee for his credit line likewise needs assurances of his finance company’ staying s power. Other things the same, then, finance companies will offer checkable deposits more efficiently than pure payments companies, because potential depositors will already have acquired information about the reliability of finance companies as depositories. Independent payments companies could, of course, assure their reliability by holding publicly traded securities; but the low cost of verifying the value of traded securities would be reflected in a yield below that on nontraded loans. I am suggesting that, on net, using the same information to assure the reliability of both credit lines and deposits allows payments services to be provided at lower cost by firms also offering line of credit services. The joint product efficiencies of combining information-intensive lending with the provision of payments services also explains why bank deposits 12 ECONOMIC REVIEW. have been valued at par, i.e., why banks have not been set up as mutual funds. Of course, practically speaking this would have required banks to hold securities valued continually in the market. Yet restricting assets this way would certainly have been feasible, especially in modern times, and it would have made banks easier to monitor. As Fama and Jensen [1983, pp. 337-410) point out, however, institutions specializing in nontraded loans are not run efficiently as mutual funds. The incentive for such institutions to employ par value deposits, whose yield is independent of the fortunes of the firm, may be understood as part of a widespread use of bonds together with equity in the financing of firms in general. Jensen and Meckling (19761 have emphasized that from the point of view of claimants, bonds are an optimal part of a financial package to monitor management and ensure an efficient choice of assets. In other words, bank deposits have been par valued because it has been efficient for banks to use them to fund nontraded loans.” IV. THE PAYMENTS SYSTEM To this point, 1 have discussed efficiencies in the means of making payments that involved bilateral relationships among banks. Here 1 discuss further efficiencies made possible by the development of private multilateral cooperative arrangements. 1 consider two historically important examples: the Suffolk Bank System and the clearinghouses. The Suffolk System emerged as a more efficient means of redeeming banknotes. The clearinghouses economized on the collection of checks. The Suffolk Bank System The Suffolk Bank System arose in early nineteenth century New England. I8 At that time, country banknotes made up the bulk of the regional circulating currency, although residents of Boston also used local checkable bank deposits to make payments. As pointed out above, normally there would be little reason for banknotes to be redeemed. In the process of circulating, however, banknotes could flow some distance from the banks that issued them. During this period the balance of payments within the region favored Boston, and country banknotes generally flowed in that direction. Because banknotes entitled the holder to commodity money (by this time, gold or silver coin) at their issuing bank only, notes bore ever-greater discounts in terms of coin the farther they traveled from JANUARY/FEBRUARY 1991 their bank of issue. The discount reflected both the transport and time costs of carrying the notes to the bank for payment and returning with the coin. If information on creditworthiness were difficult to obtain at a distance or if solvency were in doubt, the discount could include a risk premium. The cost of authenticating notes to detect counterfeits increased the discount even further. Under such conditions, it became profitable for individuals known as notebrokers to buy notes with coin in Boston and return them to their banks of issue for payment. By buying up and returning notes in bulk, notebrokers could reduce the per item transport cost. Competition among notebrokers thereby reduced the discounts on country banknotes in Boston. Carrying potentially large positions in notes of particular banks, brokers also had incentive to specialize in authenticating notes and evaluating bank credit risk. The economization on information production achieved by brokers probably also reduced the risk premium on notes. Of course, competition would remove any abnormal arbitrage profit, as brokers bid the discount down to the point where it just covered the cost of redemption. In effect, notebrokering forced the country banks and the rural areas as a whole to finance their balance of payments deficit vis-a-vis Boston with coin instead of with paper credit, i.e., banknotes. Country banks and their customers deplored notebrokering because it forced banks to call in loans in order to accumulate coin which then went to Boston. It was in this environment that the Suffolk Bank System was organized. The Suffolk System was an arrangement by which the Suffolk Bank in Boston redeemed a country bank’ notes with coin, pros vided that the country bank deposited coin at the Suffolk Bank to cover the redemption. Initially, the System was set up on a purely bilateral basis and amounted to little more than centralized notebrokering with further economies of scale. Since country banks had to redeem their notes as before, the Suffolk System was likewise unpopular outside of Boston. But because the Suffolk Bank redeemed notes at a discount while nonmembers had to redeem theirs at par, country banks were given an incentive to participate. After a while, the Suffolk System introduced a kind ofcollective net settlement, an important multilateral clearing procedure that was a precursor to that used in clearinghouses. l9 To make this possible, the Suffolk Bank ruled that it would accept, as required FEDERAL RESERVE deposits, the notes of any participating banks in good standing. This ruling allowed a bank to redeem its notes by swapping them for excess coin in another account. In effect, the procedure allowed interbank borrowing, which made more efficient use of coin on deposit, and reduced the average inventory of coin that each bank had to keep on hand. Collective net settlement should be recognized as yet another example of the substitution of credit for the use of commodity money in the payments system. As in the earlier examples, the innovative use of credit was due to the saving it afforded in reduced commodity money shipping costs and smaller commodity money reserves. Here too the use of credit was supported by extensive safeguards on all the participants, including the Suffolk Bank itself, and especially by continual monitoring of the country banks by the Suffolk Bank. One important control was the power to expel a bank judged to be excessively weak from the system. The Clearinghouses Clearinghouses emerged in various cities around the United States in the middle of the nineteenth century as private cooperative arrangements among banks to economize on check collection.20 In part, clearinghouses did for check collecting what the Suffolk Bank System did for the payment of coin against notes.21 The most well-known clearinghouse innovation was the replacement of bilateral collection procedures with collective net settlement. Each morning, clearinghouse member banks took checks to a central house for clearing. There the checks were netted out or offset against each other and a net credit or debit position against “the clearinghouse” was computed for each member bank. Later in the day, banks covered any net debit positions with government currency or coin. Funds so received paid off the net creditor banks from that morning’ clearing. s The basic efficiency gains were these. Instead of making collections individually, each bank could take its checks to a central location for collection. Thus, centralized collection itself saved significantly on transport costs. Netting out provided an additional saving by greatly reducing the volume of currency and coin that was transported in the settlement process. Moreover, to further economize on shipments of currency and coin, clearinghouse members kept the bulk of their reserves in the vaults of the clearinghouse, receiving in return claims to their reserves known as clearinghouse certificates.22 Then, instead of shipping currency and coin to settle, member banks could simply pass around BANK OF RICHMOND 13 clearinghouse certificates. The keeping of reserves at the clearinghouse, in turn, facilitated an interbank market that made possible a more efficient distribution of reserves among banks. These measures all contributed to reducing the efficient quantity of reserves that banks had to hold. By reducing checking fees, they also encouraged more intensive use of checks relative to currency on the part of the public. Along with the set of benefits just described, clearinghouses eventually provided payments finality.z3 In the absence of finality, a check deposited for collection might not be paid if either the bank against which it was written failed or the deposit account against which it was written had insufficient funds. Obviously, neither the paying bank nor the clearinghouse would pay a check where there was insufficient funds, unless the drawer of the check had a prearranged line of credit at his bank. But with finality, a check deposited for collection in the same town was given immediate credit. In other words, finality insured the check depositor against failure of the paying bank. In order to provide finality, clearinghouse member banks agreed to assess themselves if a member bank failed to cover its position with the clearinghouse later that day. The assessments were then used to pay the failing bank’ checks in s return for a lien against the receiver of the failed bank. Making use of their cooperative nature, then, clearinghouses provided a kind of check insurance to the depositors of their member banks. If checks could be deposited quickly, finality allowed a checks reliability to depend entirely on the individual issuing it. Hence, finality further enhanced the convenience of checks as means of payment. The clearinghouse represented a highly sophisticated example of efficiencies in the payments system achieved by substituting private credit for commodity money. The uses of private credit were numerous. The daily clearing and collection process routinely generated credit against the clearinghouse. Member banks held currency and coin in its vault. Extensive interbank lending and borrowing of reserves was carried out under its auspices. In addition, the clearinghouse managed an important contingent liability in the form of mutual insurance of checks in the process of collection. As we would expect, the clearinghouse imposed numerous rules and regulations on its member banks and engaged in supervision and enforcement as well. There were minimum capital requirements. Coin and currency reserves at the clearinghouse partly col14 ECONOMIC REVIEW, lateralized the debit positions of clearing banks. There were relatively frequent examinations of member banks by a clearinghouse committee. Clearinghouses also reserved the right to exclude, by vote, members shown to be weak.24 The threat of expulsion was a powerful management tool because public expulsion would represent an adverse signal to depositors and cause a bank to lose the ability to have its checks accepted for collection at other banks. It was apparently efficient to restrict membership in the clearinghouse itself to a core of well-managed and highly reliable banks. Other banks cleared their checks through the clearinghouse by retaining a member as an agent. But clearinghouses held agents liable for checks against their clients authorized for collection through clearinghouse member banks.25 Thus agents were given a powerful incentive to choose and monitor their client banks carefully. Agents thereby imposed a useful discipline on client banks.26 V. PUBLICPAYMENTSSYSTEMPOLICIES Previous sections explained the evolution of the payments system in terms of the efficiency gains had by substituting private credit for commodity money in the settlement process. Two insights were stressed. First, the shipping and inventory costs of settling in commodity money could be significantly reduced by making use of evermore sophisticated borrowing and lending arrangements. Second, these economies had to be purchased by setting up and managing evermore complicated safeguards to protect the institutional lending that supported the efficiency gains. One can imagine a payments system not in need of protection; namely, one using only government currency or coin, i.e., cash, and perhaps a postal money-order system. With the proper controls, however, users of payment services have apparently been willing to accept some credit risk for the substantial reduction in costs that the use of credit in place of cash has afforded. Here, however, I explore whether the development of the payments system by private decentralized competitive forces was deficient from the macroeconomic point of view by evaluating three prominent public payments system policies: monetary policy, central bank lending, and deposit insurance.*’ Monetary Policy Monetary policy made possible two distinct efficiency gains. First, national paper currency replaced JANUARY/FEBRUARY gold coin as the interregional 1991 means of settlement. Second, the power of the Federal Reserve to create currency provided better protection against systemic bank runs. I discuss each benefit in turn. Prior to the Civil War, interbank balances were settled in gold coin. During and following the war, however, the national government created paper currency substitutes for gold that could be used for settlement. The greenbacks, unbacked notes issued during the war, were one such paper currency. National bank notes, authorized by the National Bank Act to be issued by banks with the backing of Treasury bonds, were another. The Treasury also issued gold and silver certificates, which were warehouse receipts for the respective metals held in the Treasury. Because these currencies were liabilities of the national Treasury, they were accepted throughout the country. Though the use of gold in the settlement process had been greatly reduced locally by clearinghouses, the appearance of Treasury currency significantly reduced the shipping costs of settlement among different regions of the country.28 The Federal Reserve further reduced costs by settling interbank balances via book-entry telegraphic messages rather than by physical transportation of gold or currency. It is worth noting that clearinghouse efficiencies provided by the Federal Reserve at the national level might have been provided privately had interstate banking not effectively been prohibited. At any rate, management of high-powered money, i.e., currency plus bank reserves, by the Federal Reserve after 1914 provided another important benefit which we can understand as follows.29 We have interpreted the banking system together with clearinghouses as a set of credit arrangements that increased the efficiency of commodity money in providing payments services. In particular, we saw in Section III that it was efficient for checkable deposits to be valued at par and for banks to keep fractional reserves. Obviously, a widespread demand to convert deposits into currency could not be satisfied by such a system without a central bank. The clearinghouses, however, could protect the banking system against a run by temporarily restricting the conversion of deposits into currency. But restricting cash payments would tend to cause deposits to depreciate in terms of currency. Hence, the system was potentially unstable. Even minor banking problems which made a restriction possible could make forward-looking depositors seek to protect themselves against (or profit from) a potential depreciation by immediately attempting to convert deposits FEDERAL RESERVE into currency. In aggregate, of course, such behavior could make a restriction inevitable. In fact, between the end of the Civil War and the establishment of the Federal Reserve, there were numerous banking crises which involved the actual or expected restriction of the conversion of deposits into currency. Though these episodes were violent and disruptive, the evidence suggests that their aggregate insolvency effects were relatively small.30 In other words, the pre-Fed banking crises appear to have been due to the inherent monetary instability described above. Being able to create currency through open market security purchases, Federal Reserve monetary policy could guarantee the exchange rate between bank deposits and currency against systemwide runs. Monetary policy is effective in this regard precisely because it protects the banking system by creating the currency it needs, so depositors otherwise confident in the solvency of their banks need not worry about a depreciation in the value of their deposits in terms of currency. Hence, with a central bank “lender of last resort,” widespread runs need not develop, at least in the absence of real systemwide insolvencies.31 Hence, monetary policy protects the payments system in a way that the private market cannot. Central Bank Lending In contrast to monetary policy, central bank lending involves making loans to individual banks with funds acquired by selling off other assets, usually government bonds. In other words, I am defining central bank lending to be analogous to private financial intermediation in that it neither creates nor destroys high-powered money. Obviously, because it involves making loans, central bank lending must be accompanied by provisions to monitor and enforce compliance with certain restrictions on potential borrowers. In the public sector, these are known as supervision and regulation. The three major categories of Federal Reserve lending are all importantly related to payments system policy. Although discount window credit is not generated in the payments system proper, it is valued in large part for the assistance it provides to individual banks in order to protect the payments system.32 In fact, the Fed’ discount window is often cited as a s comparative advantage for Federal Reserve management of the payments system.33 Daylight overdrafts constitute a second category of Fed lending. They BANK OF RICHMOND 15 are intraday credits, granted by the Federal Reserve to depository institutions making payments over Fedwire, the Fed’ electronic funds transfer network.34 s Though quantitatively less significant, Federal Reserve lending also takes the form of float generated in the process of clearing checks.35 I evaluate, in turn, discount window lending and credit extended in the process of making payments. While open market operations are seen as capable of handling aggregate monetary conditions, the discount window is valued for its ability to direct potentially large quantities of funds, on very short notice, to individually troubled banks. No one argues that the discount window should be used to rescue insolvent banks, only that it be used to aid temporarily illiquid banks. While the distinction between the two is crucial for evaluating central bank discount window lending more generally, we can sidestep it here.36 The reason is that, in practice, the Federal Reserve fully collateralizes its discount window lending. Hence, discount window lending has involved little risk for the Fed. But what then explains the widespread use of discount window loans by banks in trouble? After all, private lenders should be eager to lend on the same terms as the Fed. Moreover, the Fed does not appear to charge a below-market rate for its emergency credit assistance. The answer appears to be that banks cannot legally pledge specific assets against privately borrowed funds, i.e., private lenders cannot perfect a collateral interest in specific assets of a borrowing bank. In case of insolvency, then, private lenders must become general creditors. Government agencies, however, such as the U.S. Treasury and the Federal Reserve, are allowed to perfect a collateral interest in specific assets of a bank to which they lend funds.37 Discount window advances may be secured by a wide range of bank assets. The riskier and less liquid the asset, however, the greater the haircut off book value that the Fed will lend on. The pledging of particular assets to borrow funds is similar, in principle, to selling them for cash. If the need for funds is expected to be temporary, however, borrowing on the basis of pledged assets is more economical. It avoids the greater transaction cost of a sale, including for loan sales the cost of restructuring a loan servicing relationship. Hence, borrowing from the Fed on pledged assets dominates selling those assets. The effect of fully collateralized discount window lending, then, turns on the pledging rules. If the rules were the same for the Fed and private lenders, 16 ECONOMIC REVIEW, discount window lending would make little difference, as long as no subsidy were involved in Fed lending. It is beyond the scope of this paper to analyze the socially optimal configuration of pledging rules. But allowing the Fed to select good collateral to back its loans permits weak banks to more cheaply obtain funds to continue operating, possibly pledging their best collateral at the discount window to pay out uninsured depositors, i.e., the hot money, prior to a bank’ being closed. Currently, then, the discount s window can delay the declaration of insolvency, while effectively moving uninsured depositors from last to first in line. This, of course, is at the expense of the deposit insurance fund. On the other hand, under current pledging rules the discount window is better able to save temporarily illiquid but solvent banks from bankruptcy, which is a social benefit. However, if it is socially efficient for the Fed to have pledging privileges, shouldn’ such privileges t be given to private lenders as well? As mentioned in Section III, the efficiency gains of fractional reserve banking could not be had unless depositors gave up perfected collateral interest. But couldn’ private bank t debt such as certificates of deposit be made eligible for perfected collateral? The point is that whatever pledging rule is judged to be socially optimal, it is difficult to see why the Fed and private lenders should not both be subject to it, in which case unsubsidized fully collateralized discount window lending would make little difference. My evaluation of Federal Reserve credit extended in the process of making payments is considerably different than that for discount window lending. First of all, daylight overdrafts and float generated in the process of making payments are not perfectly collateralized as are discount window loans. Moreover, daylight overdrafts are conceptually related to the credit generated by clearinghouses in connection with the provision of finality as discussed above. The fact that it was efficient for private clearinghouses to accept the generation of credit in that regard suggests that some portion of daylight overdrafts may be efficient. Since it is essentially feasible for the Fed to monitor reserve accounts electronically on a real time basis, it would also be feasible to eliminate daylight overdrafts. 38 However, to do so would make it costlier for banks to manage their reserve flows during the day. Banks would likely respond with a combination of increased use of correspondent balances for clearing purposes, increased effort to coordinate inflows and outflows of funds, and larger reserve accounts. So daylight overdrafts should be JANUARY/FEBRUARY 1991 reduced only to the extent found efficient based on proper pricing policy and the absence of subsidies. Of course, the price of Federal Reserve credit generated in the payments system should also cover the cost of the supervisory and regulatory controls that the Fed must administer to protect its loans. In other words, the Fed should be careful to allocate such management costs efficiently as well, just as private clearinghouses had to allocate their costs. It has been said that the Fed’ discount window gives s it an advantage in managing the payments system. It should be clear that this makes little sense given the way the Fed runs the discount window. However, if it is efficient for a national clearinghouse to oversee the payments system, it is efficient for an institution like the Federal Reserve to do so. In the absence of restrictions on interstate branching, however, a national clearinghouse might easily have been organized by a group of private nationwide banks.39 On the basis of this discussion, one can appreciate the concerns of some policymakers for maintaining a separation between banking on one hand, and finance and commerce on the other, and for limiting direct access to the payments system.40 The separation of banking from finance and commerce would maintain a degree of homogeneity that would facilitate the monitoring and enforcement of safeguards in the interbank credit market. Moreover, as mentioned above, it was efficient for private clearinghouses before the Fed to limit their membership to a relatively exclusive core of banks, allowing other banks access to the clearing system through agent-member banks. This suggests that it is efficient for the Fed to restrict direct access to its national clearing system as well, both to protect Fed lending generated in the payments system and to protect the interbank credit market.41 Deposit Insurance Deposit insurance is a promise to make good the value of covered deposits, in return for a bank’ s assets, in the event of a failure. The guarantee is essentially a put option on the assets of the bank that gives management the right to sell those assets to the guarantor for the value of the covered deposits. 42 Because deposit insurance is a potentially costly contingent liability whose value is influenced by a bank manager’ choice of assets, the s guarantor must protect its funds by monitoring insured banks and enforcing restrictions on their behavior. Uninsured deposits and minimum capital requirements are two key provisions for protecting FEDERAL RESERVE the deposit insurer’ funds. The discussion of deposit s insurance below points out some pitfalls of such provisions. It then uses insights from the discussion of private payments arrangements to suggest a tough exclusion principle as a potential remedy, and to critique an alternative proposal, narrow banking. First, however, it points out a deficiency in the payments system that deposit insurance helps to correct. As it is organized in the United States, deposit insurance is financed by assessments on participating banks. Because it does not involve the creation or destruction of currency, deposit insurance is neither necessary nor sufficient to protect the banking system against the monetary instabilities described above. It is not designed, as central bank lending is, to provide line of credit assistance to temporarily illiquid but solvent banks; nor does deposit insurance have anything to do with providing finality in the settlement process. If deposit insurance has a role, it is a means of allowing depositors to better pool the risk of individual bank failures. Individual banks have an incentive to diversify to the point where the marginal benefit is just offset by the higher agency costs due to the reduced stake in the loans originated.43 Nontraded loan portfolios are most efficiently diversified among those institutions specializing in informationintensive lending themselves, i.e., banks. Branching is probably the most important means of diversification, though interbank deposits, purchases and sales of loans, and loan syndications can provide the same benefits. The U.S. political system has, however, greatly restricted both intra- and interstate branching. The risk pooling made possible by deposit insurance may be useful as a means of diversifying bank assets in the presence of branching restrictions.44 In other words, deposit insurance may be viewed as overcoming a deficiency in the payments system. The deficiency, however, arises not from a private market failure, but from inefficient political interference in the market for corporate control in banking.4s While deposit insurance probably substitutes to some extent for diversification through free branching, it is beyond the scope of this paper to say how well it does so, especially relative to the alternatives mentioned above. It is possible, however, to point out some weaknesses in the means of protecting the insurance fund that tend to make deposit insurance inefficient. Consider uninsured deposits. These cushion the insurance fund by making it more likely that bank assets will cover insured deposits in the event of a failure. In practice, however, uninsured BANK OF RICHMOND 17 deposits may not be a reliable cushion for two reasons. First, as we saw earlier, discount window lending makes it easier for uninsured deposits to be withdrawn from a weak bank before it becomes insolvent. Second, it is difficult for a public authority subject to political pressure to successfully precommit to not bailing out uninsured depositors ex post, especially in large bank insolvencies. In principle, bank capital also provides a cushion to protect the insurance fund. However, without the power to reorganize or recapitalize a weak bank before its net worth goes to zero, capital cannot provide a reliable cushion either. Given that uninsured deposits and bank capital are unreliable cushions, an attractive alternative suggested by the behavior of the pre-Fed clearinghouses is to use the power to exclude. The insurer could reserve the right to exclude a bank from participating in the deposit insurance program if its capital falls below minimum requirements, or if it is perceived to be weak and mismanaged.46 As was the case for the clearinghouses, the threat of expulsion would be a powerful disciplining device because its announcement would represent an adverse signal. If society wished to protect the depositors of an expelled bank, it could offer deposit insurance briefly following the announcement. Such a guarantee, though, would require higher minimum capital requirements and tougher participation standards to protect the insurer; but it might be necessary to make the exclusion principle politically viable. Roughly speaking, an efficient exclusion rule would fix the marginal cost of being tough (the compliance, monitoring, and enforcement costs) at the point where it equaled the expected marginal utility cost of claims on the insurer. Such a rule could leave the insurer open to some risk, though it would provide the optimal degree of protection. A well-known proposed alternative to deposit insurance is the fail-safe, or narrow, bank.47 This proposal involves restricting the assets backing checkable deposits to short-term marketable securities with little chance of declining in value due to credit or interest rate risk. One might imagine the Fed imposing such restrictions on banks in the payments system. It appears that narrow banking could, in principle, provide near perfect protection of the payments system with relatively little monitoring and enforcement costs. It would do so, however, by destroying the efficient joint application of information-intensive lending to payments services and loans, reducing the rate 18 ECONOMIC REVIEW, banks could offer on checkable deposits. One of the themes of the paper, however, is that it has always been possible for individuals to employ perfectly safe means of making payments, but with proper controls the public has accepted credit risk for the reduction in cost it has afforded. Moreover, since narrow banking would do nothing to provide a better diversification of nontraded loans to help overcome branching restrictions, it should not be viewed as an alternative means of risk pooling or insurance. Narrow banking would protect the checkable deposit guarantee against abuse by bank managers. But checkable deposits are only a small part of total deposits, and their share is likely to shrink under narrow banking because of the lower checkable deposit interest rate. Unless the government could precommit to not guaranteeing other deposits, narrow banking would provide only marginal protection against abuses. By establishing the principle that a portion of deposits ought to be perfectly safe, narrow banking might even raise the expectation of a government guarantee for other deposits. Closing the deposit insurance agencies might lower expectations of such a guarantee, but weakening government controls on bank asset choice could lead to more severe problems if banks continued to expect such a guarantee. On net, narrow banking would appear to offer little relative to deposit insurance augmented with a tough exclusion principle as outlined above. %JMMARY This paper has analyzed the evolution and strutture of the key components of the payments system: currency, the banking system, clearinghouses, the central bank, and deposit insurance. It began by pointing out efficiencies, such as recognizability and portability, that led particular commodities to be used as money. It explained the evolution of the payments system as driven by efficiency gains from substituting credit, i.e., claims on particular institutions, for commodity money. Two insights were stressed. Shipping and inventory costs of settling in commodity money were significantly reduced by making use of evermore sophisticated borrowing and lending arrangements. These economies were accompanied by evermore elaborate safeguards to protect the institutional lending that supported the efficiency gains. Fractional reserve banking, banknotes, demand deposits, and checks were all explained as economizing on the use of commodity money. Systems to evaluate credit, monitor and enforce loan agreements, and extend credit on short notice are JANUARY/FEBRUARY 1991 productive both in originating loans to nonfinancial borrowers and in managing lending to support an efficient provision of payments services. This, I argued, explains why it has been efficient for payment services and information-intensive loans to be provided by the same set of institutions, i.e., banks. In addition, I pointed out that institutions specializing in nontraded loans could not be run efficiently as mutual funds. Par value deposits, like bonds, are an optimal part of a financial package to most efficiently monitor management and ensure an efficient choice of assets. Hence, this argument also explains that bank deposits have been par valued because it has been efficient to use them to fund nontraded loans. The paper also discussed the Suffolk System and the check clearinghouses, two multilateral arrangements to further economize on the provision of payments services. They introduced centralized collection, collective net settlement, centralized holding of reserves, more extensive interbank lending, and payments finality. All involved more sophisticated uses of private credit to reduce payments costs. Consequently, the cooperative organizations imposed numerous rules and regulations on members and engaged in extensive supervision as well. For example, there were capital requirements and frequent examinations of member banks. Equally important was the power to exclude, by vote, a member shown to be weak. The private cooperative arrangements are particularly interesting because they represent the middle ground between an entirely decentralized payments system and one dominated by public authority. Hence, they provide examples, for comparison with actual and proposed public policies, of cooperative arrangements driven by efficiency rather than political concerns. In the last part of the paper I focused on the possible need for public policies to protect the payments system. To repeat, it has always been possible to make payments safely with cash, but users of payments services have been willing to accept some risk for the benefits that private credit in place of commodity money has afforded. However, I explored whether the private development of the payments system was deficient by evaluating monetary policy, central bank lending, and deposit insurance in light of the earlier analysis. Two features of efficient private bank namely, par value deposits and fractional implied a useful role for monetary policy the payments system. The clearinghouses structure, reserves, to protect protected FEDERAL RESERVE the banking system against widespread runs by temporarily restricting the conversion of deposits into currency. But currency restrictions were disruptive and the possibility of their use increased the likelihood of widespread runs themselves. Monetary policy was useful in this regard because it could, by creating the needed currency, protect the banking system against such disruptions. In contrast to monetary policy, central bank lending neither creates nor destroys high-powered money. It involves making loans to individual banks with funds acquired by selling government bonds. I pointed out that private credit markets would be willing and able to provide emergency credit assistance on the same fully collateralized terms as the Fed discount window. Pledging rules explain the use of Fed emergency credit assistance. The efficiency gains of fractional reserve banking could not be had unless depositors gave up perfected collateral interest. This is reflected in the fact that banks cannot legally pledge specific assets against privately borrowed funds. The Fed’ advantage is that it is allowed to perfect a cols lateral interest. I briefly considered altering the pledging rules. But whatever rule is judged to be socially optimal, it is difficult to see why the Fed and private lenders should not both be subject to it, in which case unsubsidized fully collateralized discount window lending would make little difference. The Federal Reserve also extends loans, most importantly, as daylight overdrafts, in the process of making payments. Such loans are not perfectly collateralized as is discount window credit. Daylight overdrafts are conceptually analogous to the credit generated by private clearinghouses in connection with the provision of finality. Hence, some portion of Fed daylight overdrafts may be efficient. Likewise, it was efficient for private clearinghouses to limit their membership to an exclusive core of banks, with other banks accessing the clearing system through agentmember banks. This suggests that it is efficient for the Fed to restrict direct access to its national clearing system as well, to protect Fed daylight overdrafts and the interbank credit market. Deposit insurance was the last public payments system policy to be evaluated. I interpreted such insurance literally as a means of allowing bank depositors to pool the risk of individual bank failures, not as a means of protecting the banking system against aggregate shocks. I argued that deposit insurance could be viewed as overcoming a deficiency in the payments system. But the deficiency arose because intra- and interstate branching, which is one BANK OF RICHMOND 19 important means for banks to diversify nontraded loans, has been greatly inhibited by the political system. I also pointed out some weaknesses in the use of uninsured deposits and bank capital as means of protecting the insurance fund. Current pledging rules and discount window lending policy make it easier for uninsured deposits to be withdrawn from a weak bank before it is declared insolvent. It is also difficult for public authority not to bail out uninsured depositors ex post. Likewise, without the power to reorganize or recapitalize a weak bank before its net worth goes to zero, capital cannot provide a reliable cushion either. In light of this point, I discussed the narrow bank proposal as a substitute for deposit insurance. My feeling, though, is that narrow banking would be unnecessarily costly because it would destroy the efficient joint application of information-intensive lending to the production of payments services and loans. Moreover, narrow banking would do nothing to provide a better diversification of loans. Lifting branching restrictions would best do that. Most importantly, although it would protect the checkable deposit guarantee from abuse by bank managers, narrow banking would not protect any additional deposit guarantee such as might be difficult to avoid in the event of a large bank failure. On the basis of the behavior of the pre-Fed clearinghouses, I argued that a tough exclusion principle would provide an attractive alternative to narrow banking. Banks could continue to fund informationintensive loans with checkable deposits, but the insurance agency could expel a weak or mismanaged bank, or one whose capital fell below a minimum requirement. The agency could even refuse to insure a bank too large or insufficiently diversified to handle safely. If society wished to protect depositors whose bank was expelled, it could do so by requiring sufficiently high minimum capital requirements and tough participation standards to protect the insurer. ENDNOTES 1. See Lucas , McCallum 119833, and Townsend  for recent theoretical work motivating and emphasizing the medium of exchange role of money. 2. Jevons [ 18751 contains excellent descriptive and analytical material on the evolution of the payments system. 3. King and Plosser I19861 focus on this point. 10. An important exception, of course, was the temporarily fluctuating currency price of deposits that resulted from the restriction on cash payments during the pre-Fed banking crises. See Friedman and Schwartz [ 19631. Private banknotes and non-par checks could circulate at a discount. However, when presented in person at the bank upon which they were drawn, they were paid at par. 4. See Townsend 11980 and 19861, and references contained therein, for theoretical analyses of these issues. 11. Fama [ 19851 contains a nice discussion of this view of bank lending. See Goodhart ] 19873 and James ] 19871 for further discussion of this point. 5. Humphrey 119841, p. 6, reports about 70 percent of all transactions as taking place with cash, though by value cash transactions account for only about 1.5 percent of the total. 12. See Gorton and Haubrich [ 19871 for a discussion and interpretation of the recent rise in loan sales. Fama  and McCallum [198.5] discuss the possibility of an accounting system of exchange without money. See also de Roover 119793 and Usher 119671 on the early evolution of banking. 13. Williams  makes this point with regard to grain banking. 6. Richards (19291 contains a good discussion of goldsmith bankers and the evolution of English paper money. 14. Since a check represents a personal promise to pay cash in the future, its acceptability requires a means of judging the reliability of the writer. Hence, checks are used when reliability is assured, such as for repeated purchases at the same firm, e.g., for rent or for the purchase of groceries. 7. The fact that a warehouse could charge a storage fee, i.e., pay a negative rate of interest, does not diminish the usefulness of the analogy. 15. It is worth noting that the use of trade credit among nonbanks is analogous to the use of interbank balances among banks. 8. Boyd and Prescott [ 19861, Smith and Warner [ 19791, and Watts and Zimmerman [ 19831 contain excellent discussions of these issues. 16. Lindow [19631 reports a ratio of total bank capital (equity, loan loss reserves, and subordinated debt) to risk assets (total assets less cash and U.S. Treasury securities) from 1863 to 1963. The ratio falls from 60 ‘ percent in 1880, to about 20 percent at the turn of the century, to under 10 percent by the 1960s. 9. See the discussion in Jensen and Meckling [ 19761, section 4.2. 20 ECONOMIC REVIEW, JANUARY/FEBRUARY 1991 17. Strictly speaking, this argument explains only why bank deposits are par valued. It does not explain why they are valued in nominal units and not, for example, indexed to the price level. Perhaps it is because banks evolved as commodity money warehouses. In any case, this is a more general question which is beyond the scope of this paper to address. 35. The Monetary Control Act of 1980 directed that Federal Reserve check float be priced at the federal funds rate. Hence, Fed check float has fallen from 7.4 billion dollars in the first half of 1979 to under 1 billion dollars today. See “Tug-of-War Over Float,” , U.S. Congress, Th Role of the Federal Resew in Check Cleatingand tke Nation’ s PaymentsSystem 119833, and Young . 18. See Whitney . 36. Goodfriend and King (19881 evaluate the feasibility and desirability of discount window lending to illiquid but solvent banks. 19. Mullineaux , p. 890. 20. Cannon [ 191 l] and Spahr [ 19261 contain good institutional histories of check clearing. 37. See Anztian.lbipn&nce , Vol. 10, pp. 390-401 for the banking law on the pledging of bank assets. 21. Financial center banks, having numerous correspondent relationships with country banks, also provided check collection economies similar to those provided by the Suffolk System for note redemptions. 22. Westerfield The ability of depository institutions to use repurchase agreements (RPs) as a funding instrument is a breach in the pledging prohibition for private lenders. Using RPs, legally characterized as a sale and repurchase of securities, effectively allows a depository institution to give private lenders a collateral interest in the RPd securities. Bank use of RPs is limited by a 1969 Federal Reserve rule restricting RP collateral to direct obligations of the United States or its agencies. This restriction precludes a significant role for private emergency credit assistance to banks based on RPs. [ 19211, pp. 634-39. of AcroLation 23. The Constitution the Nm York Clearing/rouse , Section 13, p. 9. of 24. For example, T/re Constitution the New York Clearinghouse Astitian [19031, Section 20, p. 13, provided for expulsion of a member by majority vote. of 25. See, for example, The Constitution the Nm York Clearing/rouseAssociation , Section 25, pp. 14-15. Thrifts borrow on a secured basis using RPs, mortgagebacked bonds, and Federal Home Loan Bank advances. The 1980 Monetary Control Act also gives thrifts access to the Federal Reserve’ discount window. s Thrifts, however, have had little need for the Fed’ discount s window given the other means of collateralized borrowing available to them. 26. Gorton and Mullineaux 119871, and Timberlake 119843 emphasize the private regulatory and supervisory nature of clearinghouses. 27. For alternative discussions of policy issues, see Eisenbeis , Heurtas (19873, and Ireland 119873. Prior to passage of the Financial Institution Reform, Recovery, and Enforcement Act of 1989 (FIRREA), it was unclear whether the deposit insurance agencies would respect a collateral interest for RP lenders. Such uncertainty has been greatly reduced under FIRREA. FIRREA (Sec. 212) views an RP as a “qualified financial contract” and states that no person shall be stayed or prohibited from exercising his right to liquidate RP collateral. Thus, the way is cleared for greater private RP-based emergency credit assistance to thrifts. 28. See Garbade and Silber . 29. See Goodfriend  for a discussion of the efficiency gains, feasibility, and mechanics of central banking under a gold standard. 30. Benston, et al. , pp. 53-60, and Goodfriend King [ 19883, make this point. 31 and Goodfriend and King  emphasize that last resort lending is monetary policy. It is effective because the provision of high-powered money can prevent nominal interest rate increases and asset price declines from making the banking system insolvent. 32. For example, Continental Illiiois Bank borrowed extensively at the Fed discount window from May 1984 to February 1985. It was in the window for over 4 billion dollars during much of that time. See Benston, et al. [ 19861, pp. 120-24. 33. See, for example, Flannery . 34. Mengle, Humphrey, and Summers , p. 12, reported total funds transfer daylight overdrafts of 76 billion dollars per day. This is an enormous number when one considers that total reserve balances with Reserve Banks were then around 35 billion dollars. Daylight overdrafts are currently not priced, though plans are now in place to do so by 1992. Overdrafts are interest free loans. Therefore, depository institutions have little incentive to economize on their use. To limit somewhat the use of intraday credit the Fed monitors depository institutions according to “caps” and relatively informal guidelines, resorting to consultations with bank officials when necessary. FEDERAL RESERVE Uninsured creditors of thrifts have shifted out of deposits and into RPs as such institutions have become troubled. Below, the article emphasizes that the Fed discount window allows uninsured depositors to move from last to first in line. In the case of troubled thrifts, however, RPs and FHLB advances, rather than discount window loans, have facilitated this process. 38. The new Swiss Interbank Clearing System instituted in January 1988 has done so, at least for non-security transactions. 39. For example, a national clearinghouse run by private banks was established in Canada around the turn of the century, well before the Canadian central bank was founded in 1935. 40. See Corrigan [ 19873. s 41. Goodfriend and Whelpley 11987) document the Fed’ regulatory role in the evolution of the federal funds market. 42. See Merton (19771. BANK OF RICHMOND 21 diversification and risk pooling. Neither is capable of protecting against aggregate shocks. As discussed in Section V, aggregate monetary shocks must be addressed with monetary policy. As Goodfriend and King  emphasize, protection of the banking system against aggregate real shocks must be in terms of a tax and transfer fiscal policy. 43. Agency costs include the costs of structuring, monitoring, and bonding a set of contracts among agents with conflicting interests, plus the residual loss incurred because the cost of full enforcement of contracts exceeds the benefits. See Jensen and Meckling 119761, pp. 306-10. 44. For a related discussion see Brickley and James 11987). Although nationwide branch banks would be diversified against local risks, as Edwards [ 19881 argues, hundreds of smaller banks would remain viable in a deregulated system. The large diversified banks, however, would be positioned to provide small bank depositors with private insurance, either directly or through loan syndications. 45. White  provides evidence at the state level that deposit insurance was seen as a substitute for branching. 46. This suggestion is very close in spirit to that advocated in Benston and Kaufman [ 19881. See Stelzer [ 198 l] for an interesting discussion of the antitrust implications of exclusion. It must be emphasized, however, that branching and deposit insurance only yield benefits associated with 47. See, for example, Litan 119861. REFERENCES American Jurispmdence, 1963, Vol. 10 (The Lawyers Cooperative Publishing Company, Rochester, N.Y.). Eisenbeis, Robert A., 1987, “Eroding Market Imperfections: Implications for Financial Intermediaries, the Payments System, and Regulatory Reform,” in Restmctwing tke Financial System, Federal Reserve Bank of Kansas City, 19-54. Baxter, William F., 1983, “Bank Interchange of Transactional Paper: Legal and Economic Perspectives,” J&maL of Law and Economics 26, October, 541-88. Fama, Eugene F., 1980, “Banking in a Theory of Finance,” Jouma! of MonetaryEconomics6, January, 39-57. Benston, George J. and George G. Kaufman, 1988, “Risk and Solvency Regulation of Depository Institutions: Past Policies and Current Options,” in William S. Haraf and Rose Kushmeider, eds., Restmctuting Banking and Finantial Services in America (American Enterprise Institute, Washington, D.C.). , 1985, “What’ Different About Banks?” JoumaL s 29-39. of MonetaryEconomics 15, January, Benston, George J., Robert A. Eisenbeis, Paul M. Horvitz, Edward J. Kane, and George G. Kaufman, 1986, Perspectiva on Safe and Sound Banking, (MIT Press, Cambridge, Mass.). Boyd, John H. and Edward C. Prescott, 1986, “Financial Intermediary Coalitions,” Journal of Economic Thory 38, April, 211-32. Fama, Eugene F. and Michael C. Jensen, 1983, “Agency Problems and Residual Claims,” JoumaL of Low and Economics 26, June, 327-49. Flannery, Mark J., 1988, “Payments System Risk and Public Policy,” in William S. Haraf and Rose Kushmeider, eds., Restmcmting Banking and FinanciaZ services in Ameriico (American Enterprise Institute, Washington, D.C.). Friedman, Milton, 1959, A Program for Monetary Stabihy (Fordham University, New York City). Brickley, James A. and Christopher M. James, 1987, “The Takeover Market, Corporation Board Composition, and Ownership Structure: The Case of Banking,” Journal of Law and Economics30, April, 161-80. Friedman, Milton and Anna J. Schwartz, 1963, A Monetav Historyof the UnitedStates, 1867-1960, (National Bureau of Economic Research, New York City). Cannon, James G., 19 11, C/earingHouses: Thr History,Models, andAdministration, London: Smith, Elder, and Company, 1901, reprinted in National Monetary Commission,Vol. 6, Washington, D.C. Garbade, Kenneth and William L. Silber, 1979, “The Payment System and Domestic Exchange Rates: Technological Versus Institutional Change,” Journalof MonetaryEconomics 5, January, l-22. Constitution of the Nm 1903. Goodfriend, Marvin, 1987, “Central Banking Under the Gold Standard,” in CameghRockester ConferenceSeries on Public Pohy, forthcoming. York Clearing House Association,May Corrigan, E. Gerald, 1987, FinancialMatket Stmcture: ALonger fia, Federal Reserve Bank of New York Annual Report. de Roover, Raymond, 1979, Th Rlj, and Lleclineof tke Medici Bank, f397-1494 (W.W. Norton and Company, New York). Edwards, Franklin R., 1988, “Consolidation, Concentration, and Competition Policy in Financial Markets: The Past and the Future, ” in William S. Haraf and Rose Kushmeider, eds., Restmctun~g Banking and Financial Serwices in A&a (American Enterprise Institute, Washington, D.C.). 22 ECONOMIC REVIEW, Goodfriend, Marvin and Robert G. King, 1988, “Financial Deregulation, Monetary Policy, and Central Banking,” in William S. Haraf and Rose Kushmeider, eds., Restructuring Banking and Financial Sewices in AmeriGo(American Enterprise Institute, Washington, D.C.). Goodfriend, Marvin and William Whelpley, 1987, “Federal Funds: Instrument of Federal Reserve Policy,“.in M. Goodfriend, Monetav PO&~ in Practice, Federal Reserve Bank of Richmond. JANUARY/FEBRUARY 1991 Goodhart, C.A.E., 1987, “Why Do Banks Need a Central Bank?” oxfor Economic Papm 39, March, 75-89. Gorton, Gary and Donald J. Mullineaux, 1987, “The Joint Production of Confidence: Endogenous Regulation and Nineteenth Century Commercial-Bank Clearinghouses,” Journal of Monq, &dir, and Banking 19, November, 457-68. Gorton, Gary B. and Joseph G. Haubrich, 1987, “The Paradox of Loan Sales,” in Metging Cornmenial and Investment Banking, Federal Reserve Bank of Chicago, 123-44. Heurtas, Thomas F, 1987, “Risk in the Payments System, in U.S. Congress, House, Committee on Government Operations, Stmctutz and Regulation of Financial Firms and Holding Companies (Part 3) 99th Congress, 2nd session, 361-89. Humphrey, David B., 1984, Tke U.S. PaymentsSystem: Costs, Ptiting, Competition. Monograph Series in Finance and Economics, New York University. Ireland, Oliver I., 1987, “Payment System Risk,” in U.S. Congress, House, Committee on Government Operations, Stmcture and Regulation of Financial Finnr and Holding Companies, Part 1, 99th Congress, 2nd session, 500-8. James, Christopher, 1987, “Some Evidence on the Uniqueness of Bank Loans,” Jouma~ofF;nan&lE 19, December, 217-35. Merton, Robert C., 1977, “An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees,” Journal of Banking and Finance 1, No. 1, 3-l 1. Mullineaux, Donald J., 1987, “Competitive Monies and the Suffolk Bank System: A Contractual Perspective,” Southern EconomicJournal 52, April, 884-98. Richards, R.D., 1929, T/le E&y Histutyof Banking in Engfand (P.S. King and Son, Ltd., London, U.K.). Smith, Clifford W., Jr. and Jerold B. Warner, 1979, “On Financial Contract: An Analysis of Bond Covenants,” J&ma/ of Financiai LGonomics June, 117-61. 7, Spahr, Walter Earl, 1926, Th Cleating and Collection Check of (Bawlers Publishing Company, New York). Stelzer, Irwin M., 1981, Selected Antitmxt Cases (Richard D. Irwin, Inc., Homewood, Illinois). Timberlake, Richard H., 1984, “The Central Banking Role of Clearinghouse Associations,” Journal of Money, Credit, and Banking 16, February, 1-15. Townsend, Robert M., 1980, “Models of Money with Spatially Separated Agents,” in John H. Kareken and Neil Wallace, eds., Modelsof Monetav Economics(Federal Reserve Bank of Minneapolis, Minneapolis). , 1986, “Financial Structures as Communication Systems,” in Colin Lawrence and Robert Shay, eds., Technologial Innovation, Reguiation, and the Monetary Economy (Ballinger Publishing Company, Cambridge, Mass.). Jensen, Michael C. and William H. Meckling, 1976, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of FinanCal Economics 3, October, 305-60. 1983, The Morgan Guaranty Jevons, William S., 1875, Moneyand the Mechanrjmof Iixdange (D. Appleton and Company, New York). “The Tug-of-War Over Float,” Survq, December,1 1-14. King, Robert G. and Charles I. Plosser, 1986, “Money as the Economics17, Mechanism of Exchange,” Journalof Monetary January, 93-l 15. U.S. Congress, House, The Subcommittee of the Government Operations and the Committee on Banking, Finance, and Urban Affairs, The Role of the Federal Reserve in Check C/earing and the Nation’ PaymentsSystem, Hearings, 98th s Congress, 1st session, 1983. Lindow, Wesley, 1963, “Bank Capital and Risk Assets,” The National Banking Review, Comptroller of the Currency, U.S. Treasury Department, September, 29-46. Litan, Robert E., 1986, “Taking the Dangers Out of Bank Deregulation,” Bookings Review, Fall, 3-12. Lucas, Robert E., Jr., 1980, “Equilibrium in a Pure Currency Economy,” in John H. Kareken and Neil Wallace, eds., Mode/ of Monetary Economics (Federal Reserve. Bank of Minneapolis, Minneapolis). McCallum, Bennett, 1983, “The Role of Overlapping Generations Models in Monetary Economics,” in Karl Brunner and Allan H. Meltzer, eds., Money, Monetary Policy, and Finan&/ Znsti~tiotzs, Carnegie-Rochester Conference Series on Public Policy 18, Spring, 9-44. , 1985, Bank Deregulation, Accounting Systems of Exchange, and the Unit of Account: A Critical Review,” in Karl Brunner and Allan H. Meltzer, eds., The New Monetary Economics, Fiscal Issues, and Unemployment, Carnegie-Rochester Conference Series on Public Policy 23, 13-45. Mengle, David L., David B. Humphrey, and Bruce J. Summers, 1987, “Intraday Credit: Risk, Value, and Pricing,” Federal Reserve Bank of Richmond Economic Review, January/February, 3-14. FEDERAL RESERVE Usher, A.P., 1967, Tke Ear/y History of Deposit Banking in MeditteraneanEurope (Russel and Russel, New York). Watts, Ross L., and Jerald L. Zimmerman, 1983, “Agency Problems, Auditing, and the Theory of the Firm: Some Evidence,” Journal of Law and Economics 26, October, 613-33. Westerfield, Ray B., 192 1, Banking Prim$~ks and Practice, Vol. 3, (The Ronald Press Company, New York). White, Eugene Nelson, 198 1, “State-Sponsored Insurance of Bank Deposits in the United States, 1907-1929,” Journal of EconomicHistory41, September, 537-57. Whitney, D.R., Cambridge, 1878, TireSt&/k Bank (The Riverside Press, Mass.). Williams, Jeffrey C., 1984, “Fractional Reserve Banking in Grain,” Journal of Money, Credit, and Banking 16, November (part l), 488-96. Young, John E., 1986, “The Rise and Fall of Federal Reserve Float,” Federal Reserve Bank of Kansas City Economic Review, February, 28-38. BANK OF RICHMOND 23 A Reserve Bank for Richmond James Parthemos* Not less than eight nor more than twelve. That was the number of regional reserve banks specified in the Federal Reserve Act of 19 13. To implement its provisions, the Act called for the establishment of a Reserve Bank Organization Committee made up of the Secretary of the Treasury, the Secretary of Agriculture, and the Comptroller of the Currency. The first two of these offices were held, respectively, by William Gibbs McAdoo and David F. Houston. The third was vacant at the time of the passage of the Federal Reserve Act, but shortly afterward President Wilson appointed John Skelton Williams, a well-known banker and businessman of Richmond, Virginia, to fill the vacancy. Senate action on that appointment, however, was delayed until mid-January. In early January, McAdoo appointed H. Parker Willis to head a special subcommittee of technical experts, styled the Preliminary Committee on Organization to assist with the work. Not content to await the report of this group, McAdoo and Houston, constituting a quorum of the Organization Committee, set out to hold their own hearings. Hearings were held first in New York, beginning on January 4, then in Boston, with the Committee returning to Washington for hearings on January 15. Following these, McAdoo and Houston traveled some 10,000 miles around the country and held hearings in 18 cities. In the course of these hearings 37 cities asked to be made headquarters of a reserve bank, supporting their petitions with generous reams of economic data mixed with large dollops of civic pride and booster spirit. Of the hearings, Houston wrote: It soon appeared that city, state, and sectional pride was involved; and that we were in for a great deal of roasting no matter what we decided. It also became obvious that if we created fewer banks than the maximum fixed by law, the Reserve Board would have no peace till that number was reached. . . . There was a vast amount of state and city pride revealed to us in the hearings; and to hear some of the speeches one would have thought that not to select the city of the advocate would mean its ruin and that of their (sic] territory. The author retired in 1985 as Senior Vice President and Director of Research of the Federal Reserve Bank of Richmond. A slightly longer version of this article, complete with footnotes, is available upon request. l 24 ECONOMIC REVIEW, The petition of the city of Richmond, Virginia, was heard at the Washington meeting on January 1.5. Also heard at these Washington meetings were delegations from Philadelphia, Pittsburgh, Baltimore, Washington, West Virginia, North Carolina, and South Carolina. The Campaign for a Richmond Location The Richmond banking community and the city’ s two major newspapers followed closely the progress of the Glass-Owen bill (the currency bill ai it was generally referred to at the time) through the legislative mill. The major role played by Virginians in shaping the bill and directing it through Congress gave the legislation special interest locally. Yet this interest did not translate into sentiment for locating a reserve bank in Richmond until after the bill became law. Contemporaneous newspaper accounts credit the incumbent governor, William Hodges Mann, with the initial suggestion that an effort be made to locate a reserve bank in Richmond. According to these accounts, Governor Mann, in a letter dated December 2, 1913, to Oliver J. Sands, a prominent Richmond banker, noted impending passage of the currency bill and suggested that Richmond might well be an appropriate site for one of the several reserve banks envisaged. Sands is reported to have approached the local clearinghouse association with the idea and to have found the members skeptical. According to one account, four of the six clearinghouse banks thought it would be “useless to work for a [reserve] bank for Richmond,” while the chairman of the association “doubted that the idea was worth a formal meeting.” Sentiment in favor of an active effort to have Richmond designated as a reserve bank site did not develop until after enactment of the bill on December 23. Articles in the local press on December 24, 25, and 26 did not include Richmond in listings of cities likely to be chosen as locations for reserve banks. On December 27, however, the city’ evening s paper, the N~XXU Leader, carried a front-page story under a three-column headline: “Reserve Bank To JANUARY/FEBRUARY 1991 Be Sought Here.” It reported that Sands had called a meeting of all local banks eligible for membership in the new system for Monday afternoon, December 29, at the Business Men’ Club, to be s followed by a meeting of the members of that club. The story noted that Atlanta was already “in the field as a candidate for one of the regional banks” and that “it is the belief of many bankers that the reserve bank to be located in the South will be placed either in that city or in Richmond. . . .” It added that the Richmond campaign “must accordingly be prosecuted with vigor.” Obviously the local banking community, perhaps under Sands’ initiative, had, quite suddenly, upgraded Richmond’ chances. The reasons for this are not s clear. On December 23, the day that President Wilson signed the Federal Reserve Act, it became known that John Skelton Williams, a Richmonder, would be appointed Comptroller of the Currency. That appointment, if confirmed by the U.S. Senate, would place the choice of regional reserve cities in the hands of a native son and two other Southerners, as McAdoo was a native of Georgia and Houston, of North Carolina. Whether the notion that an Organization Committee so constituted would tend to look with special favor on Richmond played a role in the reevaluation is moot. In any case shortly after passage of the Act it became clear that a sizable number of cities, including some in the Old South, would be vying for a regional reserve bank. In that context, the idea that Richmond, as a long-time leader of the Old South, might prove a likely site for a regional bank appears altogether reasonable independently of the makeup of the Organization Committee. The key role played by Virginians in devising, legislating, and now implementing the new system no doubt provided encouragement. But that it was the critical factor in the decision of the city’ s leaders to seek a reserve bank is questionable. That the Richmond leaders were not prepared to count on political favoritism is indicated by their retention at some early stage of two of the nation’ highly s regarded professional banking consultants to evaluate the case for locating a reserve bank in Richmond. These consultants-Charles A. Conant of New York and 0. P. Austin of Washington, D.C.-came to Richmond and after several days study pronounced Richmond an eminently appropriate site. Whatever the case, the December 29 meetings at the Business Men’ Club were decisive, dispelling s the doubts expressed earlier by the clearinghouse banks. The bankers’ meeting, under the chairmanFEDERAL RESERVE ship of Sands, quickly and unanimously passed the following resolution: Resolved: That the banks of Richmond cooperate with the commercial bodies of this city to secure the nomination of Richmond as the location of one of the federal reserve banks, believing that its banking capital and surplus, its geographical location and its railroad facilities with all points in the territory named, as well as its proximity to the great trade center, renders it the most convenient for those cities for the transaction of their business. As the natural point of trade for the South Atlantic states and portions of Tennessee and West Virginia it is entitled to such consideration. It is the most important city in finance, trade and population in the territory named. It is in the trend of trade and finance to the North and East and numbers now among its depositors a large number of banks in the sections named. The Business Men’ Club, meeting the same day, s endorsed the resolution and joined the bankers in calling on all local civic groups to appoint committees to constitute a grand Committee on Locating a Federal Reserve Bank in Richmond. From that point until the selection of reserve bank sites on April 2, the local press joined the city’ s several civic groups in a campaign remarkable for its unbridled American booster spirit and for its effectiveness in putting together a convincing case in a brief span of time. Civic groups responded promptly and on December 31 the Committee for Locating a Federal Reserve Bank in Richmond was formally established. An executive committee was appointed to plan and direct the campaign. Sands was named chairman of this committee. A slogan was adopted: “A Southern Bank for A Southern People.” The Committee went to work immediately, with enthusiasm. Headquarters were set up in the Business Men’ Club and a clerical staff quickly assembled. s Literature promoting Richmond’ advantages over s other South Atlantic cities was hastily prepared for dissemination over a broad area deemed to comprise an appropriate Richmond reserve district. Local teams worked feverishly gathering data from the city’ banks, railroads, commercial establishments, s and other organizations for preparation of briefs to be presented to the Organization Committee. Field committees were set up to visit key cities in the Southeast to solicit support for the Richmond site. Time was short since it was known early in January that the Organization Committee would hear Richmond’ claim on or about January 15. s In delineating an appropriate Richmond reserve district, the Richmond leaders obviously wanted to justify their slogan: “A Southern Bank for A Southern BANK OF RICHMOND 25 People.” But the slogan itself occasioned some confusion. Should there be just one Southern bank for Southern people or could there be two? At that early stage it was not clear just how many regional banks would be established and judgments regarding the geographical limits of a proposed Richmond district were necessarily tentative. There was some tendency to think in terms of the old Confederacy and field committees were set up to visit cities as distant as Birmingham, Alabama and Houston, Texas. But it was decided to place before the Organization Committee a proposed district that embraced Virginia, the Carolinas,. Florida, the southern half of West Virginia, and large parts of eastern Kentucky, eastern Tennessee, and eastern Georgia. The boundaries of the proposed district might well have been influenced by the Richmond leaders’ perception of the competition they confronted. Washington, Baltimore, and Atlanta were viewed as principal competitors, although the first mentioned appears to have been taken progressively less seriously with the passage of time. Without powerful senators and congressmen to press its case, with little standing as a commercial or financial center, and with general suspicions that an institution located in the nation’ capital would be subject s to political influence, Washington was at a disadvantage. The inclusion of a sizable portion of the state of Georgia might well have been designed to denigrate Atlanta’ claim and to focus attention on s New Orleans as the likely site, next to Richmond, of an appropriate Southern reserve bank. The initial exclusion of Maryland was rationalized on grounds that Maryland was neither a truly Southern state nor properly a part of the same geographic region as the area south of the Potomac. But there was also a suggestion here that Baltimore might more appropriately be lumped with Philadelphia rather than with the South Atlantic states. Despite the great geographic extent of the proposed district, the Richmond campaign concentrated its promotional efforts heavily in the two Carolinas. A team under the leadership of W. T. Dabney, business manager of the Richmond Chamber of Commerce, toured the two states between January 6 and January 17 touting the advantages of Richmond and the benefits to the Carolinas that would result from the location of a reserve bank in that city. Both local newspapers followed the tour closely day by day, reporting with obvious satisfaction the support expressed in virtually all the cities visited. Meanwhile, the staff at headquarters at the Richmond Business 26 ECONOMIC REVIEW, Men’ Club worked long hours busily preparing s promotional literature for circulation among business and banking groups in the key cities of the proposed district and receiving a mounting number of endorsements for Richmond, mainly from banks in the Carolinas. A problem developed for the Richmond touring group when, while the tour was in progress, Charlotte and Columbia decided to seek regional banks. The campaigns of these two cities were mounted hastily, however, and lacked the comprehensive organization and drive of the Richmond campaign. They were seriously hampered, moreover, by the fact that many of the leading bankers of their states had already openly pledged support for Richmond. This was especially the case with respect to Charlotte. Bankers in Raleigh, Winston-Salem, Rocky Mount, Tarboro, Concord and in numerous smaller towns had enthusiastically endorsed the Richmond candidacy and the state’ bankers’ association was s pledged to send a delegation to support the Richmond cause at the January 1.5 hearings in Washington. In South Carolina, Spartanburg, Greenville and Charleston had already strongly endorsed Richmond and by mid-January some South Carolina bankers were mounting an effort to coax Columbia bankers into a like endorsement. The Charlotte and Columbia campaigns can best be explained, perhaps, as efforts to position these cities as sites for branches of the regional head offices at some later date. In any case, the Richmonders handled this problem adroitly, refusing to be drawn into an open confrontation with major cities of the Carolinas. Rather their tactic was to seek endorsement of Richmond as the second choice of both Charlotte and Columbia. By mid-January the basic strategy underlying the Richmond effort had crystallized firmly. It was, first, to forge a solid alliance of Virginia with the Carolinas, the three states to constitute the core of a reserve district to be expanded as necessary to meet the statutory capital requirements for a reserve bank. An important element in this alliance was general agreement that the Carolinas should express unalterable opposition to being linked to any city to their south or their west. The oft-repeated argument was that the normal commercial and financial flows from the South Atlantic states ran from the south to the north and northeast and could be accommodated adequately only by a city to their north and preferably by one fairly close to the great commercial and financial centers-of the East. Against that background, JANUARY/FEBRUARY 1991 strong emphasis was placed on the substantial advantages of Richmond as .a transportation and communication center relatively easily accessible to even remote parts of the Southeast and within quick reach of all the large Eastern centers. I The strategy also contemplated dealing with rivals. There was general understanding of the probability that location of a bank at Philadelphia would seriously undercut the chances of Baltimore and Washington. Hence Richmonders at a fairly early stage tended to favor Philadelphia. Southward, a systematic effort was launched to put banks in the Carolinas on record as opposing any connection with Atlanta. Charlotteans, in particular, actively ,opposed Atlanta, tending to favor New Orleans over that city, believing perhaps that a regional bank in Atlanta would prejudice Charlotte’ chances for even a branch bank. s The Washington Hearings The Richmond campaign was managed with notable skill, commanding the plaudits even of its rivals. Floods of promotional literature were disseminated over the South Atlantic region, reaching small towns as well as the principal cities. The tours of the traveling teams-referred to variously as ‘ eminently “missionaries” or “boosters’ -proved successful in creating a crucial solidarity between Virginia and the Carolinas. The state of Virginia was mobilized fully and enthusiastically behind the city’ s effort, with newspapers in every section offering dayby-day accounts of the progress of the campaign. In the best spirit of American boosterism, the city’ s mayor, the state’ governor and governor-elect, and s the general assembly .were all pressed into the service of the campaign. Similarly, the state’ congress sional delegation was committed to using its influence and best efforts on behalf of Richmond. Meanwhile the local committee was preparing to make its case before the Organization Committee on January 15. Much of the burden of preparing the brief to be presented fell on George J. Seay who had also been a leading performer in the presentations made by the traveling groups in the Carolinas. Seay was selected to make the oral presentation before the Organization Committee. There were only 18 days between the time Seay was-retained by the local committee and the date of the hearings and many of these days were spent promoting Richmond’ case s in the Carolinas. Despite the brief period of time available ‘ him Seay produced a well-reasoned brief, to offering much statistical data. in support of. Richmond’ candidacy. The argument was predicated on s FEDERAL RESERVE the establishment of a reserve district, made up mainly of South Atlantic states with parts of West Virginia, Kentucky, and Tennessee. The.. brief emphasized: (1) The’ city’ geographical location,, providing a s natural point of linkage between the’South’ Atlantic and the great centers’ of the Northeast in the predominantly south-to-north flow of commerce and finance. ‘ . (2) .The. city’ superior transportation and coms munications facilities, with north-south -and eastwest rail lines,. supplemented by river and coastal waterways allowing .quick and economical contact with virtually every point in the proposed district, thus providing a *natural point for clearing checks and distributing currency. (3) Virginia’ preeminence among Southern states s in banking and Richmond’ extensive banking cons nections, both as a holder of bankers’ balances and a lender, with all parts of the proposed district, showing Richmond to be a natural reserve center despite its exclusion from the list of official reserve cities. (4) Richmond’ importance as a commercial as s well as financial center, with long-standing friendly business connections with all parts of the proposed district. The brief offered banking, financial, and business statistics to compare Virginia, favorably, with other Southern states and to show Richmond to be better situated than any other city in the proposed district to become the site of a reserve bank. Finally, much was made of the heavy support for lthe Richmond candidacy throughout the proposed district but especially in the Carolinas. The local committee worked feverishly at organizing an impressive appearance before the Organization Committee. Delegations from the Carolinas, including high officers from each of the two states’ banking associations, were enlisted to accompany the Richmond delegation to Washington and to express their support before the Organization Committee. Governor Mann, Governor-elect Stuart and representatives from the General Assembly accompanied the Richmond delegation, which far -outnumbered that of any other city making presentations at the Washington hearings. The hearings were held in the office of John Skelton Williams, then an Assistant Secretary of the Treasury, and presided over by Secretary McAdoo. The chief.protagonist was Seay. In his presentation BANK OF’ RICHMOND I 27 he demonstrated an impressive knowledge of the details and intentions of the Federal Reserve Act as well as of the economic characteristics of the proposed district. Despite a grandiloquent style that was more appreciated in 19 14 than today, and a generous use of hyperbole in pressing Richmond’ claims, he s was generally given high grades by his contemporaries as an advocate of the city’ cause. s Supplementing Seay’ presentation were shorter s statements by William T. Reed, T. M. Carrington, S. C. Mitchell, and Sands. The statements of the first three were concerned with Richmond’ impors tance as a commercial and manufacturing center, its commercial and industrial development in recent years, and its potential for growth in the future. Sands’ statement was directed at demonstrating why a branch, rather than a regional head office, could not adequately serve the area that looked to Richmond for commercial and financial leadership. Following these statements, John R. Saunders, a member of the Virginia Senate, offered the rhetorical support of the Virginia General Assembly. There was some anomaly in the position of the Carolinians who had come to support Richmond’ s claims. At the time of the hearings Charlotte, N.C., and Columbia, S.C., were vigorously pressing their own campaigns. A strong show of support for Richmond would accordingly undercut these campaigns. This might prove especially embarrassing for Charlotte, whose delegation was scheduled to be heard on the l&h, following Richmond’ presens tation. Nevertheless both Carolinas’ delegations came out with strong and unambiguous support for Richmond. Both also argued vigorously against being placed in an “east-west” as opposed to a “northsouth” district. They opposed, with equal vigor, being connected with any city to their south or west. The Revised Brief The Richmonders left the hearings confident that they had made a convincing case, yet acknowledging that there was still work to be done. McAdoo and Houston had raised a number of questions at the hearings, suggesting a need for a more complete brief than the hastily prepared fust one. Accordingly, Seay undertook to provide a more systematic and complete essay, documenting his case more thoroughly with banking and economic data on the proposed district. This brief was submitted to the Organization Committee on February 17. While some sentiment had developed for making adjustments in the proposed district,‘ Seay held fast to the initial boun28 ECONOMIC REVIEW, daries. The covering letter, however, suggested that the proposed district could be extended to include the District of Columbia, Maryland, and northern West Virginia without prejudice to the argument for a Richmond location. The added area, it was noted, could be served by a branch at Baltimore. The revised document, while more carefully drawn than the first, repeated essentially the same arguments as the initial ones elaborated at the January 1.5 hearings. It did, however, include additional evidence buttressing the contention that Richmond was overwhelmingly the popular choice in the proposed district. It reported a poll of some 1,350 banks in the region which showed Richmond to be the first choice of 952, second choice of 305, and,third choice of 78. Thus an overwhelming majority expressed moderate-to-strong preference for Richmond. Of twelve other cities for which preference was expressed, none received more than 112 first preference votes nor more than 163 moderate-to-strong preference votes. Even more than the first brief, the second laid heavy emphasis on the solidarity of Virginia and the Carolinas, insisting that the three states constituted a nucleus for a south-to-north district that could best be served by a regional bank at Richmond. Seay wrote: . . . there is a very strong feeling in Virginia, North Carolina, and South Carolina that they must be included together in any zone which may be formed, and that whatever territory may be incorporated in their zone, a Federal Reserve Bank located in Richmond would serve their interests better than if located in any other city. The interests of these three states are too closely interwoven to be separated. As in the first brief, Richmond’ advantages were s touted in grandiloquent, often florid, prose. Seay closed it with a turgid and unashamedly hyperbolic emotional appeal: Richmond has a place in the affections of the South which no other city possesses. She has a place in the annals of the nation and the world \which is imperishable. The debt of the nation to Virginia is inextinguishable. It is difficult to see how this Republic could have been formed without Virginia. Richmond has that dignity of standing, that atmosphere of sentiment and history, that position in science and learning, which render her worthy of any honor or distinction that can be bestowed upon her, and the intelligent judgment of the whole country, having a knowledge of these considerations, would approve the location of a Federal Reserve Bank in Richmond. JANUARY/FEBRUARY 1991 The names of Virginians will be associated for all time in the financial history of this country with the Federal Reserve Act. All of these considerations preeminently distinguish Richmond as the location of a Federal Reserve Bank. Thus did Seay dun the Organization Committee for the historic services of Virginia and Richmond. But the Richmond leaders were not content to rest their case strictly on Seay’ brief. Two additional s briefs were prepared. The first of these was prepared by a consultant, 0. P. Austin, who sought to demonstrate, first, that the proposed district constituted a distinct and differentiable economic region, with a diverse agricultural and industrial base sufficiently large to require its own regional reserve bank. Second, he undertook to show that Richmond was the ideal site for the reserve bank for this district. He argued that the “great mass of distinctively southern products can be more intelligently understood and financed from a distinctively southern s city. . . .” The interests of the region’ producers, he added, could be “better served from Richmond than Washington, which has no active business relation with the producing, manufacturing, or commercial interests, or from Baltimore, which is still farther removed from the area of the chief production of these peculiar and distinctively ‘ local products.” The second supplement to Seay’ brief was a s memorandum prepared by William T. Reed of the Richmond Chamber of Commerce and titled “Statement Showing Freight Rates from Richmond to southern West Virginia, eastern Kentucky, eastern Tennessee, North and South Carolina and Georgia; also tonnage from Virginia cities into North and South Carolina and Georgia.” According to this memorandum the railroads serving the proposed district “years ago recognized Richmond as the proper distributing point, and [the proposed district] as the natural territory to Richmond, owing to the fact that they were enabled to give quick service, and from one to four days quicker delivery than Baltimore, or any city north of us.” Rates into the proposed district from Richmond, it noted, were accordingly fixed at 13 percent below those from Baltimore. The memorandum also gave statistics on tonnage shipped from Richmond and other major Virginia cities to the Carolinas, Georgia, and Florida, noting that data for shipments to eastern Tennessee, eastern Kentucky, and southern West Virginia were not readily available. It openly questioned the claim made by Baltimore’ s representatives at the Washington hearings that FEDERAL RESERVE. Baltimore’ tonnage to the Carolinas, Georgia and s Florida exceeded Richmond’ s and challenged Baltimore to produce the statistics. Seay’ extended brief supplemented by these two s addenda, constituted the Richmond case as finally presented to the Organization Committee. These three elements, along with supporting statistical charts and maps, were bound together in hardcover, under title of A Natural and Economic Tmitory jbr a Federal Reserve DistrictwithRichmondRF th Location of the Bank, and distributed generously throughout the proposed district. Thus Seay’ grandiloquent s appeal was addressed not only to the Organization Committee but also to much of the Old South by way of mobilizing support for the claims of the capital of the fallen Confederacy. The Choice Richmond’ s two daily newspapers followed closely the progress of the Organization Committee’ s grand tour, reporting every rumor and speculation regarding Richmond’ chances of securing a regional s bank. Press comment reflected increasing confidence on the part of the campaign’ leaders who appeared s convinced that they had made a strong case. There was general satisfaction with the quality of the revised brief. With the help of the press, leaders were able to maintain a high pitch of enthusiastic support from virtually every organized group in the state, while its congressional delegation pressed the Richmond case in Washington. Despite rival campaigns by Charlotte and Columbia, support for Richmond in both Carolinas was strong and growing. These rival campaigns lost momentum after mid-February, with both cities coming out in favor of Richmond as a strong second choice. Great hope was placed in presenting a united front with the two Carolinas, insisting that the three states be placed in the same district with the reserve center located to accommodate northsouth flows of commerce and finance. This, it was thought, would establish an important Richmond advantage over Atlanta. As for the northern end of the proposed district, an important consideration was the question of the size of the reserve bank that would almost surely be established.in New York. Given the heavy concentration of banking capital and resources in a relatively small geographic area of the Northeast, the problem of keeping the several reserve banks of reasonably uniform capitalization, as required by law, could be addressed only if the reserve districts there could be kept geographically small. As this problem received BANK OF RICHMOND 29 increasing attention, there emerged a high probability that the area north of the Potomac and east of the Great Lakes would have to be divided into three reserve districts, a probability which was well appreciated by the Richmond leadership. New York and Boston seemed certain choices. The contest for the third was between Philadelphia and Baltimore and the outcome was of crucial interest to Richmond. The choice of Baltimore would almost certainly doom Richmond’ chances, while the choice of Philadelphia s would undercut the cases of Baltimore and Washington. Of this, the Richmond leaders were quite aware. As the work of the Organization Committee progressed and was commented on and analyzed in the press, Richmond’ leaders appeared to have increass ing reasons for optimism. In their view, the city’ s superior transportation and communications links between the South Atlantic and the great centers of the Northeast had been demonstrated. Hence Richmond could be shown to be a natural clearing point for checks originating in the South Atlantic states as well as a natural reserve center. On top of this they could add the city’ historic claim to cultural leaders ship of the Old South, which was no small matter, and a claim on the chief architects of the new Reserve Act. Now that, in their own perception, the claims of their chief rivals were crumbling, there was every reason to expect a favorable outcome to their intense efforts. Rumors that Richmond would in fact be chosen for one of the reserve banks began to appear in the press in March. On March 25, the Washington correspondent of the Nms L,eader noted “persistent reports . . . in circulation in Washington that Richmond will be selected by the Organization Committee as one of the twelve regional bank cities. . . .” He added: Three weeks ago your correspondent told of the intimation in semi-official circles that the Virginia capital city was in the lead for the reserve city of South Atlantic states banking region. He then quoted a story in the Nm York &n of March 25 naming, “Upon reliable authority,” the following “tentative list” of reserve cities: “Boston, New York, Washington or Richmond, Chicago, St. Louis, San Francisco, Kansas City, Cincinnati, Atlanta or New Orleans, Dallas or Houston, and Minneapolis.” 30 ECONOMIC REVIEW, On the following day the same journal carried a front-page story entitled “Richmond to Get Regional Bank.” The story, attributed to unofficial but “high and trustworthy sources,” noted that Richmond had won her fight for a regional bank. But it added that the Organization Committee had not yet voted on the issue. Rather it reported that the Committee had ruled out Baltimore and Washington on grounds that a bank at Philadelphia was necessary to contain the size of the bank at New York. The Organization Committee’ s announcement came on April 2. By prearrangement, John Skelton Williams, the Comptroller of the Currency, had agreed to telephone the Richmond campaign to convey the decision immediately following the Committee’ final meeting, scheduled for the late s afternoon of that day. The Richmond, leaders expected a call at around 6 p.m. To receive it they gathered, in high hopes, in the banking offices of John L. Williams, father of the Comptroller of the Currency. The city’ campaign leaders, along with s Governor Stuart and other political leaders, some one hundred according to press reports, were present. The expected call came and the Comptroller of the Currency talked directly to E. L. Bemiss, his brotherin-law and a prominent local banker. Bemiss undertook to repeat for the benefit of the group each sentence of the communication. The Comptroller provided a touch of drama to the occasion as he toyed with the expectations of the crowd. He began by announcing District 1, with the reserve bank at Boston, and outlining the boundaries of the district. He did the same for District 2, New York: then District 3, Philadelphia; and District 4, Cleveland. Meantime, Seay, George C. Gregory, and Sands, sat before large maps of the United States tracing out the boundaries described by Williams. Then without explanation, Williams skipped District 5 and shifted to District 12, San Francisco, then moved on to 11, Dallas: 10, Kansas City; 9, Minneapolis; 8, St. Louis; and 7, Chicago. He then announced, in what the local press called “a spirit of grim humor” that that was all. The crowd knew better, however, since it could be seen from the maps that the great southeastern section of the country was left without a reserve bank. Pressed, Williams mockingly admitted that there was another district, centered on Atlanta. When he laid out the boundaries of that district, it was clear that there remained yet another made up of Maryland, the District of Columbia, West Virginia excluding four panhandle counties, Virginia JANUARY/FEBRUARY 1991 and the Carolinas. After a pause to allow the crowd to mull the question of whether the center of that final district would be at Baltimore, Washington, or Richmond, Williams ended the suspense. On the announcement that Richmond was the choice, the local leaders joined hands and gave a loud cheer. The Reaction The announcement touched off a fever of excitement locally, putting the city in a mood for high celebration. Local newspapers in the days following were filled with self-congratulatory accounts of how the city earned the distinction, heaping praise upon the campaign leaders. On April 3, the morning after published a the announcement, the Times-Dispatch special 16-page Federal Reserve Section, chronicling the details of the long campaign and including pages of advertisements by local banks and businesses congratulating the city on the successful issue of the campaign. Much credit for the campaign’ success was attris buted to the brief presented to the Organization Committee. “The brief was convincing,” one story noted. “Richmond’ claim was based upon Richs mond’ financial strength and its ability to serve the s section included in its region.” Seay’ role in the cams paign was emphasized and his brief was reprinted in full. The Richmond team, the editor added, “presented a case unexcelled by any laid before the Organization Committee.” The Richmond press was especially profuse in its expression of gratitude to support from neighboring states. Recognizing the crucial help of these supporters, the editor of the Times-Dispatch wrote on April 3, “. . . Richmond would not this morning be a Federal reserve city had not our friends in Virginia, in North Carolina, in South Carolina, in East Tennessee and in West Virginia made it so.” Like expressions appeared in an editorial of the same day in the News LRader. Both newspapers featured pages of pictures of leading supporters from other state as well as local leaders. The significance of the reserve bank for the future of Richmond was discussed at length-and not without exaggeration-in both papers. Each carried special articles by some of the leading individuals involved in the Richmond campaign. For the TimesDispatchof April 3, for example, in an article under the headline “What Reserve Bank Means to Richmond,” Sands wrote: FEDERAL RESERVE The establishment and operation of an institution of such momentous power and wide influence as the Federal Reserve Bank of Richmond will give to the city of Richmond great prominence and will centre [sic] here the whole financial operations of this large and wonderfully prosperous territory. He added that on the night of the announcement “far sighted businessmen” predicted “great growth” in Richmond, commercially, industrially, and financially. A leading local banker was quoted as expressing a belief that Richmond would become one of the great cities of the country, noting that there was “practically no limit to what may be the ultimate outcome to this city of the action that has been taken today.” Every story-even every advertisement-in the April 3rd editions exuded euphoric evaluations of the city’ future. Richmond was referred to as a “finans cial Gibraltar,” the center of a “new financial empire,n the “seventh greatest financial center of the country.” Expectations ran high. In the exhilaration of victory, the city’ Chamber s of Commerce hastily planned a celebration to honor the campaign’ leaders and workers. A banquet s at the Jefferson Hotel honored the campaign’ s executive committee. Special honors were reserved for George C. Gregory, executive secretary of the committee, and invited guest George A. Holderness, president of the North Carolina Bankers Association and a strong supporter of Richmond’ candidacy from s the beginning. Some 800 attended the mass meeting and buffet supper. McAdoo, Houston, and Williams were invited to share in the occasion but all pleaded the pressure of additional work toward organizing the new system. The entire state rejoiced with Richmond at the news of the successful issue of the city’ campaign. s Editorials and news stories in the press of the state’ s other leading cities reflected the same exhilarationand the same exaggerated expectations of future benefits-noted in the Richmond newspapers. The banking communities of the Carolinas also expressed general satisfaction. The Charlotte, N.C., Daily O/U~# of April 4 noted that the choice met with general approval in Charlotte and throughout the state. Similar expressions appeared in the leading newspapers of both Carolinas, with some manifesting an enthusiasm approaching that of the Richmond press. BANK OF RICHMOND 31 The Baltimore Challenge r The selection of Richmond as the site of a reserve bank was not universally endorsed. The banking communities of Washington and Baltimore reacted with disbelief, their spokesmen suggesting that politics and favoritism had been determining factors in the Organization Committee’ decision. These two s great cities, Th Wkdington Postreported, “must now do all reserve business through [al comparatively small institution in the former capital of the Confederacy.” In both cities, civic pride and self-esteem had suffered a blow. The reaction in Washington and Baltimore was part of a much broader criticism of the Organization Committee. Of the 37 cities seeking a reserve bank, 25 were perforce disappointed. McAdoo, Houston, and Williams all came under personal attack for allegedly using influence to locate reserve banks in their home states. The choice of cities was subject to acrimonious debate in both chambers of Congress. In the Senate a resolution was passed calling on the Committee to submit the briefs of all cities applying for a reserve bank along with the reasons for its choices. The Committee responded in a report dated April 10, 1914. The report noted that in the poll of banks made for the Committee by the office of the Comptroller of the Currency, Richmond received more votes than any other city in the district- 168 as against 128 for Baltimore and only 2.5 for Washington. It pointed out, moreover, that leaving out the states of Maryland and Virginia, Richmond received from the rest of the district triple the votes for Baltimore. It cited the latest reports to the Comptroller as indicating that the business of the national banks of Virginia, including Richmond, exceeded that of their counterparts in Maryland, including Baltimore, or in any other state in the Fifth District. The same reports, it added, showed Richmond’ national banks were lending in the 13 s Southern states more than the national banks of any city except New York. Outside of Virginia and Maryland, the loans of Richmond’ national banks s to the remaining parts of the Fifth District were twice as great as those of the national banks of Baltimore and Washington combined. Despite the Committee’ prompt defense of its s decision, the choice of Richmond over Baltimore and of Atlanta over New Orleans continued to 32 ECONOMIC REVIEW. arouse opposition. The choice of Richmond found little favor in New York, where many bankers were critical of the delineation of reserve districts along the Atlantic seaboard. Especially in Washington and Baltimore, the hand of John Skelton Williams was seen as the determining factor in the Richmond location. Baltimore’ s leaders proceeded to mount a multifaceted campaign to reverse the Organization Committee’ choice of Richmond and to have the s reserve bank moved to Baltimore. They quickly formed a committee made up of the local board of trade, the clearinghouse association, the chamber of commerce, and a large miscellany of local trade associations. The city’ leaders expressed a deters mination to carry their appeal beyond the Organization Committee, if necessary, to the Federal Reserve Board when it was organized and even to Congress. The local press was an enthusiastic participant in these efforts, carrying stories and editorials detailing the “injustice” to the city. The press played a key role, especially in efforts to arouse enthusiastic popular support for the campaign. To that end the city’ leaders organized a massive demonstration in s downtown Baltimore on the evening of April 15. On April 29 Baltimore’ committee addressed a s letter to the Organization Committee requesting that the choice of Richmond be reviewed and noting that in the absence of action by the latter committee, an appeal would be made to the Federal Reserve Board when that body was constituted. The Baltimore group also requested that the Committee delay the organization of the Richmond reserve bank pending Federal Reserve Board action on the appeal. The Committee refused to grant either request. Nothing daunted, the Baltimore committee’ pros fessional staff proceeded to put together a carefully structured brief to support the appeal to the Federal Reserve Board. The Baltimore appeal, along with this brief, was filed with the Federal Reserve Board on September 11, 1914. The Richmond leadership, backed strongly by the local press, responded sharply to the Baltimore campaign. Something of an editorial war developed between the newspapers of the two cities. In spite of the efforts of the Baltimore media and city leaders to redirect the location of the reserve JANUARY/FEBRUARY 1991 bank, the Organization Committee forged ahead with the selection of Richmond. By mid-October, the Richmond reserve bank had been incorporated and its board of directors had been chosen. These included two top leaders of the Baltimore campaign, William Ingle, who was named chairman and Federal Reserve Agent, and Waldo Newcomer, chosen a Class A director. Such a prime position in the management of the new institution tended to assuage Baltimore’ s FEDERAL RESERVE loss and the city’ banking community apparently s accommodated itself to the Richmond choice, hoping to become a branch site. The appeal, however, remained before the Federal Reserve Board, which never acted on it. The issue was settled by a ruling by the Attorney General of the United States holding that the Board did not possess the authority to change the location of a reserve bank within a district. Thus ended the Baltimore challenge. BANK OF RICHMOND 33