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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

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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

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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

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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 [1980], McCallum 119833, and Townsend [1980]
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 [1980] 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 [1984] 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,” [1983], U.S. Congress, Th
Role of the Federal Resew in Check Cleatingand tke Nation’
s
PaymentsSystem 119833, and Young [1986].

18. See Whitney [1878].

36. Goodfriend and King (19881 evaluate the feasibility and
desirability of discount window lending to illiquid but
solvent banks.

19. Mullineaux [1987], p. 890.
20. Cannon [ 191 l] and Spahr [ 19261 contain good institutional
histories of check clearing.

37. See Anztian.lbipn&nce
[1963], 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
[1903], 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 [1903], 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
[1987], 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 [1979].
29. See Goodfriend [1987] for a discussion of the efficiency
gains, feasibility, and mechanics of central banking under
a gold standard.
30. Benston, et al. [1986], pp. 53-60, and Goodfriend
King [ 19883, make this point.
31

and

Goodfriend and King [1988] 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 [1988].
34. Mengle, Humphrey, and Summers [1987], 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 [1988]
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 [1981] 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.

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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