Question

What were some of the weaknesses of the national banking system that gave rise to the Federal Reserve Act?

Answer 1

The national banking act of 1863 and 1864 was made to give more rights to federal banks than state banks. The banking system was good enough in issuing notes but it also had certain problems and weaknesses in it which led to creation of federal reserve. Some of the main weaknesses of this banking system was inelasticity in issuing notes, immobility of the reserves, and absence or lack of availability of discount market.

In certain seasons, the need for money in the economy was very high, while in some off season it was very less. A sound banking system would ensure that the amount of bank notes in the market will in increase when the demand is high and it will reduce when there is no such demand. Therefore, bank notes should be elastic as per the demand in the economy for the bank notes. But under the national banking system, a bank was not allowed to print notes till it is backed with equal amount of government securities deposits in the treasury. Therefore, printing of more notes and increase of its circulation has depended more on market of government bonds instead of demand for money in the market, which made it inelastic.

Also, there were mismatch of reserves, unlike today, under national banking system there were no fixed rate of reserves that should be kept by banks. In some state banks were reserving as high as 25% of their deposits, while in some it was only 15%. Therefore, in case of harder times for banks which were keeping less reserves would not get help from stable banks with higher reserves and this can lead to bank failures and distrust on banking system in general.

Therefore, these were some of the weaknesses which compelled governments to implement a federal reserve structure that would ensure proper and effective regulation of banking system and which would not be reliant on government for the purpose of managing money circulation in the economy and also other banking matters.