Federal Reserve Act Summary

  • Last updated on November 10, 2022

By establishing the Federal Reserve system, the Federal Reserve Act of 1913 provided a central banking arrangement with the potential to improve the functioning of the American economy’s financial sector.

Summary of Event

In the wake of the severe financial panic of 1907, Panic of 1907 the Aldrich-Vreeland Act of May 30, 1908, Aldrich-Vreeland Act (1908)[Aldrich Vreeland Act] authorized emergency currency issues and established a National Monetary Commission National Monetary Commission to study the issue of permanent reform. The commission supported the 1911 bill sponsored by Senator Nelson Wilmarth Aldrich that called for a banker-controlled single central bank with branches, but public opinion weighed against the bill. Although the Aldrich bill was not passed, it outlined the basis for the Federal Reserve Act, which was enacted into law on December 13, 1913. The act represented the culmination of two decades of debate concerning how deficiencies in the American banking system could best be remedied. Federal Reserve Act (1913) Federal Reserve system Banking;legislation [kw]Federal Reserve Act (Dec. 23, 1913) [kw]Reserve Act, Federal (Dec. 23, 1913) [kw]Act, Federal Reserve (Dec. 23, 1913) Federal Reserve Act (1913) Federal Reserve system Banking;legislation [g]United States;Dec. 23, 1913: Federal Reserve Act[03480] [c]Banking and finance;Dec. 23, 1913: Federal Reserve Act[03480] [c]Laws, acts, and legal history;Dec. 23, 1913: Federal Reserve Act[03480] Glass, Carter Warburg, Paul Moritz Aldrich, Nelson Wilmarth Bryan, William Jennings Wilson, Woodrow [p]Wilson, Woodrow;Federal Reserve Act

The preamble to the 1913 law enumerates its goals: to provide for the establishment of Federal Reserve banks, to supply currency in amounts appropriate to the needs of the economy, to afford means of rediscounting commercial paper, and to establish more effective supervision of banking in the United States. The preamble does not mention discretionary central bank intervention intended to stabilize the economy countercyclically, but this type of intervention became commonplace. The twelve branches of the central bank were expected to operate fairly automatically. Changes in gold reserves would lead to corresponding movements in currency and credit under the rules of the international gold standard Gold standard then in effect. Federal Reserve bank note and deposit liabilities would automatically expand and contract according to the volume of U.S. business activity.

Under the law, banks that were members of the Federal Reserve system would own the Federal Reserve banks, as they would be required to purchase shares. The member banks would elect six of the nine directors of the system. The Federal Reserve Board, Federal Reserve Board appointed by the president of the United States, would exercise general supervision of the system and implement policy. President Woodrow Wilson would not agree to putting full control of the system in the hands of bankers. Instead, the Federal Advisory Council would make recommendations regarding the operations of the Federal Reserve Board and the Federal Reserve banks. The council was to be composed of twelve members, with the board of directors of each Federal Reserve bank electing one member.

All national banks, numbering about seventy-five hundred at the time, were required to join the system. Some national banks converted to state charters to avoid joining the system. State-chartered banks were permitted to join, but they were not required to do so. At first, very few chose to join, but amendments to the Federal Reserve Act in 1916 made membership more attractive. In response to the amendments and to President Wilson’s appeal to join the system out of patriotism, about nine hundred of the nineteen thousand state-chartered banks joined by the end of 1918.

Carter Glass, chairman of the House Banking Subcommittee and a key sponsor of the act, never tired of insisting that the Federal Reserve system was not a central bank. The decentralized nature of the system, with twelve separate banks, came as a response to a deep-rooted suspicion of concentrated financial power and hostility to Wall Street financial interests. Central banking had been tried twice before in the United States with mixed success. The Federal Reserve banks were expected to provide loose supervision, rather than strict control, of the monetary system of the United States.

The boundaries of the twelve Federal Reserve bank districts reflected convenience and how business was conducted at the time. District boundaries split twelve states. Most of Pennsylvania, for example, was in the third district, headquartered in Philadelphia, but the western counties were in the Cleveland district. The Boston district comprised all six New England states except for Fairfield County, Connecticut, which was part of the New York City district.

The system as a whole was under the supervision of the seven-member Federal Reserve Board, appointed by the president. It included the secretary of the treasury and the comptroller of the currency as ex officio members. Two of the five other members were to have experience in finance. That requirement was eliminated in 1922, when the number of freely appointed members was increased to six, so that an “agriculturalist” could be added to the board.

Charles S. Hamlin, Hamlin, Charles S. a Boston lawyer, was the first governor, or head, of the Federal Reserve Board. Frederic Delano, Delano, Frederic a Chicago railway executive, was the first vice governor. The other appointed members were Paul Moritz Warburg, a partner in the investment banking firm of Kuhn, Loeb & Company; W. P. G. Harding, president of the First National Bank of Birmingham, Alabama; and Adolph C. Miller, professor of economics at the University of California. Miller and Hamlin remained on the board until it was reorganized in 1936.

The amount of national bank notes issued previously had depended on the profitability of national bank ownership of government securities. By 1865, a congressional resolution had recognized the need for a paper currency that could change in its amount circulated according to the requirements of legitimate business. The Federal Reserve Act represented a shift from a bond-based to an asset-based currency reflecting the volume of commercial transactions. The amount of currency would expand and contract automatically to meet the needs of trade. To satisfy the followers of Democratic leader William Jennings Bryan, who opposed a strict gold standard, Federal Reserve notes were made obligations of the U.S. Treasury, although they were not given the status of legal tender until 1933. To ensure an appropriate volume of currency for each district, each Federal Reserve bank was made responsible for issuing its own notes.

Banks that were members of the Federal Reserve system had the right to “rediscount” loans that they had issued, using them in effect as collateral against loans from the Federal Reserve banks in their districts. To simplify this procedure, a 1916 amendment to the Federal Reserve Act permitted advances to member banks secured by this type of collateral or by U.S. government securities. The district reserve banks established the interest rate charged for discounts and advances “with a view of accommodating commerce and business,” according to the words of the law. In the early years of the system, discount rates varied among the districts, with the rate structure adapting to local conditions. After 1917, the rates tended to uniformity.

Loans that were eligible to be discounted, or used as security for loans from the Federal Reserve banks, were defined elaborately in the law. That definition relied heavily on the commercial loan theory, also known as the real bills doctrine. Loans eligible for discounting were to be self-liquidating; that is, they were not to be speculative but instead were to finance carrying, production, or marketing costs for products that already had been contracted for sale. In order to encourage development of a market in bankers’ acceptances, a source of credit to finance international transactions, the Federal Reserve system stood ready to buy them at favorable rates.

Member banks were required to keep reserves against withdrawals by depositors as a safety measure. Mandatory reserves of member banks were lower than previously required of national banks and could be kept as vault cash or as deposits at a Federal Reserve bank. The reduction in required reserves was deemed appropriate in view of the centralization of reserves within the Federal Reserve system and the availability of rediscounting at the Federal Reserve banks, through which member banks could get cash to meet withdrawals. The 1913 law also distinguished between demand deposits and time (including savings) deposits, requiring a much lower percentage of the latter to be set aside as reserves. Under a June, 1917, amendment, all required reserves had to be in the form of deposits at a Federal Reserve bank. Vault cash no longer counted, but the percentages of deposits that had to be held as reserves declined dramatically. Later, vault cash would again be counted against the reserve requirement.

Significance

With the opening in November, 1914, of check-clearing facilities of the twelve Federal Reserve banks came significant improvements in the payments mechanism. Circuitous, time-consuming arrangements to collect payment on out-of-town checks were no longer needed. Member banks were required to pay the face value of checks drawn against them when those checks were presented for collection at a Federal Reserve bank.

The Federal Reserve system had a goal of making payment of checks at face value, or “par,” universal. That goal was abandoned under pressure from Congress after the U.S. Supreme Court declared in 1923 that state laws protecting nonpar payments were constitutional. By the end of 1928, almost four thousand state banks that were not members of the Federal Reserve system chose to be “nonpar banks.” Ineligible because of this choice to clear checks through the Federal Reserve system, these banks turned to large “correspondent” banks in financial centers to collect out-of-town checks and for other services. Many banks eligible for clearing services through the Federal Reserve system also found it more convenient to use correspondent banks. Member banks, in addition to keeping legal reserves with their local Federal Reserve banks, continued to keep active balances with correspondent banks. Private banks thus did not abandon their prior relationships to take full advantage of what the Federal Reserve system had to offer.

The federal government itself made little use of the Federal Reserve banks before World War I. The U.S. Treasury continued to use national banks as depositories, but beginning in 1916 it increasingly did business through the Federal Reserve banks. The role of the Federal Reserve system as fiscal agent of the government was enhanced when subtreasuries, an arrangement in effect since 1846, were discontinued in 1921.

An amendment to the Federal Reserve Act in September, 1916, allowed advances by Federal Reserve banks to member banks to be secured by the member banks’ holdings of U.S. government securities. At the time, the federal debt was declining, and most of it served to secure national bank notes. That situation changed radically within a few months as the United States entered World War I. The U.S. Treasury used the Federal Reserve system to finance a swelling national debt on easy terms. Reserve banks made loans at preferential rates to member banks that in turn made loans to purchasers of war bonds. The Federal Reserve did not regain its freedom to raise the rates it charged on loans to member banks (the discount rate) until November, 1919, after installment payments on the Victory Loan of April, 1919, had been completed.

In the face of a severe postwar recession in 1920-1921, the discount rate was not reduced until May, 1921, a year after the index of wholesale prices had peaked. The Federal Reserve Act allowed for open-market operations (purchases and sales of government securities by the Federal Reserve system) as a device to make the discount rate effective and to control interest rates in the open market. In 1922, the Federal Reserve system bought $400 million in securities, partly as a means of obtaining earnings so that it could pay the dividends to member banks that were required by law. In 1923, open-market operations began to be used as a major instrument to control credit conditions.

During the economic downturn between May, 1923, and July, 1924, the Federal Reserve system cut the discount rate and the Open Market Committee authorized purchases of government securities as a means of providing banks with reserves that they could then lend out. Similar measures were taken in response to the milder recession between October, 1926, and November, 1927.

The Federal Reserve banks were expected to act as a “lender of last resort” to member banks, providing loans to financially sound member banks that could not get loans elsewhere. This provision was expected to prevent financial panics, as depositors did not have to worry about banks running short of cash to meet withdrawals as long as those banks were financially sound. Banks could simply discount some of their loans at the local Federal Reserve bank if they temporarily came up short of cash.

The stock market boom of the late 1920’s led Federal Reserve system officials to worry that speculation in the market would absorb excessive amounts of credit. They therefore increased the discount rate in January, 1928, in an attempt to slow speculative lending. They reversed direction and eased credit slightly when stock prices collapsed in the fall of 1929. The system largely stood by, however, as the means of payment (currency plus demand deposits) declined by about one-fourth between 1929 and 1933 and as the American banking system collapsed in the early 1930’s. When banks failed, many depositors lost most or all of their money.

Bank runs and losses inflicted on small depositors by bank failures prompted passage of the Banking Act of 1933, which established the Federal Deposit Insurance Corporation (FDIC). Through the FDIC, deposits were insured against bank failure. In 1935, Congress reorganized and significantly strengthened the Federal Reserve system, giving it more centralized control over the American banking system in the hope that greater control could be used to avoid a recurrence of the disaster of the early 1930’s. Federal Reserve Act (1913) Federal Reserve system Banking;legislation

Further Reading
  • citation-type="booksimple"

    xlink:type="simple">Board of Governors of the Federal Reserve System. The Federal Reserve System: Purposes and Functions. Washington, D.C.: Author, 2002. An official exposition for the general public. Periodically updated.
  • citation-type="booksimple"

    xlink:type="simple">Burgess, Warren Randolph. The Reserve Banks and the Money Market. Rev. ed. New York: Harper & Brothers, 1936. Overview featuring the impact of monetary policy actions on financial markets, written by an expert who was with the Federal Reserve Bank of New York from 1920 to 1938.
  • citation-type="booksimple"

    xlink:type="simple">Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, N.J.: Princeton University Press, 1963. A seminal work that finds federal banking policy errors at the root of the Great Depression. Although challenged on some points, the authors’ view has remained the accepted interpretation of the role of the Federal Reserve system in raising interest rates at crucial times and in exacerbating banking panics.
  • citation-type="booksimple"

    xlink:type="simple">Goldenweiser, Emanuel Alexander. American Monetary Policy. New York: McGraw-Hill, 1951. A presentation in straightforward prose by an economist who was director of research and statistics for the Federal Reserve Board from 1926 to 1945.
  • citation-type="booksimple"

    xlink:type="simple">Greider, William. Secrets of the Temple: How the Federal Reserve Runs the Country. New York: Simon & Schuster, 1987. A highly politicized, populist approach to the Federal Reserve system, contending that it has been too restrictive in its policies and that it should democratize money.
  • citation-type="booksimple"

    xlink:type="simple">Hafer, R. W. The Federal Reserve System: An Encyclopedia. Westport, Conn.: Greenwood Press, 2005. Provides a comprehensive explanation of the structure, processes, and policies of the Federal Reserve system and describes key events in the system’s history.
  • citation-type="booksimple"

    xlink:type="simple">Moore, Carl H. The Federal Reserve System: A History of the First Seventy-Five Years. Jefferson, N.C.: McFarland, 1990. Concise, clear, and interestingly written account by an economist associated for thirty-two years with the Federal Reserve Bank of Dallas.
  • citation-type="booksimple"

    xlink:type="simple">Timberlake, Richard H. “Federal Reserve Act.” In Encyclopedia of American Business History and Biography: Banking and Finance to 1913, edited by Larry Schweikart. New York: Facts On File, 1990. Interpretive essay focusing on the relationship between the gold standard and the Federal Reserve Act. Argues that the clearinghouse associations had functioned well and needed no further government control.
  • citation-type="booksimple"

    xlink:type="simple">Warburg, Paul Moritz. The Federal Reserve System: Its Origin and Growth. 2 vols. New York: Macmillan, 1930. A collection of writings by the German-born banker who labored indefatigably for central bank reform and sound practice.
  • citation-type="booksimple"

    xlink:type="simple">Wells, Donald R. The Federal Reserve System: A History. Jefferson, N.C.: McFarland, 2004. Describes American banking practices before formation of the Federal Reserve and then presents a full history of the Federal Reserve system, including information on the system’s relationship to each presidential administration and how the system has evolved under different leaders over the years. Includes an appendix listing all members of the Federal Reserve Board of Governors through 2003.
  • citation-type="booksimple"

    xlink:type="simple">West, Robert Craig. Banking Reform and the Federal Reserve, 1863-1923. Ithaca, N.Y.: Cornell University Press, 1977. A scholarly monograph on the intellectual background to the Federal Reserve Act.
  • citation-type="booksimple"

    xlink:type="simple">Wheelock, David. The Strategy and Consistency of Federal Reserve Monetary Policy, 1924-1933. New York: Cambridge University Press, 1991. Asserts that the Federal Reserve acted consistently with its earlier policies in the late 1920’s and did not play a crucial role in causing or prolonging the Great Depression.
  • citation-type="booksimple"

    xlink:type="simple">White, Eugene Nelson. The Regulation and Reform of the American Banking System, 1900-1929. Princeton, N.J.: Princeton University Press, 1983. Points out the weakness of failing to incorporate branching, and notes that during the reforms of the 1930’s, banks that participated in stock market activities were less vulnerable than those that did not.
  • citation-type="booksimple"

    xlink:type="simple">Willis, Henry Parker. The Federal Reserve System. New York: Ronald Press, 1923. An insider’s in-depth view by one of the men who drafted the Federal Reserve Act.

Panic of 1907

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Banking Act of 1933 Reorganizes the American Banking System

Banking Act of 1935 Centralizes U.S. Monetary Control

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