This global financial crisis inspired the monetary reform movement and led to the creation of the Federal Reserve System.

The Panic of was the first worldwide financial crisis of the twentieth century. It transformed a recession into a contraction surpassed in severity only by the Great Depression. Moen and Tallman argued that the experience of the Panic of changed how New York Clearing House bankers perceived the value of a central bank because the panic took hold mainly among trust companies, institutions outside their membership.

The central role of New York City trust companies distinguishes the Panic of from earlier panics. Trust companies were state-chartered intermediaries that competed with banks for deposits.

Trusts were not, however, a central part of the payments system and had a low volume of check clearing compared with banks.

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As a result, they held a low percentage of cash reserves relative to deposits, around 5 percent, compared with 25 percent for national banks. Because trust-company deposit accounts were demandable in cash, trusts were just as susceptible to runs on deposits as were banks. Despite their minor role in the payments system, trusts were large and important to the financial system.

Trust companies loaned large sums directly in New York equity markets, including New York Stock Exchange brokers. Trusts did not require collateral for these loans, which had to be repaid by the end of the business day. Brokers used these loans to purchase securities for themselves or their clients and then used these securities as collateral for a call loan — an overnight loan that facilitated stock purchases — from a nationally chartered bank.

Trusts were a necessary part of this process, because the law prohibited nationally chartered commercial banks from making uncollateralized loans or guaranteeing the payment of checks written by brokers on accounts without sufficient funds. Runs on trust company deposits, however, short-circuited their role as the initial liquidity provider to the stock market.

The Panic of had many elements in common with the financial crisis of Examining the sequence of events in makes the parallels clear.

On October 16, , two minor speculators, F. Augustus Heinze and Charles W. Morse, suffered huge losses in a failed attempt to corner the stock of United Copper, a copper mining company traded on the curb. Four days later, the New York Clearing House made a public announcement that the Heinze-related member banks like Mercantile National Bank had been examined and deemed to be solvent, calming their depositors. The Clearing House also forced out the management of these banks, including Heinze and Morse.

The New York Clearing House then offered these banks loans that were eventually exchanged for clearing house loan certificates, one of the benefits of membership in the Clearing House Association. While the Clearing House had been able to quash the runs on the national banks associated with Heinze and Morse, they were spreading to the trust companies. On Friday, October 18, news broke that the president of Knickerbocker Trust, Charles T. Barney, was an associate of Morse. The National Bank of Commerce extended credit to Knickerbocker Trust to cover those withdrawals.

The bank then requested a loan from the New York Clearing House on the behalf of Knickerbocker Trust on Monday, October The Clearing House denied the request because its resources were reserved for the support of its member institutions.

Knickerbocker and most other trust companies in New York were not members. After this denial, a request for aid was made to J. Following these announcements, the run on Knickerbocker intensified. The suspension of Knickerbocker Trust sparked the full-scale financial crisis in New York City.

The runs on deposits spread among the trusts and were most intense at the Trust Company of America. Morgan changed his mind and quickly released aid, as did the New York Clearing House banks. However, depositors continued to withdraw funds from Trust Company of America for two more weeks. An upward spike in the call money interest rate — the rate of interest on overnight loans on stock collateral offered at the New York Stock Exchange — was among the first signals of distress and tightening credit see Figure 1.

On the day Knickerbocker closed, October 22, the annualized rate jumped from 9. At times, there were no credit offers at that rate.

The New York Stock Exchange remained open largely because of the legendary actions of Morgan, who solicited cash from large financial and industrial institutions and then had it delivered directly to the loan post at the exchange to support brokers who were willing to extend credit.

After an unusual delay of five days, the New York Clearing House Committee met on Saturday, October 26, and formed a panel to facilitate the issuance of clearing-house loan certificates. On the same day, the New York Clearing House banks — those institutions central to the payment system — chose to restrict the convertibility of deposits into cash.

Those gold imports appear to have been instrumental in spurring the recovery of the New York City financial market. The parallels between the crises in and are striking. During , the financial crisis was centered on investment banks, institutions without direct access to the Federal Reserve System. In , widespread depositor withdrawals occurred at New York City trust companies — intermediaries outside the New York Clearing House, the effective lender of last resort.

In effect, both financial crises started outside the large banks serving as payments centers. Yet the crises created havoc within markets and among banks that were central to the payments system. Both crises challenged the existing mechanisms used to alleviate crises. The trust companies in were like the shadow banks in the financial crisis of Short-term lending during the recent crisis came largely from some shadow banks hedge funds and money market mutual funds to fund other shadow banks investment banks.

The rescue of Bear Stearns — which was faced with a run by its shadow bank lenders before it was bought by JPMorgan Chase with a loan from the Federal Reserve — was analogous to the support received by Mercantile National Bank from the New York Clearing House in October The failure of Lehman Brothers in September and the suspension of Knickerbocker Trust in October also share a dubious distinction — each episode marked the beginning of the most severe financial crisis in each era.

Knickerbocker Trust and Lehman Brothers, each isolated from their respective lender of last resort, nevertheless had a notable difference. Knickerbocker Trust was in suspension, whereas Lehman Brothers failed.

In contrast, the remnants of Lehman Brothers have been purchased by a variety of firms around the world. Lehman's customers required nearly six years to receive their payments, and the net losses to Lehman creditors have not yet been accounted for completely.

Ever since former Fed Chair Ben Bernanke, during his time as a Stanford professor, investigated the link between credit crises and real economic outcomes in a seminal paper, research on this important topic has been controversial. One lesson from examining and comparing the Panics of and is that problems arising in short-term, overnight lending markets can be the initial catalyst for economic disruption during a panic. New work on the Panic of uncovers further key linkages between financial distress and failure among financial intermediaries trust companies and the relatively poor performance of the nonfinancial firms that depended upon them for loans and other financial services.

Industrial output fell 17 percent in , and real GNP fell by 12 percent. But unlike the Great Depression or the recent Great Recession, the real sector recovered rapidly, in little over a year after The Panic of took place over one hundred years ago, before the establishment of the Federal Reserve System, the Federal Deposit Insurance Corporation, or the Securities and Exchange Commission -- institutions designed to bring stability to banking and financial markets.

Before these institutions, the National Banking Acts provided the regulatory structure guiding the day-to-day behavior of banks, particularly the largest and most interconnected ones. During a panic, however, the acts provided little guidance to bankers coping with large-scale withdrawals of deposits. The private New York Clearing House provided a structure for addressing crisis events, and it imposed rules and standards on member bank behaviors to discipline members and maintain sound practices.

Modern regulatory institutions have supplanted this role. The era before is a fertile ground for researchers interested in the underlying causes of systemic effects like panics because the behavior of key market participants was less affected by potential actions of government regulators. Borrowers, however, needed loans to buy collateral before getting the call loan from the bank.

Sereno Pratt , explains the sequence of transactions in detail. See Frydman, Hilt, and Zhou , Gorton and Tallman , Moen and Tallman , and Fohlin, Gehrig, and Haas Philip Woods provides a detailed description of the background behind the speculative endeavors of Heinze and Morse here. Note, however, that there are factual errors regarding the failures. See Bruner and Carr and Tallman and Moen for an event summary. Frydman, Hilt, and Zhou and Tallman highlight recent research and discoveries.

See Moen and Tallman for evidence regarding the benefits of clearinghouse membership during the panic. Frydman, Hilt, and Zhou , and Fohlin, Gehrig, and Haas , suggest that the Panic of resulted largely from rumor. See Tallman , 58 for a detailed explanation of clearing house loan certificates as they were used in the National Banking era crises. See Moen and Tallman for an empirical analysis of the actual issues by the New York Clearing House from to Trust companies did not restrict the convertibility of deposits into cash at any point during the panic.

It is possible that such an action, if coordinated and supported, could have reduced the massive withdrawal of over 36 percent of deposits from New York City trust companies between August 22 and December 19, Deposits at New York City national banks actually increased during that period. See Gorton and Tallman for a discussion of the role of gold inflows during the panics in and See also Odell and Weidenmier , Rodgers and Payne , and Rodgers and Wilson See Gorton , for the full description of his approach to financial crises.

The discussion above is our adaptation of those arguments.

See Frydman, Hilt, and Zhou For comparable evidence for the modern instance of , see Chodorow-Reich National banks are still regulated by the Office of the Comptroller of the Currency, a bureau of the US Department of the Treasury. The regulatory structure was not designed to intervene during crisis.

Interventions by the US Treasury, however, took place in several pre-Fed panics.

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The Treasury was not guided by explicit regulation. Rather, it was guided by the intuition of the current secretary of the Treasury, most notably Leslie Shaw. See Taus and Timberlake The Panic of Benjamin Strong, Central Banker. Brookings Institution, Faber and Faber, Ltd. Firm-Level Evidence from the Financial Crisis. Fohlin, Caroline, Thomas Gehrig, and Marlene Haas.

Evidence from the Panic of Frydman, Carola, Eric Hilt, and Lily Y. Trust Companies and the Impact of the Panic of Slapped by the Invisible Hand: Oxford University Press, Tallman, "Close but not a Central Bank: The New York Clearing House and Issues of Clearing House Loan Certificates," in Current Federal Reserve Policy Under the Lens of Economic History. Cambridge University Press, The San Francisco Earthquake and the Panic of Rodgers, Mary Tone, and James E.

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Equity Expectations and Ended the Panic of Rodgers Mary Tone, and Berry K. Parker and Robert Whaples, New York: Central Banking Functions of the United States Treasury: Columbia University Press, Monetary Policy in the United States: An Intellectual and Institutional History. University of Chicago Press, The Fed's Functions Related Resources. Your Gateway to the History of the Federal Reserve System.

Explore The Federal Reserve Topic. The Panic of This global financial crisis inspired the monetary reform movement and led to the creation of the Federal Reserve System. Moen and Ellis W. Endnotes 1 See Frydman, Hilt, and Zhou for empirical evidence in support of this view. Bibliography Bernanke, Ben S. The Work of Wall Street , New York: Written as of December 4, Related Essays Before the Fed: The Historical Precedents of the Federal Reserve System Banking Panics of the Gilded Age.

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