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U.S. History/What are some of the key differences and similarities between the National Bank and the Federal Reserve?

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QUESTION: I'm reading a biography on George Washington, and as someone who knows fairly little about economics and banking, I'm struggling to fully understand what the National Bank's purposes and functions were. I believe that the National Bank was a "central bank", much like the modern day Federal Reserve. However, my understanding of the Federal Reserve, (or just central banks in general), is fairly minimal.

Would you be able to explain (in basic terms) what some of the key aspects of the National Bank were, and in what ways it was both similar to and different from the Federal Reserve?

Thank you!

ANSWER: Hello,

Both the Bank of the United States, created during George Washington's Administration, and the Federal Reserve, created in the early 20th Century, were designed to help the Federal government maintain a stable economy.  But the two went about it very differently and were very different in scope.

The Bank of the US was actually private owned.  It received a corporate charter from the Federal government and had certain restrictions placed on what it could do, but it was financed by private investors and run by private businessmen.  It's power came from the fact that it was the official depository of all federal tax revenues.  It could use that money to provide loans to governmental and private organization, thus having a say in whether major projects or initiatives could get start up capital.

The Federal Reserve has far more power and responsibility.  Like the Bank, it serves a a depository for federal tax funds.  Also, with its power to extend credit, it can essentially create a larger money supply in the national economy.  But unlike the Bank of the US, the Fed also has regulatory authority over all private banks in the country.  It can affect the availability of money by changing the amount of cash banks are required to hold in reserve.  It can take over banks that are deemed fiscally unsound.

The Federal Reserve Board is a government entity, created by Congress, but it operates independently of the President.  The President appoints board memberss, but cannot tell the Fed what to do and cannot fire any of its members.

- Mike


---------- FOLLOW-UP ----------

QUESTION: Thank you! That really helps me have a better understanding of the distinctions between the two. There are a few points that I'd like to follow up on though, if that's okay.

You say that the National Bank would "provide loans to governmental and private organizations", while the Federal Reserve has the "power to extend credit". In this situation, is there a difference between providing a loan and extending credit? I would tend to think of the two actions as the exact same, and so my assumption is that you simply chose different phrases for the sake of variation in your writing, but anytime I try to understand econ, I find myself on shaky ground. It seems that various terms can have various meanings, and that similar concepts can have minute differences. Sorry for my desire for specificity here - I just really want to make sure that I grasp this properly.

Are you also able to specify exactly which entities the Federal Reserve is able to extend credit to? The government? Private businesses? Other banks? Or all three?

Thanks again!

Jeremiah

ANSWER: There is a technical difference between making a loan and extending credit.  Extending credit means offering someone the ability to draw on borrowed resources as they wish.  Making a loan is actually giving them the money.  But I wasn't really trying to make any distinctions.  Both entities could extend credit or make loans.  In that case their powers were essentially the same, although the Bank of the US had greater limits on how much money they could lend than the Fed does (even after inflation).

The Fed can lend money to banks or private entities, although they really don't do this like a commercial bank.  The Fed has what is called a "discount Window" that allows banks to borrow money overnight to maintain proper liquidity.  It does not ordinarily make long term loans to banks.  The Fed does sometimes make loans to private companies, although this is rare and usually in times of emergency, such as the 2008 crash.  The Fed does not lend money to the Federal government.  Federal government loans are done through the Department of Treasury.

- Mike


---------- FOLLOW-UP ----------

QUESTION: I really appreciate your willingness to follow up with me on some of these finer points.

So the Federal Reserve cannot make loans to the Federal government, although the National Bank could. Both have/had the capacity to make loans to private businesses. And the Federal Reserve is able to make loans to banks through its "discount Window". That's really helpful.

When you say that the discount window is used to help banks "maintain proper liquidity", do you mean that it's used to help banks meet the reserve limit? Is this the main (or only) reason that the Federal Reserve would make a loan to a bank? If so, then since the National Bank (or perhaps I should be calling it the Bank of the US) could not set a reserve limit, does that mean that the Bank of the US would not make loans to banks? Or would they do so for some other reason?

When you say that "Federal government loans are done through the Department of the Treasury", are you saying that the Treasury makes loans to the Federal government? Or are you simply saying that the Treasury is the department of the Federal government responsible for making loans to other entities? Your phrasing seems to imply the former interpretation, but since your previous sentence was about making loans *to* the Federal government, the context seems to imply the latter interpretation. Of course, I don't understand how the Treasury could make loans *to* the Federal government, since that would seem to create a situation in which the Federal government would be loaning money to itself. But then, hard to grasp concepts seem to happen with regularity when one is dealing with economics, haha. :)

Answer
To understand the purpose of Federal Reserve, it might help to take a step back and explain banking more.

Private banks take in money from depositors and lend money to people needing loans.  Since banks have to pay money to depositors and make profit from loans, they like to lend out more than they have.  For more on how banks do this, you may find this link provides more detail:

http://www.cnbc.com/id/100497710

But essentially, banks don't just have a lot of cash sitting in a vault.  It is lent out to other entities in order to help the bank earn profits.  Banks must keep a small percentage of cash reserves on hand, but this is a very small percentage of what their total deposits and loans.  If a large percentage of depositors wanted their money bank all at once, the bank would not have it.  This uses to happen with some frequency.  There would suddenly be a bank panic where depositors thought a bank might be going bankrupt.  They would all rush to get their money out (called a "run" on the bank).  Of course the bank never has enough cash on hand for all depositors, so those who arrived late got nothing.  The might get their money back later if the bank had enough assets or could bring in money owed on loans, but usually the reason there was a run on the bank to begin with was that the bank had bad loans and could not cover all deposits.  So, some people lost their money.

To put an end to the problem of bank panics, the Federal government has two programs to proteted depositors.  One if the FDIC.  This is essentially insurance on your deposit.  If a bank goes bankrupt, and cannot pay back all the depositors, they can get their money from the FDIC.  The second entity is the Federal Reserve.  The Fed knows that the bank is "liquid" in that is has assets in the form of collectable debt from its borrowers, but that it might not have enough cash on hand for people who just might want their money today (this is the reserve limit set by the Fed).  If a bank does not have the necessary reserve at the end of the day, they can borrow the money from the Fed's discount window an pay a small amount of interest on that amount.  Typically these loans are only overnight loans, meaning they get paid back the next day.  Of course, a bank can take out another loan the next day if needed.  It times of crisis, where there is a cash shortage, such as during the 2008 crash, the Fed can lend money for longer periods of time, but this is not the norm.

The Bank of the US was a private bank.  It could not tell other banks how to run their business.  It could not require that they hold reserves, or much of anything else.  But the Bank of the US could lend money to banks.  It could do so however it wanted and under whatever terms in wanted.  This gave it a great amount of leverage over banks since the Bank of the US could provide loans only to banks that operated the way it wanted them to operate.

When I said the Department of Treasury handled government loans, I did not mean that the Department lent money to the government.  Treasury is actually a part of the Federal Government, and as you point out would be lending to itself.  If the government needs money, the Department of Treasury sells bonds to the public.  The Department takes the cash from those bond sales, pays of interest on existing bonds, and keeps the rest available for other departments to draw on based on Congressional authorizations.  

U.S. History

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Michael Troy

Expertise

I can answer just about any question on early American History. My specialties are the American Revolution through the Civil War/Reconstruction. I also have greater expertise in matters relating to military, political or legal history.

Experience

I have lectured at George Washington University regarding the Civil War, as well as several elementary school Civil War demonstrations. I was also a member of a Civil War reenactment group for about 10 years.

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http://unlearnedhistory.blogspot.com

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J.D. University of Michigan B.A. George Washington University

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Truman Scholar

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