1907 Bank Panic
Introduction
In the year 1907, the United States experienced one of the worst financial crises preceding the Great Depression. There was a great panic among different financial institutions in New York, which spread to the entire financial system. In the following year, the real GNP of the U.S. decreased by 11%. The industrial production also decreased by 16%, doubling the rate of unemployment. Despite several studies being carried out to determine the cause of the 1907 panic, no single research has been conducted to determine its consequences, specifically the effects of the financial intermediation on the economy of the United States. Nevertheless, the outbreak of the Panic of 1907 occurred after a number of outrageous revelations about investment of certain renowned financiers in the U.S. The link between the trust organizations and their customers was responsible for remitting the financial crisis to non-financial organizations.
Background of the Panic
The panic of 1907 took place after several economic shocks that preceded the Great Depression. Initially, the earthquake and fire that took place in San Francisco in the year 1906 had a substantial financial bearing on the nation (Odell & Weidenmeir, 2004). There was gold inflow in the U.S. at that time and insurers were paying their claims according to San Francisco policies. Consequently, the Bank of England and French and German central banks responded by raising the discount rates to inverse the flow of gold. Furthermore, the Bank of England also ceased accepting the American financial bills that were used to settle gold imports bill to the U.S. As a result, there was a decrease in the American security markets since the collateral for the bills was sold, thus leading to significant outflow of gold in the U.S. Furthermore, weak harvest of cotton in the same year resulted in decreased export revenues, further worsening the financial situation in the nation (Hanes and Rhodhe, 2013). Therefore, the New York market experienced a fall in 1907 on reduced gold reserves and vulnerable shocks.
During the same period, the banking system in New York was also undergoing significant structural transformations. This was in form of rapid growth of trust organizations. For instance, in the ten years ending 1907, the trust company’s assets in New York had fundamentally increased. The advantages of trust systems led to the growth of the institutions. Initially, the trust companies were established to serve as fiduciaries; however, they enjoyed extensive privileges like holding equity debt and underwriting distribution securities. They also issued loans and competed with national bank for deposits. Trust companies operated under permissive state laws, thus not being under the strict rules of the state like the National Banking Act. They normally focused on providing finances to corporate investments and acquisitions. At the beginning of the panic, the trust companies played a crucial function in the financial markets. In many cases, they provided lending and underwriting services, purchased securities and acted as sources of finances to several organizations. Moreover, the entities enjoyed the directorates of prominent bankers and former U.S. Treasury Secretaries that enhanced their performances and reputation.
The quick explosion of the trust companies might have played a significant role in the financial crises in New York. For Instance, while banks located in the State were obliged to hold reserves equal to 25% of their total deposits, the trust companies were not required to hold any reserves until the year1906. In the same year, a 15% reserve was imposed on the entities; however, they were only obliged to hold 15 % if it in cash (Frydman et al., 2012). Furthermore, the national banks also excluded trust organizations from the New York House Association (NYCHA), which was a private entity that enhanced clearance and facilitated lending to kits members during crisis times. The trust companies were allowed to access the NYCHA through clearance from member banks if only they maintained a minimum amount in their reserves. When the 1907 panic arose, no clear mechanism was in place to facilitate collaboration among the trust companies or offer a loan to the entities that were facing liquidity.
This paper examines the New York Panic of 1907 by discussing the background information, events that led to the panic, outcomes, and lessons learned. The paper also provides a recommendation based on the information provided in the essay and different scholars.
Economic Historic Findings
Beginning of the Panic
The 1907 panic affected the financial markets severely, particularly the prevalent runs on the trust companies that started in October. The runs were occasioned by events that had no direct links with the trust companies. The runs were prompted by a thwarted move to bend the shares of the United Copper Organization, a mining concern, which led losses among the involved risk-takers. According to experts, it was believed that the run on trust companies was occasioned by the fear of depositors in the entities that the institutions might have suffered losses, which were mere speculations. The characters behind the speculation were mining tycoon Augustus Heinze and Speculators E.R. Thomas and Charles W. Morse. These individuals accessed some of the small banks and financed their ventures using the banks’ resources. These banks experienced losses during the attempt to fraud shares of the United Copper. In October 16, the run started on the Mercantile National Bank, which was controlled by Heinze, Morse and Thomas. They managed to plea for aid from the NYCHA and the institution declared that it would support any financial institution linked to the three individuals. Nevertheless, this was on the condition that they resign from all their headship positions in the Mercantile organization and other financial institutions (Frydman et al., 2012). However, their expulsion, followed by the liquidation of Mercantile, had a bad implication on the public in New York leading to a perception that they had embezzled funds.
It is apparent that no single trust organization was connected to the thwarted United Copper scandal. Nevertheless, a prominent financier Charles Barney, who doubled as the president of the Knickerbocker and director of Trust Company Africa, which were among two main trust organizations in New York, was known to have had links with Morse. This was during his reign at National Bank of North America that was controlled by Morse. Furthermore, the three gentlemen were also board members of other trust companies. This information was widely spread by the media. As a result of the losses and solvency of Mercantile National Bank and other entities controlled by the three, there were high concerns about the trust companies associated with them. This led to depositors’ withdrawals in trust companies with Knickerbocker being the first to be affected. Its president Birney was dismissed due to his alleged association with Morse, but the entity suffered a severe run (Frydman et al., 2012). This process spread panic among other trust companies. Despite calls by trust companies that all was well, the situation worsened and most of them started calling in loans and liquidated their assets to build cash reserves.
Fig 1. Connection between speculators and trust companies
J.P Morgan Rescue Plan
To control the growing crises, Morgan organized a team of bankers he trusted on October 19 and tasked them with a responsibility of determining the solvency plan of the entities that had been affected. Morgan was one the respected financiers at the time and had a personal interest in the whole situation. Initially, he had come up with initiatives that had helped the financial markets, for instance, offering emergency lending to the U.S Treasury and intervening in the foreign exchange market in the year 1895 to uphold the dollar on the gold standard. During the panic, Morgan initiated a number of salvages to the trust companies, security dealers in New York that were crucial in solving the financial crisis.
Knickerbocker was the first trust company that attracted Morgan’s appeal. On October 21, he pledged to assist the company the following day if the institution would be solvent. The following day, on October 22, all the panicked depositors that formed long queues in Knickerbocker were paid their dues and Morgan’s men who were assessing the condition of the entity were unable to determine if the trust company was due for solvency. The trust organization, therefore, did not receive any aid, which made it to be shut down by midday. A report by the receivers of the trust company ascertained that the institution was solvent and all depositors received all their cash.
The following day, Morgan also planned an emergency lending to the Trust Company of America after some dramatical experiences in the institution. The loans offered by Morgan allowed the institution to continue with its operations. On November 3, Morgan organized a meeting of all trust companies’ presidents in his library that went overnight. During the meeting, he compelled all the presidents to jointly pledge a $25 million to assist the Trust Company of America and other trust institutions that were at the verge of collapsing.
The American Trust Company was the worst in the history of the United States with the organization having to pay approximately more that $34 million in a few weeks’ time (Frydman et al., 2012). Nevertheless, due to Morgan’s initiatives, the institution was locked down, and Knickerbocker was the only trust company that was shut down. Morgan rescue machinery was as a result of his organizations resources’ strength in offering emergency loans to the trust institutions and his influence on the financial markets. In financial crises, it is risky for a financial institution to reduce its interest loans and lend to an ailing institution, especially a competing firm. However, through his demonstration and power, he was able to influence other institutions to take the costly private risk, which was beneficial to the whole market. He also helped other institution from failing, for instance, the Moore & Schley investment bank and U.S. Steel.
Morgan’s personal interests in saving the ailing institutions was apparent by his refusal to save Knickerbocker at the same time working hard to salvage the Trust Company of America.
Consequences of the Panic
After the events of the panic that saw heavy withdrawals from and out of banking institutions, the New York Clearing House issued clearinghouse loan certificates aimed at offering liquidity to its members. Following the developments, banks in New York suspended their convertibility of deposits into currency. This measure was soon adopted by other banks across the U.S. leading to several legal sections from their respective state governments. By November, most trust companies in New York were making payments through certified checks at the NYCHA instead of cash. The national banks maintained the status quo of not converting deposits into cash until the year 1908. The ban in effect made some of the significant transactions to be difficult (James et al., 2011). Nevertheless, the ban also diffused the spread of the panic in the banking sector and prevented the complete downfall of the banking system.
Furthermore, during the panic, contracted lending in New York focused more on the trust companies. Before the panic, the overall volume of the New York trust company loans was almost equal to those of the state’s national banks. The contraction of loans by the trust companies was reduced during the panic period, particularly from August to December that year. On the other side, loans by New York national bank were also affected to a lesser extent. In this situation, the trust banks apparently did everything to protect themselves availed by their powers and small borrowers were the most affected casualties.
Furthermore, the New York Panic took place at a time when credit markets were experiencing a lot of stress that resulted in a general narrowing in liquidity. The panic, which led to mass withdrawals at the trust companies, gestured the commencement of financial catastrophe. This is because there were widespread initiatives to withdraw deposits from all the intermediaries. Under this kind of situation, the public tries to hold a higher portion of assets in liquid or cash rather than deposits. The resulting feature is a credit crunch among the institutions making it a banking crisis that affected the banking system in New York.
Recommendations
Morgan’s interventions to help the financial institutions were significant but short term. This necessitated the long-term need for a solution to avoid a repeat of the situation in the future. Many people and experts saw the need of the central banking system in the United States. The situation would have been everted if there could be a last lender in form of the centralized bank. However, many people feared government involvement in the central bank that would affect the financial system. That was a better decision since small financial institutions were prone to crisis than the central bank because it could be used as a shock absorber to protect the economy and the financial system (Bruner, 2008). The movement for centralized bank was initiated by Nelson Aldrich and was adopted by the Congress and passed as Aldrich-Vreeland Act (Bruner, 2008). The act also established a special fund set aside to offer banks with emergency loans depending on the reserves they held in the centralized bank.
Additionally, the National Reserve Association was also established, which foresaw the monitoring and distribution of funds to the banks whenever they needed help. However, Aldrich plans never came to realization since many people feared infiltration by powerful government forces. The nation still saw the need for financial reforms to protect the U.S currency. This led to the passage of the Federal Reserve Act by the Congress on December 22, 1913 to establish the Federal Reserve Banks that was aimed at protecting the currency and supervising other banks. It was also the last resort lender that offered assistance to banks in times of panic. Therefore, the passage of Federal Reserve Act was significant in the history of the United States as it would help to deal with such financial crises in the nation without spilling worst effects like the panic. It is also recommended that the Federal Reserve would act as the controller of other financial institutions to control their activities, for example, the Trust Companies, which experienced less regulation and control.
Conclusion
Financial panics are normal when it comes to monetary matters. Nevertheless, the Panic of 1907 revolutionized the U.S. financial history. It came at a time when the nation was trying to salvage the effects of a natural disaster. The panic also triggered significant changes that were made in the history of the United States that are still being felt. The panic was as a result of poor decision-making and policies by few individuals who led to trust failure and bankruptcy of the National Treasury. This affected other industries and employment due to the decline of the industrial production. Despite the negative outcomes of the panic, the nation went through a significant period that helped it set up structures that have assisted it to remain firm economically despite numerous challenges like the Great Depression.
References
Bruner, R. F., & Carr, S. D. (2008). The Panic of 1907: Lessons learned from the market’s perfect storm. John Wiley & Sons.
Frydman, C., Hilt, E., & Zhou, L. Y. (2012). Economic Effects of Runs on Early ‘Shadow Banks’: Trust Companies and the Impact of the Panic of 1907(No. w18264). National Bureau of Economic Research.
Hanes, C., & Rhode, P. W. (2013). Harvests and financial crises in gold standard America. The Journal of Economic History, 73(01), 201-246.
James, J., McAndrews, J., & David, F. W. (2011). Suspensions of Payments under the National Banking Act. Working paper, University of Virginia.
Odell, K. A., & Weidenmier, M. D. (2004). Real shock, monetary aftershock: The 1906 San Francisco earthquake and the panic of 1907. The Journal of Economic History, 64(04), 1002-1027.