This continues from the previous post: Coffee and Banking Clearinghouses. It explains how clearinghouses started to perform many of the functions we identify with Central Banks today.
To understand modern central banks, it is useful to look at how they evolved out of the needs of the banking system. The Clearinghouse seems like a mechanical and unimportant part of the system. It is a way for the banks to clear checks written between any two banks in the system. However, as we will see in this post. This simplicity is deceiving. Many aspects of Central Banks emerge directly from the functions of clearinghouses. In this post, we will summarize the article “Private ClearingHouses and the Origins of Central Banking by Gary Gorton, published in Business Review, Jan-Feb 1984.
By 1850, the 50 banks in New York found that daily bank-to-bank clearing could not be completed in time. The use of checks had soared, and if each bank had to clear with every other bank, 50 x 49 = 2450 transactions would be required to complete clearings. In contrast, creation of a central clearinghouse substantially reduced the transaction cost of clearing. Every bank only needed to calculate ONE net figure – total incoming checks minus total outgoing checks. If this was positive, it would receive gold from the clearinghouse. If negative, it would pay gold to the clearinghouse. With 50 transactions, one between each bank and the clearinghouse, the market would clear. Once the efficiency of this system became apparent, it was widely imitated throughout the USA and elsewhere.
Once the clearinghouses were setup, there were some natural extensions to their functions. Clearing involved giving or taking gold to each of the fifty banks. If each of the banks had some reserves in the Clearinghouse, the clearing could take place in-house. The Clearinghouse would keep the reserves for all the banks, and simply adjust entries in its book regarding which bank has how much gold. No actual gold needed to be moved, saving transactions and security costs. This system was improved and supplemented by the addition of specialized “Clearing House Specie Certificates”. Banks could deposit gold at certain large and secure designated banks and receive these certificates for use at clearing. The certificates would be equivalent to gold, but would be much easier to transport and have much higher security.
The Role of Banking Crises
Evolution of functions of the clearinghouses occurred in response to banking crises which used to occur regularly following the ending of business cycle booms. In the fractional reserve banking system, each bank holds only a fraction of the gold which it owes to its depositors. All of the banks would collapse (become il-liquid) if all depositors demanded gold in return for their deposits. In a crisis, only a few banks would actually be in financial trouble, but depositors did not have information as to which banks are sound and which are not. So there would be a general panic as depositors rushed to demand gold. Such a general rush could collapse the banking system. Many measures were developed to quell these panics. One of the first was temporary suspension of liquidity. Depositors were not allowed to convert deposits to gold. But this would only be a temproray and delaying measure. In order to meet demand for gold, clearinghouses created a new instrument called the Clearing House Loan Certificate”. Whereas the Specie Certificate had to be backed by gold, the Loan Certificate was backed by other financial assets of the bank. These Loan Certificates could be used by banks at the clearing just like the Specie Certificates. This reduced the need for gold at inter-bank clearing, in order to make gold available for payment to depositors. It was in the collective interest of banks to prevent bank failures, since failure of one bank could easily trigger a panic which would take down the entire system. That is why some flexibility (use of loan certificated instead of specie certificates) in interbank clearlngs was accepted by all banks. The Loan Certificates were issued as a collective liability of the banking system (and hence valid even if any particular bank failed) and they were issued with collateral backing of financial assets worth significant more than the loan. Use of these loan certificates was able to prevent a financial crisis in 1960, by making enough gold available to meet depositor demand.
The clearinghouse loan certificates were used only for inter-bank transactions at clearing, and not issued to general public. Later, the success of this model led to an extension. The Loan Certificates could be exchanged for Clearing House currency, which could be given to general public. While the clearinghouse issued currency was not a perfect substitute for government issued currency, it was the joint liability of the entire private banking system, and hence much safer than checks of any particular bank. Use of the clearinghouse currency substantially expanded the ability of banks to respond to crises by issuing their own certificates which would substitute for gold. These developments led to clearinghouses having the following functions normally associated with Central Banks. First, they became the lender of the last resort, issuing both clearinghouse loan certificates and also clearinghouse currency to banks in need, against financial assets of the bank. Secondly, they became creators of currency in times of need. Third, associated with these functions, they became regulators of the banking industry. This was because, in order to issue Loan Certificates or Clearinghouse Currency to member banks, it was necessary to be sure that the bank was sound. This required a certain amount of regulatory authority on part of the clearinghouse.
The regulation of private banks was achieved by a combination of measures. State Laws in the USA required transparency – each bank was required to publish a statement of accounts weekly which would show it reserve position, assets and liabilities. Clearinghouses generally required the maintenance of 20% gold reserves against deposit liabilities. They also required the private banks to submit to audits, as a condition of joining the clearinghouses. From this summary, it seems clear that most of the features of Central Banks were already initiated by private banking clearinghouses.