Working Paper

Did the Founding of the Federal Reserve Affect the Vulnerability of the Interbank System to Systemic Risk?

Abstract: As a result of legal restrictions on branch banking, an extensive interbank system developed in the United States during the 19th century to facilitate interregional payments and flows of liquidity and credit. Vast sums moved through the interbank system to meet seasonal and other demands, but the system also transmitted shocks during banking panics. The Federal Reserve was established in 1914 to reduce reliance on the interbank market and correct other defects that caused banking system instability. Drawing on recent theoretical work on interbank networks, we examine how the Fed?s establishment affected the system?s resilience to solvency and liquidity shocks and whether these shocks might have been contagious. We find that the interbank system became more resilient to solvency shocks but less resilient to liquidity shocks as banks sharply reduced their liquidity after the Fed?s founding. The industry?s response illustrates how the introduction of a lender of last resort can alter private behavior in a way that increases the likelihood that the lender will be needed.

Keywords: Federal Reserve System; Contagion; Systemic risk; Seasonal liquidity demand; Interbank networks; Banking panics; National Banking system;

JEL Classification: E42; E44; E58; G21; N11; N12; N21; N22;

https://doi.org/10.17016/FEDS.2016.059

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2016-07-18

Number: 2016-059

Pages: 46 pages