Bank Panic of 1907

What Was the Bank Panic of 1907?

The Bank Panic of 1907 was a short-lived banking and financial crisis in the U.S. that occurred at the beginning of the twentieth century.

It resulted from the collapse of highly-leveraged speculative investments propagated by easy money policies pursued by the U.S. Treasury in the preceding years. This led to runs on New York banks and trust companies that had been financing these risky investments and to shrinking stock market liquidity as smaller regional banks, in turn, drew down their deposits from the New York banks.

Without a central bank to fall back on, leading financiers (most notably J.P. Morgan) stepped in and put their own money on the line to bail out the surviving Wall Street banks and other financial institutions. This event became the impetus for the establishment of the Aldrich Commission and the infamous meeting at Jekyll Island, Georgia, where the foundations for the Federal Reserve System would be laid.

Understanding the Bank Panic of 1907

The Bank Panic of 1907 occurred during a six-week stretch, starting in October 1907. In the years leading up to the Panic, the U.S. Treasury, led by Secretary Leslie Shaw, engaged in large-scale purchases of government bonds and eliminated requirements that banks hold reserves against their government deposits. This fueled the expansion of the supply of money and credit throughout the country and an increase in stock market speculation, which would eventually precipitate the Panic of 1907.

The role of New York City trust companies played a critical factor in the Panic of 1907. Trust companies were state-chartered intermediaries that competed with other financial institutions. That said, trusts were not a main part of the settlement system and also had a low volume of check-clearing relative to banks.

Consequently, trusts at the time had a low cash-to-deposit ratio relative to national banks — the average trust would have a 5% cash-to-deposit ratio versus 25% for national banks. Since trust-company deposit accounts were demandable in cash, trusts were at risk for runs on deposits just like other financial institutions.

The specific trigger was the bankruptcy of two minor brokerage firms. A failed attempt by Fritz Augustus Heinze and Charles W. Morse to buy up shares of a copper mining firm resulted in a run on banks that were associated with them and had financed their speculative attempt to corner the copper market.

This loss of confidence triggered a run on the trust companies that continued to worsen even as banks stabilized, The most prominent trust company to fall was Knickerbocker Trust, which had previously dealt with Heinze. Knickerbocker — New York City's third-largest trust — was refused a loan by banking magnate J..P Morgan and was unable to withstand the run of redemptions and failed in late October.

This undermined the public's confidence in the financial industry in general and accelerated the ongoing bank runs. Initially, the panic was centered in New York City but it eventually spread to other economic centers across America.

In an attempt to head off the ensuing series of bank failures, Morgan, along with John D. Rockefeller and Treasury Secretary George Cortelyou, provided liquidity in the form of tens of millions of loans and bank deposits to several New York banks and trusts.

In the following days, Morgan would strongarm the New York Banks to provide loans to stock brokerages to maintain stock market liquidity and prevent the closure of the New York Stock Exchange (NYSE). He later also organized the Tennessee Coal, Iron, and Railroad Company (TC&I) buyout by Morgan-owned U.S. Steel to bail out one of the largest brokerages, which had borrowed heavily using TC&I stock collateral.

A spike in the interest rate on overnight collateral loans, provided by the NYSE, was one of the first signals that trouble was brewing. Specifically, annualized rates spiked from 9.5% to a whopping 70% on the very same day that the Knickerbocker shut down. Two days after, it was at 100%.

The NYSE managed to stay open mainly because of J.P. Morgan, who obtained cash from established financial institutions and industrial behemoths. Morgan then provided it directly to brokers who were willing to take on loans.

After a hold-up of several days, the New York Clearing House Committee got together and developed a panel to promote the insurance of clearinghouse loan certificates. They provided a short-term boost in liquidity and also represented an early version of the window loans provided by the Federal Reserve.

Aftermath of the Panic

The panic's impact led to the eventual development of the Federal Reserve System.

Uncomfortable with the prospect of putting their personal wealth on the line to stabilize the financial system that had made them rich, major bankers including Morgan and others, along with their political allies in the Congress and the Treasury, advanced plans to make it a public responsibility to bail out the markets as needed.

Ironically, enacting this agenda into law would ultimately rely on populist impulses among the politically dominant Democrat party to rein in the excesses and perceived abuses of the moneyed class and big bankers of Wall Street.

Known as the Aldrich Plan, after sponsoring Senator Nelson Aldrich, this plan would go on to form the framework for the Federal Reserve Act of 1913 and the Federal Reserve System that it would create.

The newly created Federal Reserve would act as a central prudential authority, controlling the nation's supply of money and credit and serving as lender of last resort to bail out over-leveraged, insolvent, and otherwise at-risk financial institutions. Then-Assistant Treasury Secretary Charles Hamlin was the first chair and Benjamin Strong — a key member of Morgan's company — became the president of the Federal Reserve Bank of New York — the most important regional Federal Reserve Bank.

Why the Federal Reserve Was Created

The Panic of 1907 supplied all the proof that drastic financial reform in the U.S. was needed.

The initial act passed by the federal government was called the Aldrich-Vreeland Act. It was passed in 1908. The purpose of the bill was to act as more of an emergency currency effort rather than a reformation to banking. Thanks to the Aldrich-Vreeland Act, an organization called the "National Currency Associations" was created. It was composed of a minimum of 10 financially fit banks and allowed them to issue emergency banknotes.

The act also led to the creation of the National Monetary Commission, whose research paved the way for the Federal Reserve to be established in 1913. It was the government's belief that a central bank was required to guarantee liquidity in times of strain through the regulation of the monetary supply.

Specifically, the Fed had three main purposes: to serve as a lender of last resort, to serve as a fiscal agent for the U.S. government, and to act as a clearinghouse.

Parallels to the 2008 Financial Recession

The parallels between The Bank Panic of 1907 and the 2008 recession are striking.

The Great Recession of the late 2000s was centered around investment banks and shadow banks without direct access to the Federal Reserve System, whereas its predecessor spread from trust companies that existed beyond the New York Clearing House. In essence, both events started outside of traditional retail banking services but still ushered in distrust for the banking industry among the broader public.

Both were also preceded by a time of excess in the U.S. monetary and financial markets. The Panic of 1907 was preceded by the Gilded Age, during which monopolies such as Standard Oil dominated the economy. Their growth led to the concentration of wealth among select individuals. Teddy Roosevelt referred to the "predatory man of wealth" in one of his speeches.

Similarly, the period before the 2008 recession was characterized by loose monetary policy and growth in numbers at Wall Street. Tales of excess at banking and financial services institutions abounded as they raked in revenues after doling out dubious loans to Americans.

The aftermath of the 1907 bank run led to the creation of the Federal Reserve, while the 2008 recession prompted new reforms such as Dodd-Frank. These mechanisms intended to protect the major financial interests from the effects of a financial meltdown after taking unreasonable risks while persuading the public that the government was doing something to fix these underlying problems.

In 1907, Mercantile National Bank received plenty of financial support from the New York Clearing House. That's analogous to the rescue of investment bank Bear Stearns during the height of the panic in 2008. For the uninitiated, Bear Stearns faced a serious run by its lenders right before it was ultimately purchased by J.P. Morgan Chase (with the help of a loan from the Federal Reserve).

The collapse of Lehman Brothers in 2008 is also quite analogous to the closing of Knickerbocker Trust. Each incident essentially marked the beginning of a downward spiral in the financial markets at the time. But while Knickerbocker was simply suspended for a short period in order to prevent depositors from accessing their accounts, Lehman Brothers completely collapsed as its customers needed roughly six years to receive their entitled funds.

What Problems Did the Panic of 1907 Expose?

The Panic of 1907 exposed several of the problems of the National Banking Act of 1864. One of the biggest issues with the act was that it didn't cover all banks.

Was There a Depression in 1908?

The 1907 panic triggered a sharp recession, with GNP falling 12% in 1908. But the economy bounced back relatively quickly, avoiding a prolonged depression.

Did the Panic of 1907 Lead to the Great Depression?

The Great Depression started in 1929, more than two decades after the Panic of 1907.