BANKING SYSTEM, BANKING HISTORY; FINANCIAL KNOWLEDGE, GREAT THINGS TO KNOW ABOUT THE AMERICAN BANKING HISTORY
COMMERCIAL BANKING -------KNOWLEDGEFINANCIAL.COM
The fundamental functions of a commercial bank during the past two centuries have been making
loans, receiving deposits, and lending credit either in the form of bank notes or of "created"
deposits. The banks in which people keep their checking accounts are commercial banks.
There were no commercial banks in colonial times, although there were loan offices or land banks
that made loans on real estate security with limited issues of legal tender notes. In 1781 Robert
Morris founded the first commercial bank in the United States—the Bank of North America. It
greatly assisted the financing of the closing stages of the American Revolution. By 1800, there
were twenty-eight state-chartered banks, and by 1811 there were eighty-eight.
Alexander Hamilton's financial program included a central bank to serve as a financial agent of
the treasury, provide a depository for public money, and act as a regulator of the currency.
Accordingly, the first Bank of the United States was founded 25 February 1791. Its $10 million
capital and favored relationship with the government aroused much anxiety, especially among
Jeffersonians. The bank's sound but unpopular policy of promptly returning bank notes for
redemption in specie (money in coin) and refusing those of non-specie-paying banks—together
with a political feud—was largely responsible for the narrow defeat of a bill to recharter it in 1811.
Between 1811 and 1816, both people and government were dependent on state banks. Nearly all
but the New England banks suspended specie payments in September 1814 because of the War
of 1812 and their own unregulated credit expansion.
The country soon recognized the need for a new central bank, and Congress established the
second Bank of the United States on 10 April 1816. Its $35 million capitalization and favored
relationship with the Treasury likewise aroused anxiety. Instead of repairing the overexpanded
credit situation that it inherited, it aggravated it by generous lending policies, which precipitated
the panic of 1819, in which it barely saved itself and generated wide-spread ill will.
Thereafter, under Nicholas Biddle, the central bank was well run. As had its predecessor, it
required other banks to redeem their notes in specie, but most of the banks had come to accept
that policy, for they appreciated the services and the stability provided by the second bank. The
bank's downfall grew out of President Andrew Jack-son's prejudice against banks and monopolies,
the memory of the bank's role in the 1819 panic, and most of all, Biddle's decision to let
rechartering be a main issue in the 1832 presidential election. Many persons otherwise friendly to
the bank, faced with a choice of Jackson or the bank, chose Jackson. He vetoed the recharter.
After 26 September 1833, the government placed all its deposits with politically selected state
banks until it set up the Independent Treasury System in the 1840s. Between 1830 and 1837, the
number of banks, bank note circulation, and bank loans all about tripled. Without the second bank
to regulate them, the banks overextended themselves in lending to speculators in land. The panic
of 1837 resulted in a suspension of specie payments, many failures, and a depression that lasted
until 1844. -------------KNOWLEDGEFINANCIAL.COM
Between 1833 and 1863, the country was without an adequate regulator of bank currency. In
some states, the laws were very strict or forbade banking, whereas in others the rules were lax.
Banks made many long-term loans and resorted to many subterfuges to avoid redeeming their
notes in specie. Almost everywhere, bank tellers and merchants had to consult weekly publications
known as Bank Note Reporters for the current discount on bank notes, and turn to the latest Bank
Note Detectors to distinguish the hundreds of counterfeits and notes of failed banks. This situation
constituted an added business risk and necessitated somewhat higher markups on merchandise. In
this bleak era of banking, however, there were some bright spots. These were the sulffolk Banking
System of Massachusetts (1819–1863); the moderately successful Safety Fund System(1829–
1866) and Free Banking (1838–1866) systems of New York; the Indiana (1834–1865), Ohio (1845–
1866), and Iowa (1858–1865) systems; and the Louisiana Banking System (1842–1862).
Inefficient and corrupt as some of the banking was before the Civil War, the nation's expanding
economy found it an improvement over the system on which the eighteenth-century economy had
Secretary of the Treasury Salmon P. Chase began agitating for an improved banking system in
1861. On 25 February 1863, Congress passed the National Banking Act, which created the
National Banking System. Its head officer was the comptroller of currency. It was based on several
recent reforms, especially the Free Banking System's principle of bond-backed notes. Nonetheless,
the reserve requirements for bank notes were high, and the law forbade real estate loans and
branch banking, had stiff organization requirements, and imposed burdensome taxes. State banks
at first saw little reason to join, but, in 1865, Congress levied a prohibitive 10 percent tax on their
bank notes, which drove most of these banks into the new system. The use of checks had been
increasing in popularity in the more settled regions long before the Civil War, and, by 1853, the
total of bank deposits exceeded that of bank notes. After 1865 the desire of both state and
national banks to avoid the various new restrictions on bank notes doubtless speeded up the shift
to this more convenient form of bank credit. Since state banks were less restricted, their number
increased again until it passed that of national banks in 1894. Most large banks were national,
The National Banking System constituted a substantial improvement over the pre–Civil War
hodgepodge of banking systems. Still, it had three major faults. The first was the perverse elasticity
of the bond-secured bank notes, the supply of which did not vary in accordance with the needs of
business. The second was the decentralisation of bank deposit reserves. There were three classes
of national banks: the lesser ones kept part of their reserves in their own vaults and deposited the
rest at interest with the larger national banks. These national banks in turn lent a considerable part
of the funds on the call money market to finance stock speculation. In times of uncertainty, the
lesser banks demanded their outside reserves, call money rates soared, security prices
tobogganed, and runs on deposits ruined many banks. The third major fault was that there was no
central bank to take measures to forestall such crises or to lend to deserving banks in times of
In 1873, 1884, 1893, and 1907, panics highlighted the faults of the National Banking System.
Improvised use of clearinghouse certificates in interbank settlements some-what relieved money
shortages in the first three cases, whereas "voluntary" bank assessments collected and lent by a
committee headed by J. P. Morgan gave relief in 1907. In 1908 Congress passed the Aldrich-
Vreeland Act to investigate foreign central banking systems and suggest reforms, and to permit
emergency bank note issues. The Owen-Glass Act of 1913 superimposed a central banking system
on the existing national banking system. It required all national banks to "join" the new system,
which meant to buy stock in it immediately equal to 3 percent of their capital and surplus, thus
providing the funds with which to set up the Federal Reserve System. State banks might also join
by meeting specified requirements, but, by the end of 1916, only thirty-four had done so. A
majority of the nation's banks have always remained outside the Federal Reserve System,
although the larger banks have usually been members. The Federal Reserve System largely
corrected the faults to which the National Banking System had fallen prey. Admittedly, the
Federal Reserve had its faults and did not live up to expectations. Nevertheless, the nation's
commercial banks had a policy-directing head and a refuge in distress to a greater degree than
they had ever had before. Thus ended the need for the Independent Treasury System, which
finally wound up its affairs in 1921.
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Only a few national banks gave up their charters for state ones in order to avoid
joining the Federal Reserve System. However, during World War I, many state banks
became members of the system. All banks helped sell Liberty bonds and bought
short-term Treasuries between bond drives, which was one reason for a more than
doubling of the money supply and also of the price level from 1914 to 1920. A major
contributing factor for these doublings was the sharp reduction in reserves required
under the new Federal Reserve System as compared with the pre-1914 National
By 1921 there were 31,076 banks, the all-time peak. Every year, local crop failures,
other disasters, or simply bad management wiped out several hundred banks. By
1929 the number of banks had declined to 25,568. Admittedly, mergers eliminated a
few names, and the growth of branch, group, or chain banking provided stability in
some areas. Nevertheless, the 1920s are most notable for stock market
speculation. Several large banks had a part in this speculation, chiefly through their
investment affiliates. The role of investment adviser gave banks great prestige until
the panic of 1929, when widespread disillusionment from losses and scandals
brought them discredit. --------KNOWLEDGEFINANCIAL.COM
The 1930s witnessed many reforms growing out of the more than 9,000 bank
failures between 1930 and 1933 and capped by the nationwide bank moratorium of
6–9 March 1933. To reform the commercial and central banking systems, as well as
to restore confidence in them, Congress passed two major banking laws between
1933 and 1935. These laws gave the Federal Reserve System firmer control over the
banking system. They also set up the Federal Deposit Insurance Corporation to
insure bank deposits, and soon all but a few hundred small banks belonged to it.
That move greatly reduced the number of bank failures. Other changes included
banning investment affiliates, prohibiting banks from paying interest on demand
deposits, loosening restrictions against national banks' having branches and
making real estate loans, and giving the Federal Reserve Board the authority to raise
member bank legal reserve requirements against deposits. As a result of the
Depression, the supply of commercial loans dwindled, and interest rates fell sharply.
Consequently, banks invested more in federal government obligations, built up
excess reserves, and imposed service charges on checking accounts. The 1933–
1934 devaluation of the dollar, which stimulated large imports of gold, was another
cause of those excess reserves.
During World War II, the banks again helped sell war bonds. They also converted
their excess reserves into government obligations and dramatically increased their
own holdings of these. Demand deposits more than doubled. Owing to bank
holdings of government obligations and to Federal Reserve commitments to the
treasury, the Federal Reserve had lost its power to curb bank-credit expansion. Price
levels nearly doubled during the 1940s.
In the Federal Reserve-treasury "accord" of March 1951, the Federal Reserve System
regained its freedom to curb credit expansion, and thereafter interest rates crept
upward. That development improved bank profits and led banks to reduce somewhat
their holdings of federal government obligations. Term loans to industry and real
estate loans increased. Banks also encountered stiff competition from rapidly
growing rivals, such as savings and loan associations and personal finance
companies. On 28 July 1959, Congress eliminated the difference between reserve
city banks and central reserve city banks for member banks. The new law kept the
same reserve requirements against demand deposits, but it permitted banks to
count cash in their vaults as part of their legal reserves.
Interest rates rose spectacularly all during the 1960s and then dropped sharply in
1971, only to rise once more to 12 percent in mid-1974. Whereas consumer prices
had gone up 23 percent during the 1950s, they rose 31 percent during the 1960s—
especially toward the end of the decade as budget deficits mounted—and climbed
another 24 percent by mid-1974. Money supply figures played a major role in
determining Federal Reserve credit policy from 1960 on.
Money once consisted largely of hard coin. With the coming of commercial banks, it
came also to include bank notes and demand deposits. The difference, however,
between these and various forms of "near money"—time deposits, savings and loan
association deposits, and federal government E and H bonds—is slight. Credit
cards carry the confusion a step further. How does one add up the buying power of
money, near money, and credit cards? As new forms of credit became more like
money, it was increasingly difficult for the Federal Reserve to regulate the supply of
credit and prevent booms. --------KNOWLEDGEFINANCIAL.COM
Since 1970 banking and finance have undergone nothing less than a revolution. The
structure of the industry in the mid-1990s bore little resemblance to that established
in the 1930s in the aftermath of the bank failures of the Great Depression. In the
1970s and 1980s, what had been a fractured system by design became a single
market, domestically and internationally. New Deal banking legislation of the
Depression era stemmed from the belief that integration of the banking system had
allowed problems in one geographical area or part of the financial system to spread
to the entire system. Regulators sought, therefore, to prevent money from flowing
between different geographical areas and between different functional segments.
These measures ruled out many of the traditional techniques of risk management
through diversification and pooling. As a substitute, the government guaranteed bank
deposits through the Federal Deposit Insurance Corporation and the Federal
Savings and Loan Insurance Corporation.
In retrospect, it is easy to see why the segmented system broke down. It was
inevitable that the price of money would vary across different segments of the
system. It was also inevitable that borrowers in a high-interest area would seek
access to a neighboring low-interest area—and vice versa for lenders. The only
question is why it took so long for the pursuit of self-interest to break down regulatory
barriers. Price divergence by itself perhaps was not a strong enough incentive.
Rationing of credit during tight credit periods probably was the cause of most
innovation. Necessity, not profit alone, seems to have been the cause of financial
Once communication between segments of the system opened, mere price
divergence was sufficient to cause flows of funds. The microelectronics revolution
enhanced flows, as it became easier to identify and exploit profit opportunities.
Technological advances sped up the process of market unification by lowering
transaction costs and widening opportunities. The most important consequence of
the unification of segmented credit markets was a diminished role for banks.
Premium borrowers found they could tap the national money market directly by
issuing commercial paper, thus obtaining funds more cheaply than banks could
provide. In 1972 money-market mutual funds began offering shares in a pool of
money-market assets as a substitute for bank deposits. Thus, banks faced
competition in both lending and deposit-taking—competition generally not subject to
the myriadregulatory controls facing banks.
Consolidation of banking became inevitable as its functions eroded. The crisis of the
savings and loan industry was the most visible symptom of this erosion. Savings
and loans associations (S&Ls) had emerged to funnel household savings to
residential mortgages, which they did until the high interest rates of the inflationary
1970s caused massive capital losses on long-term mortgages and rendered many
S&Ls insolvent by 1980. Attempts to re-gain solvency by lending cash from the sale
of existing mortgages to borrowers willing to pay high interest only worsened the
crisis, because high-yield loans turned out to be high risk. The mechanisms
invented to facilitate mortgage sales undermined S&Ls in the longer term as it
became possible for specialized mortgage bankers to make mortgage loans and
sell them without any need for the expensive deposit side of the traditional S&L
Throughout the 1970s and 1980s, regulators met each evasion of a regulatory
obstacle with further relaxation of the rules. The Depository Institutions Deregulation
and Monetary Control Act (1980) recognized the array of competitors for bank
business by expanding the authority of the Federal Reserve System over the new
entrants and relaxing regulation of banks. Pressed by a borrowers' lobby seeking
access to low-cost funds and a depositors' lobby seeking access to high money-
market returns, regulators saw little choice but capitulation. Mistakes occurred,
notably the provision in the 1980 act that extended deposit insurance coverage to
$100,000, a provision that greatly increased the cost of the eventual S&L bailout. The
provision found its justification in the need to attract money to banks. The mistake
was in not recognizing that the world had changed and that the entire raison d'être of
the industry was disappearing. ------KNOWLEDGEFINANCIAL.COM
Long-term corporate finance underwent a revolution comparable to that in banking.
During the prosperous 1950s and 1960s, corporations shied away from debt and
preferred to keep debt-equity ratios low and to rely on ample internal funds for
investment. The high cost of issuing bonds—a consequence of the uncompetitive
system of investment banking—reinforced this preference. Usually, financial
intermediaries held the bonds that corporations did issue. Individual owners, not
institutions, mainly held corporate equities. In the 1970s and 1980s, corporations
came to rely on external funds, so that debt-equity ratios rose substantially and
interest payments absorbed a much greater part of earnings. The increased
importance of external finance was itself a source of innovation as corporations
sought ways to reduce the cost of debt service. Equally important was increased
reliance on institutional investors as purchasers of securities. When private
individuals were the main holders of equities, the brokerage business was
uncompetitive and fees were high, but institutional investors used their clout to
reduce the costs of buying and selling. Market forces became much more important
in finance, just as in banking.
Institutional investors shifted portfolio strategies toward equities, in part to enhance
returns to meet pension liabilities after the Employment Retirement Income Security
Act (1974) required full funding of future liabilities. Giving new attention to maximizing
investment returns, the institutional investors became students of the new theories
of rational investment decision championed by academic economists. The capital
asset pricing model developed in the 1960s became the framework that institutional
investors most used to make asset allocations.
The microelectronics revolution was even more important for finance than for
banking. Indeed, it would have been impossible to implement the pricing model
without high-speed, inexpensive computation to calculate optimal portfolio
weightings across the thousands of traded equities. One may argue that
computational technology did not really cause the transformation of finance and that
increased attention of institutional investors was bound to cause a transformation in
any event. Both the speed and extent of transformation would have been impossible,
however, without advances in computational and communications technologies.
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THE 16 DAYS THAT SHOOCK THE US ECONOMY IN SEPTEMBER, 2008.
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COMMERCIAL REAL ESTATE
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OCTOBER 2008 ----- WASHINGTON - The government will buy an ownership
stake in a broad array of American banks for the first time since the Great
Depression, Treasury Secretary Henry Paulson said late Friday, announcing
the historic step after stock markets jolted still lower around the world despite
all efforts to slow the selling stampede
Separately, the U.S. and the globe's other industrial powers pledged to take
"decisive action and use all available tools" to prevent a worldwide economic
"This is a period like none of us has ever seen before," declared Paulson at a
rare Friday night news conference. He said the government program to
purchase stock in private U.S. financial firms will be open to a broad array of
institutions, including banks, in an effort to help them raise desperately needed
The administration received the authority to take such direct action in the $700
billion economic rescue bill that Congress passed and President Bush signed
Earlier Friday, stock prices hurtled downward in the United States, Europe and
Asia, even as President Bush tried to reassure Americans and the world that
the U.S. and other governments were aggressively addressing what has
become a near panic.
A sign of how bad things have gotten: A drop of 128 points in the Dow Jones
industrials was greeted with sighs of relief after the index had plummeted
much further on previous days. The week ended as the Dow's worst ever, with
the index down an incredible 40.3 percent since its record close almost exactly
one year earlier, on Oct. 9. 2007.
Investors suffered a paper loss of $2.4 trillion for the week, as measured by the
Dow Jones Wilshire 5000 index, and for the past year the losses have totaled
It was even worse overseas on Friday. Britain's FTSE index ended below the
4,000 level for the first time in five years; Germany's DAX fell 7 percent and
France's CAC-40 finished down 7.7 percent. Japan's benchmark Nikkei 225
index fell 9.6 percent, also hitting a five-year low. For the week, the Nikkei lost
nearly a quarter of its value. Russia's market never even opened.
Paulson announced the administration's new effort to prop up banks at the
conclusion of discussions among finance officials of the Group of Seven major
industrialized countries. That group endorsed the outlines of a sweeping
program to combat the worst global credit crisis in decades.
Earlier this week, Britain had moved to pour cash into its troubled banks in
exchange for stakes in them — a partial nationalization.
Paulson said the U.S. program would be designed to complement banks' own
efforts to raise fresh capital from private sources. The government's stock
purchases will be of nonvoting shares so it will not have power to run the
The purchase of stakes in companies would be in addition to the main thrust of
the $700 billion rescue effort, which is to buy bad mortgages and other
distressed assets from financial institutions. The aim is to unthaw frozen credit,
get banks to resume more normal lending operations and stave off severe
problems for businesses and everyday Americans alike.
It would mark the first time the government has taken equity ownership in
banks in this manner since a similar program was employed during the
In 1989, the government created the Resolution Trust Corp. to deal with the
aftermath of the savings and loan crisis. It disposed of the assets of failed
savings and loans.
Paulson and Federal Reserve Chairman Ben Bernanke met with their
counterparts from the world's six other richest countries late in the day as the
rout of financial markets sped ahead despite earlier dramatic rescue efforts in
the U.S. and abroad.
In a statement at the end of that meeting, the G7 officials vowed to protect major
banks and to prevent their failure. They also committed to working to get credit
flowing more freely again, to support the efforts of banks to raise money from
both public and private sources, to bolster deposit insurance and to revive the
battered mortgage financing market.
They did not provide specifics beyond that five-point framework.
At the White House earlier in the day, Bush said, "We're in this together and
we'll come through this together." He added, "Anxiety can feed anxiety, and that
can make it hard to see all that's being done to solve the problem."
He made it clear the United States must work with other countries to battle the
worst financial crisis that has jolted the world economy in more than a half-
"We've seen that problems in the financial system are not isolated to the United
States," he said. "So we're working closely with partners around the world to
ensure that our actions are coordinated and effective."
Fear has tightened its grip on investors worldwide even as the United States
and other countries have taken a series of radical actions including an
unprecedented, coordinated interest rate cuts by the Federal Reserve and other
major central banks.
Besides the United States, the other members of the G7 meeting in
Washington are Japan, Germany, Britain, France, Italy and Canada. Finance
officials also planned to meet with Bush Saturday at the White House.
"We are in a development where the downward spiral is picking up speed,"
said Germany's Finance Minister Peer Steinbrueck, who wanted to see an
orchestrated response among the G7.
So did French Finance Minister Christine Lagarde, who said a "coordinated,
synchronized and rightly timed approach" was needed.
An even larger group of nations — called the G20 — will meet with Paulson on
Saturday evening. How the world's finance officials and central bank presidents
can better contain the spreading financial crisis also will dominate discussions
at the weekend meetings of the 185-nation International Monetary Fund and the
World Bank in Washington.
The British, who recently announced a plan to guarantee billions of dollar worth
of debt held by major banks, have been pitching that idea to the rest of the G7
The idea behind all these ideas — as well as bold steps previously announced
in recent weeks — is to get credit flowing more freely again.
In the United States, hard-pressed banks and investment firms are drawing
emergency loans from the Federal Reserve because they can't get money
elsewhere. Skittish investors have cut them off, moving their money into safer
Treasury securities. Financial institutions are hoarding whatever cash they
have, rather than lending it to each other or customers.
The lending lockup — which is making it harder and more expensive for
businesses and ordinary people to borrow money — is threatening to push the
United States and the world economy as a whole into a deep and painful
In Europe, governments have moved to protect nervous bank depositors.
Germany pledged to guarantee all private bank savings and CDs in the country,
and Iceland and Denmark followed suit. Ireland went even further by also
guaranteeing Irish banks' debts. The United States will temporarily boost
deposit insurance from $100,000 to $250,000 in cases where its banks or
savings and loans fail.
The Fed, meanwhile, has repeatedly tapped its Depression-era authority to be
a lender of last resort, not only to financial institutions but also to other types of
companies. Earlier this week, the Fed said it would buy massive amounts of
companies' debts, in another unprecedented effort to break through the credit
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..The Twelve Federal Reserve Districts... LEARN MORE ABOUT THEM...
..FDIC: FEDERAL INSURANCE CORPORATION, LEARN MORE ABOUT THIS GREAT INSTITUTION...
..Board of Governors of the feral Reserve System. ...WHAT THEY DO?
Influences money and credit conditions in the U.S., supervises and regulates banking,
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Securities and Exchange Commission (SEC)
U.S. Securities and Exchange Commission: official Federal Agency website, including news,
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Top 6 Biggest U.S. Government Financial Bailouts In History!
The passage into U.S. law on October 3, 2008, of the $700 billion financial-sector rescue plan
is the latest in the long history of U.S. government bailouts that go back to the Panic of 1792,
when the federal government bailed out the 13 United States, which were over-burdened by
their debt from the Revolutionary War
Internal Revenue Service [IRS] Tax Information For Businesses....
IRS: Tax Information for Individuals...
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IRS: Frequently Asked Tax Questions and Answers. You Have Questions, IRS Has the
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United States Financial Regulation...
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Until 1863, US banks were regulated by the states. The Federal Government had twice established a
national bank, but abandoned both efforts. In 1863, the Civil War had been raging for two years, and the
Federal Government was desperately short of cash. Secretary of the Treasury Salmon P. Chase came up
with an innovative source of financing.
The Federal Government would charter national banks that would have authority to issue their own
currency so long as it was backed by holdings in US Treasury bonds. The idea was implemented as the
National Currency Act, which was completely rewritten two years later as the National Banking Act. The
act formed the Office of the Comptroller of the Currency (OCC) with authority to charter and examine
national banks. In this way, a dual system of banking was launched, with some banks chartered and
regulated by the states and others chartered and regulated by the OCC.
As a response to the financial panic of 1907, the 1913 Federal Reserve Act formed the Federal Reserve
System (the Fed) as a central bank and lender of last resort. The system included several regional Federal
Reserve Banks and a seven-member governing board. National banks were required to join the system,
and state banks were welcome to. Federal Reserve notes were introduced as a national currency whose
supply could be managed by the Fed. The notes were issued to reserve banks for subsequent transmittal
to banking institutions as needed. The new notes supplanted the OCC's purpose related to currency, but
that organization continued to be the primary regulator of national banks.
your world. ------------------------------KNOWLEDGEFINANCIAL.COM
Prior to 1933, US securities markets were largely self-regulated. As early as 1922, the New York Stock
Exchange (NYSE) imposed its own capital requirements on member firms. Firms were required to hold
capital equal to 10% of assets comprising proprietary positions and customer receivables.
By 1929, the NYSE capital requirement had developed into a requirement that firms hold capital equal to:
5% of customer debits;
a minimum 10% on proprietary holdings in Treasury or municipal bonds;
30% on proprietary holdings in other liquid securities; and
100% on proprietary holdings in all other securities.
During October 1929, the US stock market crashed, losing 20% of its value. The carnage spilled into the
US banking industry where banks lost heavily on proprietary stock investments. Fearing that banks would
be unable to repay money in their accounts, depositors staged a “run” on banks. Thousands of US banks
BANKING HISTORY CONTINUE... --------------KNOWLEDGEFINANCIAL.COM
Glass-Steagall also formed the Federal Deposit Insurance Corporation (FDIC) to provide deposit insurance
for commercial banks. All member banks of the Federal Reserve were required to participate. Other banks
were welcome to participate upon certification of their solvency. The FDIC was funded with insurance
premiums paid by participating banks. Deposits were insured up to USD 2,500—if a bank failed, the FDIC
would make whole depositors for losses on deposits up to USD 2,500. That insurance level has since
been increased to USD 100,000.
Two other acts addressed the securities markets. The 1933 Securities Act focused on primary markets,
ensuring disclosure of pertinent information relating to publicly offered securities. The 1934 Securities
Exchange Act focused on secondary markets, ensuring that parties who trade securities—exchanges,
brokers and dealers—act in the best interests of investors. Certain securities—including US Treasury and
municipal debt—were exempted from most of these acts' provisions.
The Securities Exchange Act established the Securities and Exchange Commission (SEC) as the primary
regulator of US securities markets. In this role, the SEC gained regulatory authority over securities firms.
Called broker-dealers in US legislation, these include investment banks as well as non-banks that broker
and/or deal non-exempt securities. The 1938 Maloney Act clarified this role, providing for self regulating
organizations (SRO’s) to provide direct oversight of securities firms under the supervision of the SEC.
SRO’s came to include the National Association of Securities Dealers (NASD) as well as national and
regional exchanges. Commercial banks continued to be regulated by the OCC or state regulators
depending upon whether they had federal or state charters.
In 1938, the Securities Exchange Act was modified to allow the SEC to impose its own capital
requirements on securities firms, so the SEC started to develop a Net Capital Rule. Its primary purpose
was to protect investors who left funds or securities on deposit with a securities firm. In 1944, the SEC
exempted from this capital rule any firm whose SRO imposed more comprehensive capital requirements.
Capital requirements the NYSE imposed on member firms were deemed to meet this criteria.
Mutual funds, and especially closed-end mutual funds, were hit hard in the 1929 crash. A number of
abuses came to light—some closed-end funds had been little more than Ponzi schemes—prompting
Congress to pass the 1940 Investment Company Act regulating mutual funds. With a few exceptions—
which encompass most of today's hedge funds—this granted the SEC regulatory authority over investment
companies. Congress also passed the 1940 Investment Advisers Act, regulating the relationship between
mutual funds and their investment managers.
Between 1967 and 1970, the NYSE experienced a dramatic increase in trading volumes. Securities firms
were caught unprepared, lacking the technology and staff to handle the increased workload. Back offices
were thrown into confusion trying to process trades and maintain client records. Errors multiplied,
causing losses. For a while, this “paperwork crisis” was so severe that the NYSE reduced its trading
hours and even closed one day a week. In 1969, the stock market fell just as firms were investing heavily
in back office technology and staff. Trading volumes dropped, and the combined effects of high expenses,
decreasing revenues and losses on securities inventories proved too much for many firms. Twelve firms
failed, and another 70 were forced to merge with other firms. The NYSE trust fund, which had been
established in 1964 to compensate clients of failed member firms, was exhausted.
The US stock market declined through 1969. ----------KNOWLEDGEFINANCIAL.COM
In the aftermath of the paperwork crisis, Congress founded the Securities Investor Protection Corporation
(SIPC) to insure client accounts at securities firms. It also amended the Securities Exchange Act to require
the SEC to implement regulations to safeguard client accounts and establish minimum financial
responsibility requirements for securities firms.
As a backdrop to these actions, it came to light that the NYSE had failed to enforce its own capital
requirements against certain member firms at the height of the paperwork crisis. With its trust fund failing,
it is understandable that the NYSE didn’t want to push more firms into liquidation. This inaction marked the
end of SROs setting capital requirements for US securities firms.
In 1975, the SEC updated its capital requirements, implementing a Uniform Net Capital Rule (UNCR) that
would apply to all securities firms trading non-exempt securities. As with earlier capital requirements, the
capital rule’s primary purpose was to ensure that firms had sufficient liquid assets to meet client
obligations. Firms were required to detail their capital calculations in a quarterly Financial and Operational
Combined Uniform Single (FOCUS) report.
During the Great Depression, the Fed had implemented Regulation Q that, among other things, capped the
interest rates commercial banks could offer on savings account deposits. The intent was to prevent
bidding wars between banks trying to grow their depositor bases. Rising interest rates during the 1970s
contributed to a migration of larger institutional deposits to Europe, where interest rates were not limited
by Regulation Q. The emergence of money market funds, which pooled cash to invest in money market
instruments, caused further erosion of bank deposits.
In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act. Among other
things, this terminated the Regulating Q ceiling on savings account interest rates, effective in 1986. In
response to this and an ongoing decline in bank capital ratios, bank regulators implemented minimum
capital requirements for banks. There was some debate about what should be included in a bank's capital.
This was resolved by defining two classes of capital. A bank's primary capital would be a bank's more
permanent capital. It was defined as owners' equity, retained earnings, surplus, various reserves and
perpetual preferred stock and mandatory convertible securities. Secondary capital, which was more
transient, included limited-life preferred stock and subordinated notes and debentures. In 1981, the Fed
and OCC implemented one capital requirement, and the FDIC implemented another. Generally, these
specified minimum primary capital ratios of between 5% and 6%, depending on a bank's size.
Because these requirements were based on a bank's assets, they were particularly susceptible to
regulatory arbitrage. Various modifications were made to the primary capital requirements, but it was soon
clear that basing capital requirements on a capital ratio was unworkable. In 1986, the Fed approached the
Bank of England and proposed the development of international risk-based capital requirements. This led
to the 1988 Basel Accord, which replaced the asset-based primary capital requirements for US
commercial banks. The concepts of primary and secondary capital were incorporated into the new accord
as tier 1 and tier 2 capital.
As time went on, the Glass-Steagal separation of investment and commercial banking was gradually
eroded. Some of this stemmed from regulatory actions. Much of it stemmed from market developments not
anticipated by the act.
BANKING HISTORY CONTINUE... ------------KNOWLEDGEFINANCIAL.COM
Glass-Steagall did not prevent commercial banks from engaging in securities activities overseas. By the
mid 1980s, US commercial banks such as Chase Manhatten, Citicorp and JP Morgan had thriving
overseas securities operations. Currencies were not securities under the Glass-Steagall Act, but since
exchange rates were allowed to float in the early 1970s, they have entailed similar market risk.
In 1933, futures markets were small and transacted primarily in agricultural products, so they were not
included in the legal definition of securities. Also, depression era legislators did not anticipate the
emergence of active OTC derivatives markets, so most derivatives did not fall under any definition of
securities. By the early 1990s, commercial banks were taking significant market risks, actively trading
foreign exchange, financial futures and OTC derivatives. They did so while enjoying FDIC insurance and
membership in the Federal Reserve system. Neither of these benefits was available to the investment
banks with whom they were increasingly competing.
Commercial banks focused on the prospect of repealing Glass-Steagal and related legislation. This would
open the door to the creation of financial supermarkets that combined commercial banking, investment
banking and insurance. Due to the nature of their business, commercial banks generally had more robust
balance sheets than investment banks, and they could expect to dominate such a new world. There would
be profits from cross-selling deposit taking, lending, investment banking, brokerage, investment
management and insurance products to a combined client base. There would also be troublesome
conflicts of interest.
While he was chairman of the Federal Reserve, Paul Volker fought efforts to ease the separation between
commercial and investment banking. Allen Greenspan replaced Volker in 1987, and he brought with him a
more accommodating attitude. Section 20 of the Glass-Steagall Act had always granted modest
exemptions allowing commercial banks to engage in limited securities activities as a convenience to
clients who used the bank’s other services. ------------KNOWLEDGEFINANCIAL.COM
Tentatively under Volker, but aggressively under Greenspan, the Fed reinterpreted Section 20 to expand
that authorization. In various rulings during the late 1980s, the Fed granted certain commercial banks
authority under Section 20 to underwrite commercial paper, municipal revenue bonds, mortgage-backed
securities and even corporate bonds. In October 1989, JP Morgan became the first commercial bank to
underwrite a corporate bond, floating a USD 30MM bond issue for the Savannah Electric Power Company.
A flood of commercial bank underwritings followed.
The Fed also allowed commercial banks to acquire investment bank subsidiaries through which they
might underwrite and deal in all forms of securities, including equities. These became known as Section
20 subsidiaries. There were limitations on the use of Section 20 subsidiaries. The most restrictive was a
cap on the revenue a commercial bank could derive from securities activities under Section 20. In 1986,
the Fed had set this cap at 5%. It was expanded to 10% in 1989 and again in 1996 to 25%.
Congress attempted to repeal Glass-Steagall in 1991 and again in 1995. Both attempts failed, but the stage
was set. The Fed had already gutted much of Glass-Steagall. Commercial banks were deriving
considerable revenues from investment banking activities. Their lobbyists had arrayed considerable
forces in Congress ready to make another attempt. Glass-Steagall was teetering, and all that was needed
was for someone to step forward and topple her.
That is what John Reed and Sanford Weill did. Reed was CEO of Citicorp, a large commercial bank holding
company. Weill was CEO of Travelers Group, a diverse financial services organization. It had origins in
insurance but had recently acquired the two investment banks Salomon and Smith Barney and merged
them into a single investment banking subsidiary. In 1998, Reed and Weill merged their firms, forming
Citigroup, a financial services powerhouse spanning commercial banking, investment banking and
insurance. This was an aggressive move that could easily have been blocked by regulators.
A permissive Fed was supportive of the deal, which forced the hand of Congress. In 1956, Congress had
passed the Bank Holding Company Act, which had supplemented Glass-Steagall by limiting the services
commercial banks could offer clients. The Citicorp-Travelers merger violated the 1956 act, but there was a
loophole. The Holding Company Act allowed for a two-year review period—with an optional extension to
five years—before the Fed would have to act. The newly formed Citigroup was the world's largest financial
services organization, but it was operating under a five-year death sentence. If Congress didn't pass
legislation during those five years, Citigroup would have to divest some of its businesses.
Pressure on Congress was immense. In 1999, they passed the Financial Services Modernization Act, and
President Clinton signed it into law. The act is also known for the names of its sponsors—the Gramm-
Leach-Bliley Act—but detractors have called it the Citigroup Authorization Act. This sweeping legislation
finally revoked the Glass-Steagall separation of commercial and investment banking. It also revoked the
1956 Bank Holding Company Act. It permitted the creation of financial holding companies (FHCs) that may
hold commercial banks, investment banks and insurance companies as affiliated subsidiaries. Those
subsidiaries may sell each others products. Within a year of the new act's passage, five hundred bank
holding companies formed FHCs. ---------------KNOWLEDGEFINANCIAL.COM
Although it was sweeping, the Financial Services Modernization Act was, in some respects, a half
measure. It dramatically transformed the financial services industry, but it did little to transform the
regulatory framework. Prior to the act, commercial banks, investment banks and insurance companies
had been separate, and they had oversight from separate regulators—the Fed and OCC for commercial
banks, the SEC for investment banks, and state regulators for insurance companies. Who would now
oversee the new FHCs that combined all three industries? The answer is no one. The act adopted a
"functional" approach to regulation. The Fed and OCC now regulate the commercial banking functions of
FHCs. The SEC regulates their investment banking functions. State insurance regulators regulates their
insurance functions. The act has opened the door to abuses across functions, but no regulator is clearly
positioned to identify and address these.
At the same time that Glass-Steagall was being torn down, dramatic growth in the OTC derivatives market
led to concern that there was no regulator with clear authority to oversee that market. A 1982 amendment
to the Securities Exchange Act specified that options on securities or baskets of securities were to be
regulated by the SEC. This left structures such as forwards and swaps outside the SEC's jurisdiction. It
also excluded derivatives on interest rates or foreign exchange. A regulator with authority most relevant
to these derivatives was one whose original purpose was unrelated to financial markets. This was the
Commodity Futures Trading Commission (CFTC).
Congress formed the CFTC under the 1974 Commodity Exchange Act (CEA). It had exclusive jurisdiction to
regulate commodity futures and options. Whether this authority encompassed OTC financial derivatives
was not legislatively clear and motivated several law suits.
As a debate raged over how OTC derivatives should be regulated—or if they even should be regulated—
there was pressure for the the CFTC to act. Because its authority was not clear, the CFTC hesitated, and
market participants were generally opposed to the CFTC intervening. Position papers were written by
industry groups and government agencies. Inevitably, there were some turf skirmishes as different
regulatory agencies tried to position themselves for a role in any new regulatory regime. A strong
argument against increased regulation of OTC derivatives was that it would drive the market overseas—
as had happened 20 years earlier to the market for USD deposits.
Finally, Congress acted in 2000 by passing the Commodity Futures Modernization Act (CFMA). This
amended the 1974 Commodity Exchange Act, exempting all OTC derivatives. The CFTC was not to regulate
OTC derivatives. The market was to remain largely unregulated.
Overheated technology stocks formed a bubble that collapsed during 2000. In 2001, the broader market
also fell sharply. On September 11 of that year, terrorists hijacked airliners, slamming two of them into
New York's World Trade Center. Another hit the Pentagon in Washington, and a fourth fell in a
Pennsylvania field. With the terrorist attacks, the bad news seemed to accelerate. Within weeks, the Wall
Street Journal was reporting on a brewing scandal at energy trading powerhouse Enron. -----
The firm had been using accounting gimmicks and outright deception to inflate profits and hide debt. In
December, it filed for bankruptcy—the largest in US history. In 2002, that record was broken by the
bankruptcy of telecommunications firm WoldCom, which had inflated its 2000-2001 income by a whopping
USD 74.4 billion. Enron and WorldCom were just the two most prominent in a slew of bankruptcies and
accounting scandals, which included Global Crossing, Tyco, Rite Aid, Xerox, and others. In 2002,
Accounting firm Arthur Andersen was convicted of a single charge stemming from its lackluster auditing
of Enron. That action forced Andersen, one of the largest and most respected auditors in the world, to go
out of business. In 2005, the US Supreme Court overturned the decision, concluding that the presiding
judge had given the jury faulty instructions. This decision came too late to save Arthur Andersen.
There was plenty of blame to go around. Corporate executives had cooked books while lining their
pockets. Analysts at investment banks had recommended stocks they knew were dogs in a quid pro quo
that ensured banking business from those same firms. Accounting firms had been cross-selling consulting
services to audit clients. Increasingly, their auditors had shied away from challenging management of
firms so as to not jeopardizing those lucrative consulting engagements.