The Federal Reserve and Other Banks
For Kids - The Collapse of the American Banking System
The decisions of banks, the Federal Reserve System, and individual depositors brought about the collapse of the American banking system.
The Federal Reserve System: It started with decisions made by the Federal Reserve Banks. In the 1930s, there were 12 Federal Reserve Banks in the United States, just as there are today. Each Federal Reserve Bank was responsible to watch and help the banks in their region, and to ensure that local banks in their region did not fail. In the 1930s, if a bank failed, all the money depositors had in that bank would disappear forever. So, if a bank failed, a great many people would lose their savings. As part of this system, set up originally in 1913, local banks could borrow money from the Federal Reserve Bank in their region. They had to pay these loans back with interest. It was expensive to borrow money from the Federal Reserve Banks. It was an avenue of last resort.
Decision of Banks: In 1931, the Federal Reserve raised the interest rate. When the interest rate goes up, typically the value of bonds goes down. Between poor investments, bonds and stocks with lessened values, and too many risky loans that were not being paid back, some banks found themselves short of cash. To stay in business, these banks applied to the Federal Reserve Bank in their region for a loan. That is what the Federal Reserve Banks were designed to do. But the regional presidents of the 12 Federal Reserve Banks were commercial bankers. They turned down requests from local banks if they believed the local banks were not a good risk, and would not be able to pay them back. With their request for a loan denied, and without being able to raise enough cash from their investments to stay in business, many local banks failed.
Individual Depositors: As word of these failures spread across the country, it caused a panic. Many depositors wanted to pull their money out of the bank before their own bank failed. No bank had enough cash on hand to satisfy the demands of nearly all their depositors at once. When banks turned to the Federal Reserve Banks for help, the Federal Reserve Banks decided to do nothing. Bank after bank failed, due in a great part to the massive numbers of people pulling their money out of banks at the same time, while the Federal Reserve Banks watched, but continued to do nothing. By the time Roosevelt was elected president in 1932, 9,000 banks had failed.
A Bank Holiday: The first thing Roosevelt did to start fixing things was to close all the banks. He went on the radio and started the first of his "Fireside Chats". He explained to listeners why he closed the banks and how this would help people. He explained how banking worked. Roosevelt explained on the radio to Americans why it was important for people to leave their money in the banks that were still open. He did what he could in his first "Fireside Chat" to restore faith in the American banking system and in the Federal government's commitment to directly help people affected by the Great Depression. He only closed the banks for three days, only long enough to put in place a new banking system that protected people's savings. As he promised Americans on the radio, if the bank failed, their savings would be protected by the Federal government. He made the Federal Reserve Banks grant loans and get cash to local banks in their region, so when their doors reopened, they could handle the probable rush. But people listened. When the banks opened, some rushed to pull out their money. But others waited. They believed in Roosevelt. They trusted Roosevelt. His election and the programs he pushed by Congress, his New Deal, was the beginning of the end of the Depression. It took many years and many programs, but finally 1941 (some argue 1945), the Great Depression was over.
It is important always to know how your bank works. Before you deposit money in a bank today, ask that bank what happens to your money if that bank fails. Is your money insured? If so, how does that work? Do not be shy about asking questions. It's your money. Make sure it's protected.
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