Beginning in October 1907, the Bank Panic of 1907, also known as the financial panic of 1907, devastated the US economy for six weeks. The Treasury, under Secretary Leslie Shaw, was actively acquiring government bonds and eliminating the need for banks to hold reserves for government deposits before the panic.

This policy led to an increased supply of money and credit across the nation, fueling speculation in the stock market. This critical factor would later contribute to the financial panic of 1907.

Causes of the Panic of 1907

The immediate cause of the panic was the bankruptcy of two small brokerage firms following a failed attempt by Fritz Augustus Heinze and Charles W. Morse to monopolize the copper market. This failure led to a loss of confidence and triggered a bank run on institutions associated with them.

The Knickerbocker Trust, New York City's third-largest trust company, was the most significant casualty. Knickerbocker's failure, exacerbated by J.P. Morgan's refusal to extend a loan, heightened public distrust in the financial sector and led to a broader spread of the bank panic in 1907.

In response to the escalating crisis, influential figures like J.P. Morgan, John D. Rockefeller, and Treasury Secretary George Cortelyou intervened. To stabilize the situation, they infused tens of millions in loans and deposits into various New York banks and trusts.

Morgan also played a pivotal role in maintaining stock market liquidity by urging New York banks to extend loans to stock brokerages, preventing the New York Stock Exchange (NYSE) closure. He also arranged for U.S. Steel to acquire the Tennessee Coal, Iron, and Railroad Company (TC&I) to save a significant brokerage firm that used TC&I stock as collateral.

A sharp rise in NYSE overnight loan interest rates signaled the crisis. Rates shot up from 9.5% to an extraordinary 70% on the day Knickerbocker Trust closed, and just two days later, they reached 100%. The NYSE remained operational primarily due to Morgan's efforts to secure cash from major financial and industrial institutions and direct it to needy brokers.

The New York Clearing House Committee created a system for issuing clearinghouse loan certificates to address the liquidity crisis further. This strategy provided a temporary liquidity boost and served as a precursor to the types of emergency lending that would later be characteristic of the Federal Reserve.

Consequences of the Panic

A significant financial panic in 1907 led to the creation of the Federal Reserve System. The 1907 financial panic showed the need for a more robust system to prevent future crises. Famous financiers like J.P. Morgan, who had profited from the financial system, were reluctant to risk their fortunes to stabilize the market. Due to this indecision, they and their congressional and Treasury allies proposed public market bailouts.

Senator Nelson Aldrich's Aldrich Plan laid the groundwork for the Federal Reserve Act of 1913 and the Federal Reserve System. The Federal Reserve was created to oversee the nation's monetary and credit system. It also provided loans to overleveraged, insolvent, or risky financial institutions as a last resort.

Assistant Treasury Secretary Charles Hamlin became the Federal Reserve's first chair. Benjamin Strong, a prominent Morgan employee, was named president of the Federal Reserve Bank of New York, the most potent regional bank in the Federal Reserve System.

Democratic populists founded the Federal Reserve to regulate affluent bankers and Wall Street personalities' immoderate practices and perceived misconduct. This action marked a shift in US financial stability management, with the Federal Reserve now overseeing and strengthening the banking system.

Reasons for Establishing the Federal Reserve

The Panic of 1907 emphasized the need for major US financial reforms. This crisis prompted government action.

The U.S. government responded with the 1908 Aldrich-Vreeland Act. Instead of restructuring the banking system, this legislation addressed currency issues quickly. This created National Currency Associations. This consortium of at least ten economically solvent banks was authorized to issue emergency banknotes.

Additionally, the Aldrich-Vreeland Act created the National Monetary Commission. This commission's research laid the groundwork for the Federal Reserve in 1913. The government established a central bank to regulate money supply and ensure liquidity during financial crises.

The Fed was founded with three goals. Initially, it was a lender of last resort, providing emergency funds. It also managed the U.S. government's monetary operations as a fiscal intermediary. Finally, the Federal Reserve was charged with clearing financial transactions.

Responses to the 1907 financial panic helped restructure the US financial system. They changed the government's financial regulation and stability strategy to address the Panic of 1907.

Similarities Between the 2008 Financial Crisis and the 1907 Bank Panic

The 2008 financial crisis shares notable similarities with the bank panic of 1907. Both crises began outside traditional retail banking, leading to widespread distrust in the banking sector. The panic of 1907 emerged from trust companies, while the 2008 crisis involved investment and shadow banks, lacking direct Federal Reserve support.

These financial crises followed periods of economic extravagance. The Gilded Age, marked by the dominance of monopolies like Standard Oil and significant wealth concentration, preceded the panic of 1907. Teddy Roosevelt notably criticized the era's wealthy elite. The 2008 crisis came after a time marked by Wall Street's expansion and questionable lending practices by financial institutions.

Both crises led to significant regulatory changes. The panic of 1907's aftermath saw the creation of the Federal Reserve, which aimed to safeguard financial interests and assure the public of government action against financial excesses. Similarly, the 2008 crisis resulted in reforms like the Dodd-Frank Act, addressing the risks of financial imprudence.

The financial panic of 1907 saw the Mercantile National Bank supported by the New York Clearing House, akin to Bear Stearns' rescue in 2008 with J.P. Morgan Chase's purchase, backed by a Federal Reserve loan.

Furthermore, the collapse of Lehman Brothers in 2008 mirrors the troubles faced by Knickerbocker Trust in 1907. Both events marked significant downturns in their respective financial markets. However, while Knickerbocker only paused operations temporarily, Lehman Brothers faced a complete downfall, with customers waiting years to reclaim their funds.