What Led to the Creation of the Federal Reserve?

The state of the American banking system before the creation of the Federal Reserve was at the mercy of the inelasticity and unpredictability of the nation's bank credit and money supply. The unpredictability was in great part due to the fact that smaller banks routinely siphoned off their reserves to the larger banks, creating a system in which the funds of the smaller bank were theoretically guaranteed by the larger reserve banks. This system proved effective enough as long as the economy remained flexible through the normal ebb of flow of conflicting demands and supplies, with some banks lowering their reserves while others increased them. When the system fell apart due to its inherent flaw was during those periods of economic uncertainty that produced widespread public demand for currency and suddenly all the smaller banks were hitting the larger banks for their reserves.

For well over a century the U.S. had no system for facilitating efficient transfers of large deposits from the bigger banks to the smaller banks. The very fact that regions where there was a sudden extreme rush to withdraw currency had no way of quickly receiving those funds served to intensify the sense of growing panic that tended to create a domino effect: Banks that were unable to rapidly receive reserves from the central bank would begin taking actions that not only added to the general feeling of panic, but also created more economic stability. For instance, banks would demand urgent repayment of outstanding debts, refuse new loan applications and even begin selling securities in an effort to raise immediate supplies of currency. The consequences of these actions by the bank included sharp drops in the prices of those securities and making borrowing for the bank more difficult, as well as created uncertain fluctuations in interest rates.