The National Bank Act of 1863 aimed at bringing all banks under federal authority. Commercial banks chartered under provisions of this National Bank Act were essentially the same as commercial banks chartered under state laws, except the charters were granted by the federal government and the collateral securing their notes had to be United States government bonds. The principal features of this act which concern us are the bank note regulations and the reserve requirements.
　　Any bank notes issued by national banks were secured by Treasury bonds deposited by the hanks with the Controller of
　　Currency; note issuance was limited to 90 percent of par or market value, which ever was lower. However, instead of the expected rush to join the National Banking System, many commercial banks preferred to continue operating under state laws. In an attempt to force these state banks into the system, a 10 percent annual tax on bank notes outstanding was passed. The result of this punitive tax was to eliminate state bank notes, but not state-chartered banks. They turned instead to deposit banking in place of bank note issue.
　　The reserve requirements of the national banks were determined by their location. There were three classes of banks in the National Bank System: The central reserve city banks in New York, Chicago, and St. Louis; reserve city banks in other major financial centers; and finally, the so-called country banks. The reserve requirements were 25 percent in vault cash against all note and deposit liabilities for the central reserve city banks, 25 percent also for reserve city banks, one half of which might be held as a deposit with a central reserve city bank; and 15 percent for country banks, three-fifths of which might be held as deposit balances in reserve or central reserve city banks.
　　An important feature of the correspondent relationship was the provision that country banks might borrow from their city correspondents. As long as relatively few country banks wanted to borrow or withdraw funds, the system worked fine. But when many or all country banks wanted to borrow or withdraw funds from their city correspondent banks at the same time, trouble resulted. And such simultaneous massive demands did occur. For example, every summer and fall commercial banks in agricultural areas had to draw on their reserve balances for funds to finance crops through to harvest. In many cases they had to borrow from the city banks. The currency provided was the city banks’ own reserves, and the loss of these cut into their lending ability. They were less able to meet the demands of their country bank correspondents and less able to meet their own customers’ demands as well.
　　The difficulty was the inability of the banking system to create additional reserves. Whatever reserves the commercial bank system as a whole held established the limit. The commercial banks had to get along with them whether or not they were adequate. One bank might gain reserves, but only at the expense of some other bank or banks losing reserves. In 1907 bank reserves proved to be inadequate. The city banks were suddenly faced by an unusually large demand on their reserves. They were unable to obtain additional reserves so they held on to what they had, obligations to the contrary not withstanding.
　　In addition, the amount of currency in circulation no necessary relationship to the need for currency. The currency supply under the National Bank System was seasonally inelastic and responded not to the needs of trade, but rather to the price of the bonds backing the notes. Thus, if the price of the bonds rose, banks found it profitable to sell them. This action reduced the amount of circulating currency, since notes had to be retired, whether or not this was desired by the money-using public. Similarly, if the prices on b6nds fell, banks might find it profitable to buy bonds and issue notes against them, regardless of whether or not the added currency was necessary. Treasury finance also complicated the situation. If the treasury had a surplus, it might retire bonds regardless of whether this action was appropriate for the money supply. Likewise, a deficit would find the Treasury borrowing-issuing bonds even though the added money supply was not necessary for the public needs.
　　As we have seen, the National Bank System formed what might be called a financial pyramid. At the top of the pyramid were the national banks located in New York City, Chicago, and St. Louis--the central reserve cities. Banks in these three cities had to maintain all of their required legal reserves as cash in their own vaults. National banks in the smaller cities and in rural areas were permitted to keep balances with commercial banks in the larger cities. These balances were counted as part of the reserves of the smaller banks. Thus, there resulted a piling up of resources in larger cities and financial centers. Furthermore, not only did the outlying country banks maintain part of their required reserves as correspondent deposit balances with the larger central reserve city and reserve city commercial banks, they might also maintain these correspondent bank balances over and above the minimum required amount. If for any reason banks were pressed for funds by their customers, the demands ultimately converged onto the relatively few commercial banks located in the financial centers. In ordinary circumstances these larger banks could expect demands for funds by outlying banks to be offset by deposits from other out-of-town banks which were building up their balances. But if there should occur a net demand for the withdrawal of funds by out-of-town banks, the commercial banks in the financial centers might find it difficult to provide the funds requested.
　　In this situation, with the absence of a central bank to provide additional reserves, the commercial bank system found itself in periodic difficulty. The system could not generate the necessary reserves to back additional funds which might be needed. Every few years there occurred large-scale demands on the commercial banks in the financial centers for withdrawal of the funds deposited with them. These withdrawal demands would result in the wholesale liquidation of bank credit, the suspension of payments to depositors by the banks, and general financial chaos. Such situations occurred in 1873,1893, and 1907. As a matter of fact, it was the panic of 1907 that led Congress to establish the ~dri.ch .Commission-the National Monetary Commission--to investigate and recommend legislation to bring monetary order out of monetary chaos. The commission’s work was culminated in the Glass-Owen Bill, better remembered as the Federal Reserve Act.
　　This major reform in the American commercial banking system culminated years of persistent proposals that a more elastic currency supply be provided, so that the volume of money in circulation might be responsive to changes in the public’s demand for money. It also provided a central banking mechanism, so that excessive changes in commercial bank credit could be avoided by the creation or destruction of reserves in keeping with the needs of the money-using public, and by the ability of the banks to , meet their needs. Subsequent discussion will show how the Federal Reserve meets these and other duties assigned to it.