PYRAMIDING RESERVES

Pyramiding reserves refers to the practice of concentrating many small bank reserves in certain big city banks. The National Banking Acts of 1863 and 1864 established the requirement that banks maintain money reserves. Reserves are the portion of each deposit placed into the bank that is set aside in the form of vault cash or held deposits. The tempting high interest rates on inter-bank deposit balances offered by the larger banks led small rural banks to keep their reserves at large urban national banks. This practice led to the pyramiding of reserves in central cities, especially New York City.

In the nineteenth century the need for liquidity (cash on hand) of the rural banks were driven by the needs of farmers. In the planting season farmers required currency to purchase farming implements and seed. At harvest cash deposited into banks increased as farmers sold crops. As a result rural banks withdrew their reserves from the urban banks in the spring to meet farmers' demands for cash and deposited money back into the urban banks in the fall. The withdrawal of the inter-bank balances in peak agricultural season put seasonal pressures on the banking system. Consequently short-term interest rates varied seasonally by as much as six percentage points through the course of a year. Large urban banks could anticipate this demand most of the time and provide rural banks with all the cash they needed. The mere rumor, however, that a bank could not meet the needs of credit-hungry farmers and businessmen in the rural areas led to runs on banks by depositors demanding their money. Financial panics resulted in 1873, 1884, 1893, and 1904.

In an effort to end the recurring panics Congress passed the Federal Reserve Act of 1913. One of the Federal Reserve Act's main purposes was to alleviate the liquidity crises and interest rate seasonal swings exacerbated by reserve pyramiding. The act established 12 Federal Reserve Banks around the country as depositories for required reserves that previously had been held predominantly in New York City banks. This regionalization eliminated reserve pyramiding and eased the seasonal strain. The central banking system could create additional reserves in a period of high liquidity demands.

See also: Federal Reserve Act of 1913, Federal Reserve System, Financial Panic, National Bank Act of 1863