Runs on US financial institutions have periodically erupted during periods of economic stress. When contagion took hold, they contributed to severe and prolonged depressions, including those that followed the Panic of 1819, the Panic of 1837 and the Panic of 1873. The underlying mechanics are relatively simple.
Illiquid Assets Held at Appraised Values: Banks and bank-like financial structures invest in assets that they expect to generate returns in excess of those promised to depositors or investors. The spread represents the institution’ s profit. But problems arise when the underlying assets cannot be liquidated promptly at their stated or“ appraised” values during periods of stress.
Liquidity Offered Against Illiquid Assets: Investors are offered liquidity on terms shorter than the time required to sell the underlying assets at their marked values. Under normal conditions, only a small percentage of investors seek
The Mechanics of a Run
withdrawals at any given time. During periods of stress, however, withdrawal demands can exceed available liquidity, forcing asset sales at prices below stated valuations.
Right to Suspend Withdrawals or Redemptions: Many financial structures reserve the right to suspend withdrawals or redemptions during periods of market stress. These provisions are intended to avoid forced asset sales at distressed prices. While such protections may stabilize appraised asset values, they also create incentives for investors to withdraw funds before restrictions are imposed.
Absence of a Lender of Last Resort: Traditional banks under the Federal Reserve System have access to a lender of last resort, which can provide liquidity against assets during panics. Many bank-like financial structures lack access to such support. Without an external liquidity backstop, these institutions become vulnerable to self-reinforcing withdrawal pressure.
Wall Street during the bank panic in October 1907. Federal Hall National Memorial, with its statue of George Washington, is seen on the right.
The Panic of 1907 and the Federal Reserve Act of 1913
“ Something has got to be done. We may not always have Pierpont Morgan with us to meet a banking crisis.”
— Senator Nelson W. Aldrich
On April 18, 1906, residents of San Francisco were jolted awake by a massive earthquake. Within days, a large percentage of the city was either leveled by the quake or destroyed by fire. The earthquake also triggered a financial chain reaction that slowly made its way to New York City. By October 1907, the combination of bank withdrawals to fund reconstruction in San Francisco and the recurring pressure of the agricultural financing cycle rendered New York City banks and trusts highly vulnerable to panic.
In mid-October, the panic began when an amateur stock operator, Otto Heinze, attempted to corner the stock of United Copper. After the scheme failed, Heinze defaulted on his loans, forcing several brokerage firms into bankruptcy. With liquidity tight, the failure of the brokerage firms triggered a run on the banking system. If not for the heroic effort of J. Pierpont Morgan to rally support from the largest national banks and trust companies, the entire financial system would have collapsed.
The Panic of 1907 inspired several key reforms, but it took six years before Congress and President Woodrow Wilson concluded that re-establishing a central bank was essential. The opposition eventually relented, and President Wilson signed the Federal Reserve Act into law on December 23, 1913.
In November 1914, the system was up and running, and for the first time in history, the United States had a fully functional central bank. Currency stability was maintained by the issuance of Federal Reserve notes. Bank regulation was strengthened by the Fed’ s new powers to examine and demand adjustments to banking practices. Finally, the Federal Reserve became the first US central bank to have the power to serve as a lender of last resort to short circuit future runs on the financial system.
The Federal Reserve was designed to prevent the recurrence of destabilizing bank runs. Yet within two decades, the institution would allow the greatest banking collapse in American history.
www. MoAF. org | Fall 2026 | FINANCIAL HISTORY 21