The Financial Panic That Led to the Start of the Federal Reserve

In 1907, a virulent financial panic exposed just how fragile America’s banking system was. The jolt led lawmakers to call for creating a lasting central bank: the Federal Reserve.

In October of that year, a cascade of bank runs rattled both Wall Street and Main Street. Within weeks, the stock market had lost nearly half its value from the year before. Clearinghouses—bank associations that pooled resources—partially suspended cash payments in 73 cities. Loans by New York trust companies dropped by more than a third, and factories saw production tumble 16 percent. The economy itself shrank, with the real gross national product falling 11 percent.

The crisis finally convinced lawmakers that the U.S. needed a central authority that could pump money into the economy during emergencies. Six years later, Congress passed the Federal Reserve Act, paving the way to create the nation’s first lasting central bank.

Today, the Federal Reserve—or Fed—still serves as the economy’s steady hand: guiding interest rates, acting as a lender of last resort, policing banks and ensuring that money flows smoothly through the system.

Before the early 20th century, the U.S. banking system was a patchwork of private banks called trust companies. No central authority existed to coordinate them.

That wasn’t an accident—it reflected a deep and longstanding suspicion of centralized financial power. “A lot of the Founding Fathers really feared giving either the biggest bankers in the U.S. or politicians in Washington control over interest rates,” says Gary Richardson, a professor of economics at the University of California, Irvine, who served as the Federal Reserve’s historian from 2012 to 2016.

Problem was, trust companies, which were lightly regulated, failed often; and without a central authority to steady the system, panics became routine. Between 1865 and 1913, the U.S. suffered at least five major financial crises. One big reason: The money supply was capped. Banknotes were backed by U.S. government bonds and tied to gold and silver reserves. And the amount of currency in circulation could only be changed by an act of Congress—a slow, political process, says Richardson.

This rigid system clashed with the needs of the country. Every fall, when farmers, who made up the bulk of the population, flooded the market with crops, they used the proceeds to pay workers and settle debts. The high seasonal demand for cash routinely spiked interest rates—and fostered instability.

For that reason, bank runs often struck in the fall. But in 1907, fresh shocks turned routine autumn jitters into full-blown panic. The 1906 San Francisco earthquake and the 1900 Galveston hurricane in Texas had forced insurance companies to raise enormous amounts of cash to pay claims, draining reserves.

Then came a spectacular gamble. A group of New York millionaires tried to corner the market for United Copper stock, betting that soaring demand for the material—driven by America’s electrification—would make them rich. They borrowed heavily, bought up shares and prepared to cash in. Instead, the scheme collapsed. Loans weren't repaid. Panic spread.

One of New York’s biggest institutions, Knickerbocker Trust Company, slammed its door on depositors, denying them access to their deposits. That single move sent shock waves through the banking system, igniting a nationwide crisis.

But while financial panics weren’t new in the U.S., “there was really nothing the federal government could do to step in during these periods,” says Richardson. In such moments, the task of saving the system often fell to influential private financiers.

In 1907, that meant J.P. Morgan, the financial titan who started the bank that still holds his name. At 70, he became a one-man de facto central bank, summoning bank leaders to his private library on Madison Avenue in Manhattan. He ordered them to open their books, locked the doors and refused to let anyone leave until they pledged millions to keep the system afloat, according to Colin B. Bailey, director of The Morgan Library. He even enlisted Treasury officials to bolster confidence.

His dramatic intervention restored short-term confidence. But it also exposed a troubling truth: The U.S. financial system rested not on public authority but on the will and judgment of a few powerful men.

The 1907 rescue steadied markets, but it left Americans uneasy. Why should private financiers decide which institutions lived or died? As Richardson notes, “Imagine today if … [a] new reform … bill was written by the CEO of Goldman and the CEO of Citibank.”

Congress responded. Senator Nelson Aldrich led the charge, forming the National Monetary Commission to study solutions, including central banking systems abroad, such as the Bank of England. In 1910, Aldrich gathered five bankers and a former Treasury official for a secret meeting on Jekyll Island, off the coast of Georgia. Behind closed doors, they sketched a blueprint for what would become the Federal Reserve.

After years of fierce debate and some key changes, Congress passed the Federal Reserve Act in December 1913. The law created 12 regional reserve banks overseen from Washington—a compromise that avoided a single, all-powerful central bank while still giving the nation a way to adjust the money supply, serve as a lender of last resort and coordinate banking across regions. It marked a turning point in U.S. economic history.

At first, the Fed was hailed as a success. But its decentralized structure limited its power. During the Great Depression, regional banks often pulled in different directions, worsening the crisis. The Banking Act of 1935 reshaped the Fed, shifting authority to the Board of Governors in Washington, D.C., and creating the Federal Open Market Committee to set monetary policy.

The Fed’s creation was part of the Progressive Era’s larger wave of reforms, which included antitrust laws, the creation of the Federal Trade Commission and the national park system. From those chaotic weeks in 1907 grew one of the world’s most powerful central banks, an institution that still shapes the U.S. and global economy more than a century later.