The Organisation of Banking in America: Decentralisation without Freedom
The Scottish experiences served as a forceful example in support of the claims of the free-banking school, but appeals to American history can hardly be said to have been so fortunate. The American case was evoked as evidence by both sides in the controversy, but so far as the system as a whole is concerned, it cannot be described as an illustration for either. It was decentralised without freedom; it lacked the essential characteristics both of central banking and of free banking proper.
The distribution of powers between the Federal and the State authorities left legislative control in banking matters in the hands of both. The country started off with a natural dislike of centralised institutions and a jealous regard for individual State rights. Nevertheless, the need for funds in the War of Independence impelled the Federal Government to take the first initiative in the banking sphere in the promotion of the Bank of North America. The lack of a genuine commercial need for banking facilities at this very early period in America's industrial development caused great difficulty in getting private capital for such an enterprise, and the Government was obliged to become a substantial shareholder in the Bank. It shared the unpopularity of all central institutions, and after the war its charter was repealed.
Not very long afterwards banks began to set up in the more progressive States under the separate legal systems of the various States concerned. The usual procedure at the beginning was to apply for a charter which gave the bank the privilege of limited liability. In most cases the charter contained clauses limiting the amount of liabilities the banks might legally incur to a certain multiple of their paid-up capital, and in some instances it imposed also a lower limit on the denomination of notes. In very few States did unchartered banks set up with unlimited liability. Almost as soon as any possibility arose of private individuals and unincorporated associations wanting to set up without charter, restrictions were placed on their entry into the banking business by the legislatures concerned. Most of the eastern States passed laws similar to the 1818 law of New York, which made both deposit banking and note issue conditional on special legal authorisation, and the majority of the Western States followed up the same policy. But the actual effect of this rule varied from State to State according to the ease with which charters were obtainable. There was least stringency in the east, which was, of course, the district in which there was most call for banking facilities. The most liberal policy was to be found in New England and more especially in Massachusetts and Rhode Island, where charters were granted to nearly all
who applied for them. In New York already established banks seem to have exercised a powerful influence in persuading the legislature to refuse to grant charters to new competitors; and there was an increasing tendency to restriction the further you went south and west.
Meanwhile, a second attempt had been made to run a central bank. This was the Federal institution, known as the First Bank of the United States. From its parent bank at Philadelphia the company had early begun to develop branches, and this caused much annoyance to the State banks and their legislatures. The opposition of the Republican Party was forceful enough to secure its suppression when its charter came up for renewal in 1811.
The disappearance of this bank and its branches was followed by a rapid growth of State banks. In 1811 there had been about eighty-eight, and within the next three years a hundred and twenty new bank charters were granted. Most of these banks lent heavily to the Federal Government when war was declared in 1812, and their excessive issues caused about three-quarters of them to seek the sanction of their respective Governments to suspensions of cash payments in 1814. After this their issues expanded still further and their notes fell to discounts ranging from 10 to 30 percent. The
resumption of specie payments nominally took place in 1817, but in 1819 there was a further suspension, which lasted two more years.
The foundation of these early banks was much more often based on political influence than on real commercial necessity. It was attended by abuses in the paying in of capital which were often directly aided by the State. In the case of the First Bank of the United States itself, the United States Government subscription of $200,000,000 was a purely fictitious book entry. Some of the banks had scarcely any capital at all, and nearly all of them had much less than was nominally subscribed, and since the liability of shareholders was limited, there was very little protection for the creditors. The State legislatures, when they did at last set themselves the task of opposing these fraudulent practices, experienced incredible difficulties in framing legislation to deal with them.
Another feature of these early banking formations was their close connection with State Treasuries. It was a common practice for States to require banks to make loans when necessary to the State chartering them. Special provisions were often made for this in their charters, and in addition Acts were passed from time to time authorising specific loans. The result of this frequently was that the banks were so heavily "‘loaned up" to the Government as to have practically no substance left for supplying commercial demands, a factor which must have contributed considerably to their early excesses.
The result of the autonomy of the rather small sparsely populated area of the State was that the banking system tended to assume a very fragmentary nature. A State bank had rights to carry on business only within the borders of the State from which it received its charter. This meant that America could not develop a branch system of banking, and it was perhaps in this circumstance that the chief justification lay for an institution such as the First Bank of the United States. Secretary of the Treasury, Gallatin, expressed the opinion some years later that if the Bank of the United States had been in existence in 1814, the chaotic banking disturbances of that year would not have occurred. The most essential condition for the suppression of excess note issues is their presentation for payment at frequent intervals. A very serious trouble throughout the history of American banking was the lack of a regular system of clearing the notes of the various banks. Notes tended to travel considerable distances, and since a bank in one State had no branches in any other State and generally no correspondents either, there existed no ready-made agencies for collecting the notes of rival banks and presenting them for payment. This was a function that the First Bank had begun successfully to perform, and its consequences must undoubtedly have been to curb the tendencies of the local banks to excessive note issues.
Another experiment in centralised banking institutions was made in 1816 with the foundation of the Second Bank of the United States. In common with the First Bank, part of its capital was subscribed by the Government, and it was to be the depository of the balances of the Federal Treasury without obligation to pay interest on them. It had, moreover, the right to establish branches without consulting the Governments of the States concerned. A new feature of its charter was a clause intended to minimise the likelihood of cash suspensions, by imposing a penalty, in the event of its failing to meet its obligations on demand, in the form of a 12 percent tax on the amount in default.
Gallatin maintains that it was only as a result of the organisation of this bank that the State banks were prevailed upon to resume cash payments, since it was the Second Bank which proposed a convention to which the State banks finally agreed. It is interesting to note that one of the stipulations made by the State banks was that the Bank of the United States should, in any emergency that might menace the credit of any of the said banks, contribute its resources to any reasonable extent in their support. This is a very early declaration of the view that it is the duty of the central bank to act as lender of last resort.
The Second Bank of the United States and its twenty-five branches soon came into conflict with the defenders of State rights, and of course the State banks backed up the opposition. The chief objection brought by the latter against the Bank was that it "accumulated their notes and then presented them for redemption in coin." "War" was declared on the Bank by Jackson when he succeeded to the Presidency in 1829. The first blow was struck in 1833 when he gave orders for the Government deposits to be removed from the Bank and deposited instead in selected State banks. Shortly afterwards the renewal of the Bank's charter was vetoed. This put an end for many decades to all projects for a central bank.
General suspensions of cash payments occurred in 1836, except in New England, where the banks again kept above water. Probably the worst feature of the American system and the one to which, combined with the exclusion of the entry of new firms, much of the chaos was due, was the extreme laxity with which principles of bankruptcy were applied to insolvent banks. Take as an example the State of New York. In charters granted before 1828 there were provisions that if a bank suspended payment for a certain period (usually three months) it should cease operations unless it obtained permission to continue, after an examination of its affairs, from the Chancellor of the Circuit, and if at the end of a year it still did not resume payment, it should surrender its rights altogether. Charters created after 1828 shortened the unconditional period allowed to ten days. But in 1837 all these rules were made completely ineffectual because the State legislature passed a Suspension Act allowing suspending banks to continue for a year without applying to the Commissioner. Other States followed New York's example and passed Suspension Laws of an even more pernicious nature.
Further suspensions took place in 1839, but were confined this time to Pennsylvania and the States further to the south and west. Boston and the eastern States sustained payments. Pennsylvania passed laws legalising the suspension on condition that the banks should make certain loans of money to the State, and it was arranged that they should resume specie payments in January, 1841. The obligation to lend to the Government naturally had the effect of making it more difficult, if not impossible, for the banks to resume payments, and the date for resumption was postponed by another Act which, in return for further subscription to a Government loan, allowed the banks to continue the suspensions until the loan was repaid, which might be any time up to five years.
The losses sustained by the Federal Treasury in the suspensions of 1836 and 1839 called forth proposals for making the Treasury independent of the banks.
From the 'forties onwards State banking showed signs of improvement. Most of the States had by this time succeeded in framing provisions for securing the paying up of capital by subscribing shareholders. The more difficult task was to remove the tendencies towards expansions and to secure note-holders against losses due to suspensions. A major deficiency over the whole of the American banking structure had long been the infrequency of the return of notes to their issuers. One of the earliest and most successful attempts to secure that notes were redeemed more often was a voluntary system put into force by the Suffolk Bank of Massachusetts. Bank-notes circulated at places distant from their issuing bank at discounts varying with the difficulty of sending them home for redemption. The smaller was the chance of its notes being presented for payment, the larger was the volume of notes that a bank could safely issue. The result of the lack of any machinery for ensuring the collection of notes was therefore that banks began purposely to place themselves at long distances from the most important centres of business. This was what happened in Massachusetts. The banks of Boston found themselves at a distinct disadvantage because the country banks were securing practically the entire circulation even in Boston. Large numbers of country bank-notes never returned to the banks that had issued them, but remained in Boston circulating without hindrance at the recognised rate of discount. The Boston banks made several attempts to systemise the sending back of notes for redemption. The most successful was the Suffolk Bank system. This bank arranged for New England country banks to keep with it permanent deposits of $5,000 plus a further sum sufficient to redeem notes reaching Boston. The Suffolk undertook to receive at par the notes of banks who made such deposits, and the notes of country banks who refused to come into the scheme would be sent back for redemption. The Suffolk Bank, moreover, refused admittance to its clearing agency to banks whose integrity was not above suspicion. This had the intended effect of curtailing the circulations of the country banks.
The Massachusetts legislature also passed a law, in 1843, to secure the more frequent return of notes by providing that no bank should pay over its counter any notes but its own. A similar law was passed in Louisiana. Other States placed penalties on the default to pay notes in specie on demand, either by the imposition of a percentage tax on the amount involved or by making the offending bank liable to the forfeiture of its charter. This latter measure should have been the most effective if it had been rigidly enforced. Specifications as to reserve requirements also began to emerge in many of the States. The most stringent of these was that of Louisiana requiring a specie reserve of one-third against circulation plus deposits.
In other cases efforts were directed not to preventing the over-issues and ensuring redeemability of notes on demand, but to giving some protection to the note-holder in the actual event of suspensions following such an over-issue. Several States adopted the practice of giving notes a prior lien on assets. Another measure adopted was that of double liabllity which made bank shareholders liable for the debts of the bank to an amount equal to their respective holdings of shares over and above the amount of capital actually invested by them in the bank. The most ambitious scheme was the New York Safety-Fund system. This was a system of compulsory insurance of banks against unmet liabilities. The banks paid contributions to a fund to be allocated to the paying out of the liabilities of insolvent banks where they exceeded their assets. There was, of course, a tendency under this scheme to subsidise weak institutions at the expense of the stronger and more prudently managed ones, especially as the insurance premium was not assessed on the basis of actuarial risks, but was merely computed as a percentage on the capital of the bank. It also had the further unhealthy effect of weakening the public scrutiny over the issues of particular banks, and many of the banks were tempted by this fact itself to risk bigger issues. Between 1840 and 1842 eleven of the safety-fund banks failed, the fund was exhausted, and the solvent banks had to be called upon for increased contributions. Future contributions were also mortgaged in advance for charges in respect of an issue of State bonds made to replenish the fund. After the bankruptcy of the fund in 1842, it was made security for notes only and no longer for deposits as well, but it still proved inadequate.
We have already observed that the banking business in the United States, or at least over the greater part of it, was in the first half century of its growth by no means open to free entry. But from 1838 onwards there was a change of policy in several of the States which made it possible for banks to set up without having to obtain a charter. The new policy was inaugurated by New York in 1838 in a so-called Free-banking Law. Under this law it was made permissible for any person or association to issue notes, provided they had deposited with the Comptroller the equivalent amount in the form of certain securities. All stocks of the United States and those of States approved by the Comptroller were eligible, and, in addition, certain bonds and mortgages on real estate. Should a bank default on its notes, the Comptroller would sell the collateral securities in order to redeem them. The first effect of the newly granted freedom was a wild dash to establish banks.
Immediately on the passage of the bill arrangements were made for the formation of over a hundred and thirty new banks; about half of these had actually started business a year later and nearly half of them had gone out of business after another three years. The idea in the minds of many of the bank organisers seems to have been that if their notes were secured, nobody would ever demand their redemption. Many of them set up solely for the purpose of issuing notes, but in 1848 the State passed legislation requiring banks to undertake discount and deposit business as well as note circulation.
The bond deposit system had the effect of tying up bank investment in certain lines, usually Federal or State bonds. Mortgage and other real estate business soon proved to be too illiquid to provide backing for notes. It also had the rather peculiar effect of making the amount of the note circulation depend on the prices of Federal and State bonds. It meant also that while banks, constituted on other lines, could realise their assets in order either to get funds for redeeming their notes or to decrease the amount of notes in circulation, the bond deposit banks had very little chance of doing this, because their capital was tied up in Government securities which they were not free to sell until they had first reduced their note circulation, a feature which put them at a considerable disadvantage in comparison with the chartered banks. Moreover, the system was by no means a perfect guarantee of note redemption, because when a bank failed, many State stocks could be disposed of only at a discount.
Parallel with the beginnings of this movement in favour of a greater measure of competition, there took place in some other States foundations of State monopolies. Early in the nineteenth century Indiana and Illinois had prohibited banks unless the State should judge fit to establish one out of its own funds. The Bank of Indiana and the Bank of Ohio, founded in 1834 and 1845, respectively, were both State monopolies. Illinois followed the New York free banking plan in 1851, and Indiana and Wisconsin did the same a little later.
The improvement that took place in American banking in the twenty years preceding the Civil War was especially noticeable in the eastern region. The banking system was by no means perfect at this period, but except for the international crisis of 1857, when suspensions of specie payments
were general over most of the United States, the situation was far steadier than ever before. It is very probable that this improvement was not attributable to any considerable extent to State regulations relating to bond deposit guarantees for notes. In fact, the State authorities seem to have become, after a time, rather lax in the enforcement of the law, and the State Comptroller was usually satisfied if the bank had in its own possession the prescribed assets and was prepared to present them for his examination when he paid the bank visits on certain days. This gave scope for a system of window-dressing by which the banks passed round the same block of securities for exhibit on the appropriate days. The law was thereby rendered ineffective. Much the greater weight is to be attached to the more rigid enforcement of specie payments between banks by frequent exchange of notes, due in great part to the spread of the Suffolk system and to the institution of the New York clearing-house.
The Civil War provided the occasion for a radical change in the banking system of the whole country. The banks in the South gave their support to the secession and ceased remittances to the North, and since they had a large net liability towards the banks in the North the latter lost heavily, but they managed to keep above water by contracting their lending operations and were, in fact, in a very strong position regarding specie reserves. Pressure soon came however, from the side of Governmental financial needs. Secretary of the Treasury Chase experienced excessive difficulty in borrowing from the public, partly as a result of the very bad state of the finances in the preceding administration. Chase called a conference of the New York, Boston and Philadelphia banks, and with him they drew up a plan for
assisting the Government by advancing $50,000,000. Chase insisted on the loan being paid in specie, and at the same time he started the issue of United States notes payable on demand which further weakened the banks, since if they accepted the Government notes they were obliged to redeem them in coin. The result was that at the turn of the year (1861-62) the banks of New York, Boston and Philadelphia suspended payments. The Treasury followed by ceasing likewise to redeem the Treasury notes in coin. This was followed up by a bill for issuing legal tender irredeemable paper to the extent of $150,000,000, a measure which was strongly opposed by the banks, among others. One of the chief arguments for making the Government notes legal tender was to force the banks to accept them. Two further issues, each of $150,000,000, were made within the twelve months following. After that the issue of greenbacks was stopped, and Chase had recourse to a new scheme for obtaining funds by the sale of Government securities, namely, the National Bank system. This was an extension to a National or Federal, instead of a State, basis of the bond deposit system. By an Act of 1864 banks of not less than five associates, and having a capital of not less than $50,000, were allowed to form freely if they secured their notes by the deposit with the United States Treasurer of registered bonds of the United States. The amount of notes must not be more than 90 percent of the market value of the bonds lodged and not more than 100 percent of their par value. In the event of a bank defaulting on its notes, the United States Treasury would sell the bonds and pay the notes itself. The Treasury also had a prior lien on the general assets of the failed bank for any claims that could not be met out of the proceeds of the bond sales, and, further, the shareholders were subject
to double liability. The banks must also keep a certain reserve proportion of their notes plus deposits in the form of legal tender currency, which in the years of their foundation meant of course greenbacks as well as specie. The primary motive for setting up this system was, of course, the creation of a large market for Government bonds, but it was contemplated from the beginning that the new National banks would in time replace the old State banks and much emphasis was placed on the benefits of a uniform currency. Provisions were made in the original Act for State banks to come into the scheme by conforming to the conditions of the Act, and, as they failed to come in voluntarily as fast as the Government had hoped, an Act was passed in 1865 to penalise those not entering the system by the imposition of a tax of 10 percent on their note issues. This was practically the death-blow to a great number of the State banks so far as they were dependent on note issue.
In the first years the notes of the National banks were not far short of being legal tender currency, since, although their acceptance between individuals was not compulsory, the Government was to receive them at par in all revenue collections except customs duties and to pay them at par for salaries, wages and debts, except for interest on the public debt and the redemption of greenbacks. Moreover, since lawful money in which notes were to be redeemable meant greenbacks as well as specie, there was an exceptionally large volume of reserve material available against which the National banks could expand their note issues. In spite of all this, by 1867 a large part of the National bank-notes were circulating at a discount against greenbacks and a number of the National banks had already failed in that year.
It seems that people at first placed undue faith in the security of the new notes and perhaps regarded them as not liable to over-issue. For this reason the notes tended to keep out in circulation longer without being sent in to the issuing
bank for redemption and there was thus lacking an effective check on the amount that any one bank could keep in circulation, until it was presently realised that it is a mistake to regard a security backing as good as specie.
The really substantial improvement that might have been effected through the National Banking Law was one that the authorities failed to realise, namely, the provision of facilities for a branch banking system. On the contrary the National banks were forbidden, except under special circumstances, to establish branches.
Some of the peculiarities of the bond deposit system as a means of regulating note issues have already been mentioned in connection with the free banking system of New York. We shall have occasion to refer again to these problems in a later chapter on the American experiences leading up to the Federal Reserve Act.