Banking up to 1860

"When I was young, people called me a gambler. As the scale of my operations increased, I became known as a speculator. Now I am called a banker. But I have been doing the same thing all the time."
Sir Ernest Cassel, British financier.

Prior to 1776, the English crown did not permit the establishment of banking facilities within its American territories. Various American colonies did proceed to issue notes and paper, (fiat money, not backed by gold or silver, but instead by government legislation and decree), however this is not our story here. The lack of banking - or more correctly - credit facilities within the colonies was as much a grievance as any other amongst colonists that led to the War of Independence.

After 1788, the states surrendered their right to print notes and the new federal power took over, led by Alexander Hamilton establishing recognized banking procedures along central bank lines with the First Bank of the United States. All states however maintained their right to charter banks by issuing licenses, which the states proceeded to do with remarkable dexterity.

The history of banking can be divided into quite clear eras:

1791 - 1811, First Bank of the United States, playing a sort of a central bank type role.

1811 - 1816, banking in the hands of state chartered banks.

1816 - 1836, Second Bank of the United States, again adopting a quasi central bank role in the economy of the time.

1836 - 1913, no central bank of any kind.

1836 - civil war, the so-called 'free banking' era.
1863 - 1913, national banking (federally issued bank charters).

1913 - current, The Federal Reserve System.

Each of the cycle chapters includes discussion of the relevant eras pertaining to banking, to which the following could be added.

Prior to 1836:

The first banks were established in major US ports, Boston, New York etc. which was where the commercial need was initially greatest. As settlement went westward, banks were never far behind; the need out west being, amongst other things, to assist farmers in buying land and equipment with which to commence farming. Certainly by 1820, most town folk at least would have been quite familiar with the process of banking and how to use bank supplied credit in the form of coin, notes and deposits.

Until about 1860, if you went to a bank and succeeded in gaining a loan, the bank gave you bank notes, which it printed, equal to the amount of the loan granted. In reality, these notes were nothing more than IOU's, though at the time you may not have thought of them in this way. As borrower, you then naturally spent these notes to buy what you wanted, putting the notes into circulation.

If you preferred holding gold and silver, in the form of coin, rather than these printed bank notes, the law allowed you to go into the bank which issued the note and exchange it for gold or silver coins to the equivalent value. Under normal conditions, the bank could not refuse your demand, but as the various chapters show, times were not always normal. Generally though, the notes issued by a bank did represent an enforceable contract between the holder of the note and the issuing bank for you to swap the note into gold or silver coin. The bank note's value however was only ever as good as the assets of the bank.

It was a profitable activity for banks to issue notes as loans, since it was realized early on that they could print and issue notes in excess of the quantity of gold and silver coin (specie) that was held in the vaults: fractional reserve banking. The leverage was about ten to one. And in addition to the leverage, interest could be earned on the loans so made at about six to seven percent per annum. Individual banks fought bitterly to retain the right to print their own notes: a right jealously guarded and continually fought for, against the insistent demands of the US Federal government (and many US Presidents naturally suspicious of the banks and their power) to exert at least some sort of control over often out of control US banking activities. This is a constant theme running throughout 19th century US history.

Within the local community, there was soon in circulation as many varied and colorful notes as there were banks in the region. These notes were not necessarily of standard denominations either, as we are used to today. The process rested on confidence; an unfamiliar bank note might not prove acceptable in settlement of a transaction, so in this manner, bank notes mostly circulated within their own state of issue only, though there were exceptions. And most state charters allowed for the establishment of just one bank per charter, prohibiting banks from opening branches in other towns, or of operating across state lines. (This limitation on banking - a development that only ever occurred in the United States, went on to have quite dramatic consequences for the country in later years.)

Therein lies several problems. Firstly, would bank A accept notes from bank B as a deposit ? If so, this raised the problems of inter-bank dealing and note redemption. These days it is all done by Federal Reserve cheque clearing services. Back then, bank A in accepting another bank's notes, would promptly return the notes to the issuing bank, bank B, and request the equivalent specie (note redemption) in return. This however, involved the cost of returning the notes, so bank B's notes were often just put back into circulation by bank A. No bank appreciated having its notes returned for redemption and sought to have their notes remain in circulation for as long as possible. Note redemption lowered reserves and forced a contraction in lending.

Another problem; banks earn their profit by lending (creating credit). A loan was effected by printing and issuing notes to the borrower; hence the temptation to over-issue notes.

Yet another problem occurred in a downturn of business activity. If there arose the fear of a bank not being able to convert its bank notes into gold or silver on demand, a 'run' on the bank was possible. Customers would, of course, want to get to the bank before the gold ran out, which, of course, needed to be done before everyone else got there first, which escalated the rush. Since all banks were independent of each other, and in the absence of a central bank, if the gold in the vaults did actually run out, the bank was out of business if it could not convert its assets quickly enough into the gold being sought by its depositors.

Since most banking required a charter, those who got one naturally sought to protect themselves from additional competition. A vested interest was created. But states generally also received a revenue stream from the banks as they prospered, in the form of dividends if the state took an investment in part of the stock of the bank, or in the form of a tax on the capital of the bank, which some states chose to do. So there was pressure to issue more charters. The state-chartered banks were generally incorporated concerns.

Granting by the state of a bank charter was not always done with the public welfare in mind. In fact often it had more to do with the personal gain of the promoter and his ability to sway the legislature through political connections. A bribe was often helpful; a precedent established by the Philadelphia bank in getting its charter from the Pennsylvania legislature with the help of a $135,000 'donation'. (Bodenhorn, Antibellum Banking in the United States.) So states earned revenue in this way as well.

History indicates there were many requests for state banking charters, always more than were granted. Charters were often rejected or delayed in the legislature, especially where competition for an existing bank would result, which resulted in numerous 'private' or unincorporated banks starting up operations. Not a lot is known about these banking establishments, but some states sought to restrict their activities and business affairs by passing laws against them, or prohibiting their note issue. For those banks that were chartered, once the charter was obtained, the bank could open for business. A paid-up capital was required, and was accumulated by the issue of shares, for which there were usually plenty of buyers: namely early insurance companies, other savings banks and wealthier individuals. One historian, Naomi Lamoreaux, described the raising of the necessary capital by promoters in New England this way: "By securing a charter for a bank, (the promoters) obtained a vehicle that, almost as if by magic, could assist them in raising funds. First, the incorporators subscribed for a controlling interest in the new bank's stock; then, when payment for the stock became due, they borrowed the requisite sum from another institutionů As soon as the state's examiners had satisfied themselves that the new bank's capital had actually been deposited, the investors could borrow back the money they had tendered for their stock (using the stock itself as security for the loan) and repay the original debtů" (Lamoreaux, Insider Lending: Banks, Personal connections and Economic Development in Industrial New England, 1994, page 19.)

The First Bank of the United States was able to carry out a modest supervision of state chartered banks by immediately returning to these banks any of their notes that were deposited with it. Should a state bank refuse to redeem its notes, the First Bank of the United States could choose to stop accepting such notes for US government transactions, like payment of duties for instance. Such activity may have contributed to its political opposition and the ultimate non-renewal of its federal license.

The First Bank of the United States was also a large lender to the federal government, which it did by either issuing notes directly to the government treasury (the same as to any borrower), or by simple book entry. It was this lack of lending alternative during the 1812 war with England that helped ripen the circumstances for the creation of the Second Bank of the United States. Raising taxes was never popular, and the floating of bonds did not prove very successful at this time, so the state banks had to be approached for loans. The federal power base soon wanted its own bank. The Second Bank of the United States was therefore created and started operations in 1816, lasting until 1836. Its demise created the era of free banking. And in this era of free banking, essentially anyone could open a bank and issue bank notes, as long as adequate capital could be provided.

Free banking, 1836 to the civil war:

The states of Michigan and New York were first to adopt some changes to established banking laws, around 1837. Up to 1836, any incorporated entity - of limited liability - could issue notes as a bank if it had gained government (generally state government) approval, via a charter. Now, or notably after the 1837 panic, those same incorporated entities no longer required the approval of an increasing number of state legislatures if they wanted to open a bank. And with the demise of the Second Bank of the United States there was now no effective oversight by a federal body either. Hence the term 'free' banking. It must be noted though, this did not mean open slather for bank creation, or that laws pertaining to banks were the same laws pertaining to other incorporated entities. This was not the case; there were still in existence government laws applicable to banks only. It's just that anyone could set up a bank by adhering to such laws. In effect, the charters were done away with. This was one of the main reasons for movement by states into free banking; to make banking less politicized, and make bank note issue safer through better laws. However, as can be noted in the relevant cycle chapters, this did not change the underlying system; which is bank lending (credit creation) on government granted licenses, mostly land value. So it was never likely to solve what it was meant to; the elimination of the business cycle and a banking panic in the corresponding downturn.

In the states where free banking came into operation, the main applicable laws meant the following:

Generally, a minimum subscription capital was required (as paid in).

Banks were required to deposit government bonds with the state, to the value of the bank notes being issued. The government then signed the notes and handed the signed notes back to the bank for use. Since the bonds to be deposited had to be well recognized, actively traded bonds, this would have helped value the worth of the bank and its notes. This may have helped improve public confidence in the notes. It also meant in the event of bank failure, the bonds could at least be sold off and the proceeds given back to creditors; i.e. the note holders and depositors.

The law of convertibility of notes into specie still applied, so banks continued to hold reserves of this kind to do so. Therefore the banks of this era still operated on a fractional reserve basis; so a liquidity problem in the event of a run was still problematic.

States reserved the right to inspect each bank, and also required (a first) that information be given over to the public about their activities.

A bank office was permitted in one location only, so branch banking was still unavailable to bank customers as we would be used to today. This in one way gave rise to the term 'wild-cat' bank, where a bank chose to operate in a hard-to-find location (though obviously there had to be customers) out with the wild cats, making it that much harder to have its notes redeemed.

As might be guessed, so many notes came to be issued by different banks in this free-banking era, and so many counterfeits of those notes, that it became essential for business to keep on hand a special guide for purposes of note identification. These were called bank note reporters. On the whole though, most of the banking system probably operated in an honest fashion, going about its business of creating credit in the usual manner. However there are many colorful and varied stories of rogue bank behavior in this era and the ease with which such a proliferation of bank notes could be made subject to counterfeit.

The Federal Reserve Board of San Francisco suggests in historical articles on its web site there were more than 30,000 different notes in circulation toward the end of this era, one-third of which might have been counterfeit. It notes the Bank of Battle Creek, in Michigan had its teller, Tolman W. Hall leave via the back door if a note holder ever entered the bank. Another, the Farmers Bank of Sandstone, lived up to its name by offering to redeem its notes in local commodities to any note holder coming to the bank; one sandstone whetstone for each one dollar note presented. And the story goes that the Jackson County bank vault contained boxes with silver coin visible at the top, though further inspection revealed merely colored glass, lead and nails underneath. The era of free banking was taxed out of existence when the post civil war federal government put a 10% tax on all state bank notes, to improve the operation of its newly designed national banking system.

There was one development in the 1850's however that should be further noted: the developing connection between banking and securities markets. To provide for redemption in active port cities, and to provide local currency for its merchant clients, banks not situated in these developing US port cities would keep cash on deposit with the banks there. New York City developed over time as the most important city in this regard. The New York banks paid interest to the banks that kept deposits with them. They could afford to do this because those very same deposits were lent out by the New York banks to customers wanting loans for investment in the developing New York stock and bond markets; loans that could be called in by the bank at a moments notice. The call - or margin - loan developed into an attractive business for the banks, (Myers, The New York Money Market), making stock markets that much more responsive to changes in the rate of interest.

Follow up references:

Bodenhorn, Howard. Antebellum Banking in the United States, EH.Net Encyclopedia, edited by Robert Whaples, September 5 2001.

Dwyer, Gerald P. Jr., Wildcat Banking, Banking Panics, and Free Banking in the United States, Economic Review, Federal Reserve Bank of Atlanta, Dec 1996.

Lamoreaux, Naomi. Insider Lending: Banks, Personal connections and Economic Development in Industrial New England, Cambridge University Press, 1994.

Myers, Margaret. The New York Money Market: Origins and Development, Columbia University Press, 1931.

Rolnick, Arthur J., and Weber, Warren E., Free Banking, Wildcat Banking and Shinplasters, Research Department, Federal Reserve Bank of Minneapolis.

Sylla, Richard. US Securities Markets and the Banking System, 1790 - 1840, Economic Review, Federal Reserve Bank of St. Louis, May / June 1998.

Copyright: Phil Anderson, 2004

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