From the Classroom - Howard N. Bodenhorn

Lafayette faculty are experts in their fields. Interests among the 188 members range across the full spectrum of scientific, technological, and humanistic knowledge. In "From the Classroom," faculty members give insight into their particular subject, providing a window on the intellectual rigor that characterizes the environment of academic excellence at Lafayette. This issue features an excerpt from State Banking in Early America: A New Economic History by Howard N. Bodenhorn (copyright © 2003 by Oxford University Press).

"Experimenters and Risk Takers"

To the extent that a single theme emerges from a work that considers regional differences, it is that the United States benefited from its free banking philosophy. [This] should not be confused with free banking in the sense that Austrian economists, such as Lawrence White and George Selgin, and others use the term. They have in mind a very specific set of laissez-faire conditions, facilitating the emergence of a spontaneous order of inside and outside money. Austrian free banking theorists assume that the government defines neither the unit of account nor the medium of exchange. Both arise endogenously from the free contracting between banks and their customers. Early American banks, no matter how liberal the chartering requirements, were not free banks in this sense. The federal government defined the base money (gold and silver) and the unit of account (the dollar). . . .

Within the narrower U.S. context, free banking is generally used to refer to a very specific set of legal conditions for opening a bank defined by a New York state law of 1838. Under [it], a prospective banker could open a bank wherever and whenever he chose once he registered with the state comptroller and deposited a specified quantity of state or federal bonds as a guarantee against fraud and failure. Instead of free banking, a better description of this process would be "bond-secured note issue" banking, which admittedly flows less trippingly off the tongue. Regardless of the term used to describe it, New York's law proved versatile, exportable, and popular, and some variant was eventually adopted in 21 states. . . .

I use [the term] free banking to reflect the workings of the early American Madisonian polity, in which state governments ceded as little power to the federal government as seemed practicable. This decentralized federalism provided state legislatures with a great deal of flexibility in their approach to economic issues. . . . Thus, Massachusetts and Rhode Island chartered banks liberally, but they tended not to take an activist role. Neither provided much capital to new banks, neither put insinuative government officials onto the boards of directors of banks, and neither state offered any implicit guarantees to the banks' customers. In Virginia, the state provided one-fifth of the Bank of Virginia's initial capital, appointed directors, and inspected the books, but it left most of the decisions to the board of directors elected by the private shareholders. Kentucky, Tennessee, Illinois, and others stepped in when private investors would not and formed wholly state-owned banks, which provided banking services as the state endeavored to attract settlers and push the frontier westward. . . .

Where branch banking succeeded in Virginia, it failed in Alabama. Bond-secured note issue succeeded in New York, but it failed in Michigan and Minnesota. A state-owned bank thrived in South Carolina; another imploded in Illinois. The lesson—one that is important for modern developing countries who may too quickly attempt to imitate the banking structures of the developed world—is that a successful banking system is one that is flexible, predictable, and incentive-compatible; one that meets the needs of borrowers, depositors, and shareholders; and one that reduces downside risks to a generally agreed-upon level. . . .

Historically, outsiders view Americans as experimenters and risk takers. Nowhere is that more apparent than in their early banking policies. . . . Early banks could not legally open for business until they received a charter from a state legislature. After the American Revolution, there was a large, pent-up, derived demand for investment funds and banks seemed a good way to supply them. High demand for loanable funds, and low supply, meant that the profit potential was great. . . . Bankers were just as innovative and entrepreneurial as leaders in other sectors and they underwrote and financed industrial experimentation. . . .

New England and the Middle Atlantic
New England banks were not impersonal dispensers of credit in anonymous markets. Rather, they were formed by and served as the financial arms to extended kinship networks of artisans, traders, and manufacturers. . . . [Another defining characteristic was] the Suffolk system. The Suffolk Bank of Boston operated a regional clearinghouse for banknotes, thereby facilitating the use of currency in trade. While traditional interpretations emphasize the benefits accruing to the public from the operation of the system . . . the Suffolk used intimidation and coercion to put and keep the clearing system in place [and because it] mispriced its services, an alternative network was established and the system collapsed. . . .

America's first commercial bank, the Bank of North America, was chartered by the Continental Congress to assist war finance. After the war, the bank came under attack in the Pennsylvania legislature, its charter was revoked, and the bank nearly removed to Wilmington, Delaware. Within a short time, its charter was restored, but Pennsylvania chartered a rival institution. The political antagonism surrounding the charter mongering that took place in Middle Atlantic state houses expressed itself in cutthroat competition in Philadelphia, New York City, and Baltimore. Economists generally view such competition favorably, but it inhibited these banks from cooperating in the face of common threats. Distrust inhibited the establishment of clearinghouses until the 1850s. Moreover, state demand for credit and the insistence that banks finance the construction of canals and other internal improvement projects undermined bank stability and placed them in harm's way during economic downturns.

. . . [T]he New York Safety Fund [was] America's first experiment in bank liability insurance. The panic of 1819 and the wave of bank failures that followed induced legislators to seek out alternatives to shareholder liability as a means of protecting noteholders and depositors from losses due to bank failure. New York legislators debated several proposals between 1819 and 1827 before they finally settled on the suggestion of a Syracuse lawyer. While the legislature did not accept the details of his mutual guaranty system, it established a coinsurance scheme similar to the modern Federal Deposit Insurance Corporation. Each bank paid insurance premiums to a common fund from which noteholders of failed banks were reimbursed. The safety fund was innovative and ahead of its time in some regards, but the system collapsed just nine years after its establishment when 11 banks failed in rapid succession. . . . [T]he safety fund's bankruptcy resulted from a host of contributing factors, including excessive risk-taking, adverse selection, fraud, and inadequate supervisory oversight. . . .

The South and West
Although these two regions were culturally distinct, they adopted similar banking policies. In both regions, banks received large state subsidies, they became embroiled in various public infrastructure projects, and they operated in accordance with what historians have labeled the "commonwealth ideal." That is, banks were expected to promote social welfare and the common good. . . . [S]outhern and western banks were designed to help late-developing economies catch up with early developers. A secondary role of these institutions was to insulate the regional economy from the potentially devastating effects of financial panics, extended recessions, and debt-deflation cycles. In effect, these banks reinflated depressed economies, which slowed or stemmed a rising tide of personal and business bankruptcy. . . .

In an effort to encourage immigration and commercial agriculture [in the Deep South, state- subsidized so-called plantation banks] simultaneously monetized agricultural economies and provided long-term mortgage credit for farm purchase and improvement. In the end, this experiment failed, but not as much from an inherent inconsistency between the two objectives as from bad timing. Six of seven plantation banks, with a combined capital in excess of $20 million, were established in the mid-1830s and had inadequate opportunity to establish themselves on a sound footing before the panics of 1837 and 1839 devolved into an extended commercial depression. . . . .

[B]ranch banking promoted financial stability. Where the large number of small unit banks in the northeastern United States inhibited the formation of effective mutual guaranty coalitions, the small number of large branch banks in the South and West encouraged the establishment of such coalitions. There was, however, an arduous learning process. New evidence shows that interbank coalitions formed in the late 1830s were neither as effective nor as stable as those formed in the late 1850s. The lessons learned in the earlier period translated to success 20 years later. . . .

Toward Rationalization
[B]anking services grew in accordance with overall growth in the economy [in the early 19th century]. One exception was the mid-1830s, when a speculative wave poured over the United States and banking grew faster than most economic indicators. High credit demand drove up bank profitability, which induced entry and increased bank capital and specie leverage ratios. The bubble burst when actions at the Bank of England sharply drove up short-term interest rates, which diminished bank profitability and pushed some into insolvency. After 1843, bank lending and private investment moved together up to the outbreak of the Civil War. Federal policy during the war, particularly the National Banking Acts of 1863 and 1864, rationalized U.S. banking structure and diminished the importance of state banking and the differences inherent in a decentralized federalism.