Online Library of Liberty: Economics, vol. 2: Modern Economic Problems

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CHAPTER 8

BANKING IN THE UNITED STATES BEFORE 1914

§1. The First and Second Banks of the United States. § 2. Banking from 1836 to 1863. § 3. National Banking Associations, 1863-1913. § 4. Defects of our banking organization before 1913. § 5. Lack of system. § 6. Inelasticity of credit. § 7. Periodical local congestion of funds. § 8. Unequal territorial distribution of banking facilities. § 9. Lack of provision for foreign financial operations. § 10. The “Aldrich plan.”

§1. The First and Second Banks of the United States. The form of our present banking system has been affected by various economic and political events, a knowledge of which is helpful to an understanding of the present banking system in our country.

Alexander Hamilton, the great first Secretary of the Treasury in Washington’s cabinet, advocated the charter of a central national bank as one portion of his larger plan of national financiering. His purpose was realized in the chartering, in 1791, of the First Bank of the United States for a period of twenty years. The capital for this institution was in small part subscribed by the government, but mostly by private capitalists. The management of the bank was left almost entirely in private hands. The central bank established branches in many parts of the country, issued banknotes which circulated everywhere without depreciation, acted as the governmental depository of funds and as governmental agency in various ways. It seems to have been successful and useful as a banking institution until the expiration of its charter in 1811, but it was touched by the contemporary controversies over state rights and was from the first opposed by those who feared the growth of a strong central government. This opposition prevented the extension of its charter.

In 1816, however, after only a moderate discussion, the Second Bank of the United States was chartered for a period of twenty years. This, also, in its purely banking aspects, seems to have been distinctly successful, conducting numerous branches in various parts of the country, maintaining at all times the parity of its notes, facilitating domestic exchange throughout the country, and enjoying unquestioned credit and solvency. However, this bank became, even in a greater degree than did the First Bank, the creature of political rivalries. In the period of rising democratic sentiment typified and led by Andrew Jackson, the bank came to be looked upon as the embodiment, or the stronghold, of plutocratic interests. Jackson’s suspicions and hostility to a central bank were magnified by the untactful conduct of the head of the bank, and Congress permitted its charter to expire by limitation in 1836, near the close of Jackson’s administration. In the light of history the change of policy must be pronounced unfortunate, the more so because it committed the then leading political party to opposition against a better organization of banking on a national scale. The

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action was directly that of Jackson, but the fixing of the blame is not an entirely simple thing.

§2. Banking from 1836 to 1863. The federal government, which up to that time had deposited its funds in the central bank and its branches, and in local state banks, established the “independent treasury” in 1840. This was abolished in 1841, but reëstablished in 1846, and continuously maintained until January, 1921, when the Federal Reserve Board took over all nine of the offices and sub-treasury branches. By this plan the government kept its money of all kinds in various depositories (or subtreasuries) in charge of public officials. While from 1792 to 1836 almost continuously a central banking system was in operation, other banks, organized under state charters, were steadily increasing in number. They received deposits, issued banknotes under state laws, and cared for local commercial needs. The abolition of the central national bank in 1836 left to the various state-chartered banks for twentyseven years all the banking functions of the country. A few of the states became stockholders in central state banks, or even undertook to conduct a banking business, with unsatisfactory results. The banks of some states (notably those of New England and New York), conducted as private enterprises under careful regulation and held to strict standards by public sentiment, for the most part maintained a high credit; but many banks, under lax laws and regulations, were guilty of great abuses of credit and of downright dishonest practices. The evils were more especially apparent in connection with excessive issues of bank-notes.

§3. National Banking Associations, 1863-1913. No further step was taken in federal legislation until 1863, when, in the midst of the Civil War, local “national banking associations” were chartered. The purpose was in part to provide banks under national charters for banking purposes (both of deposit and of issue), and in part it was to make a wider market for United States bonds at a time when government credit was at low ebb. The plan adopted followed the experience of New York state (from 1829 on) with a system of bond-secured banknotes. Congress provided that every bank taking out a national charter must purchase bonds of the United States and deposit them with the Treasurer of the United States, in return for which it would receive banknotes to the amount of 90 per cent of the denomination or of the market value of the bonds, whichever was the smaller. (In 1900 this was changed so that notes could be issued to the full amount of the denomination of the bonds.) Notes of failed banks or of banks that go out of business are redeemed from the guaranty fund held at Washington and from the proceeds of the sale of the bonds. Bank-notes issued on this plan, being secured by the bonds and a redemption fund, rest ultimately on the credit of the government, not on the credit of the bank. They are not promptly sent back for redemption to the banks issuing them, as should be done if they were typical banknotes. They may circulate thousands of miles away from the bank that issued them, and for years after the bank has gone out of business. They are perfectly safe for the holder, but are not an “elastic currency,” increasing or diminishing with the needs of business. The changes in their amount depend upon the chance of the banks to make more or less in this way than by any other use of their capital, and this in turn depends largely on the price of bonds and on the rate of interest they bear. From 1864 to 1870 fortunes were made from this source, but thereafter banks could make little more from note issues than they could by investing the same amount in other ways. Many banks

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for a long period did not avail themselves in the least of their privilege of issue. The notes were subject to a tax.1

A national bank (as the law now stands) may be organized, with $25,000 capital in towns not exceeding three thousand population, with $50,000 in towns not exceeding six thousand, with $100,000 in cities not exceeding fifty thousand, and with $200,000 in large cities. Three cities, New York, Chicago, and St. Louis, have long been designated as central reserve cities, and some forty-seven other cities as reserve cities, in which the reserves of banks have always been required to bear a considerably larger proportion to their deposits than in other cities.2 Other banks might, until 1914, count as part of their legal reserves their deposits in reserve city banks, up to a certain proportion. The national banks in the larger cities thus became the great capital reservoirs of cash for the whole country.

National banks have been subject to stricter inspection than have been the banks in most of the states, a fact that has strengthened public confidence in their stability. Except in this and the other respects above mentioned, a national charter offered few, if any, attractions to small banks, a majority of which have found it more advantageous to operate under state charters because of less stringent regulations as to amount of capital, reserves, and supervision.

§4. Defects of our banking organization before 1913. Taken altogether, the national banks in the United States between 1863 and 1913 represented great banking power and very efficient service for the community in times of normal business, as with few exceptions did also the state banks. But in several respects it long ago became apparent that our banks were operating less satisfactorily than those of several other countries. American banking organization had failed to keep pace with the increasing magnitude and difficulty of its task. Especially at the recurring periods of financial stress, such as those of 1873, 1893, 1903, and 1907, our banking machinery showed itself to be wofully unequal to the strain put upon it. Financial panics were more acute here than in any other land, and this fact clearly was traceable in large part to defects in the banking situation. In academic teaching and in public conferences of bankers, business men, publicists, and students, the subject was continually discussed after 1890. At length Congress in 1908 created a “National Monetary Commission” to inquire into and report what changes were necessary and desirable in the monetary system of the United States or in the laws relative to banking and currency. After the most extended inquiry and discussion that the subject had ever received, the commission submitted its report in January, 1912. The defects to be remedied, as enumerated in the report3 may be reduced to the following five headings: (a) Lack of system. (b) Inelasticity of credit. (c) Periodic local congestion of funds. (d) Unequal territorial distribution of banking facilities. (e) Lack of provision for foreign banking.

§5. Lack of system. Only in a loose sense could the banks of the United States be said (before 1914) to constitute a system at all. Both national and state laws dealt with individual banks only. It was not legal for a bank to establish branches in another city, as is done in most countries. The several national banks in one city were legally quite separate. It was only by voluntary agreement that in some of the larger cities they came together into clearing-house associations. They made possible some measure of

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coöperation which, small as it was, proved at times of stress to be of much service within a limited sphere for the local communities. But even with the aid of these organizations the banks were unable in times of emergency to avoid the suspension of cash payments.

There was no provision whatever for the concentration of bank revenues so that each bank would be supported by the strength of the other banks if a movement began to withdraw deposits in unusual amounts. Each bank then was compelled for selfprotection to call for any sums it had deposited with other banks,4 and to keep for its own use all the reserves it might have in excess of its own immediate needs. This threw a great strain upon the banks in the reserve cities, which in normal times had become the depositories of a good part of the reserves of the banks in other places. Thus developed a spirit of panic, like the fright of theater-goers crowding toward the door at the cry of fire.

The maintenance of the government’s independent treasury contributed to the difficulties by causing the irregular withdrawal of money from circulation and thus depleting bank reserves in periods of excessive government revenues and by returning these funds into circulation only in periods of deficient revenues. Efforts to modify this system by a partial distribution of the public moneys among national banks, had resulted, it was charged, in discrimination and favoritism in the treatment of different banks and of different sections of the country.

§ 6. Inelasticity of credit. Our banks, considered both separately and collectively, were unable to increase their lending powers quickly and easily to respond to business needs. The need of greater elasticity of credit was felt in the more or less regular seasonal variations within the year, and in the more irregular variations in cycles of years from periods of prosperity to those of panic and depression in business. The inelasticity was necessitated by illogical federal and state laws restricting absolutely the further extension of credit when the reserves fell below the percentage of deposits (15 or 25 per cent) fixed by law. Reserves thus could not legally be used to meet demands for cash payments at the very time when most needed. This feature has been likened to the rule of the prudent liveryman who always refused to allow the last horse to leave his stable so that he would never be without a horse when a customer called for one. The refusal of credit by the banks at such times when they still had large amounts of cash in their vaults increased the need and eagerness of the public to draw from the bank all the cash they could, and often precipitated the insolvency of the banks. Clearly, some means were needed to enable the lending power of the individual banks to be increased at such times, so that no customer with good commercial paper need fear to be refused a loan even though the rate of interest might have to be somewhat higher for a few days or weeks than the normal rate.

Our bond-secured bank-notes lacked almost entirely the quality of elasticity needed to meet these changing business needs.5 Their value being dependent primarily upon the amount and price of United States bonds, they might be most numerous just when least needed as a part of our circulating medium.

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§7. Periodical local congestion of funds. In times of general confidence each bank finds it profitable, and is tempted, to extend its credit to the extreme limit permitted by the law governing the proportion of reserves to deposits. Of the 15 per cent reserves that were required in the so-called “country” banks, three fifths (9 per cent) might be kept in banks in reserve cities; and of the 25 per cent in reserve city banks, 12½ per cent might be kept in central reserve cities. There it counted as part of the depositing banks’ legal reserves, was a fund upon which domestic exchanges could be drawn, and earned a small rate of interest (usually 2 per cent) paid by banks in reserve and central reserve cities to their “country” correspondents. By this process of pyramiding, reserves in very large part came to be kept in New York city, where they could be lent “on call,” and the largest use for call loans was in stock-exchange speculation. Thus every period of prosperity encouraged an unhealthy distribution of reserves, gave an unhealthy stimulus to rising prices, and “promoted dangerous speculation.”

§8. Unequal territorial distribution of banking facilities. Another aspect of this concentration of surplus money and available funds in the larger cities was the comparatively ample provision of banking facilities in the cities and in the manufacturng sections, and imperfect provision in the agricultural districts. The whole financial system seemed designed to induce the poorer country districts to lend temporarily available funds at low rates of interest to be used speculatively in cities, instead of enabling the richer districts, the cities, to lend to the rural districts for productive enterprise. The rates of bank discount in different sections of our country have long been most unequal—lowest in the largest cities and highest in the rural South and West—whereas in Canada, with a different system of banking, the rates have long been much more approximately uniform in urban and agricultural districts.

Indeed, our national banking development has been predominately urban and commercial to the neglect of rural and agricultural interests. National banks were (until 1913) forbidden to make loans on real estate, and this greatly “restricted their power to serve farmers and other borrowers in rural communities.” There was in the more agricultural regions, “no effective agency to meet the ordinary or unusual demands for credit or currency necessary for moving crops or for other legitimate purposes.” The lack of uniform standards of regulation, examination, and publication of reports in the different sections prevented the free extension of credit where most needed. Finally, the methods and agencies for making domestic exchange of funds were, compared with other countries, imperfect and uneconomical even in normal times, and could not “prevent disastrous disruption of all such exchanges in times of serious trouble.”

§ 9. Lack of provision for foreign financial operations. Not without its influence on public opinion was the consideration that we had “no American banking institutions in foreign countries.” Many bankers and business men felt, as did the Commission, that the time had come when the organization of such banks was “necessary for the development of our foreign trade.” Foreign banks in South America and the Orient, handling American trade, were believed to favor their own countrymen rather than the interests of American merchants. In contrast with the European nations with their centralized control of banking, we had “no instrumentality that” could “deal

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