The Historian's Perspective
New Jersey currency note, 1776. "THIS bill of ONE SHILLING and SIX-PENCE Proclamation is emitted by a Law of Colony of New Jersey, passed in the Fourteenth Year of the Reign of his Majesty King George the Third." (GLC00184.17)
The U.S. Banking System: Origin, Development, and Regulation
by Richard Sylla
Banks are among the oldest businesses in American history—the
Bank of New York, for example, was founded in 1784, and as the recently
renamed Bank of New York Mellon it had its 225th anniversary in 2009.
The banking system is one of the oldest, largest and most important
of our industries. Most adult Americans deal with banks, often on a
fairly regularly basis. Nonetheless, banks and banking seem rather mysterious.
What do banks do? Why have they for so long been an integral part of
our economy? Why, as in the financial crisis that commenced in 2007
and still lingers with us, do banks every so often get into trouble
and create serious problems for the country?
Banks have two important economic functions. First, they operate a
payments system, and a modern economy cannot function well without an
efficient payments system. We make most of our payments by writing checks,
swiping credit cards issued by banks or tied to them, and by paying
bills via online banking. Most of the money stock of the country is
in fact bank money; the rest of the currency is “legal tender”
issued by the government, namely Federal Reserve Notes and coins. We
have confidence in bank money because we can exchange it at the bank
or an ATM for “legal tender.” Banks are obligated to hold
reserves of “legal tender” to make these exchanges when
we request them.
The second key function of banks is financial intermediation, lending
or investing the money we deposit with them or credit they themselves
create to business enterprises, households, and governments. This is
the business side of banking. Most banks are profit-seeking corporations
with stockholders who provide the equity capital needed to start and
maintain a banking business. Banks make their profits and cover their
expenses by charging borrowers more for loans than they pay depositors
for keeping money in the bank. The intermediation function of banks
is extremely important because it helped to finance the many generations
of entrepreneurs who built the American economy as well as the ordinary
businesses that keep it going from year to year. But it is inherently
a risky business. Will the borrower pay back the loan with interest?
What if the borrower doesn’t repay the loan? What happens to the
banking system and the economy if a large number of borrowers can’t
or won’t repay their loans? And what happens if, in the pursuit
of profit, banks do not maintain levels of reserves and capital consistent
with their own stability?
******
There were no modern banks in colonial America. Colonial Americans gave
credit to each other, or relied on credit from merchants and banks in
Great Britain. Money consisted of foreign coins and paper money issued
by the governments of each colony.
There were no American banks as late as 1781, when young Alexander
Hamilton, who would become the most financially astute of the founding
fathers, wrote to Robert Morris, Congress’s superintendent of
finance, that “Most commercial nations have found it necessary
to institute banks and they have proved to be the happiest engines that
ever were invented for advancing trade.” Hamilton recommended
that a bank be founded, and a few months later Morris persuaded Congress
to charter the new nation’s first bank, the Bank of North America
located in Philadelphia. Three years later, Boston merchants founded
the Massachusetts Bank and Hamilton became a founder of the Bank of
New York. When George Washington became our first president under the
Constitution in 1789, these were the only three banks in the United
States. They were local institutions, not part of a banking system in which banks routinely receive and pay out one another’s liabilities.
Washington tapped Hamilton to be our first secretary of the treasury.
In his first two years in office Hamilton moved quickly, and often controversially,
to give the United States a modern financial system. He implemented
the federal revenue system, using its proceeds to restructure and fund
the national debt into Treasury securities paying interest quarterly.
He defined the U.S. dollar in terms of gold and silver coins; these
would serve as reserves backing bank money as banks proliferated. And
Hamilton founded a national bank, the Bank of the United States (BUS),
a large corporation capitalized at $10 million, with 20 percent of its
shares owned by the federal government, and with the power to open branch
banks in U.S. cities.
Hamilton’s policies induced others to fill out the other major
components of a modern American financial system. The BUS prompted state
legislatures to charter more banks—there were about thirty of
these by 1800, more than 100 by 1810, 500-600 by the 1830s, and 1500-1600
on the eve of the Civil War. These banks were corporations, and the
states also chartered many non-bank business corporations. Active securities
markets emerged in the early 1790s when some $63 million of new U.S.
national debt securities and $10 million of BUS stock stimulated the
development of trading markets in a number of cities and the establishment
of stock exchanges in Philadelphia and New York. A distinctly modern
U.S. financial system did not exist in the 1780s, but was firmly in
place by the mid 1790s, after which it expanded rapidly to serve, even
foster, the rapid growth of the U.S. economy. The banking system was
a key component of it.
Since most banks were business enterprises chartered by state legislatures,
banking became highly politicized. A party in control of the legislature
would grant bank charters to its backers and not those of the other
parties. Banks also became sources of revenue: state governments invested
in banks and earned dividends from them, they charged banks fees for
granting charters of incorporation, and they taxed them. Individual
legislators accepted bribes to help some banks get charters, and to
prevent other banks from getting them. By the 1830s, to get away from
the politicization and corruption involved in legislative chartering,
a few states began to enact “free banking” laws. These general
incorporation laws made the granting of bank charters an administrative
rather than a legislative function of government. This increased the
access of Americans to banking. The result of free banking, according
to banking historian Bray Hammond, was that “it might be found
somewhat harder to become a banker than a brick-layr, but not much.”
The BUS, the national or central bank, also proved to be politically
controversial. Some thought it was unconstitutional and a threat to
states’ rights. Many state bankers resented its ability to compete
with them, to regulate their ability to make loans, to branch across
state lines, and to have the federal government’s banking business
to itself. When the BUS’s charter came up for renewal in 1811,
it was defeated by the narrowest of margins when the vice president
broke a tie vote in the Senate. That weakened the ability of the government
to finance the War of 1812. In 1816 Congress therefore chartered a second
BUS, an even larger corporation than the first.
History repeated itself in the early 1830s when, after both houses
of Congress voted to re-charter the BUS, President Andrew Jackson vetoed
the bill and his veto could not be overridden. The second BUS, like
the first, did a good job of regulating American banking and promoting
financial stability. But Jackson thought it had too many privileges
and was too friendly to his political opponents. The BUS federal charter
expired in 1836. The United States would not again have a central bank
until 1914 when the Federal Reserve Act went into effect.
Without a central bank to provide oversight of banking and finance,
the expanding banking system of the 1830s, 1840s, and 1850s suffered
from some major problems, even as it supplied the country with ample
loans to finance economic growth. One problem was financial instability.
Banking crises occurred in 1837, 1839-1842, and 1857, years when many
banks had to suspend convertibility of their bank notes and deposits
into coin because their coin reserves were insufficient. A good number
of these banks failed or became insolvent when borrowers defaulted on
their loan payments. The banking crises led to business depressions
with high unemployment.
Another problem was a chaotic currency. In those days, the government
provided only coins. Paper money—bank notes—was issued by
just about every individual bank. By 1860 there were 1,500-1,600 such
banks, most of which issued several denominations of notes. Hence, throughout
the United States there circulated about 8 to 9 thousand different looking
pieces of paper, each with the name of a bank on it and a number of
dollars which the named bank promised to pay in coin if the note were
presented to it. It was costly, of course, to return a note of, say,
a Georgia bank received in New York to the bank in Georgia, so such
notes circulated at discounts the farther they were from the issuing
bank. Note brokers earned a living by buying bank notes at a discount
and returning them en masse to the issuing banks for payment
in coin. This was not an efficient payments system for an expanding
economy. Moreover, it was one in which counterfeiting of bank notes
thrived because with so many different looking notes in circulation,
it was hard to tell a real one from a fake.
Abraham Lincoln’s Union government during the Civil War solved
the problem of a chaotic currency, and at the same time the more pressing
problem of how to finance the war. The solution, introduced in 1863,
was to get the federal government back into the business of chartering
banks. The new national banks, like free banks under earlier state laws,
would issue a uniform national currency printed by the government and
backed by U.S. bonds. National banks had to purchase the bonds to back
bank notes they issued, making it easier for the Lincoln administration
to sell bonds and finance the war against the Southern confederacy.
National bank currency would be safer than state bank notes—if
a bank defaulted or failed, the U.S. bonds backing them could be sold
to pay off holders of the failed bank’s notes. In effect, national
bank notes were a liability of the federal government, not the bank.
Discounts on bank notes, a problem of the previous era, disappeared,
improving the national payments system.
The intent of the National Bank law was that the old state banks would
convert to national charters. But not all of them did, so Congress in
1865 passed a prohibitive tax on state bank notes. That ended the issue
of state bank notes. But it did not end state-chartered banking because
many state banks could continue as deposit-taking banks without issuing
notes. Shortly after the Civil War most U.S. banks were national banks.
But by the end of the nineteenth century, state banking had recovered
sufficiently to rival national banking. The United States had what came
to be called a “dual banking system” of national and state
banks, and the system persisted into the twenty-first century. National
bank notes, however, disappeared in the 1930s, replaced by today’s
national currency, Federal Reserve Notes.
During the half century from 1863 to 1913, the country continued to
be without a central bank. It had a uniform national currency and a
better banking system than the one before 1863, but it was still prone
to financial instability. Banking panics occurred in 1873, 1884, 1893,
and 1907. The last was especially embarrassing because by 1907 the U.S.
economy was the largest in the world, as was the U.S. banking system.
There were about 20,000 banks in 1907, and there would be 30,000 by
the all-time peak in the early 1920s. U. S. bank deposits were more
than a third of the total world deposits, and approximately the same
as combined deposits of German, British, and French banks, the next
three largest systems. The European countries had central banks—bankers’
banks—that could lend to banks under stress, and as a result they
had fewer banking crises than did the United States.
****
So in 1913, after three-quarters of a century without a central bank
and a period punctuated by a number of banking crises, Congress created
a new central bank, the Federal Reserve System (the Fed). The Fed was
organized in 1914, and by the end of the year the twelve regional Reserve
Banks, coordinated by the Federal Reserve Board in Washington, D.C.,
were open for business. The new system was a decentralized central bank
in keeping with the long American tradition of not wishing to have concentrated
financial power in either Wall Street or Washington, D.C.
The Fed further improved the payments system by operating a national
check-clearing system. It also introduced Federal Reserve Notes, which
gradually replaced national bank notes and Treasury-issued currency,
making the national currency still more uniform. The Fed also had the
power to expand and contract its currency and credit, which served to
reduce seasonal fluctuations in interest rates, enhancing economic stability.
As we know from recent experience, the Fed did not eliminate banking
crises. But crises were far less frequent than when there was no central
bank. Indeed, there have been only two major banking crises in ninety-six
years, 1930-1933 and 2007-2009. Or possibly three if we add the savings
and loan (S&L) crisis of the 1980s, although S&Ls at the time
of the crisis were not considered to be banks and had their own set
of regulators. (In the wake of that crisis the S&Ls that survived
essentially became banks.) Earlier in U.S. history, in the forty years
when the two Banks of the United States existed, there was only one
banking crisis, in 1819. Compared to the seventy-eight year period from
1836 to 1914, which witnessed seven banking crises, the two eras of
central banking look pretty good: a crisis once every thirty to forty
years on average, instead of once every eleven years. The presence of
a central bank with a mandate to lend to solvent but illiquid banks
and to the money and capital markets in times of stress enhanced financial
stability and reduced the incidence of banking crises.
The Fed, however, rather infamously did little to prevent the failure
of thousands of U.S. banks in the period 1930-1933, a lapse that contributed
to making the Great Depression of the same years the worst economic
slump in American history. The reasons for the lapse are still not clear.
Some historians contend that decisive action to prevent the contagious
failure of so many banks was impossible because the leadership of the
Fed was weak and divided. The Board in Washington disagreed with some
of the regional Reserve Banks on what actions to take, and the regional
Banks disagreed with one another. Others say that the Fed thought it
had to defend the convertibility of the dollar to gold, which led it
to contract rather than expand credit during critical periods of the
slide into the Great Depression.
In the wake of the Depression, President Franklin Roosevelt’s
“New Deal” administration sponsored a number of important
banking reforms. Roosevelt’s first action in March 1933 was to
close all of the nation’s banks, the so-called Bank Holiday, and
then he assured the nation that when banks re-opened the public would
not have to worry about their solvency. The Banking Act of June 1933,
often called the Glass-Steagall Act because of its chief congressional
sponsors, introduced federal deposit insurance, federal regulation of
interest rates on deposits, and the separation of commercial banking
from investment banking. The Banking Act of 1935 essentially created
the Fed as we know it today. It strengthened the central bank’s
powers and made them less decentralized than they had been during the
Fed’s first two decades.
New Deal banking reforms ushered in a long period of banking stability
lasting from the 1930s to the 1980s. That stability, however, was purchased
at the cost of making American banking less competitive, less innovative,
and more regulated than it had been before the 1930s. It became increasingly
clear by the 1960s and 1970s that heavily regulated commercial banking
was losing market share in finance to the less regulated and more innovative
institutions and markets of Wall Street. An example of this was the
money market mutual fund. It provided depositors with the option of
earning the high, unregulated interest rates of Wall Street’s
money market instruments instead of the lower regulated rates that could
be paid by commercial banks and S&Ls. That led bank depositors to
withdraw funds from the banking system and place them in money market
funds, a process called “disintermediation.” The markets
of Wall Street gained, and the banking system became a smaller and smaller
component of the overall financial system.
Banks and their political supporters responded by calling for deregulation.
The New Deal’s ceilings on deposit interest rates were repealed
in the 1980s. So were some of the regulations that prevented S&Ls
from competing with banks. Congress removed long-standing restrictions
on interstate banking in 1994. Bank mergers, once suspect for reducing
competition, were increasingly allowed. Today the country has far few
independent banks than in the past, about 8,000. But many of the remaining
banks have a large number of branches and even more ATMs. Americans
now are never very far from a banking facility.
In 1999, Congress repealed the Glass-Steagall Act that had effectively
separated commercial and investment banking. The business of banking,
long stifled by regulation, suddenly became more exciting. Increasingly,
banks were not limited in their lending by the size of their deposit
bases. They could obtain more funding to make more loans and purchase
new forms of securities by accessing the Wall Street and international
money markets.
In retrospect deregulation may have led banking to become too exciting
for its own good and that of the country. In the early 2000s, cheap
credit led to a housing and commercial real estate boom that turned
into a bubble. Assuming—contrary to historical experience—that
home prices could not go down, banks and other lenders made numerous
mortgage loans on liberal and increasingly innovative terms. They also
increased their investments in mortgage-backed securities created by
Wall Street banks. When, in the middle of the decade, house prices stopped
rising and began to fall, increasing numbers of borrowers defaulted
on their mortgage loans, causing steep drops in the values of mortgage-backed
securities.
Banks holding mortgage loans and mortgage-backed securities were in
trouble. The decline in the value of the assets—the loans and
securities on their balance sheets—threatened to wipe out their
capital and make them insolvent. Unlike the 1930s, depositors did not
panic and rush to withdraw their funds from banks because now they were
protected by federal deposit insurance. But money market lenders had
no such insurance, and they began to refuse to lend to the banks. In
2007, and even more in 2008, market funding for banks dried up. Only
massive interventions by the Fed and the U.S. Treasury prevented a catastrophic
banking and financial crisis on the order of that of the early 1930s.
As we know, the crisis has been a bad one. But it could have been a
lot worse if the Fed and other financial authorities had acted as they
did in the Great Depression.
As this is written, Congress is in the process of reconciling differences
between the financial reform bills that the House and Senate have passed.
The outcome will lay the groundwork, as did the 1930s banking reforms,
for the next chapter in the long history of the American banking system.
Like the reforms introduced during the Lincoln administration in the
1860s and the Roosevelt administration in the 1930s, the reforms that
are now emerging under the Obama administration are sure to increase
government oversight of the banking system. But if history is any guide,
these reforms will not put an end to banking crises.
Richard Sylla is Henry Kaufman Professor of the History of Financial Institutions and Markets, and Professor of Economics at New York University, a Research Associate of the National Bureau of Economic Research, and Chairman of the board of the Museum of American Finance.
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