Banking

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Bank of North America

The first important bank in the United States was the Bank of North America, established in 1781 by the Second Continental Congress. It was the first bank chartered by the U.S. government. Other banks existed in the colonies prior to this, most notably the Bank of Pennsylvania, but these banks were chartered by individual states. In 1787 the Bank of North America changed to a Pennsylvania charter following controversy about the legality of a congressional charter. Other large banks were chartered in the early 1780s by the various states, primarily to issue paper money called bank notes. These notes supplemented the coins then in circulation and assisted greatly in business expansion. The banks were also permitted to accept deposits and to make loans.

Because there were no minimum reserve requirements on deposits, bank notes were secured by the assets of the issuing banks. Most assets took the form of business loans. The only restraint on a bank’s ability to extend loans was the public’s unwillingness to accept its notes. Acceptance of a bank’s notes usually was determined by the bank’s record in exchanging the notes for coins when called upon to do so. Since most of them were able to do this, the early banks enjoyed wide latitude in granting loans.

In 1791 the federal government chartered the Bank of the United States, commonly referred to as the “First” Bank of the United States, to serve both the government and the public. One-fifth of the bank’s capital was supplied by the federal government. The bank was a repository of government funds and a source of loans for individuals and the federal and state governments. The charter of the “First” Bank of the United States was allowed to lapse in 1811, in part because half of its stock was owned by foreigners but also because of opposition to the bank by more than 80 state-chartered banks. The main reason for the conflict between state banks and the “First” Bank of the United States was that the public preferred the notes of the Bank of the United States because of the bank’s excellent reputation. This made it difficult for state banks to attract customers.

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Second Bank of the United States

During the War of 1812, hard currency (coins) became scarce and many state banks stopped redeeming their notes for coins. This brought into question the underlying value of bank notes and limited their use as money. At the same time, however, banks began increasing the amount of notes they issued. This rapid increase in paper money caused prices to rise and created inflation. These developments created a demand for establishing the “Second” Bank of the United States, which was chartered in 1816. The bank had a stormy career. Many local bankers who had to compete with this government-sponsored bank opposed it, as did President Andrew Jackson. As a result of Jackson’s opposition, the federal government withdrew its deposits in 1833, and three years later, when the bank’s charter was not renewed, it went out of existence.

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Free Banking and the Safety Fund System

In 1838 New York State passed a free banking law. Before this date all incorporated banks had been chartered by states and had been granted the note-issuing privilege. Under free banking, charters could be obtained without a special act of the state legislature. The main requirement for new banks was that they post collateral of government bonds equal in value to the notes to be issued. In principle, noteholders were protected because, if the bank failed, proceeds from the sale of the collateral would be used to reimburse them. Free banking was soon adopted by other states. Because there was little regulation of new banks, many banks failed and bank fraud occurred. The free-banking years of 1837 to 1863 are also known as the Wildcat Banking era.

In New England, however, the Suffolk Bank in Boston, Massachusetts, had redeemed bank notes of out-of-town banks only if they kept on deposit amounts large enough to cover the redemptions. Since Boston was a trade center, the pressure was great on all New England banks to accept this system, known as the Suffolk banking system. Practically all New England banks had joined the system by 1825.

In the early 1800s New York State also developed the safety fund system, under which each member bank contributed a small percentage of its capital annually to a state-managed fund. The purpose of the fund was to protect noteholders in the event of bank failure. In 1842 Louisiana enacted legislation to limit the number of banks and to require them to maintain one-third of their assets in cash and two-thirds in short-term obligations.

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The National Banking Act of 1863

The Civil War (1861-1865) brought about the National Banking Act of 1863, and with it a fundamental change in the structure of commercial banking in the United States. Originally named the National Currency Act, but later amended and renamed, the National Banking Act created the system known as dual banking, in which banks could have either a state or federal charter. This system still exists in the United States. The act established the Office of the Comptroller of the Currency in the Department of the Treasury and gave it the power to issue national bank charters to any bank that met minimum requirements. The philosophy of relatively “free banking” continued until 1935 when Congress made it more difficult to obtain a bank charter. The 1863 act allowed nationally chartered banks to issue a uniform bank note backed by U.S. government bonds. The amount of the notes was not to exceed 90 percent of the value of the bonds. Officials hoped that the issuance of uniform bank notes backed by the U.S. government would guarantee the value of bank notes and thereby produce a useful nationwide currency, while also inducing state banks to take out national charters. However, because the regulations accompanying a national charter were much stricter than state charters, a movement toward federal charters did not happen as planned. In 1865 the U.S. Congress enacted a 10 percent tax on any bank or individual paying out or using state bank notes. As a result of the tax, many banks converted to national charters, but many others simply stopped issuing their own notes. Instead, these state banks began to issue their customers demand deposit money—that is, checking accounts, instead of bank notes.

By the 1870’s, deposits were well established as a substitute for paper or coin currency, and state banks experienced a revival. State charters contained several advantages over federal charters. State-chartered banks were allowed to hold lower cash reserves relative to deposits, and less capital. State-chartered banks had more flexible branching opportunities and fewer restrictions on the types of loans that could be made.

The National Banking Act was successful in correcting some failings of the pre-Civil War commercial banking system. It produced a unified national paper currency consisting primarily of national bank notes. Bank crises, however, did not disappear. Panics occurred in 1873, 1884, 1893, and 1907, although the causes of these crises varied. Between 1873 and 1907, demand deposits far outweighed bank note circulation. At times some banks were unable to make immediate payment of demands on these deposits. Consequently these banks failed, and their depositors suffered losses of all or part of the money in their accounts.

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Federal Reserve Act of 1913

The financial panic of 1907 resulted in the Federal Reserve Act of 1913. This act went further than any earlier legislation in recognizing the importance of stable money and credit conditions to the health of the national economy. Under the Federal Reserve Act, a central bank was reestablished for the United States, the first since the “Second” Bank of the United States. The new bank was charged with maintaining sound credit conditions. To achieve this goal, the Federal Reserve System was given control over the minimum amount of reserves that member banks must hold for each dollar of deposits. It also obtained the power to lend money to member banks and regulate the types of assets they can hold. Members of the Federal Reserve System include national banks, whose membership is required, and state banks, whose membership is optional. Membership requires a bank to buy stock in the Federal Reserve System. Most large banks under state charter have joined the system.

World War I (1914-1918) brought about inflation and a sharp postwar recession (economic slowdown). Although the banks had bought large quantities of U.S. government bonds during the war, they also lent large amounts of money to individuals engaged in stock market speculation. By investing in bonds, banks helped finance government expenditures during the war and the attendant expansion of American productive resources in the decade following World War I. By lending money to speculators, they became a major factor in the climb of stock prices and the wave of speculation that resulted in the crash of 1929.