In today’s anxious financial environment, when we look to the government and the Fed to step into the economy with interest rate adjustments and extra cash reserves at every downturn, it’s a little appreciated fact that there was an important pre-Federal Reserve – banking era in the United States. During the 1800’s and early 1900’s, banks were chartered by the banking authorities in each state, and laws could differ considerably one from state to another. Banks at that time functioned largely as depository institutions, with the bank’s own paper money offered as a receipt for gold held in the bank’s vaults. All hand-to-hand paper currency was convertible into specie, usually gold coin, and banks’ paper notes were heterogeneous and highly competitive in the market for customers seeking deposit and loan services. To remain profitable, banks had to compete for deposits based on the redeemability of their notes.
In practice, the decentralized legal and regulatory environment in American banking in the early and mid 1800’s generated a mixed bag of regulation-driven and market-driven banking activity. In this mix were a number of states authorizing banks under what was known as free banking law, as well as a smaller number of regional New England banks that operated in as nearly a laissez-faire environment as one gets in the industry.
‘Free banking’ was a legal designation that applied to the various states’ statutes that placed fewer than usual, but still very specific, restrictions on bank assets and capital. Banks chartered under free banking law, no matter which state one examines, were far from unregulated. Still, bank failures under free banking came to be associated not only with the perils of unregulated banking practices, but with fraudulent and unscrupulous motives allowed to take advantage of the unprotected banking community. The scandalous ‘wildcat bank’ phenomenon was (and still is, in many, many texts) attributed to excessive freedom in the banking industry of the time. Highly regulated in reality, it is almost certainly the case that free banks often failed because the existing regulations created a moral hazard and made it impossible for banks to be flexible in the face of changing market and economic conditions.
By contrast, a parallel banking arrangement known as the Suffolk System existed in New England during the period that free banking reigned elsewhere. The Suffolk’s eventual role as a central clearinghouse for bank currencies and de factoenforcer of member bank practices is an example of a laissez-faire but self-regulating system The Suffolk bank fulfilled most of the familiar depositor safety, system stability, and liquidity functions of the present-day Federal Reserve, but without a monopoly on money supply or a legal tender law.
Unlike credit creation by the Fed today, credit-creation for a single bank in this redeemable note system had a limit. Depositors’ ability to reclaim their gold on demand was paramount to maintaining a good reputation. For the note-creating bank of the 1800’s, the art of maintaining a fractional reserve redeemable currency was to carefully balance profitability and safety. And that meant continually keeping enough gold in the vault to cover depositor demands for withdrawals.
A run on the bank’s reserves—where depositors simultaneously decide to withdraw all their gold— was unusual, except when the bank’s reputation for redeemability was in question. Because banks were generally sovereign institutions, a liquidity crisis in one did not signal a system-wide problem. This tended to contain the consequences of incautious behavior effectively where market-driven profit incentives and the all-important reputation of the institution could make or break its chances of survival.
In general, American banks in the mid-to-late 1800’s provided a sound (reliable purchasing power) currency, enough credit to conduct commercial and personal affairs, a relatively safe means of storing and transferring money locally and over distances, and a simple way to keep account of monetary wealth as long as two conditions were met:
1. deliberate fraud or managerial incompetence were detectable, and revealed, well before the bank failed; this meant that the public was aware of any liquidity problem at nearly the same time that bankers were aware of it, helping to stem the behavior that could lead to insolvency and failure.
2. the means by which banks would simultaneously satisfy the demands of depositors, and the needs of borrowers, was left largely to banks themselves to discover and adjust—through market mechanisms and competition.
Next: a look at why these conditions not only produced, but were essential to healthy, competitive banking and economic activity in 19th century. Even today, that era has insights to offer into American monetary and banking policy, and U.S. economic health.