By: Bill Medley Highways of Commerce Central Banking and The U.S. Payments System By: Bill Medley Highways of Commerce Central Banking and The U.S. Payments System Published by the Public Affairs Department of the Federal Reserve Bank of Kansas City 1 Memorial Drive • Kansas City, MO 64198 Diane M. Raley, publisher Lowell C. Jones, executive editor Bill Medley, author Casey McKinley, designer Cindy Edwards, archivist All rights reserved, Copyright © 2014 Federal Reserve Bank of Kansas City No part of this book may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior consent of the publisher. First Edition, July 2014 The Highways of Commerce • III �ontents Foreword VII Chapter One A Calculus of Chaos: Commerce in Early America 1 Chapter Two “Order out of Confusion:” The Suffolk Bank 7 Chapter Three “A New Era:” The Clearinghouse 19 Chapter Four “A Famine of Currency:” The Panic of 1907 27 Chapter Five “The Highways of Commerce:” The Road to a Central Bank 35 Chapter Six “A problem…of great novelty:” Building a New Clearing System 45 Chapter Seven Bank Robbers and Bolsheviks: The Par Clearance Controversy 55 Chapter Eight “A Plump Automatic Bookkeeper:” The Rise of Banking Automation 71 Chapter Nine Control and Competition: The Monetary Control Act 83 Chapter Ten The Fed’s Air Force: A Plan for the Future 95 Chapter Eleven Disruption and Evolution: The Development of Check 21 105 Chapter Twelve Banks vs. Merchants: The Durbin Amendment 113 Afterword The Path Ahead 125 Endnotes 128 Sources and Selected Bibliography 146 Photo Credits 154 Index 160 Contents • V ForewordAs Congress undertook the task of designing a central bank for the United States in 1913, it was clear that lawmakers intended for the new institution to play a key role in improving the performance of the nation’s payments system. At the time, payments were largely dependent on the movement of checks between disconnected—and often distant—financial institutions. The process of clearing and settling was risky, slow, costly and insufficient to meet the demands of a large, growing country. The day before the Federal Reserve Act was signed into law, Rep. Carter Glass of Virginia compared the flow of payments in the economy to “highways of commerce.” Glass used this metaphor to illustrate how the Federal Reserve, through a number of regional Reserve Banks located across the country, would provide currency to fuel the economy and serve as the hub of a national clearing network for checks. Technology has progressed dramatically since then, sparking innovations with the potential to offer consumers and businesses better ways to pay. Over the past century of this evolution, Congress has repeatedly turned to the Federal Reserve to ensure these payments improvements are universally available and that the system remains safe and secure. No other institution—public or private—has that responsibility. It is a dynamic that tends to surface prominently during crisis events. It is appropriate that the central bank exercise its leadership as a retail payments regulator and network operator to ensure it is meeting this public expectation. The following pages tell the history of the Federal Reserve’s involvement in the U.S. payments system, beginning with a largely free-market system in New England during the 19th century, to the decades-long battle over interchange fees assessed on card transactions, to the present discussions over the Federal Reserve’s vision and roadmap for a faster and more secure system. This history is not all-inclusive, but it is intended to provide context to the key events and issues that inform the Federal Reserve’s future role in this critical mission area. Esther L. George President and Chief Executive Officer Federal Reserve Bank of Kansas City July 2014 Foreword • VII This cartoon from the early 1800s includes a caricature of Philadelphia banker Stephen Girard. A gold coin is floating in front of the banker, who states he must collect specie to pay his debts “or the game would be up at once.” The satirical drawing reflects the suspicion many had of banks during the post-Revolutionary era. Chapter One of A Calculus Commerce Chaos in early America In early 19th century America, paper money was easy to come by, but not so easy to use. The currency of the time was issued by private banks, and each banknote represented a promise by the issuing bank to exchange the note for an equal amount of gold or silver, known as specie, to anyone who redeemed the note in person at the bank’s counter. But using this currency also forced merchants, consumers, workers and bankers to perform a chaotic daily calculus. Bank charters issued by state legislatures came with a license to print money, and banks exercised this right fully. In the wake of the War of 1812, nearly 200 banks across the United States were printing their own currency, and by 1825, the number of banks issuing notes grew to more than 700. Soon, railroads, canal builders, insurance companies and other private businesses, with the blessings of state politicians, added their own notes to the growing pool of currency circulating throughout the country. Using cash was not as simple as handing over a piece of paper in return for a good or service. For consumers and merchants who might come across notes from dozens of different institutions in the course of their daily business, paying with currency required everyone involved to consider a series of questions: What bank issued this note? Where was the bank located? What kind of financial shape was it in? Was this a real banknote, or a counterfeit? Could the issuing bank honor its pledge to redeem the note for gold or silver? Bankers and merchants in major commercial centers, such as Boston, Philadelphia and New York dealt with this uncertain, risky and inefficient system on a daily basis, and their experiences were typical of the structural challenges faced by others across the new nation. Coins made from silver and gold ore, like that seen here, backed the currency issued by private banks during the early 19th century. A Calculus of Chaos • 1 �e state of commerce in the early 1800s The lifeblood of trade and finance in early America was the exchange of paper currency and coins made of precious metals known as “specie.” While the U.S. Constitution provided that only the federal government could mint coins, private banks determined individual paper notes’ design, denominations and quantity. For consumers and merchants who exchanged banknotes from numerous institutions as they received wages, paid creditors or shopped for goods, the value of an individual note depended on the issuing bank’s distance, its reputation and its perceived financial condition. In most major cities, there were essentially two kinds of banknotes: those issued by banks located in the same city, which circulated at face value, and those issued by rural, or “country” banks. While the city banknotes were worth their full face value in transactions, the notes issued by country banks were generally worth just 95 to 99 cents on the dollar, a discount that reflected the risk associated with accepting notes is- sued by unfamiliar and far-away rural banks. In fact, the nation’s first bank failure, in 1809, involved a distant ru- ral bank, and its story was well known throughout Boston and the rest of New England. After recognizing the problems and risks involved in the nation’s currency system, Andrew Dexter Jr., the nephew of a U.S. senator from Massachusetts, gained control of a small bank in a remote village in Rhode Island. With creditors closing in and facing personal Andrew Dexter Jr. used worthless currency printed by his Rhode Island bank to pay off his debts in Boston. financial ruin from a failing speculative The scheme unraveled and he fled to Canada. real estate project in Boston, Dexter ordered his Rhode Island bank to print notes solely so he could pay his mounting 2 • A Calculus of Chaos debts with the bank’s currency. Dexter counted on his bank’s isolated location and distance from Boston to prevent creditors and others from traveling out of state to redeem the notes for specie. However, the scheme eventually unraveled, and after Dexter fled to Canada, authori- ties discovered he had directed his bank’s cashier to print and issue a total of $600,000 in banknotes, backed by just $86.48 in specie in the bank’s vault. “Country banks have frequently, if not generally, been established with very little real capital,” wrote prominent Boston merchant Nathan Appleton, one of the first to catch on to Dexter’s scheme. “The motive and object in their establishment,” he added, was not “the investment and employment of capital, but the profit to be derived from the circulation of bank notes.” ‘Speculators and bloodsuckers’ Appleton’s concerns and views about rural banks and their motives were common throughout Boston. Rural banks regularly issued their banknotes throughout the city by making loans to individuals and businesses. The rural institutions would then order their agents in the city to re-purchase the notes at a discount and continue the cycle by making new loans. This largely unregulated practice—along with the fact that city dwellers were unlikely to travel to small, remote locations to redeem rural banknotes for specie—led many Boston merchants and bankers to accuse rural banks of issuing too many banknotes and engaging in unsafe practices. “Many banks were established in remote places, mainly for the purpose of making a profit on circulation,” wrote D.R.