A CHAPTER IN THE HISTORY OF CENTRAL BANKING THE LIBRARY COMPANY OF PHILADELPHIA State&Nat-Banking_Cover 2016.crw1.indd 1 12/16/16 12:41 PM ACKNOWLEDGMENTS The Federal Reserve Bank of Philadelphia thanks John Van Horne, former director of the Library Company of Philadelphia, and Library Company staff members Nicole Joniec and Sarah Weatherwax for their help in providing several of the images that appear in this publication. Thanks also to Professor Hugh Rockoff, Rutgers University, for clarification of some currency terminology. State&Nat-Banking_Cover 2016.crw1.indd 2 12/16/16 12:41 PM THE STATE AND NATIONAL BANKING ERAS A Chapter in the History of Central Banking fter the second Bank 1907, U.S. banks weathered—or not—a storm of runs of the United States and panics, and the nation’s economy underwent closed its doors in 1836, several periods of recession and depression. (See the United States went Panics, Recessions, and Banking Crises, pages 4–5.) through a period of No central bank. No uniform currency. An approximately 76 years economic depression. How would the country’s Aduring which it had no central bank.1 Instead, the U.S. economy continue to function? banking system during this time is generally divided into two periods: the state, or free, banking era, which BACKGROUND ran approximately from 1837 to 1863, and the national banking era, which lasted roughly from 1863 to 1913. Second Bank’s Role Also, the United States still had no uniform Although the Second Bank did not officially national currency. State-chartered banks issued their set monetary policy or regulate other banks, its own banknotes, and some nonfinancial companies prominence and broad geographic reach through issued notes that also circulated as currency. For its many branches allowed it to exert a stabilizing example, railroads issued notes to fund construction influence on the economy.3 The bank’s notes, backed projects, and other companies such as the New Hope by substantial gold reserves, gave the country a more Delaware Bridge Company were allowed to issue stable national currency. In the course of business, the notes as well. Both the railroad and bridge company Second Bank would accumulate the notes of the state notes were used as currency.2 banks and hold them in its vault. When it wanted Yet another problem facing the United States to slow the growth of money and credit, it would was a market crash in 1837 that resulted in a severe present the notes for collection in gold or silver, depression. In fact, during the period from 1837 to thereby reducing state banks’ reserves and putting The State and National Banking Eras 1 State&Nat-Banking_Inside_2016.crw1.indd 1 12/16/16 12:47 PM $1 note from an Illinois bank exchanged for just 50 cents. The amount of the discount sometimes depended on the distance between the issuing bank and the paying bank and sometimes on perceptions of how sound the issuing bank was. In addition to state-chartered banks, some companies In fact, discounts issued notes that circulated as currency, such as were so common that printers started publishing this $1 note from the New Hope Delaware Bridge Company in Lambertville, New Jersey. lists, called banknote reporters, so that bankers, Federal Reserve Bank of Philadelphia merchants, and consumers would know how much they could expect a particular note to be worth in the brakes on state banks’ ability to circulate new a particular location. This situation made it hard banknotes. To speed up the growth of money and to judge the relative value of goods and services in credit, the Second Bank would hold on to the state terms of state banks’ notes. banks’ notes, thereby increasing state banks’ reserves and allowing them to issue more banknotes through Panic of 1837 their loan-making process. But with the closing of Although the U.S. economy was expanding the Second Bank, this restraining hand disappeared. in the early 1830s, a fall in the price of cotton mid- decade, demand for payment in specie by foreign No Uniform Currency creditors that drained the specie reserves of U.S. Allowing each state bank to issue its own banks, and other factors caused financial stress in 4 banknotes created its own set of problems. For one the United States. As a result, banks had to suspend thing, such a profusion of currency—with different redeeming their notes for specie because of a lack sizes and different designs—could be confusing. of gold and silver. Consequently, many banks were For another thing—and perhaps more important— illiquid, and many failed. This crisis was fueled in banknotes exchanged at a discount, meaning that part by a lack of confidence in the nation’s paper they did not necessarily trade at face value. For currency. It would take the country six years to example, in 1842, a $1 note from a Tennessee bank recover from this economic downturn. exchanged for 80 cents in Philadelphia; likewise, a 2 The State and National Banking Eras State&Nat-Banking_Inside_2016.crw1.indd 2 12/16/16 12:47 PM many states enacted free banking laws. The term STATE, OR FREE, generally means that almost anyone could open a ANKING RA B E bank provided that person (or group of persons) In the period between the closing of met certain criteria, such as complying with the Second Bank and the start of the Civil War, minimum capital requirements and depositing the regulation of banks was in the hands of the bonds or other types of securities with the state individual states. Without the Second Bank and government to back the notes issued by the bank. its branch system, which, among other things, Michigan passed the first free banking law in 1837, helped to finance the country’s western expansion, followed by New York in 1838.7 states wanted to create more banks in order to help Some state banks had great success farmers, settlers on the frontier, and others who under free banking laws, and others encountered needed credit.5 Therefore, demand for bank charters problems. For example, although these laws increased, as did the number of banks, and state worked well in New York, Michigan did not fare banks issued more and more notes. so well under them. Generally, commercial banks in the United States had to obtain charters from state governments, usually through a special act of the legislature. However, the increase in the demand for banks and, hence, bank charters led to concerns about corruption. On This $5 state bank note was issued by the Central Bank of one side of the process, petitioners Pennsylvania in Hollidaysburg. who wanted to open a bank would Federal Reserve Bank of Philadelphia bribe state legislators in order to get a charter. On the other side, owners of existing banks The New York law centralized the issuance pressured legislators to not issue charters, since the of notes in Albany. Someone who wanted to start banks already in operation feared competition from a bank would deposit bonds with the comptroller the new banks.6 in the state capital.8 Once the comptroller’s office To try to lessen the potential for corruption accepted the bonds, the bank received an equivalent and to make the process of opening a bank easier, The State and National Banking Eras 3 State&Nat-Banking_Inside_2016.crw1.indd 3 12/16/16 12:47 PM complaint. If the bank still didn’t redeem the notes, the comptroller would sell the bank’s bonds and use the proceeds to pay off the note holders. Meanwhile, in Michigan, free banking ran into trouble. Unlike New This $1 state bank note was issued in 1861 by the York, Michigan was a state Beverly Bank, in Beverly, New Jersey. that was still developing, its growth facilitated by Federal Reserve Bank of Philadelphia the opening of the Erie Canal in 1825. Under free amount of notes. These notes were redeemable in banking laws in Michigan, prospective bankers specie on demand at the issuing bank. If, for some had to pay 30 percent of banks’ capital into a safety reason, the bank couldn’t redeem the notes, the bank fund. But banks were allowed to operate even before had to pay the note holder interest on the face value the full 30 percent had been paid and could issue of the note. Ultimately, the note holder could file a notes against the full amount of their capital. Panics, Recessions, AND Banking Crises bonds to investors to cover its obligations, the stock 1837 See text, page 2. market reacted negatively, and runs on several other large financial institutions led to their failure. The The collapse of the Ohio Life Insurance and 1857 Coinage Act of 1873 depressed the price of silver, Trust Company and a bank panic in the fall of 1857 hurting the interests of U.S. silver mines and further led to an economic crisis. More than 5,000 businesses contributing to the country’s economic problems. failed during the first year of the panic. This economic crisis led to a recession that lasted until 1879. 1873 The collapse of Jay Cooke and Co., the largest bank in the U.S. at that time, in September 1882-85 The recession of these years was 1873 triggered a panic on the stock exchange. mostly due to the end of the railroad construction Cooke’s bank was the exclusive agent for the sale boom. The end of the boom affected other industries, of Northern Pacific Railroad bonds. When the particularly iron and steel. firm could not sell a sufficient number of railroad 4 The State and National Banking Eras State&Nat-Banking_Inside_2016.crw1.indd 4 12/16/16 12:47 PM So the safety fund’s growth couldn’t keep pace under the free banking laws, only to dupe the with the number of banknotes issued.