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Arthur J. Rolnick is a senior vice president and director of research at the Federal Reserve Bank of Minneapolis, Bruce D. Smith is a professor of economics at the University of Texas at Austin, and Warren E. Weber is a senior research officer at the Federal Reserve Bank of Minneapolis and professor of economics at the University of Minnesota.*

ment intervention, likely will—produce an Lessons from a efficient payments system. In this paper, we argue that a closer examination of the Laissez-Faire history of the Suffolk Banking System calls into question this conclusion. Payments Before the Civil War, U.S. paper money consisted almost entirely of state System: banknotes—liabilities of the bank of issue that were redeemable in specie on The Suffolk demand. Locally, banknotes could be exchanged at par because they were Banking System redeemable on demand. But once they circulated beyond the community of the (1825–58) bank of issue, the notes typically were exchanged at a discount. In the normal course of business, vir- Arthur J. Rolnick, Bruce D. tually every bank received the notes of Smith, and Warren E. Weber other banks, a fact that is apparent from the balance sheets of individual banks during hould the Federal Reserve maintain its this period. For example, in Maine and strong presence in the U.S. payments Massachusetts, 98 percent of all individual Ssystem? Or should the Federal Reserve bank balance sheets show the bank holding exit and allow “the market” to produce its notes of other banks. In New York and own mechanism for making payments? Pennsylvania, the fraction is between 85 and While U.S. history is replete with examples 90 percent. Thus, during this period, banks of payments systems that appear inefficient had a substantial need to clear obligations and suggest a role for government, some among themselves. recent research on payments systems in the In the mid-1820s, the Suffolk Bank United States argues that private markets are created in New England an arrangement capable of producing safe and efficient pay- for banknote clearing that, at the time, was ments arrangements. unique in the United States. The Suffolk The classic, often-cited example of a Bank started a net-clearing system for bank- privately created and well-functioning notes. The Suffolk System operated as fol- payments system is the Suffolk Banking lows: Members of the System were required System that existed in New England to keep an interest-free deposit at Suffolk between 1825 and 1858 (see, for example, (or at one of the other Boston member Whitney 1878, Lake 1947, Redlich 1947, banks). Suffolk then accepted and net- and Calomiris and Kahn 1996). The Suf- cleared all the banknotes its members * The authors thank the Baker folk Bank of Boston operated the first deposited at par. By the early 1830s, most Library, Harvard Business School, regionwide note-clearing system in the banks in New England had become mem- for the materials provided from United States. A result of the System was bers, and, because of Suffolk’s par-clearing its Suffolk Bank Collection, and that the notes of all New England banks policy, notes issued by members of the Ed Green, Jamie McAndrews, and Randy Kroszner for their circulated at par throughout the region. System were exchanged at par throughout very constructive comments. The System’s achievements have led some the region. The views expressed herein are (Lake 1947, p. 206, and Calomiris and Kahn What is most remarkable about the those of the authors and not nec- 1996, p. 795) to conclude that unfettered Suffolk Bank is that for more than 25 essarily those of the Federal competition in the provision of payments years, it earned extraordinary profits and Reserve Bank of Minneapolis or services can—and, in the absence of govern- was the only net clearer of banknotes in the Federal Reserve System.

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New England. Why was Suffolk so prof- according to provisions of the charter itable? And why did it take so long for granted by the state in which they were another provider to enter the market? Our located. For the most part, banknotes answers to these questions are based on were redeemable in specie on demand, Suffolk’s having benefited from large although penalties for nonredemption economies of scale and scope and from were often minimal. finding ways, including some help from By the early 1800s, the Commonwealth government, to protect its market share. of Massachusetts had chartered several We find, therefore, that the Suffolk banks located not only in Boston, but also Banking System may not support the case in other parts of Massachusetts and in the for a laissez-faire approach to the payments province of Maine. The banks of Boston system. The history of the Suffolk Banking soon became concerned about the quantity System suggests that note clearing is a nat- of country banknotes (also known as ural monopoly. And there is no consensus foreign money) circulating in Boston (Red- in the literature about whether or not the lich 1947, pp. 67–68). The banks thought unfettered operation of markets in the pres- that the extensive circulation of country ence of natural monopolies will produce an banknotes was limiting their banknote busi- efficient resource allocation.1 ness and reducing their profits. We proceed as follows. In the next sec- In 1803, the Boston banks mutually tion, we present the history of the Suffolk agreed to stop accepting foreign money Bank as it evolved from an ordinary Boston from their customers in an attempt to bank into a note-clearing bank for all New increase the banks’ share of total Boston England. Then, we document the Suffolk note circulation. The result of this collu- Bank’s extraordinary profits by showing that sion, however, was much different from it was more profitable than any other bank in what the banks of Boston expected. New England during the period that the Suf- Instead of driving country banknotes out folk Banking System was in operation, and of circulation, the take-no-notes policy led we argue that the Suffolk Bank had a monop- others (known as banknote brokers) to take oly on the note-clearing business in New up the business of buying and redeeming England. Following this, we interpret the country banknotes. After 1803, a person Suffolk Banking System’s history, and we sug- in Boston who received a country bank- gest that the note-clearing business may have note could sell it to one of the city’s bro- been a natural monopoly. We also suggest kers. The brokers made a profit by buying ways that the Suffolk Bank was able to main- notes at a discount and transporting them tain its extraordinary profits for so many back to the banks of issue for full redemp- years before a new entrant was able to drive tion in specie. Consequently, despite the it out of business. In the concluding section, boycott by the city banks, country banks we draw some lessons from the Suffolk were still successful at getting their notes Banking System and recommend further to circulate in Boston. According to Mul- lines of research. lineaux (1987, p. 887), between 1812 and 1844, more than half the notes circulating in Boston were country banknotes. THE HISTORY AND EVOLU- In time, the success of the note-brokering TION OF THE SUFFOLK business (and the lack of success in driving BANKING SYSTEM country banknotes out of circulation) led some Boston banks to reconsider their pol- 1 For an example of a paper that Origins, 1818–25 demonstrates how a Pareto- icy of not accepting foreign money. Indeed, efficient equilibrium can exist in Before the Civil War, virtually the the Boston banks established their own a market with a monopolistic entire circulating medium of the United note-brokering operations some time after provider of one or more goods, States consisted of privately issued 1804, and the discount on country bank- see Edlin, Epelbaum, and Heller banknotes. These notes were issued notes was driven down to 3 percent in (1996). primarily by state banks that operated Boston (Lake 1947, p. 184).

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In 1814, the New England Bank (of other Boston banks to export country bank- Boston) introduced an important modifica- notes with the goal of eliminating foreign tion in note-brokering arrangements. The money from the city of Boston. Each New England Bank followed the strategy coalition member contributed between of purchasing the notes of country banks $30,000 and $60,000 for a total of and allowing country banks to redeem $300,000. This fund was to be used by them at the market rate of discount if they Suffolk to purchase country banknotes at kept a permanent, non–interest-bearing “the same or less discount than the New deposit with the New England Bank. The England Bank, or other banks in Boston, activities of the New England Bank and received it, and should send it home for other note brokers drove the average dis- redemption” (Whitney 1878, p. 15). Such count on country banknotes down to purchases were to continue indefinitely 1 percent by 1818. until country notes ceased to circulate in In 1818, the Suffolk Bank became the Boston. As with earlier attempts to drive seventh bank to be chartered in Boston. foreign money out of Boston, this attempt Shortly after starting operations, Suffolk was also unsuccessful. entered the note-brokering business. Suf- folk’s note-brokering activity was much like the New England Bank’s. Suffolk The System in Operation, 1825–58 bought country banknotes from mer- The failure of its note-presentment chants, individuals, and other banks at a strategy did not lead the Suffolk Bank to discount. Suffolk would then permit a exit the foreign money business. To the country bank to repurchase its notes at contrary, it was soon to become the domi- the same discount paid by Suffolk—on two nant player in this market. In May of 1825, conditions: One was that the country bank the coalition of city banks, having all but maintain a permanent, non–interest-bearing given up on driving country banknotes out deposit of $5,000 with the Suffolk Bank. of Boston, suggested that Suffolk allow The other was that the country bank main- other banks to deposit all their country tain an additional non–interest-bearing banknotes with Suffolk, which would estab- deposit as a redemption fund. Suffolk sent lish a system to net clear the banknotes it the notes of nonparticipating country received. No longer would Suffolk merely banks—country banks that refused to make buy country banknotes in order to send such deposits—home for full redemption. them back to the issuing bank for redemp- Shortly after Suffolk entered the market tion. Instead, Suffolk would accept and for country banknotes, the discount on clear at par all country banknotes that par- country banknotes declined from 1 percent ticipating banks chose to deposit. By 1826, to 0.5 percent. Because Suffolk’s competi- most of the city banks had withdrawn from tors were attracting most of the business the coalition and had become members of (by 1820 only a handful of country banks the Suffolk Bank’s note-clearing business, were holding permanent deposits with Suf- the Suffolk Banking System (Suffolk Bank folk), Suffolk began to question the value of 1826; Mullineaux 1987, p. 890). this business. By the end of that year, Suf- The Suffolk Bank’s note-clearing busi- folk decided to end the purchase of notes of ness was similar in many ways to its old nonparticipating banks. Suffolk found that note-brokering business. As before, to par- the cost of returning notes of nonparticipa- ticipate in the system, a country bank had ting banks was not much less than the dis- to maintain a permanent, non–interest- count at which the notes were purchased. bearing deposit with Suffolk or with Competition had made note brokering another Boston member of the Suffolk hardly profitable (Redlich 1947, p. 72). Banking System: For each $100,000 of In April 1824, Suffolk devised a new capital, the bank had to hold $2,000 on strategy for dealing with country bank- deposit. And, as before, a country bank notes. It formed a coalition with the six had to maintain an additional non–interest-

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bearing deposit that was, on average, suffi- By the end of 1825, Suffolk had to cient to redeem its notes received by the make some adjustments to its business. Suffolk Banking System. Boston banks had Because Suffolk had more than $1,183 in to hold only a permanent, non–interest- losses due to deficiencies (counterfeit and bearing deposit. This deposit was initially irredeemable banknotes), it entered into a set at $30,000 but was gradually reduced special agreement with the head of its for- to $5,000. eign money department. “[I]n considera- A major innovation was associated tion of $1,050 per annum, in addition to with this new arrangement. Banknotes his regular salary, he should give bonds to were cleared by netting the accounts of indemnify the bank for all deficiencies, participating banks. Prior to this time, counterfeits, mutilated or uncurrent bills no net-clearing system for banknotes had in his department” (Whitney 1878, p. 18). been established in the United States.2 For This agreement, while modified over time, example, the (Second) Bank of the United lasted for the life of the business. The States, which dealt heavily in the notes of agreement is of some significance in the state banks, practiced gross clearing, sim- history of the Suffolk Bank, because it ply presenting each state bank’s notes for indicates that Suffolk paid to shed much redemption in specie. In addition, Suf- of the risk associated with its day-to-day folk offered loans—in effect, overdraft clearing operations. privileges—to members of the System. In its early stages, the Suffolk Banking As we will argue, these innovations made System was relatively small in both its clear- the business attractive to all participat- ing and its lending activities. By the end of ing banks and ultimately very profitable. 1825, the Suffolk Bank was receiving about The netting of banknotes worked as $2 million a month in country banknotes. follows: Each day, the notes deposited by This volume of note clearing was dwarfed participating banks at Suffolk were sorted, by the Suffolk Bank’s later activities. For and the following day, the net amount was instance, the Suffolk Bank cleared $9 million posted to the account of the appropriate a month in 1841, $20 million a month in bank. The notes of nonparticipating banks 1851, and close to $30 million a month by were sent to the issuing bank for redemp- 1858 (Trivoli 1979, pp. 15, 21). To put these tion as quickly as possible. numbers in perspective, monthly clearing in The process of net clearing had value to 1825 amounted to approximately one-half Suffolk Banking System members because it of the stock of notes in circulation in Massa- lowered the cost of redeeming banknotes. chusetts; in 1841 and 1851, it was equal to Because fewer notes had to travel back the entire stock of notes circulating in Mas- to the issuing bank for redemption, less sachusetts; and in 1858, it was slightly less specie had to be physically shipped among than one-and-a-half times the stock of notes banks at a time when such shipment was circulating in Massachusetts. relatively costly. During its first years as a net clearer, The net clearing of banknotes opened Suffolk earned relatively low profits from up another business to Suffolk. Suffolk this role. Until 1833, Suffolk’s dividends became a major lender to other banks. As (which are routinely used as a measure of a net clearer, Suffolk offered the analog of profits; see Calomiris and Kahn 1996) overdraft privileges (at a price). Moreover, were no higher than those of an average by holding member bank deposits and bank in either Boston or Massachusetts. clearing member banknotes, Suffolk could According to Redlich (1947, p. 75), the establish strong relationships with banks earnings from note clearing were so low 2 There was net clearing in other and likely had an advantage over other initially that “the organization was in countries by this time, however. potential lenders in monitoring banks’ danger of being discarded by about 1830.” See, for example, the discus- activities. In short, we think that Suffolk By the early 1830s, however, the Suf- sion of note clearing in Scot- was able to exploit economies of scope in folk Banking System’s membership had land in Kroszner (1996). combining its clearing and lending activities. grown dramatically. By 1836, close to 300

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108 MAY/JUNE 1998 banks—the vast majority of banks in New period, drove Suffolk out of the note- England—were members of the Suffolk clearing business. Banking System. And while participation Opposition to the Suffolk System devel- in the System was voluntary—members oped soon after Suffolk started its note- did receive the benefits we have men- clearing business, but some 30 years passed tioned—state governments also created before another note-clearing business some additional incentives to join the emerged (Lake 1947, pp. 192-93). In 1826, System. In 1842, a Vermont law gave a a convention of country banks met in substantial tax advantage to banks that Boston to discuss a coordinated effort to were Suffolk Banking System members. oppose Suffolk, but no agreement was And a Massachusetts law passed in 1843 reached. Ten years later, a group of country prohibited banks from paying out the banks opposed to Suffolk’s control of the notes of other banks, which also gave market tried to obtain a charter for a new banks incentives to clear notes through bank for the sole purpose of establishing a the Suffolk Banking System. note-clearing system that would compete The increase in the size of the Suffolk directly with the Suffolk Banking System. Banking System eventually turned into a Members of the group argued that Suffolk healthy increase in profits for the Suffolk was essentially charging too much for the Bank. Before 1825—that is, before the services rendered, and they wanted an alter- Suffolk Bank got into the note-clearing native. They proposed that a new note- business—its annual dividend averaged clearing bank be established and that the 6.5 percent. Between 1826 and 1830, it stock of this new venture be held only by fell slightly to 6.0 percent. Between 1830 member banks, so that all members of the and 1840, however, Suffolk’s average system could share in the profits. But oppo- annual dividend jumped to 7.4 percent. nents of the new bank prevailed.4 The oppo- Between 1840 and 1850, the average nents argued that there did not appear to be annual dividend was more than 8 percent, a need for another note-clearing business, and between 1850 and 1855, it was 10 per- that the Suffolk System was working well, cent.3 Moreover, in 1839, Suffolk paid out and that until the country banks acted as a of its growing surplus a one-time 33.3 per- group to request another, no action should cent dividend (Whitney 1878, p. 41). [In be taken. Such a concerted request was not 1852, Suffolk once again accumulated a forthcoming until almost 20 years later large surplus, but, according to Whitney (Lake 1947, pp. 193, 195). (1878, pp. 41–42), the surplus was not Starting in the late 1840s, Suffolk divided among the stockholders because started to shift (or attempt to shift) more it was stolen by the bank’s bookkeeper.] of its costs and risks to member banks. As we discuss below, Suffolk’s profits were In 1849, Suffolk adopted the policy of impressive not only relative to its past per- refusing to receive notes for redemption 3 formance, but also relative to all other “unless they were assorted into two pack- Parenthetically, we do not think banks in New England. ages, one containing Boston bills only, and that the latter increase in divi- dends is attributable to changes the other issues of other banks” (Whitney going on within the Suffolk 1878, p. 41). Suffolk thereby shifted some Demise, 1858–60 Banking System. The California of its operating costs onto member banks. gold discoveries led to some While Suffolk’s earlier attempts at However, much more significant were inflation. All short-term nomi- note brokering and note presentment three events related to the Suffolk Bank’s nal interest rates in New were disappointments, its note-clearing net-clearing business. England seem to have risen at business proved very popular and prof- Throughout the operation of the Suf- this time (Homer and Sylla itable. The Suffolk Banking System folk System, Suffolk had sent all Rhode 1991). grew and prospered for more than three Island notes to the Merchants’ Bank of 4 According to Kroszner (1996), decades. The political situation changed Providence, which then cleared them with the request for a charter was in the early 1850s, however, and a competi- the Rhode Island banks. In 1852, Suffolk tabled in the state legislature tor emerged that, in a surprisingly short imposed a new minimum charge of 50 by supporters of Suffolk.

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109 MAY/JUNE 1998 cents per $1,000 of country money received country bills received” (Lake 1947, p. 195). from the Merchants’ Bank. This action On this issue, Suffolk conceded. induced the Rhode Island banks to revive In 1855, a charter was granted to the the proposal for the formation of a competi- Bank of Mutual Redemption (BMR). This tor to Suffolk whose stock would be owned bank was intended to clear notes and make by member banks (Lake 1947, p. 193). loans to member banks—as Suffolk did— This proposal did not yet take off, but it and, moreover, its stock was to be owned would shortly. entirely by banks that were members of It was also the case that Suffolk had the system. Apparently, the support of the always been exposed to some default risk on Exchange Bank was instrumental in the the notes it held between the time the notes granting of a charter to the BMR (Redlich were deposited and the time they cleared. 1947, p. 75). Suffolk was even potentially exposed to sim- Despite the support of the Exchange ilar risks on notes that were deposited by Bank and the Rhode Island banks for a System members with other Boston banks Suffolk competitor, the BMR had difficulty (Whitney 1878, p. 46). In 1853, the raising enough capital to begin operations. Exchange Bank (of Boston) refused to Indeed, it did not succeed in raising the redeem the notes of two Connecticut banks necessary capital to open its operations whose notes it had originally taken. The until 1858. Nevertheless, when the BMR Exchange Bank had deposited the notes opened, 143 banks (roughly half the banks with Suffolk, and the issuers of the notes in New England) were stockholders had defaulted. As a result, Suffolk reminded (Dewey 1910, p. 95). other Boston banks of its long-held policy The BMR operated much as the Suffolk “that the notes of country banks would be System did. It required the maintenance of received only on condition that all notes a permanent deposit and a clearing bal- would be redeemed by the agent banks” ance. But, unlike Suffolk, the BMR paid (Lake 1947, p. 194). A dispute with the interest on its deposits at a rate of 3 percent Exchange Bank ensued in which the per year. Exchange Bank claimed that it could not The reaction of Suffolk to the entry of agree to Suffolk’s terms, because it was illegal the BMR into the note-clearing business for it to guarantee the liabilities of a third was at first combative. Suffolk initially bank. Suffolk’s response was to notify the intended to fight the BMR and began by correspondents of the Exchange Bank that refusing to redeem the notes of BMR mem- it would not accept their notes in the future. bers through the BMR. Suffolk’s argument As a result, at least some of the Exchange in doing so was that the BMR held no depo- Bank’s correspondents transferred their sit with Suffolk and, hence, that banks deposits to Suffolk. The Exchange Bank was clearing through the BMR were not entitled then soon to become an important supporter to the same treatment as Suffolk System of a Suffolk competitor (Lake 1947, p. 194). members. Hence, notes issued by mem- Finally, in 1853, Suffolk announced bers of the BMR and received by Suffolk that it would receive no foreign money were sent to the issuing bank for imme- after noon each day “because the labor of diate redemption. sorting the bills was so great that the In its opening salvos with the BMR, Suf- clerks . . . had to work late at night to folk was supported neither by the other complete their labors” (Lake 1947, p. 195). Boston banks nor by the Commonwealth of In response, the other Boston banks threat- Massachusetts. On October 11, 1858, the ened to withdraw their deposits with Suf- BMR was admitted to the Boston clearing- folk and form a new bank unless Suffolk house. “On the same day the [Massachu- took country notes until 2 p.m. They setts] Bank Commissioners . . . formally argued that “the Suffolk Bank was obtain- advised the Suffolk Bank . . . that it should ing profits large enough to enable it to either continue to receive the bills of all the employ enough clerks to handle all banks which had withdrawn their deposits

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110 MAY/JUNE 1998 and to present them at the BMR or it THE SUFFOLK BANK’S should decline to receive from its deposi- PROFITABILITY tors the bills of such banks” (Lake 1947, pp. 200–01). The lack of support from In another paper (Rolnick, Smith, and the Boston banks and the attitude of the Weber 1997), we use annual data on bank state bank commissioners apparently dividends and prices of Boston bank stocks averted an open fight between Suffolk to document several facts about the profits and the BMR. of the Suffolk Bank relative to those of other Suffolk’s next step was quite different. Massachusetts banks. In this section, we On October 16, 1858, Suffolk announced summarize those results and present evi- that it would withdraw altogether from dence that the Suffolk Bank appears to have the foreign money business. This been a monopolist in the provision of note- announcement does not appear to have clearing services. been an idle threat, because Suffolk did In Rolnick, Smith, and Weber (1997), leave the business in 1860. And Suffolk’s we show that the Suffolk Bank’s profits proposed withdrawal from its note- appear fairly similar to those of other Massa- clearing activities apparently was a threat chusetts banks until 1833. From 1834 until with teeth. Because the BMR could not 1858, however, the Suffolk Bank was con- handle anything like the entire volume of sistently more profitable than any other note clearing in New England, “the bank Massachusetts bank. Several kinds of evi- presidents asked the Suffolk Bank to con- dence support these conclusions. One kind tinue receiving country money until Febru- is aggregate evidence on dividend payments. ary 28, 1859. They were met with a In Rolnick, Smith, and Weber (1997), we brusque refusal. Finally, a compromise show that until 1833, the Suffolk Bank paid was reached by which the banks were to dividends at a rate comparable to the aver- make arrangements individually with the age (or the median) of those paid by other Suffolk Bank or Mutual Redemption banks in Massachusetts. However, from bank. Under the terms made by the Suf- 1834 to 1858, Suffolk consistently paid folk Bank country money would be dividends at a rate that was 2 percentage received for a charge of twenty-five cents points higher than the typical rates paid per $1,000” (Lake 1947, pp. 202–03). either by other large Boston banks or by The 50 cents per $1,000 that Suffolk Massachusetts banks in general. This aggre- charged the Merchants’ Bank of Provi- gate evidence is supported by a bank-by- dence in 1853 thus appears to have bank comparison of dividend rates over exhibited a large monopoly-pricing the period from 1834 to 1858. This com- element. Indeed, even the 25 cents per parison indicates that although there were $1,000 charge seems high relative to some years in which a small number of Suffolk’s average costs, which, according banks paid dividends at rates equal to or to Whitney (1878, pp. 53-54), were 10 even slightly higher than those paid by the cents per $1,000 cleared. Suffolk Bank, no bank did this consistently. This was the end of the Suffolk Bank- Further, those banks whose dividends occa- ing System and the beginning of the BMR. sionally rivaled the Suffolk Bank’s were The operation of the BMR apparently almost exclusively small, non-Boston banks. benefited the country banks, whose note Rolnick, Smith, and Weber (1997) circulation rose (while that of the Boston also looks at prices of the stock of Boston banks fell) from 1858 to 1859. The BMR, banks during this period. These data however, was not profitable, and it ceased come from Martin (1886), who compiled to pay interest on deposits when Suffolk the yearly high and low stock prices of halted its own note-clearing operations in bank stocks in the Boston stock market. 1860. The BMR did not pay its first divi- For each year from 1834 to 1858, with dend until October 1860 and then only at only the exception of 1839 and 1840, the the (semiannual) rate of 2 percent. lowest price paid for shares of Suffolk

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Figure 1 profits in 1833, there was no correspond- ing increase in the profits either of other Due to Other Banks large Boston banks or of Massachusetts Suffolk As a Percentage of Total banks in general. Third, Suffolk’s profits Massachusetts were always high. Thus, its high average Percent profits cannot be viewed as compensation 80 for some unusual risks it was taking. We now present evidence that the Suf- 60 folk Bank had substantial market power and may have been a monopolist in the provi- 40 sion of note-clearing services, at least during the period from 1834 to 1858. We begin by establishing that the Suffolk Bank was by far 20 the largest holder of interbank deposits.5 We show this in Figures 1 and 2.6 In Figure 1, 0 we show the Suffolk Bank’s share of the 1825 1830 1835 1840 1845 1850 1855 1860 interbank deposit market. From 1828 to 1854, the Suffolk Bank consistently held between 30 and 50 percent of all “due to Figure 2 other banks” held by Massachusetts banks. Due to Other Banks In Figure 2, we plot the ratio of the Suffolk Ratio of Suffolk to Next Largest Bank’s holdings of “due to’s” to the next Powers of 2 largest Massachusetts bank. The vertical 4 axis in this figure is in terms of powers of 2, so that zero indicates that Suffolk’s holdings 3 are equal to those of the next largest bank, 2 1 indicates that Suffolk’s holdings are twice as large as those of the next largest bank, 1 and so forth. From this figure, we see that in most years, the Suffolk Bank’s holdings 0 of such deposits were at least twice as large -1 as those of the next largest bank. Next, we show that the identity of the -2 banks that ranked below Suffolk in terms 1825 1830 1835 1840 1845 1850 1855 1860 of the volume of interbank deposits changed frequently over time. We show Bank stock was higher than the highest this in Table 1, where we show the banks price paid for the shares of any other bank that ranked among the top five in terms of in Boston. the volume of “due to” annually from 1825 These findings allow three important until 1860. As expected from Figure 2, the points to be made with respect to the Suf- Suffolk Bank virtually always has the folk Banking System. First, to borrow largest amount of “due to’s.” However, no Whitney’s phrase, “the [Suffolk] business other bank consistently held a large share was very remunerative” (1878, p. 41). of the interbank deposit market. Up to Second, the fact that the Suffolk Bank 1845, the New England Bank and the State 5 Clearly, it was necessary for routinely earned higher profits than other Bank were the banks that most frequently banks to hold deposits with a large Boston banks suggests that, by the ranked behind the Suffolk Bank in terms bank that was performing clear- early 1830s, the Suffolk Bank was acting of the share of the interbank deposit ing services on their behalf. alone in the net-clearing business, rather market. However, after 1840, those two 6 The sources for the data used in than as the representative of a larger coali- banks were replaced in the rankings by all figures is given in Rolnick, tion of Boston banks. Moreover, when the the Merchants’ Bank of Boston and the Smith, and Weber (1997). Suffolk Bank first began to earn unusual Globe Bank, and after 1850, the Bank of

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Table 1 Ranking of Massachusetts Banks by Amount Due to Other Banks, 1825–60

1st 2nd 3rd 4th 5th

1825 City New England Other Union M&M/Tremont 1826 Suffolk City New England M&M/Tremont Other 1827 Suffolk City New England Union Other 1828 Suffolk New England Union Other State 1829 Suffolk State New England Union Other 1830 Suffolk City State New England Other 1831 Suffolk New England State Globe Other 1832 Suffolk New England Other Union State 1833 Suffolk Globe Other State Other 1834 Suffolk State City Globe Merchants’ 1835 Suffolk Merchants’ Other New England State 1836 Suffolk Merchants’ Other State New England 1837 Suffolk Merchants’ State New England Other 1838 Suffolk Globe Merchants’ New England State 1839 Suffolk Globe Merchants’ New England Other 1840 Suffolk Merchants’ Globe State Other 1841 Suffolk Merchants’ Globe Other Other 1842 Suffolk Merchants’ Globe Other State 1843 Suffolk Merchants’ Globe State New England 1844 Suffolk Merchants’ Globe Other New England 1845 Suffolk Merchants’ Globe Other Other 1846 Suffolk Merchants’ Globe Other State 1847 Suffolk Merchants’ Globe State Other 1848 Suffolk Merchants’ Globe M&M/Tremont Other 1849 Suffolk Merchants’ Globe New England M&M/Tremont 1850 Suffolk Merchants’ Other New England Commerce 1851 Suffolk Merchants’ Commerce Globe New England 1852 Suffolk Commerce Merchants’ M&M/Tremont Exchange 1853 Suffolk Merchants’ Commerce Other M&M/Tremont 1854 Merchants’ Suffolk Commerce Exchange Globe 1855 Suffolk Commerce Merchants’ Other Other 1856 Suffolk Merchants’ Commerce Exchange Globe 1857 Suffolk Merchants’ Commerce M&M/Tremont Other 1858 Suffolk BMR Merchants’ Commerce Globe 1859 BMR Suffolk Merchants’ Other Commerce 1860 BMR Suffolk Commerce Merchants’ Exchange

Commerce displaced the Globe Bank in might easily exploit economies of scope by the rankings.7 also acting as an interbank lender. Rol- We have already argued that a bank nick, Smith, and Weber (1997) documents 7 All of these banks were located engaged in net clearing on a large scale that the history of the Suffolk Bank is in Boston.

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indeed consistent with this idea. Between there is a strong presumption that Suffolk 1833 and 1858, the Suffolk Bank consis- was able to exploit both economies of scale tently held at least 15 to 20 percent of and economies of scope in its activities. all interbank loans. Moreover, the large And, indeed, the Suffolk Bank became increase in the Suffolk Bank’s profits co- unusually profitable only as it began to incided with a substantial increase in its fully exploit both types of economies.9 position as an interbank lender. Indeed, in This history of the Suffolk Banking 1833, the Suffolk Bank held three times as System is, of course, fully consistent with many interbank loans as any other Massa- this view. Suffolk was not an unusually chusetts bank. In contrast, in 1831, the profitable bank until it became a large Suffolk Bank had interbank loans approxi- enough player in both note clearing and mately equal to those of several other interbank lending. And at least equally banks. This fact clearly suggests that the telling is the observation that Suffolk was Suffolk Bank’s profits derived, at least in not willing to split its market with the part, from the exploitation of economies BMR. The failure of the market to sustain of scope in interbank lending. two net clearers is, in our minds, very sug- gestive of natural monopoly. We should emphasize at this point AN INTERPRETATION that the presence of a monopoly—either In this section, we attempt to interpret natural or otherwise—in no way neces- the facts we have just summarized and to sarily implies that any economic ineffi- answer the question, Why did it take over ciencies were associated with the operation 25 years for another New England bank of the Suffolk Banking System. Indeed, to enter Suffolk’s market? We begin the as shown by Edlin, Epelbaum, and Heller interpretation with an observation that has (1996), the presence of a monopolist that been made by many other historians of the can engage in price discrimination and Suffolk Banking System: Suffolk was a levy two-part tariffs is often fully consis- monopolist.8 We also think that Suffolk tent with Pareto efficiency. was a relatively sophisticated monopolist. In addition, if Suffolk was a natural Its pricing practices involved a two-part monopoly, there is another important tariff from 1826 on and even more elabo- question. If the Suffolk experiment were rate nonlinear pricing schemes (and price repeated at another time and in another discrimination) at later points. place, would we expect the Suffolk out- These pricing practices seem to have come to be replicated? Or, more generally, made Suffolk very effective at garnering sur- would we expect the market to produce an plus. The data indicate that while Suffolk’s efficient outcome? The answer to this profits rose dramatically in 1833, this was not question can hardly be an unequivocal yes. true for other banks in Boston or Massachu- There are many reasons, some of which are setts. The data are therefore consistent with reviewed in Sharkey (1982), why the market the notion that whatever surplus accrued to might not produce an efficient outcome in members of the Suffolk Banking System was the presence of a natural monopoly. And 8 Whitney (1878), Lake primarily captured by Suffolk itself. even an unchallenged monopolist with great (1947), Redlich (1947), and Moreover, we think that the Suffolk powers of price discrimination and with the Bodenhorn (undated) all con- Banking System was a natural monopoly. power to engage in nonlinear pricing need clude the same thing. It is not hard to construct arguments that not attain an efficient allocation of resources there are economies of scale in net clearing under all cost conditions, as noted by Edlin, 9 Of course, there may be economies of scale and scope and that these can be captured fully only Epelbaum, and Heller (1996). only over certain ranges of by a system with a single net clearer. It is In general, the ability of the market activity, as noted by Sharkey also not hard to construct arguments that to produce an efficient outcome with a (1982). At some point, con- the agent doing net clearing has cost natural monopoly depends strongly on gestion costs may reverse advantages as a provider of overdrafts and cost and demand conditions in the market decreasing average costs. as an interbank lender. Thus, we think and on the relative strategic positions of

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other potential market participants.10 Thus, implied. The fact that we have no record of even if one views the Suffolk experience such a threat may simply mean that the as supportive of the notion that the free implied threat was successful. In that case, market can be an efficient provider of pay- offering interest on deposits would have ment services, we do not see that one can been out-of-equilibrium behavior because conclude that the free market will lead to entry by a rival would never have occurred. the efficient provision of payment services With regard to the second question, under any possible configuration of mar- we think it is useful to continue to think ket conditions. in terms of the game described above. All of this leaves us with two final ques- From the viewpoint of the relative strategic tions: How was Suffolk able to deter the advantages in a game between an incum- entry of a competitor until 1858? And how bent and potential entrants, the BMR was a was the BMR able to enter in 1858 and drive potential entrant unlike any existing bank Suffolk out of the note-clearing business? because its charter permitted its stock to With regard to the first question, we be owned only by banks. In other words, think it is useful to view the industrial orga- the BMR was a rival that would be owned nization of note clearing in New England as by its customers. This situation would the outcome of a game played between the change the nature of the game because Suffolk Bank and potential rivals. Through now the rival would have a strategic posi- the historical accident of being asked by the tion that was different from that of pre- other large Boston banks to be the net vious potential challengers. Its position clearer, Suffolk was handed the position of might also be interpreted as lowering the the incumbent in the industry. Several sunk costs faced by the potential entrant, models of industry organization in the pres- because one bank could see other banks’ ence of a natural monopoly exist. Although commitments to joining the competing the underlying game in each of these models system through their purchases of stock differs, a general implication is that the in the BMR. incumbent monopolist will be able to earn Two other points are of interest with monopoly profits over an extended period if regard to the entry of the BMR. One is it enjoys some type of strategic advantage Suffolk’s reaction, which ultimately was to over potential entrants.11 withdraw from the net-clearing business. One form of such a strategic advantage This is consistent with our interpretation is some kind of barrier to entry. In the case of net clearing as a natural monopoly. The of the Suffolk Bank, one could think of a other is what the BMR did with regard to barrier to entry as the cost that a potential offering interest on deposits. When the 10 See Bagwell and Ramey entrant would have to bear in trying to sign BMR first entered the market, it offered (1996) for an interesting dis- up banks for a rival net-clearing network. interest on deposits. Once the BMR had cussion of how even an These costs are sunk because they would driven Suffolk out of the market, however, entrenched monopolist with a have to be borne by the potential entrant it adopted Suffolk’s strategy of not paying large productive capacity can even if the rival never actually entered the interest on deposits. This is consistent lack the strategic wherewithal to deter entry. note-clearing business. Of course, Suffolk with our interpretation of temporarily would have already borne these costs, so paying interest on deposits as predatory 11 See, for example, the model in they would not be relevant to its decision pricing behavior. the papers by Dixit (1980) and regarding whether or not to continue in the Ware (1984) in which the business. Another form of strategic advan- incumbent enjoys the strategic tage is the threat of predatory pricing. In CONCLUSION advantage of being able to make a capacity commitment the case of the Suffolk Bank, predatory Between 1825 and 1858, the Suffolk before the potential entrant. In pricing could have consisted of offering Bank of Boston operated the first region- the Bagwell and Ramey interest on deposits should a rival have wide note-clearing system in the United (1996) reformulation of the entered. Note that even though Suffolk States. The Suffolk Bank, chartered by the model, the strategic advantage never engaged in offering interest on Commonwealth of Massachusetts in 1818, goes to the potential entrant, deposits, such a threat still could have been evolved from an ordinary Boston bank into however.

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115 MAY/JUNE 1998 a note-clearing bank for all of New England. Kroszner, Randall S. “Comment on the Efficiency of Self-Regulated We document that it earned extraordinary Payments Systems: Learning from the Suffolk System,” Journal of profits for over 25 years and that it had a Money, Credit, and Banking (November 1996), pp. 798–803. monopoly in the interbank deposit and loan Lake, Wilfred S. “The End of the Suffolk System,” Journal of Economic markets. From this we infer that it also had History (November 1947), pp. 183–207. a monopoly on note clearing. Our interpre- Martin, Joseph G. Martin’s Boston Stock Market: Eighty-Eight Years, tation of Suffolk’s history suggests ways that Joseph G. Martin, 1886. Suffolk was able to maintain its extraordi- nary profits for so many years and also sug- Mullineaux, Donald J. “Competitive Monies and the Suffolk Bank gests that the note-clearing business may System: A Contractual Perspective,” Southern Economic Journal (April have been a natural monopoly. The latter 1987), pp. 884–98. observation is of some importance because Redlich, Fritz. The Molding of American Banking: Men and Ideas, there is no consensus in the literature Hafner, 1947. about whether or not the unfettered opera- Rolnick, Arthur J., Bruce D. Smith, and Warren E. Weber. “The Private tion of markets in the presence of natural Provision of Payments Services: The Suffolk Banking System monopolies will produce an efficient Reexamined,” manuscript, Federal Reserve Bank of Minneapolis, resource allocation. 1997. Future research should focus on wheth- er or not the Suffolk Banking System was Sharkey, William W. The Theory of Natural Monopoly, Cambridge University Press, 1982. truly unique. Some have argued that a Suffolk-type system did not exist in other Suffolk Bank. Directors’ Records, March 14, available at Baker Library, parts of the country. We think it would Harvard Business School, 1826. be useful to better document the types of Trivoli, George. The Suffolk Bank: A Study of a Free-Enterprise Clearing note-clearing arrangements that existed System, Adam Smith Institute, 1979. elsewhere to determine how they differed from the Suffolk Banking System, and if Ware, Roger. “Sunk Costs and Strategic Commitment: A Proposed Three-Stage Equilibrium,” Economic Journal (June 1984), they were different, what factors would pp. 370–78. account for the observed features of different payments systems. Whitney, David R. The Suffolk Bank, Riverside Press, 1878.

REFERENCES

Bagwell, Kyle, and Garey Ramey. “Capacity, Entry, and Forward Induction,” Rand Journal of Economics (Winter 1996), pp. 660–80. Bodenhorn, Howard. The End of the Suffolk System: A Critical Re- appraisal, manuscript, Lafayette College, Easton, Pennsylvania, undated. Calomiris, Charles W., and Charles M. Kahn. “The Efficiency of Self- Regulated Payments Systems: Learning from the Suffolk System,” Journal of Money, Credit, and Banking (November 1996), pp. 766–97. Dewey, Davis R. State Banking Before the Civil War, United States Government Printing Office (National Monetary Commission), 1910. Dixit, Avinash. “The Role of Investment in Entry-Deterrence,” Economic Journal (March 1980), pp. 95–106. Edlin, Aaron S., Mario Epelbaum, and Walter P. Heller. “Is Perfect Price Discrimination Really Efficient?: Welfare and Existence in General Equilibrium,” manuscript, University of California, Berkeley, 1996. Homer, Sidney, and Richard Sylla. A History of Interest Rates, 3rd ed., Rutgers University Press, 1991.

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