The Corner

This is the first in a two-part series on the development of banking in the U.S.

Banking in the United States began with the Bank of North America, chartered by the Continental Congress in 1781 to aid the young government in financing the War of Independence. Within a few years institutions such as the Bank of New York and the Massachusetts Bank were established.

The first Treasury secretary Alexander Hamilton felt that a true central bank was necessary to assist in the commercial development of the nation. Congress was persuaded, and in 1791 the First Bank of the United States was established. Yet the agrarian-oriented states’ rights opponents to Hamilton’s federalism carried on a battle against the bank over four decades.

After the national bank’s 20-year charter was not renewed in 1811, state-chartered banks expanded without restraint. The public lost confidence in the bank notes issued by the various state institutions — the only paper currency of the time — and rushed to redeem them for “real” money, gold. Their reserves being depleted, the banks suspended payments in specie (coin) in 1814. The breakdown of the financial system revived support for a central bank; a successor institution, the Second Bank of the United States, was chartered in 1816.

Political controversy over the bank soon resumed, especially during the tenure of Nicholas Biddle as president of the bank. Biddle’s aggressive promotion of the bank and expansion of its currency function prompted President Andrew Jackson, an avid opponent of institutionalized finance and tight money, to veto a bill renewing the charter of the bank in 1872.

The following three decades became known as the period of free banking, during which anyone who met minimum state requirements was able to establish a financial institution. Thousands of different kinds of bank notes circulated, most of them of dubious value outside the immediate area of the issuing bank. In fact, many notes were outright counterfeits and others originated in “wildcat banks,” so called because their offices were deliberately located in such remote spots (“out where the wildcats roam”) that it was difficult for a holder of the notes to try to redeem them. Even legitimate banks came and went at an alarming rate.

The financial instability in the early years of the Civil War, as well as the government’s problems in financing the war, prompted Congress to establish the first national currency in 1862. The Treasury notes were legal tender but not redeemable in specie. The following year Congress went further, creating a system under which banks would be chartered by the federal government and put under the supervision of the newly created Comptroller of the Currency.

The National Bank Act also required every bank with a national charter to redeem at full value the bank notes issued by other national banks. They were also obligated to maintain adequate reserves of gold and to deposit with the comptroller, Treasury bonds equal to one third of their capital. The notes circulated by these banks, identical in size and design, were to be the nation’s official currency.

To speed the conversion to this new system, Congress imposed a tax (first 2 percent, then 10 percent) on new bank note issues by state banks. The result was not a disappearance of state banks — many still exist today — but there was a steady acceptance of the national currency and a falling-off of counterfeit and fraudulent bank notes. The financial system was more stable than in the era of free banking but not secure enough to prevent crises such as the panics of 1873, 1893 and 1907. In the latter case, which unlike the others was primarily a banking crisis, it took a special effort by leading financier J.P. Morgan to prevent a major collapse.

Events such as these shifted public sentiment once again in favor of creating a new central bank. In 1913 Congress created the Federal Reserve System. All national banks were required and state banks were encouraged to join the system, which consisted of 12 regional reserve banks and a central reserve board. Each member bank had to buy shares in the local reserve bank equal to 6 percent of its capital and surplus. Members had to maintain reserves on deposit and could also borrow (discount) funds from the reserve bank.

The first major test of the new system came in the 1920s when a depression in agricultural prices seriously weakened banks in rural areas. The Fed was unable to prevent the failure or forced consolidation of thousands of these Main Street banks (as opposed to larger money-center banks that emerged in bigger cities to serve corporate clients). After reaching a peak of 31,000 in 1921, the number of banks in the county declined to less than 24,000 by the end of the decade. Check in next week for the conclusion.

Quote of the Week: “In great attempts it is glorious even to fail” — Vince Lombardi

Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka-based registered investment adviser – specializing in the management of stock & bond portfolios in companies which are listed on the NYSE.

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